24 Jul HOW SHOULD MIKE CONVINCE THE BOARD THAT THE NPV METHOD IS THE WAY TO GO?
The Day-Pro Chemical Corporation established in 1995 has managed to earn a consistently high rate Show more The Day-Pro Chemical Corporation established in 1995 has managed to earn a consistently high rate of return on its investments. The secret of its success has been the strategic and timely development manufacturing and marketing of innovative products that have been used in various industries. Currently the management of the company is considering the manufacture of a thermosetting resin as packaging material for electronic products. The Companys Research and Development teams have come up with two alternatives: an epoxy resin which would have a lower startup cost and a synthetic resin which would cost more to produce initially but would have greater economies of scale. At the initial presentation 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. In order to resolve this dilemma Mike Matthews the Assistant Treasurer and a recent MBA from a prestigious New England 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. Mike knows that this will be an uphill task since the board members are not all on the same page when it comes to financial concepts. The Board has 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 Mike is convinced that the net present value (NPV) method is least flawed and when used correctly will always add the most value to a companys wealth. Calculate the cash flow projections for each project (see Tables 1 & 2). The initial investment for the synthetic resin is $2000000. The initial investment for the epoxy resin is $1600000. Both projects will be depreciated on a straight-line basis to a zero salvage value. Table 1. Synthetic Resin Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Net Income $300000 $500000 $600000 $900000 $1000000 Depreciation (straight-line Net Cash Flow Table 2. Epoxy Resin Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Net Income $880000 $480000 $280000 $80000 $80000 Depreciation (straight-line Net Cash Flow After looking at the cash flow projections Mike realized that this is going to be difficult than he thought. The various capital budgeting techniques when applied to the two series of cash flows provide inconsistent results. The project with the higher NPV has a longer payback period as well as a lower Internal Rate of Return (IRR). Mike scratches his head wondering how he can convince the Board that IRR and Payback Period can often lead to incorrect decisions. Answer the following: Calculate the Payback Period of each project. Explain what argument Mike should make to show that the Payback Period is not appropriate in this case. Calculate the two projects IRR. Explain what argument Mike should make to show that the IRR measure could be misleading. Construct a graph of the NPV profiles for the two projects and calculate and explain the relevance of the crossover point. How should Mike convince the Board that the NPV method is the way to go? In looking over the documentation prepared by the two project teams it appears to Mike that the synthetic resin team has been somewhat more conservative in its revenue projections that the epoxy resin team. What impact might this have on his analysis? Show less
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