University of St.

La Salle
In Partial fulfillment of the requirements in

Comprehensive Financial Management

Case Study No. 6

The Dilemma at Day Pro

(Capital Budgeting)

Submitted by:

Raymond A. Artates
Dave Mark P. Sumagaysay
Joseph Rey S. Maquiran

Submitted to:

Felix D. Cena, CPA, Ph.D.

October 28, 2020

I- Background of the Case
The Day-Pro Chemical Corporation has managed to earn a consistently high rate of return on its
investments since its establishment in 1995. Currently, the management of the company is
considering the manufacture of a thermosetting resin as packaging material for electronic
products. The Company’s Research and Development teams have come up with two alternatives:

1. Synthetic Resin, which would cost more to produce initially but would have greater
economies of scale.
2. Epoxy Resin, which would have a lower startup costs

The project leaders of both teams presented their cash flow projections and provided sufficient
documentation in support of their proposals. However, since the products are mutually exclusive,
the firm can only fund one proposal.

Tim Palmer, the Assistant Treasurer, and a recent MBA from a prestigious mid-western university,
has been assigned the task of analyzing the costs and benefits of the two proposals and
presenting his findings to the board of directors. The board of directors are not that familiar with
financial concepts.

The Board historically had a strong preference for using rates of return as its decision criteria. On
occasions it has also used the payback period approach to decide between competing projects.
However, Tim is convinced that the net present value (NPV) method is least flawed and when
used correctly will always add the most value to a company’s wealth.

Upon initial assessment of the cash flow projections, Tim was confused. The various capital
budgeting techniques provide inconsistent results. The project with the higher NPV has a longer
payback period, as well as a lower Accounting Rate of Return (ARR) and Internal Rate of Return
(IRR). Tim scratches his head, wondering how he can convince the Board that the IRR, ARR, and
Payback Period can often lead to incorrect decisions.

II- Point of View

The point of view of Tim is taken for this case analysis. His MBA degree will help shed light on
various methods of evaluating capital investment decisions.

III- Statement of the Problem

Primary Problem:
What is the best model that the company should use in evaluating which packaging material is to
be used and which project should be accepted based on that model?

Secondary Problem(s):
1. What is the decision under each method?
2. How should Tim convince the board that the IRR measure could be misleading?
3. How can Tim convince the board that NPV method is the way to go and what is a crossover
point?
4. Is Modified Internal Rate of Return more realistic in mutually exclusive projects?
IV- Areas for Consideration

The following factors were considered in the analysis of this case:

1. The projects are Mutually Exclusive.
2. Limited background of the board to finance concepts.
3. Historical preference of the board for using rates of return as decision criteria.
4. Occasional use of payback period approach to decide on competing projects.

Projected Cash Flows for Synthetic Resin

Projected Cash Flows for Epoxy Resin

V- Alternative Course of Action

Alternative No. 1 Evaluate the project using Payback Period

The Payback Period of Synthetic Resin is 2.5 years and for Epoxy Resin is 1.5 years.

In this matter, Epoxy Resin is the best option. As we all know that the shorter the payback
period the more desirable the investment.

But there is one problem in using the calculation of payback period, it ignores the time value of
money. It does not account for what happens after payback, ignoring the opportunity cost and
the overall profitability of an investment. These are the points Tim should make to show that the
Payback Period is not appropriate in this case.
Alternative No. 2. Evaluation the project using discounted payback period

Though it indicates the profitability of a project while reflecting the timing of cash flows and the
time value of money, discounted payback period analysis still ignores the cash flows after the
payback period. Thus, it cannot tell Tim or the investors on how the investment will perform
afterward and how much value it will add in total. Tim should not ask the Board to use DPP as
the deciding factor.
Alternative No. 3. Evaluate the project using Accounting Rate of Return

If the management prefers to have 40% ARR, they would choose the Synthetic Resin. Though
Epoxy Resin is the closest to their ideal ARR, Synthetic Resin with 64% of ARR still has a
bigger return for the company, so they would prefer the Synthetic Resin if they will use this
method.

The accounting rate of return is helpful in determining a project's annual percentage rate of
return. However, the calculation has its limitations.

ARR doesn't consider the time value of money (TVM).

The accounting rate of return does not consider the increased risk of long-term projects and the
increased uncertainty associated with long periods. Also, ARR does not take into account the
impact of cash flow timing.

Alternative No. 4. Evaluate the project using Internal Rate of Return (IRR)

The internal rate of return is a metric used in financial analysis to estimate the profitability of potential
investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all
cash flows equal to zero in a discounted cash flow analysis. Companies prefer the projects with an
internal rate of return higher than the hurdle rate or required rate of return. The computation of the
Internal Rate of Return are as follows:
To check:
To check:

Based on the Internal Rate of Return of the two, Epoxy Resin should be chosen by the company
assuming that the required rate of return is 20%. Since the two are mutually exclusive projects,
only one can be chosen. The Internal Rate of Return of Epoxy resin of 42.91% is higher than
that of Synthetic Resin of just 36.63%.

Although the internal of returns indicates the project’s profitability, it is often at a very high rate
that is likely unreasonable. Following the reinvestment assumption, the rate it assumes to be
reinvested is that of the internal rate of return rather than being reinvested using the required
rate of return or the WACC.

Alternative No. 5 - Evaluate the project using Modified Internal Rate of Return (MIRR)

The modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at
the firm's cost of capital and that the initial outlays are financed at the firm's financing cost. By
contrast, the traditional internal rate of return (IRR) assumes the cash flows from a project are
reinvested at the IRR itself. The MIRR, therefore, more accurately reflects the cost and
profitability of a project. Below is the computation of the MIRR:
Based on the Modified Internal Rate of Returns, assuming a 10% required return rate, the
company should use Synthetic Resin as packaging material because it has a higher MIRR at
25.11% compared to only 22.36% MIRR of Epoxy Resin. One advantage of using the Modified
Internal Rate of Return is that it assumes that the cash flows are reinvested at the required rate
of return or the weighted average cost of capital. Hence, the rate they arrive into is more realistic
compared to the standard Internal Rate of Return. Although the modified internal rate of return
corrects some of the mistakes of the internal rate of return, the exclusive use of modified internal
rate of return has its own drawbacks. One is that it does not give you an idea of the actual value
of the choice since it only provides a rate. Also, it requires too much input such as cash flows and
required rate of return which can be very subjective and yield unreliable results.
Alternative No. 6. Evaluate the project using the Net Present Value method.

Net present value (NPV) is a method used to determine the current value of all future cash flows
generated by a project, including the initial capital investment. It is widely used in capital budgeting
to establish which projects are likely to turn the greatest profit.. The computation for the Net
Present Value of the two options are as follows:

Based on the Net present value of Synthetic Resin and Epoxy Resin, the company should choose
Synthetic Resin as the present value of its cash flows are greater than that of Epoxy Resin at an
assumed rate of return of 10%. Following the reinvestment assumption, the synthetic resin will
yield more value in the future compared to epoxy resin.

Comparing the two options a lot closer, we can see that at 29.17% net present value of the two
are equal. This is called the crossover point.
Using the crossover point, we can further analyze and decide which option to choose. If the
required rate of return is more than the crossover rate of 29.17% there will be no conflict as the
net present value and the internal rate of return of Epoxy Resin is more than that of synthetic
resin. But assuming the required rate of return is less than 29.17%, there is now a conflict between
the two as the net present value of synthetic resin is more than that of epoxy but the internal rate
of return of epoxy is more than that of synthetic resin. This could arise due to two main reasons:

1. Timing differences. If most of the cash flows from one project come in early while most of
those from the other project come in later, as occurred with the case here the NPV profiles
may cross and result in a conflict.
2. Project size (or scale) differences. If the amount invested in one project is larger than the
other, this too can lead to profiles crossing and a resulting conflict.

When size or timing differences occur, the firm will have different amounts of funds to invest in
the various years depending on which of the two mutually exclusive projects it chooses.
The experts have always advised us to resolve the conflict by giving more weight to the net
present value of the problems in conflict as it gives us more information about the value rather
than just rates.

VI- Conclusion Recommendations

The Net Present Value method is the best way to go in analyzing capital investments decisions.
It provides us a direct measure of value of the projects that it adds to shareholder value. The
Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR) measure profitability
expressed as a percentage rate of return, which is useful to decision makers.
Further, IRR and MIRR contain information concerning a project’s “safety margin.” The modified
IRR has all the virtues of the IRR, but it incorporates a better reinvestment rate assumption and
avoids the multiple rate of return problem. So if decision makers want to know projects’ rates of
return, the MIRR is a better indicator than the regular IRR.

In summary, the different measures provide different types of information. Because it is easy to
calculate all of them, all should be considered when capital budgeting decisions are being
made. For most decisions, the greatest weight should be given to the NPV, but it would be
foolish to ignore the information provided by the other criteria. Also, looking at the MIRR and Net
Present Value methods, the results point out that the Synthetic Resin is the much better option
capital budgeting wise as it provides both greater net present value and modified internal rate of
return at an assumed required rate of return of 10%,

Based on the foregoing conclusions, it would be best for the company to adopt the use of
Synthetic Resin as packaging material for its products.