Response to the Caledonia Products Integrative Problem?

Answer 1

Response by R. Nowaid

Response to the Caledonia Products Integrative Problem

Project ranking is prioritizing projects based on a project's stream of cash flow by measuring net present value (NPV), the internal rate of return (IRR), and Macaulay duration that is calibrated based on cash-flow timing. Conflict of ranking arises when managers have to make subjective decisions due to organizational goals and needs. In a mutually exclusive projects three factors remain as key ranking elements; (1) size disparity; (2) time disparity; and (3) unequal lives.

Size Disparity

"The size disparity problem occurs when mutually exclusive projects of unequal size are examined." In the case for Caledonia Products, Project A and B may have the same initial investment amount; however, cash inflow of Project A begins in the first year but Project B begins in the fourth year. Both projects vary on net to present value, internal rate of return, and profitability index. If size disparity causes conflicting ranking among mutually exclusive projects, then the project with the largest net present value is considered; given the fact that there would be no capital rationing. Standing alone on this criteria, Project B is more viable because total NPV of Project B is higher that Project A.

Time Disparity

"The time disparity problem and the conflicting rankings that accompany it result from the differing reinvestment assumptions made by the net present value and internal rate of return decision criteria." In case of Caledonia Products, total cash flow at the fifth year for Project A is $40,000 less than Project B's, NPV for Project A is less than Project B's. Project A begins cash inflow at the first year, the payback period for Project A is 3.125 years versus 4.5 years for Project B, and IRR for Project A is 18.03% versus Project B's IRR is 14.87%. Assuming that cash inflow during life of project can be reinvested, that would make Project A to be more viable.

Unequal Lives

Using size and time disparities in conjunction with NPV and IRR may lead to conflicting results in analyzing mutually exclusive projects. A primary cause of conflicting ranking can be timing of the cash flows of the mutually exclusive projects. In the case of Caledonia Products, Project B may have higher total cash flow at maturity and NPV of Project B may be higher as well; however, Project A makes cash available now. Knowing cash is king, and Project A's cash inflow begins in the first year versus Project B's cash inflow that begins in the fifth year, and this feature would make Project A more attractive.

Analysis

Initial net investment in Project A and Project B are equal; however, total cash flow for Project A is $40,000 less than Project B's total cash flow and NPV for Project A is less than Project B's NPV.

Considering aforementioned facts one manager may consider Project B because it has greater NPV and total Project cash value; however, Project A has one main incentive, on-going cash flow throughout the Project. Project A generates continues cash flow through the life cycle of the Project; whereas, Project B requires the organization to operate without incoming cash flow until the Project is completed.

Conclusively, if the organization is in need of cash to maintain profitable operation by avoiding external financing and loan, then Project A makes most sense; however, if the organization is not in need of immediate cash, then Project B is a better decision. For example, a small construction company needs continues cash inflow to prevent expensive financing of project. On the other hand, a major meatpacking firm, which does not have cash flow problem, may wait to the delivery date to collect all its funds at a greater amount.