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Chino capital Budgeting| 4/23/2012 1

Running Head: Case 95, Capital budgeting, Chino Material Systems

Case 95, Capital budgeting, Chino Material Systems

Wassim Zhani

DR Eurico Ferreira

FIN 471-001
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Answer 1.

depreciation rate as per depreciation


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

year NCF Incremental Cash flow


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.

3) The incremental cash flows are as follows:

It is the difference in cash flow of two consecutive years.

Answer 2.

The NPV of the project is $23963.73.

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.
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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 the proposed project is 14.4%.

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.

a. The payback period of the project is 4.28yrs


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.

The IRR is 14.4% and the MIRR is 14.18%.

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.
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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
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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%
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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)

Cap Cost NPV(L)


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
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Refer excel sheet.

$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.
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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)

Depreciation Tax A.T. Cost


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.
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(b)

IRR 14.42%

Cap Cost NPV


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)

Tax rate NPV


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.

(e) The problems that might arise are as follows:

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.
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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.
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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