Explain the inputs into

1) The net initial investment outlay at year 0?

The initial investment at year 0 is $200,000 which includes taxes and delivery, and
the
cost to install the equipment $12,500. Therefore the total net cost of initial
investment
outlay at year 0 is $212,500.

2) The depreciation tax savings in each year of the projects economic life?
The depreciation tax savings in each year of the projects economic life will show
how
much the tax savings will be depreciated each year using the MACRS method.

3) The projects incremental cash flows? These cash flows are those that are relevant
to
the valuation of the project. In this case it is depreciation. Using the MACRS we can
determine for how much the project will be depreciated and what the net cash flows
will
be after tax and after depreciation. This cash flows are the sum of the depreciation
tax
saving and the after-tax cost saving.
This shows the companys profit for each of the eight years.

4) What is the projects NPV? Explain the economic rationale behind the NPV. Could
the
NPV of this particular project be different for Lone Star Petroleum Company than for
one
of Chicago Valves other potential customers?
From the calculations, the NPV is ($17301). (revise) The NPV process helps investors

determine whether or not projects are profitable. There is a very important concept
in
finance: time value of money. One dollar today is worth more than 1 dollar in the
future.
Since the net cash flows here are future projections, it is necessary to bring the
value of
the investment to its present value. If the present value is positive, the project will
be
profitable; therefore, it can be approved. If the NPV is negative, the project should
be
rejected since the costs of investment exceed the returns.
3. Calculate the proposed projects IRR. Explain the rationale for using the IRR to
evaluate capital investment projects. Could the IRR for this project differ for Lone
Star
versus for another customer?
The proposed project IRR is 16.20%. The Internal Rate of Return (IRR) is a capital
budgeting method used to decide whether they should make loam term
investments. The
IRR is defined as any discount rate that results in a net present value of zero and is
usually interpreted as the expected return generated by the investment. Yes,
because the
companies did not make the same amount. In general if the IRR is greater than the
projects cost of capital the project will add value for the company.

4. Suppose one of Lone Stars executives typically uses the payback as a primary
capital
budgeting decision tool and wants some payback information.
a) What is the projects payback period?
b) What is the rationale behind the use of payback as a project evaluation tool?
c) What deficiencies does payback have as a capital budgeting decision method?

d) Does payback provide any useful information regarding capital budgeting

decisions?
e) Strictly as a sales tool, without regard to the validity of the analysis, would the
payback
be more help to the sale staff for some types of equipment than for others? Would
this
procedure be more appropriate for projects with very long or short lives?
f) People occasionally use the paybacks reciprocal as an estimate of the projects
rate of
return. Would this procedure be more appropriate for projects with very long or
short
lives? Explain
The payback period would be 3.95 years for recovery. The rationale is to determine
how
long it will take to recover the initial investment of $212,500. The initial investment
of
$212,500 will be recovered before the 8 years of depreciation. It will be recovered
between the 3rd and 4th year, 3.95 years. The deficiencies the payback period has
as a
capital budgeting decision method are two: first, we are ignoring time value of
money
and second, we did not use the fourth cash flow value. This method is very limited
and
we do not learn whether the project is profitable or not. To solve the limitations,
there is a
method called discounted payback period. As a sales tool, the payback period could
help
estimate the number of years for the investment to be recovered. It could be
relevant for
salespersons to explain customers about which products or projects will take long
before
the investment is recovered. In that case, if the number of years is greater for some

projects than others, customers should chose the ones that take less time. At the
same
time, a project may take 10 years but the investment may be recovered after 2
years.
Whereas a project may take 5 years but the investment may be recovered at the 4
th
year. It
really depends on the cash flows and the other factors that determine those cash
flows
(example taxes or depreciation).

5. What is the projects MIRR? What is the difference between the IRR and MIRR?
Which is better? Why?
The project MIRR is 13.24%. The IRR is 16.20%. The difference between the MIRR
and
IRR is that the MIRR is the discount rate which causes the PV of a projects terminal
value to equal the PV of costs. It is found by compounding inflows at WACC (11%)
and
assumes cash inflows are reinvested at WACC. The MIRR takes care of the
inefficiencies
of IRR that are: assumption that we are reinvesting cash flows at the IRR rate and
the
assumption that cash flows are all normal (positive). If the cash flows change from
normal to non-normal, the calculator will change the IRR, giving an inaccurate
calculation.

6. Suppose a potential customer wants to know the projects for profitability index
(PI).
What is the value of the PIU of Lone Star, and what is the rationale behind this
measure?

The profitability index is calculated as the sum of net present values of the cash
flows
divided by the initial investment.
PI= 373,000/212500= 1.75 > 1 Accept project
53000
63200
52150
46200
45350
41100
36000
36000
373000

7. Under what conditions do NPV, IRR, MIRR and PI all leads to the same
accept/reject
decision? If the projects are independent accept both. When can conflicts occur? If a
conflict arises, which method should be used, and why?
When NPV is positive, the project should be accepted. The projects have to be
mutually exclusive to accept NPV. As mentioned earlier, if the NPV is negative,
the projected cash flows will not cover costs and thus, the project should be
rejected.
The IRR method helps evaluate mutually exclusive projects to determine which
one is more profitable. If IRR>WACC, the project should be accepted. It is
compared to the hurdle rate (WACC).
The MIRR is more accurate than the IRR for it considers the variation of the rate
and sign of cash flows.

 The profitability index helps determine the bang for the buck. It calculates how
much profit is being made with one dollar of investment. If the PI is greater than
1, the project can be accepted.
When conflict arise, the cross over rate can help rank which projects are more
important.
When projects are mutually exclusive, one project will have to be chosen over the
other.
The method to analyze capital budgeting varies depending on what the manager
wants.
Each method has advantages and disadvantages (profitability, liquidity, risk,
number of
years). In order to have an accurate analysis, it is recommended to use all. Although
NPV
is seen as the most valuable, but when projects are mutually exclusive, it is hard to
determine which IRR is better with that method.
8. Suppose Congress reinstates the investment tax credit (ITC), which is a direct
reduction of taxes equal to the prescribed ITC percentage times the cost of the
asset.
What would be the impact of a 10 percent ITC on the acceptability of the control
system
project? No calculations are necessary; just discuss the impact.
When the taxes are changed, the net cash flows produced by a project will change.
In this
case, 40% of taxes were being paid to calculate net present cash flows. With a
reduction
or increase, the net present value will increase or decrease respectively. The impact
on
acceptability of the control system project will be affected and it will be necessary
to
calculate the budgets again for better accuracy.
9. Plot the projects NPV profile and explain how the graph can be used.

(revise)
10. Now suppose that Chicago Valve sells a low-quality, short-life valve system. In a
typical installation, its cash flows are as follows:
Year
0
1

Net Cash Flow

($120,000)
150,000

Assuming an 11 cost of capital, what is this projects NPV and its IRR? Draw this
projects NPV profile on the same graph with the earlier project and then discuss the
complete graph. Be sure to talk about 1) mutually exclusive versus independent
projects,
2) conflicts between projects, and 3) the effect of the cost of capital on the
existence of
conflicts. What conditions must exist with the respect to timing of cash flows and
project
size for conflicts to arise?
NPV=($8,958.33)
IRR= 19.06%
Against: NPV= (17301) and IRR= 16.20%
When projects are independent and the returns are higher than the hurdle rate
(WACC),
both projects can be considered. In this case, that notion applies. In terms of the
NPV, it
is important that the value is positive. (revise NPV).For mutually exclusive projects,
if
there is a conflict in ranking after the cross over rate is calculated, both IRR and
NPVs
are compared. If the WACC is higher than the cross over rate, there will not be a
conflict
on ranking. The effect of the cost of capital depends on what project is used, the
timing,

and the other variables to consider.

For conflicts to arise there are usually coincidences of year or period of time for
projects
where the time value of money is calculated equally. In terms of size, the size
would
tend to be the same.
11. Natasha Spurrier informed Houston that all sales reps have laptop computers, so
they
can perform the capital budgeting analyses. For example, they could insert data for
their
local client companies into the models and do both the basic analysis and also
sensitivity
analyses, in which they examine the effects of changes in such things as the annual
cost
savings, the cost of capital, and the tax rate. Therefore, Houston and Spurrier
developed
the following sensitivity questions, which they plan to discuss with the sales reps.
Sensitivity analyses give some idea of stand-alone risk. It also identifies dangerous
variables and gives breakeven information. (sensitivity graph to be made).
a. Suppose the annual cost of savings differed from the projected level; how would
this
affect the various decision criteria? What is the minimum annual cost savings at
which
the system would be cost justified? Discuss what is happening and, if you are using
the
spreadsheet model, quantify your answers; otherwise just discuss the nature of the
effects.
b. Repeat the type of analysis done in Part a, but now, vary the cost of capital.
Again,
quantify your answers if you are using the spreadsheet model.

c. Repeat the type of analysis done in Part a, but now, vary the tax rate. Again,
quantify
your answers if you are using the spreadsheet model.
d. Would the capability to do sensitivity analysis on a laptop computer be of much
assistance to the sales staff? Can you anticipate any problems that may arise?
Explain
Sensitivity analysis is a technique used to determine, how different values of an
independent variable will impact a particular dependent variable under a given
assumption. I believe that the capability to do sensitivity analysis on a laptop
computer
will be much assistance to the sales staff. There can be certain problems while
doing
sensitivity analysis on a laptop, computer such as there are always variables that
are
uncertain, so there is a possibility of some errors.
12. Now suppose that Chicago Valve sells another product that is used to speed the
flow
through pipelines. However, after a year of use, the pipeline must undergo
expensive
repairs. In a typical installation, the cash flows of this project might be as follows:
Year
0

Net Cash Flow

($30,000)

1
2

150,000
(120,000)

Assuming an 11 percent cost of capital, what are this projects NPV, IRR, and MIRR?
Draw this new projects NPV profile on a new graph. Explain what is happening with
this
project.
NVP= 11,649.31

IRR= -20%
MIRR
The project is going in loss as the IRR of the said project is negative.