Finance Case Analysis

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 4th 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 1 2

Net Cash Flow ($30,000) 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.