Team Details: Team 7 (Div I)

Pulkit Agrawal I007

Sameer Dhuri I017
Jivesh Kaul I027
Adwait Nadkarni I037
Punit Sethia I046
Siddharth Srivastava I056

THE NEOGI CHEMICAL COMPANY

1. Should company accept project 1? How would you evaluate its viability make
calculation of cash flows, cost of capital and profitability of the project? Compute the
net present value and internal rate of return of the project.
Solution in Excel

2. What are the limitation of payback period and accounting rate of return as methods in
measuring an investment’s worth? What factors are usually used to justify the use of
the payback period? In what situations is it justifiable?

Limitations of payback period - 

 The time-value of money (TVM) is not taken into account and cash inflows are
adjusted accordingly. The TVM is the notion that in the future the worth of cash
today is more than that.
 The payback model fails to consider cash inflows that arise beyond the payback
period and therefore fails to compare the overall productivity of one project with
that of another.
 The consistency of the study of the payback period falls short, without taking into
account the complexities of the cash flows that may arise with capital investment. 
 This approach often fails to take into account certain factors such as risk,
financing or any other considerations that come into play with certain investment.

Limitations of ARR -

The 8 disadvantages of accounting rate of return are:

 The ignorance of the time factor-The method is known to ignore time factor when
selecting an alternate use of a fund.
 Ignorance of external factors-The method is known not to take the external factors
that hinder the profit earning capacity of a project, into consideration.
  Creates decision making problems-People will arrive at different results if the ROI
(return on investment) and the ARR (accounting rate of returns) are calculated
separately.
 Only considers accounting profits-The method does not take the cash inflow into
consideration and is only interested in accounting profits.
 ARR is not all that is required-To calculate the rate of return only the ARR
method is not required.
 Unhelpful at sometimes-Cannot appraise projects where instalments of the
investments have been made more than two times and in separate parts.
 Life period investment-The lifetime of multiple investments is not considered by
the method. But while calculating the average earnings, the lifetime of
investments are taken into account.
 Ignores time frame-The method overlooks the period that the investments take to
earn profits.

Factors that are usually used to justify the use of payback period and the situations in
which it is justifiable are:
 Money invested in a project needs to be recovered within a short period of time.
 This method of analysis is particularly helpful for smaller firms that need a short
payback period of the liquidity generated by a capital investment. The earlier it
replaces the funds used for capital investments, the sooner it can be diverted to
other capital investments. A quicker payback period also reduces the risk of loss
occurring from possible changes in economic or market conditions over
 When considering two similar investments in capital, a firm will be inclined to
select the one with the shortest payback period. The payback period shall be
determined by dividing the capital investment costs by the projected annual cash
inflows resulting from the investment.
 Some companies rely heavily on an estimation of the payback period and only
accept investments for which the payback period does not exceed a number of
years defined. And, usually, longer investment periods are not required.

3. Why NPV method considered being better than IRR method? Why do NPV and IRR
methods give different results (refer to the Exhibit II of the case)?
NPV method is considered being better than the IRR method because of its closeness
to the actual discount rate, IRR states that the cash flows earned are reinvested at the
given IRR rate which could give wrong results in a number of cases, however NPV
states that the money or the cash flow is reinvested at the cost of capital. Because of
this reason NPV is considered a better method than IRR, due to realistic reinvestment
rate assumptions which offers a better view in terms of both the profitability and the
liquidity of any project. Another, reason being that there can be multiple IRR
problems when doing the IRR Method as a result it is difficult to interpret the actual
results from the project, however in case of a NPV the interpretation is simple when it
is positive the project is profitable, if its negative, the project is not worth doing. The
same interpretation cannot be applied to the IRR method though, as we can’t come
out with inferences out of a negative IRR.
 When it comes to considering Exhibit II the NEOGI CHEMICALS COMPANY Case,
it is seen that the following are the results of the NPV and IRR method-
1. Project A NPV@10% is 4140 and IRR is 26.55%
2. Project B NPV@10% is 3824 and IRR is 37.63%
The conflicting results in the value comes due to variation in the pattern as well as
size of the cash inflows, it is seen that for year 1 project A has a cash inflow of 2000
whereas B has an inflow of 10,000 it is due to these differences, the value of the NPV
and IRR gives conflicting results. The size of the project, the tenure of the project is
same, so the only difference is created due to the variation in the size of the cash
flows.

4. You just heard Mr. Neogi saying the following: “The Project No.1 if accepted would
be financed by raising ten years 15 percent debt? Do you agree that the required rate
of return should only exceed after tax cost of debt?

No, the required rate of return should exceed the WACC and not just the after-tax cost
of debt.

5. Why is it necessary to assume that the capital structure would be maintained at a debt
equity ratio of 1:1 in the long run?

A ratio of 1 would mean creditors and investors in the company's assets are on an
equal footing. For a business with significant cash flow production, a higher debt-
equity ratio is beneficial but not preferable when a corporation is in decline. Debt
costs are generally lower, and equity costs are higher than the debt costs. Therefore, a
company in the long run should aim for 1:1 debt to equity ratio.

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