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Case Study Revised

Case Study Revised

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FinanceCase AnalysisExplain the inputs into1) The net initial investment outlay at year 0?The initial investment at year 0 is $200,000 which includes taxes and delivery, and the cost toinstall the equipment $12,500. Therefore the total net cost of initial investment outlay at year 0 is$212,500.2) The depreciation tax savings in each year of the projects economic life?The depreciation tax savings in each year of the project¶s economic life will show how much thetax savings will be depreciated each year using the MACRS method.3) The projects incremental cash flows? These cash flows are those that are relevant to thevaluation of the project. In this case it is depreciation. Using the MACRS we can determine for how much the project will be depreciated and what the net cash flows will be after tax and after depreciation. This cash flows are the sum of the depreciation tax saving and the after-tax costsaving.This shows the company¶s profit for each of the eight years.4) What is the project¶s NPV? Explain the economic rationale behind the NPV. Could the NPVof this particular project be different for Lone Star Petroleum Company than for one of ChicagoValve¶s other potential customers?From the calculations, the NPV is ($17301). (revise) The NPV process helps investors determinewhether or not projects are profitable. There is a very important concept in finance: time value o
 
money. One dollar today is worth more than 1 dollar in the future. Since the net cash flows hereare future projections, it is necessary to bring the value of the investment to its present value. If the present value is positive, the project will be profitable; therefore, it can be approved. If the NPV is negative, the project should be rejected since the costs of investment exceed the returns.3. Calculate the proposed project¶s IRR. Explain the rationale for using the IRR to evaluatecapital investment projects. Could the IRR for this project differ for Lone Star versus for another customer?The proposed project IRR is 16.20%. The Internal Rate of Return (IRR) is a capital budgetingmethod used to decide whether they should make loam term investments. The IRR is defined asany discount rate that results in a net present value of zero and is usually interpreted as theexpected return generated by the investment. Yes, because the companies did not make the sameamount. In general if the IRR is greater than the project¶s cost of capital the project will addvalue for the company.4. Suppose one of Lone Star¶s executives typically uses the payback as a primary capital budgeting decision tool and wants some payback information.a) What is the project¶s payback period? b) What is the rationale behind the use of payback as a project evaluation tool?c) What deficiencies does payback have as a capital budgeting decision method?d) Does payback provide any useful information regarding capital budgeting decisions?e) Strictly as a sales tool, without regard to the validity of the analysis, would the payback bemore help to the sale staff for some types of equipment than for others? Would this procedure bemore appropriate for projects with very long or short lives?f) People occasionally use the payback¶s reciprocal as an estimate of the project¶s rate of return.Would this procedure be more appropriate for projects with very long or short lives? ExplainThe payback period would be 3.95 years for recovery. The rationale is to determine how long itwill take to recover the initial investment of $212,500. The initial investment of $212,500 will be
 
recovered before the 8 years of depreciation. It will be recovered between the 3rd and 4th year,3.95 years. The deficiencies the payback period has as a capital budgeting decision method aretwo: first, we are ignoring time value of money and second, we did not use the fourth cash flowvalue. This method is very limited and we do not learn whether the project is profitable or not.To solve the limitations, there is a method called discounted payback period. As a sales tool, the payback period could help estimate the number of years for the investment to be recovered. Itcould be relevant for salespersons to explain customers about which products or projects willtake long before the investment is recovered. In that case, if the number of years is greater for some projects than others, customers should chose the ones that take less time. At the same time,a project may take 10 years but the investment may be recovered after 2 years. Whereas a projectmay take 5 years but the investment may be recovered at the 4
th
year. It really depends on thecash flows and the other factors that determine those cash flows (example taxes or depreciation).5. What is the project¶s MIRR? What is the difference between the IRR and MIRR? Which is better? Why?The project MIRR is 13.24%. The IRR is 16.20%. The difference between the MIRR and IRR isthat the MIRR is the discount rate which causes the PV of a project¶s terminal value to equal thePV of costs. It is found by compounding inflows at WACC (11%) and assumes cash inflows arereinvested at WACC. The MIRR takes care of the inefficiencies of IRR that are: assumption thatwe are reinvesting cash flows at the IRR rate and the assumption that cash flows are all normal(positive). If the cash flows change from normal to non-normal, the calculator will change theIRR, giving an inaccurate calculation.6. Suppose a potential customer wants to know the projects for profitability index (PI). What isthe value of the PIU of Lone Star, and what is the rationale behind this measure?The profitability index is calculated as the sum of net present values of the cash flows divided bythe initial investment.PI= 373,000/212500= 1.75 > 1 Accept project

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