Finance mini case

1. The payback period for the Synthetic Resin project is 2.5 years and the payback period for the Epoxy Resin project is 1.5 years.  The issue with using the payback period is that the scope of the analysis is very limited.  Tim would need to explain this to the board. He would have to tell them that the payback period ignores a number of critical pieces of financial information.  The payback period ignores the time value of money and it also ignores cash flows after the payback period ends.  Its sole purpose is determining when the organization will get its investment back.  This is important but it can also lead the organization to favor shorter term projects versus long term projects.  In this situation the company is looking at longer term projects and so using the payback period is a flawed.    

2. The discounted payback period for the Synthetic Resin project is 2.935 years and 1.77 years for the Epoxy Resin project.  The discounted payback period is an improvement over the payback period because it addresses a major shortfall of the payback period.  It takes into account the time value of money which the payback period does not.  If the board is using the payback period as a serious factor in the decision making process, Tim should ask them to use the discounted payback period.  The reason is that the discounted payback period provides the board with a more complete view of the situation.  By considering the discounted payback period, the reason being that it gives the board a better understanding of the time that it will take to get the company’s money back from the project.   

3. The Accounting Rate of Return (ARR), also called the Book Rate of Return,is calculated as the project’s average net income divided by average book value over the project’s 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? Tim’s 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 projects’s 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 project’s 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?

According to the table above. We can know that the Incremental IRR is greater than the cost of capital. In this situation, we should choose the plan with lower IRR, which is the Synthetic Resin plan. When we have multiple internal rates of return, cash flow streams with multiple changes of sign have multiple rates of return and IRR is inoperable. Modified IRR is a technique to deal with problem. But it violates the spirit of a Rate of Return Rule.

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?

For PI rules, we should choose the plan with highest profitability index; for NPV rules, we should choose the plan with highest NPV. From the table above, we can know that Synthetic Resin plan have both the highest PI and NPV. PI is actually a modification of NPV method. No, they don’t have significant difference in scale because PI ignores the scale of the projects. To maximize wealth under capital rationing, invest in that combination of positive NPV projects that maximize the weighted average PI. Since the investment funds are limited, I think the Profitability Index should be applied here.

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?