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The Dilemma at Day-Pro

Comparison of Capital Budgeting Techniques


The Day-Pro Chemical Company, 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 chemical 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 Companys 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, Tim Palmer, the Assistant Treasurer and a
recent MBA from Drexel 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. Tim 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, Tim is convinced that the net present value (NPV)
method is least flawed and when used correctly will always add the most value to a
companys wealth.
After obtaining the cash flow projections for each project (see Tables 1 & 2),
and crunching out the numbers, Tim realizes that the hill 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 Accounting Rate of Return (ARR)
and Internal Rate of Return (IRR). Tim scratches his head, wondering how he can
convince the Board that the IRR, ARR and Payback Period can often lead to
incorrect decisions.

Table 1. Synthetic Resin Cash Flows


Synthetic Resin
Year

Net Income

$150,000

$200,000

$300,000

$450,000

$500,000

Depreciation

$200,000

$200,000

$200,000

$200,000

$200,000

$350,000

$400,000

$500,000

$650,000

$700,000

Net Cash Flow

$(1,000,000)

Table 2. Epoxy Resin Cash Flows


Epoxy Resin
Year

Net Income

$440,000

$240,000

$140,000

$ 40,000

$ 40,000

Depreciation

$160,000

$160,000

$160,000

$160,000

$160,000

$600,000

$400,000

$300,000

$200,000

$200,000

Net Cash Flow

$(800,000)

Questions:
1. Calculate the Payback Period of each project. Explain what arguments Tim
should make to show that the Payback is not appropriate in this case.
2. Calculate the Discounted Payback Period (DPP) using 10% as the discount
rate (required rate of return). How is the DPP an improvement over the
regular Payback Period? Should Tim ask the Board to use the DPP as the
deciding factor? Explain.

3. The Accounting Rate of Return (ARR), also called the Book Rate of Return,
is calculated as the projects average net income divided by average book
value over the projects economic life. When choosing among mutually
exclusive alternatives, the ARR rule would pick the project with the highest
ARR among projects exceeding the hurdle rate. If management sets a hurdle
for the accounting rate of return of 40% accounting rate of return, which
project would be accepted? What is wrong with the ARR and this decision?
4. Calculate the IRR for each project. Tim wants to convince the Board that the
IRR measure can be misleading when choosing between mutually exclusive
alternatives. Why is the IRR decision rule unreliable in making the correct
choice between the two projects? Tims presentation should inform the
board on the different reinvestment assumptions underlying IRR and NPV
and how that relates to the reliability of the IRR decision rule.
5. An NPV profile graphs the relationship between a projectss NPV and the
discount rate (see Figure 5.6 in Chapter 5). The NPV profiles of mutually
exclusive projects highlight the possible conflict in the decisions made by
NPV and IRR and the importance of the crossover point. Construct the NPV
profiles for the two projects. Identify the IRR for both projects on the graph
and explain the relevance of the crossover point. At the cost of capital,
which projects would the NPV and IRR decision rules accept? Tim wants to
point out to the board that NPV is an absolute measure of the monetary
impact of a project on shareholder value and IRR is a relative value that
evaluates the projects return per dollar invested. What argument can Tim
advance to convince the Board that the NPV decisions are always consistent
with maximizing shareholder value?
6. Given the problem of the IRR rule in evaluating mutually exclusive projects,
an Incremental Internal Rate of Return is used as an alternative. Which
project would the Incremental IRR accept? Although not a problem here,
there could be cases in which there are multiple IRRs. In such a case, the
IRR method would be inoperable as there would be no unique IRR. When
would this be the case?

7. Calculate the Profitability Index for each proposal. How does the
Profitability Index relate to NPV? Do the synthetic resin and epoxy resin
projects significantly differ in scale? Can the Profitability Index rule be
applied here? Explain?

8. 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 than the epoxy resin team. What
impact might this have on the Payback Period, NPV, and IRR calculations
for the synthetic resin project? How does this complicate comparing the
synthetic resin and epoxy resin projects? Is being conservative in revenue
projections a good practice? What adjustments might be made?
9. In looking over the documentation prepared by the two project teams, it
appears to you that the synthetic resin technology would require extensive
development before it could be implemented whereas the epoxy resin
technology is available off-the-shelf. What impact might this have on your
analysis?