Imagine that you just completed a course in Financial Management for Entrepreneurs where you learned various techniques and tools in financial analysis. Your uncle Ben wants your advice regarding an investment he is considering. Your uncle owns a furniture company that makes 2 types of furniture: custom-made furniture for consumers and standard furniture for furniture stores.

In the past few years, his sales in both these segments have shown a steady increase of 9% annually. He is considering buying 2 types of manufacturing equipment, 1 to make custom furniture and another to make standard furniture, to be able to supply furniture to both market segments. Each type of equipment requires capital in the range of $120,000. Such equipment is generally depreciated over a 5-year time frame.

Your uncle Ben has applied for a loan of $240,000 from a local bank, and he thinks he will get a loan. However, he is not confident that he will get the loan for the entire $240,000. Also, he is not certain of the interest rate. Based on his current financial obligations, he is confident the bank will loan him at least $120,000. Also, he thinks the interest rate could be in the range of 12% to 15%.

Let's refer to the purchase of custom equipment as Project C and the purchase of standard equipment as Project S. The cash flows for these 2 equipment purchases are provided below:

Cash Flows in $(000)

Project	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Project C	-120	35	55	90	75	85
Project S	-120	82	75	65	45	30

Internal Rate of Return (IRR)

Project C IRRC = 40%

Project S IRRS = 50%

Net Present Value (NPV)

You have also been provided the following chart which shows the net present value of these 2 investment projects at different discount rates:

Project	NPV	Interest
Project C	$99.35	12.5%
Project S	$91.15	12.5%

Write a very detailed analysis that addresses the following questions:

1. What is the relevance of capital budgeting in this situation?
2. What are some implications for using internal rate of return (IRR) versus net present value (NPV) for deciding on Project C and Project S?
3. What is the difference between independent and mutually exclusively projects? Are these projects, Project S and Project C, mutually exclusive projects? Explain why or why not and include rationale to support your response.
4. What would you recommend if your uncle Ben gets approval for only a $120,000 loan from the bank and why? 
5. What would you recommend if your uncle Ben gets approval for a $240,000 loan from the bank and why? 
6. You do not know what interest rate the bank would charge. In this situation, how would you use the chart given above? Explain.
7. How would you incorporate business risk in your analysis of these projects?

Transcribed Image Text:

NET PRESENT VALUE ($000) FOR PROJECT-C AND PROJECT-S Net Present Value $250.00 $200.00 $150.00 $100.00 $50.00 $0.00 ($50.00) 0.1 0.2 IRRC = 40% 0.3 IRRs = 50% 0.4 Cost of Capital -NPV C-NPV S 0.6 0:7 018 NET PRESENT VALUE ($000) FOR PROJECT-C AND PROJECT-S Net Present Value $250.00 $200.00 $150.00 $100.00 $50.00 $0.00 ($50.00) 0.1 0.2 IRRC = 40% 0.3 IRRs = 50% 0.4 Cost of Capital -NPV C-NPV S 0.6 0:7 018

Answer rating: 100% (QA)

Capital Budgeting Analysis for Uncle Bens Furniture Company Relevance of Capital Budgeting Capital budgeting is highly relevant to Uncle Bens situation as he is considering a significant investment in ... View the full answer