Question

Harding Plastic Molding Company

On January 11, 2003, the finance committee of Harding Plastic Molding Company

(HPMC) met to consider eight 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 five years, this committee has met every month to

consider and make a final judgment on all proposed capital outlays brought up for review during

the period.

Harding Plastic Molding Company was founded in 1982 by Robert L. Harding to produce

plastic parts and molding for the Detroit automakers. For the first 10 years of operations, HPMC

has worked solely as a subcontractor for the automakers, but since then the company has made

strong efforts to diversify in order to avoid the cyclical problems faced by the auto industry. By

1998, this diversification attempt had led HPMC into the production of over 1,000 different

items, including kitchen utensils, camera housings, and photographic and recording equipment. It

had also led to an increase in sales 500 percent during the period 1992-2002. As this dramatic

increase in sales was paralleled by a corresponding increase in production volume, HPMC was

forced, in late 2001, 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 percent. Because of this increased production capacity, HPMC

has 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. Still, non-autorelated

business represents only 32 percent of HPMC’s overall business. Thus, HPMC has

continued to solicit nonautomotive 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 area are

evaluated using present value technique, assuming a 10 percent discount rate; those falling into

the safety classification are evaluated in a more subjective framework. Bedsides the requirement

that research and development projects receive favorable results from the present value criteria, a

total dollar limit is assigned to projects of this category – typically about $750,000 per year. This

limitation was imposed by Harding primarily because of the limited availability of quality

researchers in the plastics industry. He 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 measured in terms of cash flows; hence, present value

methods are not used in their evaluation. Evaluating safety projects is a pragmatically difficult

task requiring quantifying the benefits from these projects into dollar terms. Thus, safety projects

are subjectively evaluated by a management-worker committee with a limited budget. All eight

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 produced for a large discount hardware chain. The containers

would be manufactured in five different size and color combinations. This project would be

carried out over a three-year period. 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 whose 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 two years, thus making projects A and B mutually exclusive. (The cash flows

associated with projects A and B are given in Exhibit 1.)

EXHIBIT 1

Harding Plastic Molding Company

Cash Flows

Year Project A Project B

0 $-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

The second set of projects involves the renting of computer facilities over a one-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 being done by HPMC’s accounting department would

now be done by Advanced. In addition to saving bookkeeping costs, 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, as well as an

inventory control system that will keep track of all raw materials and parts in stock and reorder

when necessary, thereby reducing the likelihood of material stockouts, which has become more

and more frequent over the past there years. (The cash flows for projects C and D and given in

Exhibit 2.)

The third decision that faces the financial directors of HPMC involves a newly developed

and patented process for molding hard plastic. HPMC can either manufacture and market the

equipment necessary to mold such plastics or it can sell the patent rights to Polyplastics, Inc., the

world’s largest producer of plastics products. (The cash flows for projects E and F are shown in

Exhibit 3.) At present, the process has not been fully tested, and if HPMC is going to market it

itself, it will be necessary to complete this testing and begin production of plant facilities

immediately. On the other hand, the selling of these patent rights to Polyplastics would involve

only minor testing and refinements, which could be completed within the year. Thus, a decision

between the two courses of action is necessary immediately.

EXHIBIT 3

Harding Plastic Molding Company

Cash Flows

Year Project E Project F

0 $-30,000 $-271,500

1 210,000 100,000

2 100,000

3 100,000

4 100,000

5 100,000

6 100,000

7 100,000

8 100,000

9 100,000

10 100,000

The final set of projects up for consideration concerns the replacement of some of the

machinery. HPMC can go into one of two directions: project G suggests the purchase and

installation of moderately priced and extremely efficient equipment with an expected life of 5

years; while project H advocates the purchase of a similarly priced, although less efficient,

machine with a life expectancy of 10 years. (The cash flows for these alternatives are shown in

Exhibit 4.)

EXHIBIT 4

Harding Plastic Molding Company

Cash Flows

Year Project G Project H

0 $-500,000 $-500,000

1 225,000 150,000

2 225,000 150,000

3 225,000 150,000

4 225,000 150,000

5 225,000 150,000

6 150,000

7 150,000

8 150,000

9 150,000

10 150,000

As the meeting opened, debate immediately centered on the most appropriate method for

evaluating all projects. Harding suggested that since the projects to be considered were mutually

exclusive, perhaps their usual capital budgeting criterion of net present value was inappropriate.

He felt that, in examining these projects, they should be more concerned with some measure of

relative profitability. Both Jorgensen and Woelk agreed with Harding’s point of view, with

Jorgensen advocating a profitability index approach and Woelk preferring to use the internal rate

of return. Jorgensen argued that the use of profitability index would provide a benefit-cost ratio,

directly implying relative profitability, so that they would merely need to rank the projects and

select those with the highest profitability index. Woelk suggested that the calculation of an

internal rate of return would also give a measure of profitability and perhaps be somewhat easier

to interpret. To settle the issue, Harding suggested that they calculate all three measures, as they

would undoubtedly yield the same ranking.

From here the discussion turned to an appropriate approach to the problem of differing

lives among mutually exclusive projects E and F, and G and H. Woelk argued that there really

was no problem here, since all cash flows from these projects could be determined, any of the

discounted cash flow methods of capital budgeting would work well. Jorgensen argued that this

was true, but felt that some compensation should be made for the fact that the projects being

considered did not have equal lives.

1. What are the NPV and PI for projects A and B? The IRR for projects A and B are 27.1949% and 32.9189% respectively. Evaluate critically what has caused the ranking conflicts. Should project A or B be chosen? Might your answer change if project B is a typical project in the plastic molding industry? For example, if projects for HPMC generally yield approximately 12%, is it logical to assume that the IRR for project B of approximately 33% is a correct calculation for ranking purposes?                                                                        

Answer 1

A. NPV and PI (Profitability Index) of Projects A and B are as follows:

Workings:

Ranking:

Basis NPV and Profitability Index, Project A is the better option as both the NPV and Profitability Index are higher. However, IRR of Project A is lower than Project B leading to the ranking conflict.

Projects A and B are mutually exclusive which means only one project can be selected. Both the projects though has same investment at the beginning has different cash-flow timings. In case of Project B where the initial cash flows are higher than Project A, it can be seen that the IRR is higher as IRR tends to skew towards a higher range when there are higher cash flows initially. An unrealistic assumption that IRR makes is that all cash flows in the future are invested at the IRR rate though the discount rate changes over the life of the company. However, NPV works on the assumptions that all future cash flows are reinvested at the most realistic discount rate-opportunity cost of funds. Thus, when there is a conflict between IRR and NPV in the case of mutually exclusive projects, decision to be made basis the NPV method than IRR as NPV shows the amount of real wealth gain for the company.

Thus, Project A with higher NPV is to be chosen.

If project B is a typical project in the plastic molding industry and if projects for HPMC generally yield approximately 12%, it is not logical to assume that the IRR for project B of approximately 33% is a correct calculation for ranking purposes. Expected return tend to be higher for higher risk projects and if a project has typical risks, then it is not logical to assume higher IRR than the general yield. Also, since the decision made is basis NPV, the answer will not change.