Finance 221

Capital Budgeting Project

Due November 18 by 4 PM in your TA’s mailbox in 340 Wohlers.

 

 Your assignment solution must be typed with your name(s), TA name, and discussion section(s) typed at the top of the first page of the assignment. NO COVER PAGES.  Show your work/problem inputs for full and partial credit.  Using a spreadsheet to help with the calculations is strongly recommended.  Please an additional spreadsheet printout of your cell formulas (include gridlines and row & column headings) to show your spreadsheet work.  This assignment consists of three parts.

 

Part I:  Capital Budgeting Decision Techniques

 

The Dilemma at Day-Pro

 

 

 

          The Day-Pro chemical Corporation, established in 1995, has managed to earn a consistently high rate of return on its investments.  The secret of its success has been the strategic and timely development, manufacturing, and marketing of innovative products that have been used in various industries.  Currently, the management of the company is considering the manufacture of a thermosetting resin as packaging material for electronic products.  The Company’s Research and Development teams have come up with two alternatives: an epoxy resin, which would have a lower startup cost, and a synthetic resin, which would cost more to produce initially but would have greater economies of scale.  At the initial presentation, the project leaders of both teams presented their cash flow projections and provided sufficient documentation in support of their proposals.  However, since the products are mutually exclusive, the firm can only fund one proposal.

 

          In order to resolve this dilemma, Mike Matthews, the Assistant Treasurer, and a recent MBA from a prestigious mid-western university, has been assigned the task of analyzing the costs and benefits of the two proposals and presenting his findings to the board of directors.  Mike knows that this will be an uphill task, since the board members are not all on the same page when it comes to financial concepts.  The Board has historically had a strong preference for using rates of return as its decision criteria.  On occasions it has also used the payback period approach to decide between competing projects.  However, Mike is convinced that the net present value (NPV) method is least flawed and when used correctly will always add the most value to a company’s wealth.

 

          After obtaining the cash slow projections for each project (see Tables 1 & 2), and crunching out the numbers, Mike realized that the hiss is going to be steeper than he thought.  The various capital budgeting techniques, when applied to the two series of cash flows, provide inconsistent results.  The project with the higher NPV has a longer payback period, as well as a lower Internal Rate of Return (IRR).  Mike scratches his head, wondering how he can convince the Board that IRR, and Payback Period can often lead to incorrect decisions.

 

Table 1

 

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

 

Synthetic Resin

 

 

 

           

 

 

 

 

 

 

Net Income

 

$150,000

$200,000

$300,000

$450,000

$500,000

 

Depreciation

 

 

 

 

 

 

 

(Straight-line)

 

$200,000

$200,000

$200,000

$200,000

$200,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Cash Flow

–$1,000,000

$350,000

$400,000

$500,000

$650,000

$700,000

 

Table 2

 

Epoxy Resin

Year 0         Year 1         Year 2             Year 3           Year 4            Year 5

 

 

 

Net Income                              $440,000      $240,000          $140,000      $40,000            $40,000

 

 

Depreciation (Straight-line)    $160,000      $160,000           $160,000     $160,000          $160,000

 

 

 

 

 

 

 

 

 

 

Net Cash Flow     -$800,000     $600,000    $400,000           $300,000      $200,000         $200,000

                                                                          

Part I Questions:

 

1.        Calculate the Payback Period of each project.  Explain what argument Mike should make to show that the Payback Period is not appropriate in this case.

 

2.        Calculate the Discounted Payback Period (DPP) using 10% as the discount rate.  Should Mike ask the Board to use DPP as the deciding factor?  Explain.

 

3.        Calculate the two projects’ IRR.  How should Mike convince the Board that the IRR measure could be misleading?

 

4.        Calculate the NPV profiles for the two projects and explain the relevance of the crossover point.  Also, calculate the crossover point (rate) and construct a graph with both projects NPV profile. How should Mike convince the Board that the NPV method is the way to go?

 

5.        Explain how Mike can show that the Modified Internal Rate of Return is the more realistic measure to use in the case of mutually exclusive projects.  Include MIRR calculations for each project in your answer.

 

 

6.        In looking over the documentation prepared by the two project teams, it appears to you that the synthetic resin team has been somewhat more conservative in its revenue projections that the epoxy resin team.  What impact might this have on your analysis?

 

 

Part II: Tiger rules!

Hoping to capitalize on the excitement of Tiger Woods winning all four major golf tournaments consecutively (a Grand Slam in my book), Nike is considering branching out into the golf club manufacturing business. Nike’s plan is to produce a Tiger Slam line of woods and irons.

This project is estimated to have a 3-year useful life and would require Nike to purchase new manufacturing equipment costing $20,000,000 and additional working capital (inventory) of $1,200,000. The equipment would fall under the 3-year MACRS depreciation schedule and would have an estimated salvage value of $1,500,000 at the end of its 3-year useful life.

Nike has already paid $300,000 to Swing Scene Inc. for a golf club market analysis. Swing Scene’s market analysis indicates that Nike can sell 100,000 Tiger Slam woods for $250 each in year 1; 75,000 Tiger Slam woods for $230 each in year 2; and 50,000 Tiger Slam woods for $200 each in year 3. For the Tiger Slam iron sets, Swing Scene estimates Nike can sell 80,000 sets for $400 per set in year 1; 60,000 sets for $400 per set in year 2; and 50,000 sets for $340 per set in year 3. Nike estimates that each Tiger Slam wood will cost $120 to produce for the entire life of the project and each iron set will cost $250 to produce for the entire life of the project. Nike also estimates they will have fixed annual costs of $5,000,000 for each year of the project. Nike’s tax rate is 40 percent.

  1. What is the net investment for the Tiger Slam project?
  2. What are the net operating cash flows for years 1-3 for the Tiger Slam project?
  3. What is the terminal cash flow at the end of year 3 for the Tiger Slam project?
  4. Calculate the NPV and IRR of the Tiger Slam project if Nike’s required return is 18%. Should Nike under take this project?

 

Part III: Ship Ahoy!

TransPacific Shipping is considering replacing an existing ship with one of two newer, more efficient ones.  The existing ship is three years old, cost $32 million, and is being depreciated under MACRS using a 5-year recovery period.  Although the existing ship has only three years (years 4,5, and 6) of depreciation remaining under MACRS, it has a remaining usable life of five years.  Ship A, one of the two possible replacement ships, costs $40 million to purchase and $8 million to outfit for service.  It has a five-year usable life and will be depreciated under MACRS using a five-year recovery period.  Ship B cost $54 million to purchase and $6 million to outfit.  It also has a five-year usable life and will be depreciated under the MACRS using a five-year recovery period.  Increased investments in net working capital will accompany the decision to acquire ship A or ship B.  Purchase of ship A would result in a $4-million increase in net working capital; ship B would result in a $6-million increase in net working capital.  The projected profits before depreciation and taxes for each alternative ship and the existing ship are given in the following table.

 

Profits Before Depreciation and Taxes

 

Year

Ship A

Ship B

Existing Ship

1

$21,000,000

$22,000,000

$14,000,000

2

  21,000,000

  24,000,000

14,000,000

3

  21,000,000

  26,000,000

14,000,000

4

  21,000,000

  26,000,000

14,000,000

5

  21,000,000

 26,000,000

14,000,000

 

 

 

The existing ship can currently be sold for $18 million and will not incur any removal or cleanup costs.  At the end of five years, the existing ship can be sold to net $1 million before taxes.  Ships A and B can be sold to net $12 million and $20 million before taxes, respectively, at the end of the five-year period.  The firm is subject to a 40 percent tax rate on both ordinary income and capital gains.

 

  1. Calculate the initial outlay associated with each alternative.
  2. Calculate the operating cash flows associated with each alternative. 
  3. Calculate the terminal cash flow at the end of year 5, associated with each alternative.
  4. Calculate the NPV for each alternative using a cost of capital of 11%.
  5. Which alternative (if any) should be chosen?