INTEGRATED CASE 11-24: ALLIED COMPONENTS COMPANY

You recently went to work for Allied Components Company, a supplier of auto repair
parts used in the after-market with products from Daimler AG, Ford, Toyota, and other
automakers. Your boss, the chief financial officer (CFO), has just handed you the
estimated cash flows for two proposed projects. Project L involves adding a new item to
the firm’s ignition system line; it would take some time to build up the market for this
product, so the cash inflows would increase over time. Project S involves an add-on to
an existing line, and its cash flows would decrease over time. Both projects have 3-year
lives because Allied is planning to introduce entirely new models after 3 years.

Here are the projects’ after-tax cash flows (in thousands of dollars):

0 1 2 3
Project L -$100 $10 $60 $80
Project S -$100 $70 $50 $20

Depreciation, salvage values, net operating working capital requirements, and tax
effects are all included in these cash flows. The CFO also made subjective risk
assessments of each project, and he concluded that both projects have risk
characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You
must determine whether one or both of the projects should be accepted.

a. What is capital budgeting? Are there any similarities between a firm’s capital
budgeting decisions and an individual’s investment decisions?

Capital budgeting is a process of planning a capitalization structure through a

pool of funds contributed by investors. Mainly, surging the value of the firm and the
rate of returns to the shareholders are the goals that firms want to achieve on their
operations. Regarding to budgeting decisions, both individuals and corporations
undergo the same process of creating investment decisions. What involves on this
process is the estimation of cash flows, assessment of their riskiness, determination
of discount rates, measurement of the present value on the expected returns from
the assets and the acceptance of the projects from the basis on the greater inflows
of NVP and IRR.

b. What is the difference between independent and mutually exclusive projects?

Between with normal and nonnormal cash flows?

Cash flows that are not affected by the acceptance of the other are a
characteristic of projects that are independent. Two projects would be mutually
exclusive if the project’s acceptance affects the cash flows of the other. This could

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 mean that two or more projects can be accepted. Furthermore, such projects would
present normal cash flows if the cash outflows from the earlier years will be
accumulated into a series of cash inflows in the upcoming years. Projects with non-
normal cash flows would show a negative value of cash flows intervening between
the positive cash flows streaming in the upcoming years.

c. NPV
1. Define the term Net Present Vaue (NPV). What is each project’s NPV?
The NPV is the sum of the PV or present values of a certain project’s cash
flows. It contributes maximization to the wealth of shareholders as this is the
goal all firms want to achieve.The NPV may be solved through the use of a
formula or through a financial calculator. Either methods yield the same
answer.

Use of financial calculator (Texas Instruments):

Project L: Project S:

CFo= -100 I(NPV)= 10 CFo = -100 I(NPV)= 10

CO1= 10 CPT: NPV CO1 = 70 CPT: NPV
CO2= 60 = 18.7828 C02 = 50 = 19.9849
C03= 80 C03 = 20

CF 1 CF 2 CF N
NPV =CF 0 + + + …+
Use of formula: ( (1+r ) 1
(1+r ) 2
(1+r )N )

Project L:
10 60 80
NPV =−100+ + +
( 1+0.10 ) ( 1+0.10 ) ( 1+0.10 )3
1 2

NPV =18.7828

Project S:
70 50 20
NPV =−100+ + +
( 1+0.10 ) ( 1+0.10 ) ( 1+0.10 )3
1 2

NPV =19.9849

2. What is the rationale behind the NPV method? According to NPV, which
project(s) should be accepted if they are independent? Mutually exclusive?

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 If the NPV of a project is positive then this obviously tells that the cash
flows would generate more than enough and the project will instantly be
accepted. Otherwise, firms would abandon the project for its negative NPV. For
Project L, it has a total of $150 cash inflows with the initial investment of $100.
Returning the initial investment, providing 10% opportunity cost of capital to the
investors and having $18.78 left over on a present value basis can be sufficiently
achieved by those cash inflows of the mentioned project. Shareholders would
have the excess $18.78 PV and if the mentioned project will be accepted then
the shareholders’ wealth will increase. Same as well to Project S if it’ll be
accepted then the gains for the shareholders of Allied Company will an increase
of $19.98. If both projects are independent then they’ll be accepted because their
NPV’s are positive and this strongly indicates a great contribution to maximizing
the shareholders’ wealth. On the mutually exclusive side, Project S should be
chosen over the other project since it has a bigger value as an adage to the firm.

3. Would the NPVs change if the WACC changed? Explain.

Dependency plays a role between the cost of capital and NPV used in a project.
Therefore, if there are changes on the cost of capital then the NPV for every project
will change as well. If NPV increases more than the WACC then the cost of capital
declines and vice versa.

d. IRR
1. Define the term Internal Rate of Return (IRR). What is each project’s IRR?
Internal rate of return is defined as the discount rate that forces the NPV of
a project to equal zero (0). This one is equivalent to forcing the NPV to equal
zero. It is an estimate f the project’s rate of return. It uses the same formula
with an NPV, however, instead of using the WACC, we will equate the formula
to zero and replace r with IRR. To illustrate using the cash flows of Project L
and Project S:

CF 1 CF 2 CF N
NPV =CF 0 + + + …+
(1+ IRR)1 (1+ IRR)2 (1+ IRR)N

For Project L:
10 60 80
0=−100+ 1
+ 2
+…+ 3
(1+ IRR) (1+ IRR) (1+ IRR)

IRR = 18.1258%

For Project S:

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 70 50 20
0=−100+ 1
+ 2
+…+
(1+ IRR) (1+ IRR) (1+ IRR)3

IRR = 23.5641%

Solving the IRR using the formula entails the use of trial and error method,
which would definitely take so much time. Fortunately, like the NPV, we can
solve for the IRR using the financial calculator (Texas Instruments):

Project L: Project S:

CFo= -100 C03= 80 CFo = -100 C03 = 20

CO1= 10 CPT: IRR = CO1 = 70 CPT: IRR =
CO2= 60 18.1258% C02 = 50 23.5641

2. How is the IRR on project related to the YTM of a bond?

The yield-to-maturity bond is defined to be as a discount rate that forces the
present value of cash inflows to equal to the price of the bond. The comparison
between these two is that they are a return from whatever investment. IRR is an
expected return on the project, while the YTM is a promised return on the bond.

3. What is the logic behind the IRR method? According to IRR, which projects
should be accepted if they are independent? Mutually exclusive?
If the IRR of a project is equal to the cost of capital (WACC, in this case), it
indicates that the cash flows are enough to provide investors the required rate
of return. If it is greater than the WACC, it means that there is an economic
profit, and an economic loss if the IRR is less than the WACC.

The situation has mentioned that the cost of capital (WACC) of Allied
Components Company is 10%. Comparing to both IRRs, we can conclude
that if both projects are independent, both can be accepted, since both IRRs
are greater than 10%. On the contrary, if the projects are mutually exclusive,
we would be choosing Project S, since it has a higher IRR compared to the
other.

4. Would the projects’ IRRs change if the WACC changes?

Contrary to the NPV, the IRR of a project is independent of the WACC.
Therefore, the IRR would not change despite changes in WACC. The only
thing that would change in relation to the IRR is the accepting of a project,

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 that is, if the current IRR falls down below the new WACC, then it would be
rejected.

e. NPV Profile
1. Draw NPV Profiles for Project L and S. At what discount rate do the profiles
cross?

2. Look at your NPV profile graph without referring to the actual NPVs and
IRRs. Which project(s) should be accepted if they are independent?
Mutually exclusive? Explain. Are your answers correct at any WACC less
than 23.6%?
The NPV profile above shows that the NPV and IRR criteria had led to the same
accept reject decision when both projects are independent. However, a conflict
arises when the projects are mutually exclusive, since the NPV profile shows that
the NPV of project L is higher compared to the NPV of project S below the
crossover rate, which contradicts the actual computation.

f. Conflicts between NPV and IRR

1. What is the underlying cause of ranking conflicts between NPV and IRR?
The investment rate assumption is the underlying cause of ranking
conflicts between the NPV and the IRR.

2. What is the reinvestment rate assumption,and how does it affect the NPV
versus IRR conflict?
In the NPV calculation, there is an assumption that the cash flows can be
reinvested at the project’s WACC (cost of capital), whereas the IRR calculation lies
on the assumption that the reinvestment is at the IRR rate.

3. Which method is best? Why?

The NPV’s assumption is better compared to the IRR, because project’s cash
inflows are used as substitutes to outside capital to help the firm save from costs
derivedfrom outside capital.

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 g. MIRR
1. Define the term Modified IRR (MIRR). Find the MIRRs for Project L and S.
The modified IRR is the discount rate that equates the present value of the
terminal value of the inflows. It is compounded at the cost of capitalto the preset
value of the costs. To get the MIRR, we must first calculate the future value(FV)
of the cash inflows, then use it in the formula:
1

MIRR= [
∑ FV inflows
PV outflows ] n
−1

Project L:
n
Future Value: ( FV =PV (1+ i) )

10(1+0.10)
FV = [¿ ¿2]+ [ 60 (1+ 0.10 ) ]+[80 ( 1+ 0.10 ) ]
1 0

FV = $158.10 (in thousand dollars)

1
M IRR=
[ 158.10 3
100 ]
−1=16.4959

The MIRR may also be calculated using the financial calculator (Texas Instruments):

N=3 FV = 158.10

PV= -100 CPT: I/Y = 16.4959%

PMT = 0

Project S:

Future Value: ( FV =PV (1+ i)n )

70(1+0.10)
FV = [¿ ¿2]+ [ 50 (1+ 0.10 ) ]+[20 (1+ 0.10 ) ]
1 0

FV = $159.70 (in thousand dollars)

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 1
M IRR=
100 [
159.7 3
]
−1=16. 8876

Using the financial calculator (Texas Instruments):

N=3 FV = 159.70
PV= -100 CPT: I/Y = 16.8876%
PMT = 0

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 2. What are the MIRR’s advantages and disadvantages vis-à-vis the NPV?
Similar with the IRR, the MIRR may give contradicting results to the NPV if the
projects are mutually exclusive. MIRR, then is superior to the IRR but just a junior
to the NPV.

h. Payback Period
1. What is the payback period? Find the paybacksfor Project L and S.
The payback period is defined as the expected number of years required to
recover the cost of a project. It can be calculated by first, constructing a
cumulative cash flows table then using the data for the formula:
Project L:

0 1 2 3
Cash Flow -100 10 60 80
Cumulative Cash Flow -100 -90 -30 50

Year of recovery: 3
y /¿
¿ cum . CF of yr . bef . fullrecover
CF of yr . of full recovery
payback period= yr . bef . full recovery +¿

30/¿
¿ =2.375 years
80
payback period=2+¿

Project S:

0 1 2 3
Cash Flow -100 70 50 20
Cumulative Cash Flow -100 -30 20 40

Year of recovery: 2
y /¿
¿ cum . CF of yr . bef . fullrecover
CF of yr . of full recovery
payback period= yr . bef . full recovery +¿

0/¿
¿3 =1.6 years
50
payback period=1+¿

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 2. What is the rationale for the payback method? According to the payback
criterion, which project(s) should be accepted if the firm’s maximum
acceptable payback is 2 years, if Projects L and S are independent? If
projects L and S are mutually eclusive?
The payback is a representation of a breakeven analysis. It determines
when the cash flow will break even. Since the acceptable payback period is 2
years, therefore, only Project S will be accepted since Project L exceeded 2
years, whether independent or mutually exclusive.

3. What is the difference between the regular and discounted payback

methods?
The dicounted payback method is similar with a regular payback method
except it uses a discounted cash flow for the calculation.

4. What are the two main disadvanatages of discounted payback? Is the

payback method of any real usefulness in capital budgeting decisions?
Explain.
Discounted payback considers the time value of money but does not
consider the cash flows after the payback period. Also, it provides no specific
decision rule for acceptance.

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