Caledonia\'s Project Has a Net

Caledonia's project has a net present value of $27.6 million (Appendix a), so the company should accept the project. Net present value is the most useful means by which a capital budgeting project should be evaluated. The cash flows associated with the project are weighed against the company's cost of capital. If the discounted cash flows are positive, this implies that the project will deliver a positive return to the investors, even when the cost of capital is taken into consideration. Thus, any project with a positive net present value can be accepted on that basis, assuming that other strategic considerations are also met.

In considering the lease vs. buy decision, Caledonia needs to calculate the net present value of each option. There are different cash flows associated with each, so attention needs to be paid to including all of the relevant cash flows. For example, any salvage value would be calculated for the buy decision but not for the lease decision. The cost of the lease would be included as an operating cost, but a purchase would be a capital cost. Thus, the capital cost is going to generate some depreciation tax benefits that need to be included. Beyond the financial considerations, the company needs to take strategic factors into consideration with this decision, including the differential risk between the two options. There may also be differences in the usage of other resources that will differ depending on whether the equipment is leased or bought. All differential cash flows between the two projects should be included in the NPV calculations..

Question 12

The project simple payback for Project a is in the fifth year, and for Project B. this is also the case. The discounted payback for each project is also in the fifth year, but further along in the fifth year for Project a compared to the simple payback.

The net present value of Project a is $18,269. The net present value for Project B. is $18,690. The IRR for Project a is 18%, and the IRR for Project B. is 15%. (see Appendix B)

The cause of the ranking conflict would be that the cash flows for Project B. are weighted towards the fifth year, whereas the flows for Project a are spread more evenly throughout the project's life. The ability to re-invest the earlier flows from Project a allows that project to have a higher IRR despite having a lower NPV.