Question

II. Project Selection

Garcia Energy has recently experienced a recent surge in demand.    In order to be more productive, Garcia Energy is analyzing two potential expansion projects. Option B is more costly but provides larger cash inflows. Project A and Project B are mutually-exclusive projects. Andrew Potts believes that the impact of this decision will extend out to three years. Garcia Energy’s required return on this project is 10 percent. Computations for Option A are provided. Complete the analysis for Option B, which is over $100,000 more costly, and identify the project that should be selected. Show work to get partial credit in situations where you have incorrect final answer.

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

1.       Payback Method (4 points; Option A = 2.04 years):

2.       Discounted Payback (5 points; Option A = 2.41 years):

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

4.       Profitability Index (1.5 point; Option A = 1.22):

5.       Internal Rate of Return (1.5 point, Option A = 22.0%):

6.       Modified Internal Rate of Return (6 points; Option A = 17.46%):

7.       Discuss the advantages and disadvantages of each measure, including a discussion of why a given option would be preferred on the basis of this capital budgeting tool.   (6 points)

8.         In the Executive Summary, based on the information given, which project should be chosen by Garcia Energy? Why (2 points)

Answer 1

Based on the given data, pls find below steps, workings and answers:

1.       Payback Method : Option A is 2.04 years and Option B is 2.22 years

2.       Discounted Payback : Option A is 2.41 years and Option B is 2.68 years

3.       Net Present Value : Option A is $ 67479 and Option B is $ 43171

4.       Profitability Index : Option A is 1.22 and Option B is 1.1 times;

5.       Internal Rate of Return : Option A is 22.0% and Option B is 15.65%

6.       Modified Internal Rate of Return : Option A is 17.46% and Option B is 13.49%

7.       Discuss the advantages and disadvantages of each measure, including a discussion of why a given option would be preferred on the basis of this capital budgeting tool.

For any Project / Major CAPEX evaluations, the three most common approaches are Payback period, Internal rate of return (IRR) and Net Present Value (NPV).

The payback period determines how long it would take a company to see enough in cash flows to recover the original investment.

Payback period / Discounted Payback Period strictly looks at the time factor at which the investments are returned from the cashflows of the Project. From advantages perspective, this method is easy to apply, simple to understand, is useful incase of uncertainty and helps investors to this as a basic first step to analyse any project;

However , the disadvantages are that this method doesn’t explain the profitability of the project and Return of Investment is unknown;

Hence, this method need to be used along with the other capital budgeting tools, to make a proper decision.

The internal rate of return (IRR) calculates the percentage rate of return at which those same cash flows will result in a net present value of zero.

The Net Present Value (NPV) results in the total net cash inflows expected from a project at the present value using a discounting factor.

This is used to quantify the results in value terms from the entire project, covering all the cashflows from the project.

While most of the times NPV and IRR result in the same outcome on the feasibililty of the Project, there shall be cases of conflicting opinions as well;

Incase of analysis of a single conventional project, both NPV and IRR might provide same indicator on the evaluation of the project or not. However, while comparing two projects, the NPV and IRR may provide conflicting results.

Also, incase of mutiple cash flows trends (positive, negative, positive, negative etc) during the Project period, the IRR fails to provide answer and in this case NPV shall be useful as it covers all the cashflows - either Positive or Negative.

Hence, these need to be considered as evaluation tools and the final judgement shall be taken based on various other aspects as well; A project with lower IRR, however, more longevity might be more beneficial for an entity with a project with higher IRR with shorter life span; Many factors contribute the overall evaluation.

Profitability index is mostly inclined towards the outcome of NPV and hence the same judgements as given by NPV shall be applicable.

MIRR is a concept which calculates the expected return from the project if the proceeds from the project are reinvested at a given rate; This is a good tool for assessing the more accurate profitability than IRR; However, this tool also has its limitations as there shall be constant change in the reinvestment rates and assessing the same is not completely possible.

8.         In the Executive Summary, based on the information given, which project should be chosen by Garcia Energy? Why

Garcia Energy should choose Option A as the same is having higher NPV than Option B and also other factors like IRR, MIRR are higher for OPtion A, while the discounted payback and normal payback period are lower for Option A.

Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%);

Computation of MIRR: This can be computed using formula in Excel = MIRR("range of cashflows", discounting factor%, reinvestment factor%); Here, both discounting factor % and reinvestment factor% are considered same.

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Computation of Normal / Discounted Pay Back Period: Here, the period is computed for each project, based on cumulative normal /discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial investment); Once the value turns positive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.