CAPITAL BUDGETTING DECISION METHODS: CHICAGO VALVE COMPANY

BA 910 Financial Management

February 12, 2011 BY: Freah G. Ramos

SUBMITTED TO:

Mrs. Magdalena T. Solis, CPA Professor

1. Examine Table 1 (on the handout; Table 1 Project net Cash Flows)

2. The Projects NPV is $ 36,956.00.

3. Economic rationale behind the NPV: NPV is used to assess the impact on the economy of a project to a firm. If the NPV is positive, then it adds value to the firm. On the contrary, economic value on the company would decrease. If then the NPV equals zero, it is at a break-even point no additions or subtractions at that. The NPV of this project will vary from company to company as each company has different percent cost as to capital and (net) cash flow value.

4. Internal Rate of Return: 5%

Explain the rationale for using the IRR to evaluate capital investment projects: Internal rate of return is a discount rate that makes the present value of estimated cash flows equal to the initial investment. In other words, IRR is the discount rate at which NPV equals zero. Could the IRR for this project differ for Lone star vs for another customer?: As a general rule, yes. Each company has different before tax expenses and costs. Thus, no two company would be the same.

5. A) The Payback Period is 5.44 years.

B) Evaluation behind the use of payback as a project valuation tool?: Payback measures the expected number of years required for a company to recover a particular project cost. C) What deficiencies does payback have as a capital budgeting decision method?: (1) it ignores the time value of money (2) it ignores cash flows occurring after the payback period (3) it makes no adjustments for risk and (4) it primarily attaches no value to cash flows. D) Does payback provide any useful information regarding capital budgeting decision?: No, payback method does not measure the profitability of a particular investment. It only provide the analyst the number of years required to recover a project cost. Thus, no. E) Yes, payback could be of help given that he sales staff could compare investment turnover (on different types of equipments). F) Payback would be more useful to projects with short lives --- longer project equals greater uncertainty (as to market/economic change).

6. The projects Modified Internal Rate of Return (MIRR) is 8%.

Difference between IRR and MIRR:

(1) MIRR presupposes that positive cash flows are reinvested at the companys cost of capital while IRR assumes the cash flows from a project are reinvested at the IRR. (2) MIRR avoids the problem of multiple IRRs. Though not widely used, MIRR is better than the IRR in terms of a more realistic evaluation of the company and the project.

7. Lone Stars Profitability Index is 1.17.

Rationale behind PI: Profitability Index compares the present value of future cash inflows with the initial investment on a relative basis. Thus, PI is the ratio of the present value of cash flows to the initial investment of the project.

8. ACCEPT THE PROJECT IF:

If NPV is positive, IRR is less than percentage cost of capital, MIRR is less than percentage cost of capital and PI is positive REJECT THE PROJECT IF: If NPV is negative, IRR is more than percentage cost of capital, MIRR is more than percentage cost of capital and PI is negative IN CASE OF CONFLICT: NPV comes first followed by PI, MIRR and IRR. NPV being the most accurate measurement.

9. Cash inflows will increase due to decrease in tax rates. Thus, payback period may be shorter and NPV may also increase. 10. Projects NPV Profile.

11. Internal Rate of Return (IRR) is 25%. Net Present Value (NPV): ($8,958.33) 1 (independent) if the cash flows of one are unaffected by the acceptance of the other. (mutually exclusive) if the cash flows of one would be adversely affected by the acceptance of the other. 2 In case of conflict, management must identify the project that will contribute to profits and consequently, to the value of the firm. 3 The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal (new) costs.

12. A)

Dt Tbefrefc o cs svns aa al o fet f ot aig: Svns aig 4,0 000 5,0 000 6,0 000 7,0 000 8,0 000 NV P 0 (478 2,9) 608 ,7 3,5 695 6,3 782 9,0 879 IR R 0 72 .% 1.% 19 1.% 62 2.% 02 2.% 41 MR IR 0 93 .% 1.% 14 1.% 32 1.% 49 1.% 64 Pyak abc 0 54 .3 45 .6 39 .6 35 .0 31 .4 P I 0 08 .8 10 .3 11 .7 13 .2 14 .6

B) Data Table for Effect of cost of capital

Data Table for effect of cost of capital: NPV 0 8.0% 63,334 9.0% 54,058 10.0% 45,276 11.0% 36,955 12.0% 29,064 13.0% 21,575 14.0% 14,460 15.0% 7,698 16.0% 1,263 17.0% (4,863) 18.0% (10,700) C) Data Table for Effect of Tax Rates Cap Cost IRR 0 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% 16.2% MIRR 0 11.6% 12.1% 12.7% 13.2% 13.8% 14.4% 14.9% 15.5% 16.1% 16.7% 17.2% Payback 0 3.96 3.96 3.96 3.96 3.96 3.96 3.96 3.96 3.96 3.96 3.96

NPV -------> short PI pro 0 1.30 1.25 1.21 1.17 1.14 1.10 1.07 1.04 1.01 0.98 0.95

Dt Tbefrefc o txrts aa al o fet f a ae: Txrt a ae 2.% 00 3.% 00 4.% 00 5.% 00 6.% 00 NV P 0 6,1 661 5,8 173 3,5 695 2,2 217 729 ,9 IR R 0 1.% 97 1.% 80 1.% 62 1.% 43 1.% 21 MR IR 0 1.% 48 1.% 41 1.% 32 1.% 24 1.% 15 Pyak abc 0 37 .2 38 .3 39 .6 41 .0 42 .8

13 .1 12 .4 11 .7 11 .0 10 .3

D) Yes, sensitivity analysis in the computer is very helpful because it saves a lot of time compared to that of doing it manually. 13. NPV =($1,527.78) IRR = 0% MIRR = 14%