Your boss, the chief financial officer (CFO) for Southern Textiles, has just handed you the estimated cash flows for tw

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Your boss, the chief financial officer (CFO) for
Southern Textiles, has just handed you the estimated cash
flows for two proposed projects. Project L involves adding a new
item to the firm’s fabric 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 Southern is planning to introduce an entirely new
fabric at that time.
Here are the net cash flow estimates (in thousands of
dollars):
The CFO also made subjective risk assessments of each
project, and he concluded that the projects both have risk
characteristics that are similar to the firm’s average project.
Southern’s required rate of return is 10%. You must now
determine whether one or both of the projects should be
accepted.
a. What is capital budgeting?
b. What is the difference between independent and
mutually exclusive projects?
c. (1) What is the payback period? Find the traditional
payback periods for Project L and Project S.
(2) What is the difference between the traditional
payback and the discounted payback? What is each project’s
discounted payback?
(3) What are the main disadvantages of the traditional
payback? Explain which project has the better payback
period.
d. (1) Define the term net present value (NPV). What is
each project’s NPV?
(2) Define the term internal rate of return (IRR). What
is each project’s IRR?
e. Which is the better project according to NPV and
IRR?