Question

HARDING PLASTIC MOLDING COMPANY CAPITAL BUDGETING: RANKING PROBLEMS On January 11, 1993, the finance committee of Harding Plastic Molding Company (HPMC) met to consider 4 capital-budgeting projects. Present at the meeting were Robert L. Harding, president and founder, Susan Jorgensen, comptroller, and Chris Woelk, head of research and development. Over the past 5 years, this committee met every month to consider and make final judgment on all proposed capital outlays brought up for review during the period. Harding Plastic Molding Company was founded in 1965 by Robert L. Harding to produce plastic parts and molding for the Detroit automakers. For the first 10 years of operations, HPMC worked solely as a subcontractor for the automakers, but since then has made strong efforts to diversify in an attempt to avoid the cyclical problems faced by the auto industry. By 1993, this diversification attempt led HPMC into the production of over 1,000 different items, including kitchen utensils, camera housings, and phonographic and recording equipment. It also led to an increase in sales of 800% during the 1975–1993 period. As this dramatic increase in sales was paralleled by a corresponding increase in production volume, HPMC was forced, in late 1991, to expand production facilities. This plant and equipment expansion involved capital expenditures of approximately $10.5 million and resulted in an increase of production capacity of about 40%. Because of this increased production capacity, HPMC made a concerted effort to attract new business and consequently has recently entered into contracts with a large toy firm and a major discount department store chain. While non-auto-related business has grown significantly, it still represents only 32% of HPMC’s overall business. Thus, HPMC has continued to solicit non-automotive business, and, as a result of this effort and its internal research and development, the firm has four sets of mutually exclusive projects to consider at this month’s finance committee meeting. Over the past 10 years, HPMC’s capital-budgeting approach has evolved into a somewhat elaborate procedure in which new proposals are categorized into three areas: profit, research and development, and safety. Projects falling into the profit or research and development areas are evaluated using present value techniques, assuming a 10 percent opportunity rate; those falling into the safety classification are evaluated in a more subjective framework. Although research and development projects have to receive favorable results from the present value criteria, there is also a total dollar limit assigned to projects of this category, typically running about $750,000 per year. This limitation was imposed by Harding primarily because of the limited availability of quality researchers in the plastics industry. Harding felt that if more funds than this were allocated, “we simply couldn’t find the manpower to administer them properly.” The benefits derived from safety projects, on the other hand, are not in terms of cash flows; hence, present value methods are not used at all in their evaluation. The subjective approach used to evaluate safety projects is a result of the pragmatically difficult task of quantifying the benefits from these projects in dollar amounts. Thus, these projects are subjectively evaluated by a management-worker committee with a limited budget. All 8 projects to be evaluated in January are classified as profit projects. The first set of projects listed on the meeting’s agenda for examination involves the utilization of HPMC’s precision equipment. Project A calls for the production of vacuum containers for thermos bottles to be produced for a large discount hardware chain. The containers would be manufactured in 5 different size and color combinations. This project would be carried out over a 3-year period, for which HPMC would be guaranteed a minimum return plus a percentage of the sales. Project B involves the manufacture of inexpensive photographic equipment for a national photography outlet. Although HPMC currently has excess plant capacity, each of these projects would utilize precision equipment of which the excess capacity is limited. Thus, adopting either project would tie up all precision facilities. In addition, the purchase of new equipment would be both prohibitively expensive and involve a time delay of approximately 2 years, thus making these projects mutually exclusive. (The cash flows associated with these 2 projects are given in Exhibit 1.) The second set of projects involves the renting of computer facilities over a 1-year period to aid in customer billing and, perhaps, inventory control. Project C entails the evaluation of a customer billing system proposed by Advanced Computer Corporation. Under this system, all the bookkeeping and billing presently done by HPMC’s accounting department would be done by Advanced. In addition to saving costs involved in bookkeeping, Advanced would provide a more efficient billing system and do a credit analysis of delinquent customers, which could be used in the future for in-depth credit analysis. Project D is proposed by International Computer Corporation and includes a billing system similar to that offered by Advanced, and in addition, an inventory control system that will keep track of all raw materials and parts in stock and reorder when necessary. This inventory control system would reduce the likelihood of material stockouts, which have become more and more frequent over the past 3 years. (The cash flows for these projects are given in Exhibit 2.)

EXHIBIT 1. Harding Plastic Molding Company Cash Flows:

Year Project A Project B

$-75,000   $-75,000

1 10,000 43,000

2 30,000 43,000

3 100,000 43,000

EXHIBIT 2. Harding Plastic Molding Company Cash Flows:

Year Project C Project D

0 $-8,000 $-20,000

1 11,000 25,000

QUESTIONS What are the NPV, PI, Payback, and IRR for projects A and B? Should project A or B be chosen? Might your answer change if project B is a typical project in the plastic molding industry?

What are the NPV, PI, Payback, and IRR for projects C and D? Should project C or D be chosen?

I need help with projects C and D please.

Write Recommendation Write and present a formal recommendation for management on which projects should be undertaken (A or B, C or D). Include your supporting calculations for each grouping of projects and your reasoning for your decision. Paper should be 2-3 pages double spaced, free of grammatical errors, and have a professional appearance.

Answer 1

		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=10%=0.1
		N=Year of Cash Flow
		ANALYSIS OF CASH FLOWS OF PROJECT A
	N	Year	0	1	2	3
	CF	Cash Flow	($75,000)	$10,000	$30,000	$100,000
		Cumulative Cash Flow	($75,000)	($65,000)	($35,000)	$65,000	SUM
	PV=CF/(1.1^N)	Present Value (PV) of Cash Flow:	($75,000)	$9,091	$24,793	$75,131	$34,016
	NPV=Sum of PV	Net Present Value (NPV)	$34,016
		Payback Period =Period at which Cumulative cash flow=Zero
		Payback Period =(2+35000/100000)	2.35	Years
		Internal Rate of Return (IRR)	27.19%	(Using excel IRR function over Cash Flows)
		Profitability Index(PI)=(NPV+Initial Cost)/(InitialCost)
		Profitability Index(PI)=	1.45	(34016+75000)/75000
		ANALYSIS OF CASH FLOWS OF PROJECT B
	N	Year	0	1	2	3
	CF	Cash Flow	($75,000)	$43,000	$43,000	$43,000
		Cumulative Cash Flow	($75,000)	($32,000)	$11,000	$54,000	SUM
	PV=CF/(1.1^N)	Present Value (PV) of Cash Flow:	($75,000)	$39,091	$35,537	$32,307	$31,935
	NPV=Sum of PV	Net Present Value (NPV)	$31,935
		Payback Period =Period at which Cumulative cash flow=Zero
		Payback Period =(1+32000/43000)	1.74	Years
		Internal Rate of Return (IRR)	32.92%	(Using excel IRR function over Cash Flows)
		Profitability Index(PI)=(NPV+Initial Cost)/(InitialCost)
		Profitability Index(PI)=	1.43	(31935+75000)/75000
			NPV	Payback	IRR	PI
		Project A	$34,016	2.35	27.19%	1.45
		Project B	$31,935	1.74	32.92%	1.43
		NPV represents wealth created for shareholders
		PI represents Present Value of profits per dollar of invetments
		PROJECT A should be chosen since NPV and PI are higher
		ANALYSIS OF CASH FLOWS OF PROJECT C
	N	Year	0	1
	CF	Cash Flow	($8,000)	$11,000
		Cumulative Cash Flow	($8,000)	$3,000	SUM
	PV=CF/(1.1^N)	Present Value (PV) of Cash Flow:	($8,000)	$10,000	$2,000
	NPV=Sum of PV	Net Present Value (NPV)	$2,000
		Payback Period =Period at which Cumulative cash flow=Zero
		Payback Period =(0+8000/11000)	0.73	Years
		Internal Rate of Return (IRR)	37.50%	(Using excel IRR function over Cash Flows)
		Profitability Index(PI)=(NPV+Initial Cost)/(InitialCost)
		Profitability Index(PI)=	1.25	(2000+8000)/8000
		ANALYSIS OF CASH FLOWS OF PROJECT D
	N	Year	0	1
	CF	Cash Flow	($20,000)	$25,000
		Cumulative Cash Flow	($20,000)	$5,000	SUM
	PV=CF/(1.1^N)	Present Value (PV) of Cash Flow:	($20,000)	$22,727	$2,727
	NPV=Sum of PV	Net Present Value (NPV)	$2,727
		Payback Period =Period at which Cumulative cash flow=Zero
		Payback Period =(0+20000/25000)	0.80	Years
		Internal Rate of Return (IRR)	25.00%	(Using excel IRR function over Cash Flows)
		Profitability Index(PI)=(NPV+Initial Cost)/(InitialCost)
		Profitability Index(PI)=	1.14	(2727+20000)/20000
			NPV	Payback	IRR	PI
		Project C	$2,000	0.73	37.50%	1.25
		Project D	$2,727	0.80	25.00%	1.14
		Project C has higher Profitability Index
		Project C should be selected
		Project C gives higher wealth created per dollar of investment