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Chino Material Systems

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Wassim Zhani

DR Eurico Ferreira

FIN 471-001

Chino capital Budgeting| 4/23/2012 2

Answer 1.

year MACRS AMT DTS

1 20% 60600 21816

2 32% 96960 34906

3 19.00% 57570 20725

4 12.00% 36360 13090

5 11.00% 33330 11999

6 6.00% 18180 6545

1 70456

2 83546 13090

3 69365 -14181

4 61730 -7635

5 60639 -1091

6 55185 -5454

7 48640 -6545

8 58240 9600

1) The initial investment of the project is the sum of cost of acquisition of the plant and all the cost that is

incurred to bring to plant in its working condition like cost of installation, etc. as reduced by the salvage

value that is expected to be realized at the end of the useful life and the net amount that is realized from

the sale of old asset after taking into consideration the tax effect.

2) The depreciation system used here is MACRS. The depreciation tax shield is calculated by multiplying

tax rate and the depreciation so calculated.

Answer 2.

The NPV of any project is the present value of all future cash flows discounted at required rate of

return(cost of capital) as reduced by the initial cost of investment.

A positive NPV shows the net addition to the wealth of the equity shareholders thereby making the

project viable.

Chino capital Budgeting| 4/23/2012 3

The NPV of one project may be different from another project as the NPV depends on various factors like

cash flows, cost of capital. As the machine is common to GP manufacturing and Chinos other customers,

but they can generate different cash flows using the same machine. Furthermore, cost of capital can vary

from customer to customer. These differences can lead to different to NPVs for different customers

buying the same machine.

Answer 3.

The IRR of any project is the rate at which the present value of inflows is equal to the present value of

outflows.

The rationale behind IRR is that it tells us the actual rate of return that is required to cover the entire cost

of investment.

The IRR of two projects can be different as the IRR is calculated by discounting the cash flows.

So if the cash flows and no of years of investment is unequal then two projects will have different IRR

even if they use the same machinery for the project. IRR is project specific.

Answer 4.

b. Payback period is a capital budgeting concept which refers to period of time which is required for

a project to generate a return on investment which will cover the original investment made by a

company on the initial project cost. The shorter the payback period, the better is the project.

c. The disadvantage of payback period is that ignores an important concept which is time value of

money and therefore it may not present true picture when it comes to evaluating cash flows of a

project. It also ignores cash flows beyond the payback period and therefore it does not take into

account the complete return which a project can generate and therefore it may reject a project

which in the long term may be beneficial for a company. Hence we should use Discounted

payback period which will give us a more accurate result.

d. The advantage of using payback period is that its ease of use and anybody who is having limited

financial knowledge can apply it. It is also beneficial for those companies who are recently

established and want to know the time frame in which they would recover their original

investment, therefore those companies which do not want to take risk and want quick return on

their investments can select those projects which have low payback period and ignore those

projects which require long gestation projects.

Answer 5.

While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR,

the modified IRR assumes that positive cash flows are reinvested at a different re-investment rate and the

initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost

and profitability of a project. MIRR is better because in real life its not possible to reinvest the

intermediate cash flows at the IRR rate which needs to be re-invested at the reinvestment rate available in

the market.

Chino capital Budgeting| 4/23/2012 4

Answer 6.

The P.I. of the project is 1.08

It is the present value of inflows for per rupee of outflow.

P.I. = the present value of inflows

Initial outflow

It is an evaluation of the profitability of an investment and can be compared with the profitability of other

similar investments which are under consideration. the profitability index is also referred to as benefit-

cost ratio, cost-benefit ratio, or even capital rationing. The profitability index is one of the numerous ways

used to quantify and measure the efficiency of a proposed investment. The profitability index is also

helpful in ranking and picking projects while rationing of capital.

If P.I. is <1, reject the project as NPV is < 0 and vice versa.

Answer 7.

The condition under which NPV, IRR, MIRR and P.I. will lead to same rejection/acceptation decision is

when IRR>cost of capital.

This will result in acceptance of the project. Further when IRR > cost of capital there will be positive

NPV and also P.I.>1.

Conflicts between NPV and IRR can arise in numerous circumstances: different lives, different sizes,

different risk factors, or different timing of cash flows. The underlying cause of the conflict resides in the

assumption of cash flow reinvestment. The process of discounting and time value of money is predicated

on interest compounding and discounting is predicated on what discount rate is chosen. In IRR

calculation, the implied interest rate of reinvestment of cash flows is IRR itself. In NPV calculation, it is

the discount rate. Which of the two methods is correct depends on the choice of what is a more realistic

rate of reinvestment of cash flows: IRR or discount rate. Most often the reinvestment opportunities that a

company has are those that can earn its weighted average cost of capital, because it is what its projects

earn on average. Relying on an assumption of weight average cost of capital as the reinvestment

opportunity is also more conservative. Thus, NPV is most often the safest basis for decision. By using the

same rate of reinvestment of cash flows for NPV and IRR removes the conflict between NPV and IRR.

Answer 8.

Increase the Congress reinstates the ITC; it will have a positive impact on the project as it will reduce the

initial outlay of the project by 10% leading to an increase in NPV and a higher IRR. Thereby the project

is acceptable.

Answer 9.

NPV profile helps assess project risk. If NPV is very sensitive to discount rate - its risk is higher

compared to projects with less sensitivity. The Net Present Value (NPV) profile plots the net present

Chino capital Budgeting| 4/23/2012 5

value of a project at different level of cost of capital. From the NPV profile, we can see a relationship

between NPV and the internal rate of return (IRR) of the project.

cost of capital

80,000

60,000

40,000

20,000 npv

0

8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0%

(20,000)

(40,000)

Answer 10.

INPUT

cost of capital 12%

cash outflow

0 -150000

1 175000

OUTPUT

NPV $6,250.00

IRR

17%

Chino capital Budgeting| 4/23/2012 6

NPV PROFILE

COST OFCAPITAL NPV (S)

8.0% $12,037.04

9.0% $10,550.46

10.0% $9,090.91

11.0% $7,657.66

12.0% $6,250.00

13.0% $4,867.26

14.0% $3,508.77

15.0% $2,173.91

16.0% $862.07

17.0% ($427.35)

18.0% ($1,694.92)

0.08 71153.86

0.09 58363.76

0.1 46266.50

0.11 34814.43

0.12 23963.73

0.13 13674.10

0.14 3908.42

0.15 -5367.56

0.16 -14185.41

0.17 -22574.31

0.18 -30561.25

Chino capital Budgeting| 4/23/2012 7

$80,000.00

$60,000.00

$40,000.00

NPV (S)

$20,000.00

NPV(L)

$0.00

8.0% 9.0% 10.0%11.0%12.0%13.0%14.0%15.0%16.0%17.0%18.0%

($20,000.00)

($40,000.00)

COST

OFCAPITAL NPV (S) NPV(L)

8.0% $12,037.04 71153.86

9.0% $10,550.46 58363.76

10.0% $9,090.91 46266.50

11.0% $7,657.66 34814.43

12.0% $6,250.00 23963.73

13.0% $4,867.26 13674.10

14.0% $3,508.77 3908.42

15.0% $2,173.91 -5367.56

16.0% $862.07 -14185.41

17.0% ($427.35) -22574.31

18.0% ($1,694.92) -30561.25

1) There are certain projects that cannot be taken up together. These projects are called mutually

exclusive projects. In this case only one project can be accepted. Here, the decision is made on basis of

NPV.

Independent projects are those which are not affected by each other. They can be taken up together.

2) There can be a conflict between two projects depending upon IRR and NPV. As in the above case

project L is having a greater NPV but lower IRR than project S. thus, there is a conflict regarding which

project should be taken up. If decision is made on basis of IRR then project S is better and vice versa.

Chino capital Budgeting| 4/23/2012 8

3) If cost of capital is 14.42% (the point at which the NPV is same for both the projects) then both the

projects are equally viable, however at cost of capital less than 14.42% then Project L is better and vice

versa.

If we evaluate two projects on basis of Payback period then the project having shorter payback period

would be preferred over the one having a longer payback period, although project having longer payback

period can have higher Cash flows towards the beginning an d low cash flows towards the end as

compared to the other project. Thus, the timing of the cash flows has a conflicting effect on the decision

to choose the project.

Answer 11

(a)

Year saving Saving Net CF Cum CF

0 -302040 -302040

1 21816 48640 70456 -231584

2 34906 48640 83546 -148038

3 20725 48640 69365 -78673

4 13090 48640 61730 -16943

5 11999 48640 60639 43696

6 6545 48640 55185 98881

7 0 48640 48640 147521

8 0 48640 58240 205761

NET OUTFLOW: -302040

PV OF DEPRECIATION

TAX SAVING $80,500.45

-21539.546

This is the minimum

amount of after tax cash

flow required. $44,596.54

the pre-tax cost saving $69,682.09

If the amount of cash flow is more than 69,682.09, as calculated, then the NPV would be positive and the

project should be accepted. However, if the NPV is less than 69682.09 then the NPV would be negative

and hence the project will not be viable.

Chino capital Budgeting| 4/23/2012 9

(b)

IRR 14.42%

23963.73098

0.08 71153.86033

0.09 58363.76377

0.1 46266.50448

0.11 34814.42875

0.12 23963.73098

0.13 13674.10261

0.14 3908.416443

0.15 -5367.55754

0.16 -4185.40831

0.17 -22574.31485

0.18 -30561.25479

If the cost of capital is more than 14.32% then the NPV would be negative and the project wont be

accepted and vice versa.

(C)

MIRR 14%

(d)

0

20.0% 49,801

30.0% 33,652

40.0% 17,504

50.0% 1,355

60.0% (14,794)

If tax rate rises to 60% then it would lead to negative NPV thus making the project unviable.

1. The sales person may be unable to use the model correctly due to improper training.

2. If the functions are not properly used it might lead to misleading answers.

Chino capital Budgeting| 4/23/2012 10

Answer 12.

INPUT

cost of capital 12%

cash outflow

0 -50000

1 200000

2 -160000

OUTPUT:

NPV $1,020.41

IRR

10.56%

MIRR

13.32%

NPV

PROFILE

COST

OFCAPITAL NPV

8.0% ($1,989.03)

9.0% ($1,182.56)

10.0% ($413.22)

11.0% $320.59

12.0% $1,020.41

13.0% $1,687.68

14.0% $2,323.79

15.0% $2,930.06

16.0% $3,507.73

17.0% $4,058.00

18.0% $4,582.02

In this case as the cost of capital increases, NPV also increases showing a positive relationship. This is a

rare case as generally when cost of capital increases it leads to a fall in NPV, but here the cash inflow of

year2 is negative leading to an increase in NPV.

Chino capital Budgeting| 4/23/2012 11

NPV

5000

4000

3000

2000

1000 NPV

0

0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15 0.16 0.17 0.18

-1000

-2000

-3000

COST OF

CAPITAL NPV

0.08 -1989.026

0.09 -1182.56

0.1 -413.2231

0.11 320.59086

0.12 1020.4082

0.13 1687.6811

0.14 2323.7919

0.15 2930.0567

0.16 3507.7289

0.17 4058.0028

0.18 4582.0167

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