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Question Calculate Pay Back Period, Net Present Value, Internal Rate of Return and Profitability Index (Benefit...
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Calculate Pay Back Period, Net Present Value, Internal Rate of Return and Profitability Index (Benefit Cost Ration) of each of these projects and decide and provide your analysis which project is better. Critically evaluate your decision.
On January 11, 2005, 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 & development. Over the past five years this committee has 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 1954 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 1970 this diversification attempt had led HPMC into the production of over 1000 different items, including kitchen utensils, camera housings, phonographic and recording equipment. It also led to an increase in sales of 500 percent during 1964 to 1974 prod. As this dramatic increase in sales was paralleled by a corresponding increase in production volume, HPMC was forced, in late 1973, to expand production facilities. This plant and equipment expansion involved capital expenditure 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. While non-automotive related business has grown significantly, it still only represents 32 percent 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 area are evaluated by using present value techniques. Assuming a 10% opportunity cost, 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 the evaluation. The subjective approach used to evaluate safety projects is a result of the pragmatically difficult task of quantifying the benefits from these projects into dollar terms. Thus, these 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 utilization of HPMC’s precision equipment. Project A calls for production of vacuum containers for thermos bottles produced for a large discount hardware chain. The containers would be manufactured in five different size and colour combinations. This project would be carried out over a three-year period. Project B involves manufacture of inexpensive photographic equipment for a national photography outlet. Although HPMC currently has excess plant capacity, both 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 about two years, thus making these projects mutually exclusive. (The cash flows associated with these two projects are given in exhibit-1)
|
Year |
Project-C |
Project-D |
|
0 |
-8,000 |
-20,000 |
|
1 |
11,000 |
25,000 |
|
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 |
|
Year |
Projects-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 |
|
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 |
Solutions
Expert Solution
| Project A | ||||||||||
| NPV analysis | ||||||||||
| Year | 0 | 1 | 2 | 3 | ||||||
| Cashflows | (75,000.00) | 10,000.00 | 30,000.00 | 100,000.00 | ||||||
| PV factor @ 10% | 1.00 | 0.91 | 0.83 | 0.75 | ||||||
| PV cashflows | (75,000.00) | 9,090.91 | 24,793.39 | 75,131.48 | ||||||
| NPV | 34,015.78 | |||||||||
| IRR analysis @ 10% | IRR analysis @ 30% | |||||||||
| Year | 0 | 1 | 2 | 3 | Year | 0 | 1 | 2 | 3 | |
| Cashflows | (75,000.00) | 10,000.00 | 30,000.00 | 100,000.00 | Cashflows | (75,000.00) | 10,000.00 | 30,000.00 | 100,000.00 | |
| PV factor @ 10% | 1.00 | 0.91 | 0.83 | 0.75 | PV factor @ 30% | 1.00 | 0.77 | 0.59 | 0.46 | |
| PV cashflows | (75,000.00) | 9,090.91 | 24,793.39 | 75,131.48 | PV cashflows | (75,000.00) | 7,692.31 | 17,751.48 | 45,516.61 | |
| NPV | 34,015.78 | NPV | (4,039.60) | |||||||
| IRR using interpolation method | Profitability index @ 10% cost of capital | |||||||||
| NPV - lower rate | a | 34,015.7776 | Present value of future cashflows | 109,015.78 | ||||||
| NPV - higher rate | b | (4,039.5995) | Initial investement | 75,000.00 | ||||||
| Lower rate | c | 10.00% | PI --> PV of future cashflows / Initial investment | 1.45 | ||||||
| Higher rate | d | 30.00% | ||||||||
| IRR =c+(a*((d-c)/(a-b))) | ||||||||||
| IRR of project A ---> | 27.8770% |
| Project B | ||||||||||
| NPV analysis | ||||||||||
| Year | 0 | 1 | 2 | 3 | ||||||
| Cashflows | (75,000.00) | 43,000.00 | 43,000.00 | 43,000.00 | ||||||
| PV factor @ 10% | 1.00 | 0.91 | 0.83 | 0.75 | ||||||
| PV cashflows | (75,000.00) | 39,090.91 | 35,537.19 | 32,306.54 | ||||||
| NPV | 31,934.64 | |||||||||
| IRR analysis @ 10% | IRR analysis @ 40% | |||||||||
| Year | 0 | 1 | 2 | 3 | Year | 0 | 1 | 2 | 3 | |
| Cashflows | (75,000.00) | 43,000.00 | 43,000.00 | 43,000.00 | Cashflows | (75,000.00) | 43,000.00 | 43,000.00 | 43,000.00 | |
| PV factor @ 10% | 1.00 | 0.91 | 0.83 | 0.75 | PV factor @ 40% | 1.00 | 0.71 | 0.51 |
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