Question

Part A. Project Selection

As observed in Part I, over twenty percent of Garcia Energy’s inventory is invested in inventory. In order to make this component of its asset base more productive, Garcia Energy is analyzing two potential inventory expansion projects. Option B is more costly and provides larger cash inflows. Project A and Project B are mutually-exclusive projects. Andrew Potts believes that he the impact of this decision will extend out to three years. Garcia Energy’s required return is 10 percent on this project, which is discussed in greater detail in Part B.   Results for Option A are provided. Complete the analysis for Option B, which is over $100,000 more costly (probably bumping the inventory component of total assets above 25 percent), and identify the project that should be selected.

Option A			Option B
Initial Investment: $310,000			Initial Investment: $440,000
Year	Cash Inflow		Year	Cash Inflow
1	$151,790		1	$210,000
2	$151,790		2	$190,000
3	$151,790		3	$180,000

PART A. Capital Budgeting

a.       Payback Method (3 points; Option A = 2.04 years):

b.       Discounted Payback (4 points; Option A = 2.41 years):

c.       Net Present Value (2 points; Option A = $67,479):

d.       Profitability Index (1 point; Option A = 1.22):

e.       Internal Rate of Return (1 point, Option A = 22.0%):

f.       Modified Internal Rate of Return (5 points; Option A = 17.46%):

g.       Based on the information given, which project should be chosen by Garcia Energy? Why?

Answer 1

Time	Cash Flows	Cumulative Cash Flows	Discounted Cash Flows	Cumulative Discounted Cash Flows
0	-440000.00	-440000.00	-440000.00	-440000.00
1	210000.00	-230000.00	190909.09	-249090.91
2	190000.00	-40000.00	157024.79	-92066.12
3	180000.00	140000.00	135236.66	43170.55

Payback Period = 2 years + (40000/180000) = 2.22 years

Discounted Payback Period = 2 years + (92066.12/135236.66) = 2.68 years

NPV = sum of discounted cash flows = -440000 + 190909.09 + 157024.79 + 135236.66 = $43170.55

Profitability Index = (43170.55 + 440000)/440000 = 1.10

If IRR is ‘i’, then,

V = -440000 + 210000/(1+i) + 190000/(1+1)^2 + 180000/(1+i)^3 = 0

For i = 15%, V = 4628.9143

For i = 16%, V = -2446.1848

IRR = 15% + (16% - 15%) * (0 – 4628.9143)/(-2446.1848 -4628.9143) = 15.65%

FV of positive cash flows = 210000 * (1+10%)^2 + 190000 * (1+10%) + 180000 = 643100.0

MIRR = (643100/440000)^(1/3) – 1 = 13.49%

	Option A	Option B
Payback Period	2.04	2.22
Discounted Payback Period	2.41	2.68
NPV	67479	43171
Profitability Index	1.22	1.1
IRR	22%	15.65%
MIRR	17.46%	13.49%

Comparing all parameters, Option A is better alternative. Hence, Garcia Energy should choose Option A.