Running head: VEGETRON 1

Vegetron’s CFO Calls Again

Alexander Cueva
Alina Danh
Angela Deaton

MGMT565 – Financial Analysis and Management I

November25, 2012

Dr. Darrin DeReus

Southwestern College Professional Studies

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Abstract

This report satisfies the request to conduct financial analysis for Case Study 1, Vegetron’s CFO

Calls Again, in the textbook Principles of Corporate Finance (Brealey, Myers & Allen, 2011).

The following text examines the background and problem statement of Vegetron’s financial

situation(s) andprovides current financial details as well as available financial options. The

report analyzes Vegetron’sincome statementin order to identify NPV and IRR values for both

high and low temperature extraction processes. The NPV and IRR values are examined in order

to choose the most efficient and cost effective process. Finally, the report provides a

recommendation to utilize the high temperature extraction process backed by financial evidence

allowing a capital investment decision to be made.

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Vegetron’s CFO Calls Again

Vegetron is a mid-western company that specializes in refining and engineering.

Vegetron isresearching new investment opportunities for the business and is considering a

fermentation tank that will extract hydrated zirconium from a stockpile of powdered ore. Two

propositions exist: a low temperature fermentation tank and a high temperature fermentation

tank. Vegetron’s chief financial officer requested financial analysis of both tanks in order to

choose the right financial option. The analysis contains forecasted revenues, costs, income, and

book rates of return. In addition, the net present value and the internal rate or return values are

used as the main factors for the selection of the most efficient and cost effective process.

Vegetron Background

Vegetron’s headquarters are located in Wichita, Kansas. Vegetron has over 1,000

employees. Founded in 1990, they continue to be one of the strongest industrial leaders. They

maintain a high level of integrity and honesty in all business interactions. Their mission is to

surpass customer’s expectations in quality and delivery. In addition, they have a strong emphasis

on continuous improvement through education and consumer feedback. Vegetron’s vision is to

create value for their consumers and shareholders.

Problem Statement

Vegetron’s engineers proposed a change of design for a high temperature fermentation

tank instead of a low temperature fermentation tank to extract hydrated zirconium. The high

temperature tank is supposed to extract the substance for a shorter period of time, which is for

five instead of seven years. They are looking for a faster payback and rate of return. However,

there are some implications with the high fermentation tank.

A high temperature fermentation tank may be less efficient. The operating costs are

higher and it will generate less total revenue over the project’s life span. However, cash flows in
VEGETRON 4

years’ one through five are suspected to increase. On the contrary, the low temperature tank

might give the company a higher rate of return. Thus,NPV and IRR will be used to answer the

question of which is the better investment option for Vegetron.

Financial Options

There are several potential options and varying concepts for management to review

before deciding on a path forward. One of the main differences between the high and low

temperature extraction methods was the varying forecasted revenues, costs, income, and book

rates. In addition to those differences, the low temperature extraction method has a slower

payback (seven years) and the high temperature extraction method has a faster payback (five

years).

According to the data tables provided by Vegetron’s CFO, the high temperature

extraction method income is $30,000 per year and is half the $400,000 capital outlay, or

$200,000. The high temperature extraction method average rate of return is $30,000/$200,000 or

15%, which beats Vegetron’s 9% cost of capital in every year but the first.The low temperature

extraction method average rate of return is $28,000/$200,000 or 14%. The high temperature

extraction method has higher operating costs and generates less total revenue over the life of the

project. High temperature extraction method generates more cash flow in years 1-5.

The decision also had to be made on whether to use book income or cash flow. In the

end, it is true that accounting numbers are not a sound basis for capital investment decisions.

Another item to note is the fact that the high temperature extraction method is a last minute

proposal for a change in engineering design which could impose additional engineering and

manufacturing costs.The ultimate need is to compare the NPV and IRR values of the two

methods and make a sound financial decision from those numbers.

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Financial Details

Essential financial information was provided to our team by the CFO of Vegetron via our

textbook, Principles of Corporate Finance (Brealey, Myers & Allen, 2011). More specifically,

the following two financial tables were provided to us. These tables served as financial

statements for the low temperature extraction method and the high temperature extraction

method, respectively. Following these tables are the financial calculations our group used in

order to effectively analyze which of the two methods were most financially effective.

LOW TEMPERATURE YEAR

1 2 3 4 5 6 7
1. Revenue 140 140 140 140 140 140 140
2. Operating Costs 55 55 55 55 55 55 55
3. Depreciation 57 57 57 57 57 57 57
4. Net Income 28 28 28 28 28 28 28
5. Start-of-year book value 400 343 286 229 171 114 57
6. Book rate of return (4/5) 7% 8.2% 9.8% 12.2% 16.4% 24.6% 49.1%
(Brealey, Myers & Allen, 2011, p 125)

HIGH TEMPERATURE YEAR

1 2 3 4 5
1. Revenue 180 180 180 180 180
2. Operating Costs 70 70 70 70 70
3. Depreciation 80 80 80 80 80
4. Net Income 30 30 30 30 30
5. Start-of-year book value 400 320 240 160 80
6. Book rate of return (4/5) 7.5% 9.4% 12.5% 18.75% 37.5%
(Brealey, Myers & Allen, 2011, p 126)

Financial Analysis

This case study requires financial analysis of two separate projects. These projects have

different income statements and book rates; complete with varying revenue, operating costs, and

depreciation. A financial analysis of the two projects is completed using NPV, or net present

value. In order to effectively evaluate the financial advantages of these projects, two questions

must be answered. The first is to figure out whether or not the book rates of return reported for

the projects are useful inputs in determining the capital investment decision. The second
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question requires the evaluation of the NPV calculation for each project independently. These

questions can be found on page 126 of the textbook Principles of Corporate Finance (Brealey,

Myers & Allen, 2011).

After researching the definitions of effective financial decision making, the book rates

reported in Tables 5.1 and 5.2 on pages 125 and 126, respectively, are not useful inputs for the

capital investment decision. The book rates in those tables include depreciation which is a non-

cash expense. Depreciation is the reduction in the book or market value of an asset (Brealey,

Myers & Allen, 2011), and therefore should not be used in financial decision making.

Non-cash expenses should not be used to evaluate investment decisions. This is true

because NPV should only take into consideration cash entries. NPV, or net present value, is a

project’s net contribution to wealth- present value minus initial investment (Brealey, Myers &

Allen, 2011). In this case study, NPV is used to evaluate the investment decision and therefore,

will not include depreciation entries.

Calculating NPV

LOW TEMPERATURE YEAR

0 1 2 3 4 5 6 7
1. Revenue 140 140 140 140 140 140 140
2. Operating Costs 55 55 55 55 55 55 55
3. Depreciation 57 57 57 57 57 57 57
4. Net Income 28 28 28 28 28 28 28
5. Start-of-year book value 400 343 286 229 171 114 57
6. Book rate of return (4/5) 7% 8.20% 9.80% 12.20% 16.40% 24.60% 49.10%
Cash Flow (4+3)* -400 85 85 85 85 85 85 85
Discounted Cash Flow** (400.00) 77.98 71.54 65.64 60.22 55.24 50.68 46.50
*Cash flow = Net income + Non cash expenses
**Discounted cash flow is the cash with discount rate applied by yr.

Projected Rate of Return 9% Provided by CFO

Initial Investment $400 Provided by Tables
NPV $27.80 NPV = Sum of discounted cash flows by year minus initial
investment.
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HIGH TEMPERATURE YEAR

0 1 2 3 4 5
1. Revenue 180 180 180 180 180
2. Operating Costs 70 70 70 70 70
3. Depreciation 80 80 80 80 80
4. Net Income 30 30 30 30 30
5. Start-of-year book value 400 320 240 160 80
6. Book rate of return (4/5) 7.50% 9.40% 12.50% 18.75% 37.50%

Cash Flow (4+3)* -400 110 110 110 110 110

Discounted Cash Flow** (400.00) 100.92 92.58 84.94 77.93 71.49
*Cash flow = Net income + Non cash expenses
**Discounted cash flow is the cash with discount rate applied by year.

Projected Rate of Return 9% Provided by CFO

Initial Investment $400 Provided by Tables
NPV $27.86 NPV = Sum of discounted cash flows by year minus initial
investment.

Calculating IRR

LOW TEMPERATURE YEAR

0 1 2 3 4 5 6 7
1. Revenue 140 140 140 140 140 140 140
2. Operating Costs 55 55 55 55 55 55 55
3. Depreciation 57 57 57 57 57 57 57
4. Net Income 28 28 28 28 28 28 28
5. Start-of-year book value 400 343 286 229 171 114 57
6. Book rate of return (4/5) 7% 8.20% 9.80% 12.20% 16.40% 24.60% 49.10%

Cash Flow (4+3)* -400 85 85 85 85 85 85 85

Discounted Cash Flow** (400.00) 76.55 68.94 62.08 55.91 50.35 45.34 40.83
*Cash flow = Net income + Non cash expenses
**Discounted cash flow is the cash with discount rate applied by
year.

IRR 11.04% IRR when NPV = 0.

Initial Investment $400 Provided by Tables
NPV $0.00
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HIGH TEMPERATURE YEAR

0 1 2 3 4 5
1. Revenue 180 180 180 180 180
2. Operating Costs 70 70 70 70 70
3. Depreciation 80 80 80 80 80
4. Net Income 30 30 30 30 30
5. Start-of-year book value 400 320 240 160 80
6. Book rate of return (4/5) 7.50% 9.40% 12.50% 18.75% 37.50%

Cash Flow (4+3)* -400 110 110 110 110 110

Discounted Cash Flow** (400.00) 98.52 88.24 79.04 70.79 63.40
*Cash flow = Net income + Non cash expenses
**Discounted cash flow is the cash with discount rate applied by year.

Projected Rate of Return 11.65% IRR when NPV = 0.

Initial Investment $400 Provided by textbook.
NPV $0.00

NPV Comparison (Low Temp vs. High Temp)

$30

$20

$10
High Temp IRR is 11.65%

$0

Low Temp IRR is 11.04%

($10)

($20)

($30)

Low Temp NPV High Temp NPV

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Recommendations and Conclusion

The above analysis of Vegetron’s income statements identified NPV and IRR values for

both high and low temperature extraction processes. In summary, the NPV and IRR values for

the two different methods are:

METHOD NPV IRR

Low Temperature $27.80 11.04%
High Temperature $27.86 11.65%

There are financial rules surrounding the basis for financial decisions. Two of those rules

apply in this situation. Those rules are the NPV rule and the IRR rule. The application of those

rules is explained here: 1. NPV rule: The method that has a higher net present value is the high

temperature extraction method. The NPV for the high temperature method is $60,000 more than

the low temperature method. 2. IRR rule: The method that has a higher internal rate of return is

the high temperature extraction method. The IRR for the high temperature method is sixth tenths

of a percent higher than the low temperature extraction method.

NPV is an important decision-making tool because an investment may appear profitable

today, but once its returns are discounted it could show a net loss for the company compared to

other options (“Encyclopedia of business”, 2012). NPV is valuable in examining multiple

projects as well as it analyzes varying cash flows.Using NPV analysis, a company would be able

to quantify the future benefits between two projects. The project that provides better results for

the company will have a larger NPV.

Upon evaluating the NPV and IRR values for the low temperature and high temperature

extraction of hydrated zirconium, it is recommended that Vegetron use the high temperature

extraction method of hydrated zirconium. Our group makes the recommendation to use the high

temperature method based on the NPV and IRR values and the above rules alone.
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One caveat to this recommendation is that it is financially based only. Manufacturing

and engineering costs that may be required to make this transition have not been accounted for in

the analysis nor the basis of this recommendation. Those costs could induce a vastly different

solution.It may be in the CFO’s best interest to evaluate whether the difference between the NPV

values is significant enough to drive a change to the high temperature extraction process. In

conclusion, the high temperature extraction method, even though showing only slightly higher

NPV and IRR values, is the best project to pursue at this time, given the financial data provided.
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References

Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of corporate finance. (10 ed.). New

York, NY: McGraw-Hill.

Encyclopedia of business.(2012). Present Value. Advameg, Inc. Retrieved from

http://www.referenceforbusiness.com/encyclopedia/Per-Pro/.Present-Value.html.