Egret Printing Company, Sample of Business plans

14 pages, 6991 words

1. ————————————————-

Case Overview

Egret Printing and Publishing Company is a family owned speciality printing business. It was founded by John and Keith Belford in 1956 after they were discharged from the US Army. Patrick Hill who is the son in law of Keith Belford joined the firm in 1979 in the Accounting Department. He was promoted as a treasurer in 1988 and then as the Vice-President of Finance in 1994. His main responsibility was to look after both, the internal and external financial operations, but more importantly the internal ones. John and Keith Belford are said to possess nature that is of extreme conservatism and this was due to the fact that their father had suffered a great deal under a crushing burden of debt during the Great Depression of the 1930’s.And it was because of this that the Belford brothers vowed never to get deeply into debt.

However, Hill currently is busy carrying out a detailed analysis of four major capital investment proposals that the Belfords have identified as possible candidates for funding in the coming year. A description of each of the four projects is also given that includes information such as the costs and expected after-tax cash flows(net income plus depreciation).All of the four projects are considered to be equally risky and their risk is about the same as that of the company’s other assets.

PROJECT A: Major Plant Expansion

The company operates mainly as a full-range printer of high quality; four colours offset advertising materials, calendars, speciality tabloids, business printing and some books. Competition that exists in their market segment is based more on quality of the finished goods and rapid delivery on short notice than on the price of the various services. The volume of orders filled each month has been rising steadily over the past five years, and all indications point to a continuation or even an acceleration of this trend. Egret recently has lost several sizable contracts as there was not enough capacity to produce the material in the short time required by the customers. This projects A has thus been designed to reduce the capacity problem by constructing a new wing on the main plant. This additional space would allow Egret to hold a greater variety of paper stock in inventory and to reposition its various presses for a more efficient work flow. The expansion would also enable a new bindery room and extra space for the Special Services Department that specialises in low volume custom book printing and binding. The heart of this operation is a computerized selection and retrieval system tied directly to a computer typesetter and printing press. The expansion would also make it possible to carry out various jobs simultaneously.

2 pages, 611 words

The Business plan on Choosing the best project for the company

I would like to thank you for providing me with the essential information from your previous email to analyze the following projects Juniper, Palomino, and Stargazer. This information has provided me guidance with choosing the best project for the company. This email will provide you with the recommendation and proposal of the most beneficial project for the company. The project that fits our ...

PROJECT B: Alternative Plan for Plant Expansion

After tentatively deciding to go with Project A, an alternative, Project B was proposed. This project mainly dealt with the renovation of the present printing plant by moving some non-load bearing walls and rearranging some of the operations which would thus enable the plant to gain extra storage room and more efficiently arranged printing equipment. The modifications required are extensive and business will be lost during the renovation. Hence this alternative has the same expense as that of Project A. This project can be finished much more quickly and will allow Egret to take several major printing jobs in the next few years that otherwise will likely be lost to competitors.

PROJECT C: Purchase of New Press

The company has never been able to obtain the printing contract for high quality colour calendars that are sold by various wildlife and nature societies as it lacks the high resolution colour offset press required for such work. Under Project C the company would alleviate this by acquiring the latest equipment designed for this kind of printing function. This project could be incorporated with Project A or B with little inconvenience and the profitability of the expansion programs will not be affected by acceptance or rejection of this project. However, Project C would not be feasible if in case both Project A and B are rejected.

8 pages, 3765 words

The Business plan on Wal Mart Capital Company Ratio

Introduction Every business decision is associated in one way or another with the financial condition of the organization. The results of a working capital analysis will assist in the determination of organization! |s ability to remain in a particular line of business. The primary focus of Team C! |s analysis of Wal-Mart, Inc is its current and future financial condition. The most imperative areas ...

Project D: Upgrade of Egret’s Video Text Service

Egret had purchased a local video text services that had been operating locally for several years. It is included as extra charge feature on the local cable television system and over one half of the system’s subscriber’s pay for the video text service. The upgrade would make it possible to update the information presented on the screen much more quickly and would increase the reliability. The system has experienced a downfall in the past years where some subscribers have cancelled their participation and the growth of new sign-ups has fallen off.

Hill estimates that approximately $1.5 million will be available for new capital projects from the internal sources. The estimated cost of equity currently calculated to be 15%, has been used in the past for internal funds. Under the existing all-equity capital structure, any additional funds employed in the business will have to come from the Belford Brothers. For them to make these funds available personal security holdings will have to be liquidated.

However, Hill has been working on to change the firm’s policy by introducing the use of debt to complete the current analysis which in turn would lower the cost-of-capital. He wishes to be able to explain the advantages of debt financing to the Belford Brothers and also show them the effect of a change in the capital structure on the capital budget. He has also talked about this with the company’s bankers who have told him that the company can borrow $500,000 at an interest rate of 12% and reduce the weighted average cost of capital from the present 15%. The tax rate used by the company is 46%.After discussing about the issue with the Belford brothers Hill concluded that their opportunity cost on outside investment is 21%, while the cost of internal funds is 15% only. Hill is also working on a five year financial plan for the company, developing estimates of capital investment opportunities and financing sources for this period. However since the plan is at its initial stage so he cannot formally incorporate it into the capital budgeting recommendations for the current year. But he is confident about the fact that he will be successful in persuading the Belford brothers to use a small amount of debt financing which will lower the cost of capital and also that the recently initiated employee incentive program which is designed to generate new project ideas will bear fruit with the result that Egret Printing and Publishing company will be able to invest more money at higher rates of return in the future than it has been able to generate in the past.

4 pages, 1643 words

The Dissertation on Related Literature to the Cash Flow Management

... factor is to calculate the project cash flows of the future in real terms with real discount rates. Cash flow estimation is a must ... how it was spent over a specific period of time. A cash flow statement counters the ambiguity regarding a company’s ... cash flow information though. Deakin (1972) demonstrated employing MDA that cash flow to total debt was a significant predictor up to three years ...

2. ————————————————-

ANSWER NO.1

a) Ordinary Payback Period

Project A

| Cash Flows | Cumulative Cash Flows |

Original Investment | – 500,000 | – 500,000 |

Year 1 | 136,000 | – 364,000 |

Year 2 | 136,000 | – 228,000 |

Year 3 | 136,000 | – 92,000 |

Year 4 | 618,800 | 526,800 |

Payback Period = 3 + (92,000/618,000)

= 3.15 years

Project B

| Cash Flows | Cumulative Cash Flows |

Original Investment | – 500,000 | – 500,000 |

Year 1 | 370,000 | – 130,000 |

Year 2 | 270,000 | 140,000 |

Year 3 | 155,000 | 295,000 |

Year 4 | 49,000 | 344,000 |

Payback Period = 1 + (130,000/270,000)

= 1.48 years

Project C

| Cash Flows | Cumulative Cash Flows |

Original Investment | – 1,000,000 | – 1,000,000 |

Year 1 | 323,000 | – 677,000 |

Year 2 | 323,000 | – 354,000 |

Year 3 | 323,000 | – 31,000 |

Year 4 | 323,000 | 292,000 |

Year 5 | 323,000 | 615,000 |

Year 6 | 323,000 | 938,000 |

Year 7 | 323,000 | 1,261,000 |

Year 8 | 323,000 | 1,584,000 |

Year 9 | 323,000 | 1,907,000 |

4 pages, 1572 words

The Review on Final Year Project Report

My deepest appreciation also goes out to Mrs. Sharatul Izah Bt. Samsudin who gave me many needed support, encouragement and help throughout my project’s improvement in PSM I, and my friends who struggling with me exploring this scope. Not to forget, thanks to my family and fellow friends who encouraged me. Finally, thank you to all those involved directly and indirectly helping me out during my ...

Year 10 | 323,000 | 2,230,000 |

Payback Period = 1,000,000/323,000

= 3.1 years

Project D

| Cash Flows | Cumulative Cash Flows |

Original Investment | – 500,000 | – 500,000 |

Year 1 | 175,000 | – 325,000 |

Year 2 | 175,000 | – 150,000 |

Year 3 | 175,000 | 25,000 |

Year 4 | 175,000 | 200,000 |

Year 5 | 175,000 | 375,000 |

Payback Period = 500,000/175,000

= 2.86 years

b) Discounted Payback Period

Project A @ 15 % discount rate

0 | – 500,000 | 1 | -500,000 | -500,000 |

1 | 136,000 | 0.870 | 118,320 | -381,680 |

2 | 136,000 | 0.756 | 102,816 | -278,864 |

3 | 136,000 | 0.658 | 89,488 | -189,376 |

4 | 618,800 | 0.572 | 353,953.6 | 164,577.6 |

Discounted Payback Period = 3 + (189,376/353,953.6)

= 3.54 years

Project A @ 21 % discount rate

0 | – 500,000 | 1 | -500,000 | -500,000 |

1 | 136,000 | 0.826 | 112,336 | -387,664 |

2 | 136,000 | 0.683 | 92,888 | -294,776 |

3 | 136,000 | 0.565 | 76,840 | -217,936 |

4 | 618,800 | 0.467 | 288,979.6 | 71,043.6 |

Discounted Payback Period = 3 + (217,936/288,979.6)

= 3.75 years

Project B @ 15 % discount rate

0 | – 500,000 | 1 | -500,000 | -500,000 |

1 | 370,000 | 0.870 | 321,900 | -178,100 |

2 | 270,000 | 0.756 | 204,120 | 26,020 |

3 | 155,000 | 0.658 | 101,990 | 128,010 |

4 | 49,000 | 0.572 | 28,028 | 156,038 |

Discounted Payback Period = 1 + (178,100/204,120)

= 1.87 years

Project B @ 21 % discount rate

0 | – 500,000 | 1 | -500,000 | -500,000 |

1 | 370,000 | 0.826 | 305,620 | -194,380 |

2 | 270,000 | 0.683 | 184,410 | -9,970 |

3 | 155,000 | 0.565 | 87,575 | 77,605 |

4 | 49,000 | 0.467 | 22,883 | 100,488 |

1 page, 227 words

The Essay on Net Present Value and Appropriate Discount Rate

Energy Costs Find information on energy cost: Advantages (government websites) 2 - Cost of Equity, Appropriate Discount Rate (WACC) Cost of equity 1. Formula Risk Free Rate + (Market Premium x Overall Company Beta) 2. Each part a. Risk free rate (10-year T-bill) i. bond rating chosen * interest rate * b. Market premium c. Beta i. Appropriate Discount Rate (WACC) 1. Formula Weight of Debt x After- ...

Discounted Payback Period = 2 + (9,970/87,575)

= 2.11 years

Project C @ 15 % discount rate

0 | – 1,000,000 | 1 | -1,000,000 | -1,000,000 |

1 | 323,000 | 0.870 | 281,010 | -718,990 |

2 | 323,000 | 0.756 | 244,188 | – 474,802 |

3 | 323,000 | 0.658 | 212,534 | – 262,268 |

4 | 323,000 | 0.572 | 184,756 | – 77,512 |

5 | 323,000 | 0.497 | 160,531 | 83,019 |

6 | 323,000 | 0.432 | 139,536 | 222,555 |

7 | 323,000 | 0.376 | 121,448 | 344,003 |

8 | 323,000 | 0.327 | 105,621 | 449,624 |

9 | 323,000 | 0.284 | 91,732 | 541,356 |

10 | 323,000 | 0.247 | 79,781 | 621,137 |

Discounted Payback Period = 4 + (77,512/160,531)

= 4.48 years

Project C @ 21 % discount rate

0 | – 1,000,000 | 1 | -1,000,000 | -1,000,000 |

1 | 323,000 | 0.826 | 266,798 | -733,202 |

2 | 323,000 | 0.683 | 220,609 | -512,593 |

3 | 323,000 | 0.565 | 182,495 | -330,098 |

4 | 323,000 | 0.467 | 150,841 | -179,257 |

5 | 323,000 | 0.386 | 124,678 | -54,579 |

6 | 323,000 | 0.319 | 103,037 | 48,458 |

7 | 323,000 | 0.263 | 84,949 | 133,407 |

8 | 323,000 | 0.218 | 70,414 | 203,821 |

9 | 323,000 | 0.180 | 58,140 | 261,961 |

10 | 323,000 | 0.149 | 48,127 | 310,088 |

Discounted Payback Period = 5 + (54,579/103,037)

= 5.53 years

Project D @ 15 % discount rate

0 | – 500,000 | 1 | -500,000 | -500,000 |

1 | 175,000 | 0.870 | 152,250 | -347,750 |

2 | 175,000 | 0.756 | 132,200 | – 215,450 |

3 | 175,000 | 0.658 | 115,150 | – 100,300 |

4 | 175,000 | 0.572 | 100,100 | – 200 |

5 | 175,000 | 0.497 | 86,975 | 86,775 |

Discounted Payback Period = 4 + (200/86,975)

= 4.02 years

Project D @ 21 % discount rate

2 pages, 567 words

The Essay on Interest Rate Year Earnings European

Lagging Earnings, Interest Rates Make Year-End Rally Unlikely Many European fund managers arent going to find anything good this Christmas to be merry about. In most years, particularly lackluster ones, there seems to always be the year-end rally that puts the fund managers performance up to the standard. And makes the woes of the years financial problems on either side of the Atlantic a little ...

0 | – 500,000 | 1 | -500,000 | -500,000 |

1 | 175,000 | 0.826 | 144,550 | -355,450 |

2 | 175,000 | 0.683 | 119,525 | -235,925 |

3 | 175,000 | 0.565 | 98,875 | -137,050 |

4 | 175,000 | 0.467 | 81,725 | -55,325 |

5 | 175,000 | 0.386 | 67,550 | 12,225 |

Discounted Payback Period = 4 + (55,325/67,550)

= 4.82 years

c) Net Present Value

From above calculation of Discounted Payback Period we can determine the Net Present Value @ 15% discount rate as follows:

Project A = 164,577.6

Project B = 156,038

Project C = 621,137

Project D = 86,775

From above calculation of Discounted Payback Period we can determine the Net Present Value @ 21% discount rate as follows:

Project A = 71,043.6

Project B = 100,488

Project C = 310,088

Project D = 12,225

d) IRR (Internal Rate of Return)

Project A

Year | CFs | PVIF @ 26% | PV | PVIF @ 27% | PV |

0 | – 500,000 | 1 | – 500,000 | 1 | – 500,000 |

1 | 136,000 | 0.794 | 107,984 | 0.787 | 107,032 |

2 | 136,000 | 0.630 | 85,680 | 0.620 | 84,320 |

3 | 136,000 | 0.500 | 68,000 | 0.488 | 66,368 |

4 | 618,800 | 0.397 | 245,663.6 | 0.384 | 237,619.2 |

NPV | | | 7,327.6 | | – 4,660.80 |

IRR = lower rate + NPV of LR / NPV of LR – NPV of HR (HR–LR)

= 26 + 7,327.6/ 7,327.6+4,660.80 (1)

= 26.61%

Project B

Year | CFs | PVIF @ 35% | PV | PVIF @ 36% | PV |

0 | – 500,000 | 1 | – 500,000 | 1 | – 500,000 |

1 | 370,000 | 0.741 | 274,170 | 0.738 | 273,060 |

2 | 270,000 | 0.549 | 148,230 | 0.541 | 146,070 |

3 | 155,000 | 0.406 | 62,930 | 0.398 | 61,690 |

4 | 49,000 | 0.301 | 14,749 | 0.292 | 14,308 |

NPV | | | 79 | | – 4,872 |

IRR = Lower Rate + NPV of LR / NPV of LR – NPV of HR (HR–LR)

= 35 + 79/ 79+4,872 (1)

= 35.02%

Project C (Method 1)

Year | CFs | PVIF @ 29% | PV | PVIF @ 30% | PV |

0 | – 1,000,000 | 1 | – 1,000,000 | 1 | – 1,000,000 |

1 | 323,000 | 0.775 | 250,325 | 0.769 | 248,387 |

2 | 323,000 | 0.601 | 194,123 | 0.592 | 191,216 |

3 | 323,000 | 0.466 | 150,518 | 0.455 | 146,965 |

4 | 323,000 | 0.361 | 116,603 | 0.350 | 113,050 |

5 | 323,000 | 0.280 | 90,440 | 0.269 | 86,887 |

6 | 323,000 | 0.217 | 70,091 | 0.207 | 66,861 |

7 | 323,000 | 0.168 | 54,264 | 0.159 | 51,357 |

8 | 323,000 | 0.130 | 41,990 | 0.123 | 39,729 |

9 | 323,000 | 0.101 | 32,623 | 0.094 | 30,362 |

10 | 323,000 | 0.078 | 25,194 | 0.073 | 23,579 |

NPV | | | 26,171 | | – 1,607 |

IRR = Lower Rate + NPV of LR / NPV of LR – NPV of HR (HR–LR)

= 29 + 26,171/26,171+1,607 (1)

= 29.94%

Project C (Method 2)

PV @ 29% = 323,000 X PVIFA 29%, 10 yrs

= 323,000 X 3.178

= 1,026,494

NPV = 1,026,494 – 1,000,000

= 26,494

PV @ 30% = 323,000 X PVIFA 30%, 10 yrs

= 323,000 X 3.092

= 998,716

NPV = 998,716 – 1,000,000

= – 1,284

IRR = Lower Rate + NPV of LR / NPV of LR – NPV of HR (HR–LR)

= 29 + 26,494/26,494+1,284 (1)

= 29.95%

Project D (Method 1)

Year | CFs | PVIF @ 22% | PV | PVIF @ 23% | PV |

0 | – 500,000 | 1 | – 500,000 | 1 | – 500,000 |

1 | 175,000 | 0.820 | 143,500 | 0.813 | 142,275 |

2 | 175,000 | 0.672 | 117,600 | 0.661 | 115,675 |

3 | 175,000 | 0.551 | 96,425 | 0.537 | 93,975 |

4 | 175,000 | 0.451 | 78,925 | 0.437 | 76,475 |

5 | 175,000 | 0.370 | 64,750 | 0.355 | 62,125 |

NPV | | | 1,200 | | – 9,475 |

| | | | | |

IRR = Lower Rate + NPV of LR / NPV of LR – NPV of HR (HR–LR

= 22 + 1,200/ 1,200+9,475 (1)

= 22.11%

Project D (Method 2)

PV @ 22% = 175,000 X PVIFA 22%, 5yrs

= 175,000 X 2.864

= 501,200

NPV = 501,200 – 500,000

= 1,200

PV @ 23% = 175,000 X PVIFA 23%, 5yrs

= 175,000 X 2.804

= 490,700

NPV = 540,700 – 500,000

= – 9,300

IRR = Lower Rate + NPV of LR / NPV of LR – NPV of HR (HR–LR)

= 22 + 1,200/ 1,200+9,300 (1)

= 22.11%

| -500,000.00 | -500000.00 | -1,000,000.00 | -500,000.00 |

| 136,000.00 | 370000.00 | 323,000.00 | 175,000.00 |

| 136,000.000 | 270000.00 | 323,000.00 | 175,000.00 |

| 136,000.000 | 155000.00 | 323,000.00 | 175,000.00 |

| 618,800.000 | 49000.00 | 323,000.00 | 175,000.00 |

| | | 323,000.00 | 175,000.00 |

| | | 323,000.00 | |

NPV @ 15% | $164577.6 | $156038 | $621137 | $86775 |

NPV @ 21% | $71043.6 | $100488 | $310088 | $12225 |

IRR | 26.61% | 35.02% | 29.94% | 22.11% |

Rank the investment proposals considering the capital budget of $1.5 million.

| | | | |

Rank: C, A, B, D at 15% discount rate

C, B, A, D at 21% discount rate

The given rank has been given with the help of NPV summarized in above table. There may arise some degree of problem while choosing between project A and project B. We may rank project B in second place because it provide greater cash flow in earlier years so the Net Present Value is greater even when the discount rate is higher. Even though project A has higher NPV than project B at discount rate of 15% but the difference is much higher in favor of project B when the discount rate has increased to 21%.

We have considered Net Present Value for ranking these projects because of following reasons:

* It takes into account all cash flows.

* All cash flows are discounted at the appropriate market-determined opportunity cost of capital.

* NPV of a project is exactly the same as the increase in shareholders’ wealth as can be seen from below:

* Pay off all interest payments to creditors.

* Pay off all expected returns to shareholders.

* Pay off the original investment.

Which projects should the company choose and why?

| | | | | |

A and C | 1,500,000 | $785,714.60 | 1 | $381,131.60 | 2 |

B and C | 1,500,000 | $777,175.00 | 2 | $410,576.00 | 1 |

C and D | 1,500,000 | $707,912.00 | 3 | $322,313.00 | 3 |

A and D | 1,000,000 | $251,352.60 | 4 | $83,268.60 | 5 |

B and D | 1,000,000 | $242,813.00 | 5 | $112,713.00 | 4 |

The company should choose the combination of Project A and Project C when discount rate is 15% whereas it will be beneficial for the company to choose the combination of Project B and Project C when discount rate is 21%. The company should choose project C because it has much higher NPV than other projects with very much acceptable IRR. Furthermore, Project C i.e. Purchase of new press will enable the company to print high quality color calendars sold by various wildlife and nature societies with high resolution color gaining good competitive advantage for the company. The company should also choose Project A at 15% discount rate along with C because it has the highest NPV after project C with highest IRR among the alternative projects. The company should also choose Project B at 21% discount rate along with C because it has the highest NPV after Project C with acceptable IRR among the alternative projects.

Which discount rate is more appropriate?

15 % discount rate is more appropriate as compared to 21% for the company because at 15%, Net Present Values are higher for any project. And since decision based on NPV is the best decision to make, a higher NPVs obtained at a discount rate of 15% makes it the more appropriate discount rate to use.

Comparison of Different Projects

Fig: Comparison of NPV at different rates of all the projects

Fig: Comparison of Payback period and discounted payback period at different rates of all the projects

Fig: Comparison of IRR of all the projects

3. ————————————————-

ANSWER NO. 2

Payback Period:

It is the number of years required to recover the initial capital outlay on a project. It may be computed as indicated below if cash are equal or even,

Payback period=Original IvestmentAnnaul Cash Flow

Though the payback period is a widely used method formally or informally, it has serious limitations. Some of those are:

* Fails to consider time value of money.

* Not a measure of profitability.

* Fails to consider all the cash flows. Ignores cash flows occurring after the payback period.

* Fails to consider the magnitude and timing of cash flows.

In case of discounted payback period as well, although it considers time value of money, it fails to consider all the cash flows. Hence, payback period is good as a secondary measure only. The firm cannot fully rely on this method only for choosing among the projects.

Net Present Value:

This method requires finding the present value of the expected net cash flows of an investment, discounted at the cost of capital, and subtracting from it the initial cost outlay of the project. This rule suggests that the project is worth accepting if NPV is positive else it should be rejected. It requires that the firm knows its cost of capital or discounting factor precisely.

This method is good only if the firm knows the cost of capital or discounted factor fairly correctly and which may not be the current cost prevailing in the market. Further on, the investment that is made may not have the same level of risk throughout the entire time horizon. Another drawback is that, it wholly excludes any real option that may exist within the investment. Thus, NPV is a useful starting point to value investments, but certainly not a definitive answer that an investor can rely on for all investment decisions.

Internal Rate of Return:

The IRR is defined as the interest rate that equates the present value of the expected future cash flows, or receipts, to the initial cost outlay. The decision rule for acceptance and rejection is as below:

If IRR > k, accept project

If IRR < k, reject project

K= cost of capital

The disadvantage of using this method as our selection criteria are:

1. To understand IRR is difficult

It is difficult to understand as there may be two experimental rates because of unequal present value of cash inflow with present value of cash outflow.

2. Unrealistic Assumption

For calculating IRR we create one assumption. We think that if we invest our money on this IRR, after receiving profit, we can easily reinvest our investments profit on same IRR. This seems to be unrealistic assumption.

3. Not Helpful for comparing two mutually exclusive investment

IRR is not good for comparing two projects.

Virtually all general managers face capital-budgeting decisions in the course of their careers. The most common of these is the simple “yes” versus “no” choice about a capital investment. The following are some general suggestions to orient the decision maker in these situations.

1. Focus on cash flows, not profits. One wants to get as close as possible to the economic reality of the project. Accounting profits contain many kinds of economic fiction. Flows of cash, on the other hand, are economic facts.

2. Focus on incremental cash flows. The point of the whole analytical exercise is to judge whether the firm will be better off or worse off if it undertakes the project. Thus one wants to focus on the changes in cash flows affected by the project. The analysis may require some careful thought: a project decision identified as a simple go/no-go question may hide a subtle substitution or choice among alternatives. For instance, a proposal to invest in an automated machine should trigger many questions: Will the machine expand capacity (and thus permit us to exploit demand beyond our current limits)? Will the machine reduce costs (at the current level of demand) and thus permit us to operate more efficiently than before we had the machine? Will the machine create other benefits (e.g., higher quality, more operational flexibility)? The key economic question asked of project proposals should be, “How will things change (i.e., be better or worse) if we undertake the project?”

3. Account for time. Time is money. We prefer to receive cash sooner rather than later. Use NPV as the technique to summarize the quantitative attractiveness of the project. Quite simply, NPV can be interpreted as the amount by which the market value of the firm’s equity will change as a result of undertaking the project.

4. Account for risk. Not all projects present the same level or risk. One wants to be compensated with a higher return for taking more risk. The way to control for variations in risk from project to project is to use a discount rate to value a flow of cash that is consistent with the risk of that flow.

Comparing Projects with Unequal Lives

NPV and IRR can sometimes lead to conflicting results in the analysis of mutually exclusive projects. One reason for this potential problem is the timing of the cash flows of the mutually exclusive projects. As a result, there is a need to adjust for the timing issue in order to correct this problem.

There are two methods used to make the adjustments:

1. Replacement-chain method

2. Equivalent annual annuity

Example

There are two machines a company is considering, with cash flows as follows:

Discounted cash flows for Machine A and Machine B

Compare the two projects with unequal lives using both the replacement-chain method and the equivalent annual annuity (EAA) approach.

1. Replacement-Chain Method

In this example, Machine A has an operating lifespan of six years. Machine B has an operating lifespan of three years. The cash flows for each project are discounted by @ 8.4%

* NPV of Machine A is equal to $2,926.

* NPV of Machine B is equal to $1,735.

The initial analysis indicates that Machine A, with the greater NPV, should be the project chosen.

* The IRR of Machine A is equal to 8.3%.

* The IRR of Machine B is equal to 15.5%.

This analysis indicates that Machine B, with the greater IRR, should be the project chosen.

The NPV analysis and the IRR analysis have given us differing results. This is most likely due to the unequal lives of the two projects. As such, we need to analyze the two projects over a common life.

For Machine A (project 1), the lifespan is six years. For Machine B (project 2), the lifespan is three years. Given that the lifespan of the longest project is six years, in order to measure both over a common life, we must adjust the lifespan of Machine B to six years.

Because the lifespan of Machine B is three years, the lifespan of this project needs to be doubled to equal the six-year lifespan of Machine A. This indicates that another Machine B would have to be purchased (to get two machines with a lifespan of three years each) to get to the six-year lifespan of Machine A – hence, the replacement-chain method.

The new cash flows would be as follows:

Figure 11.9: Cash flows over a common life

* NPV of Machine A remains $2,926.

* NPV of Machine B is now $3,098 given the adjustment.

The initial analysis indicates that Machine B, with the greater NPV, should be the project chosen. Recall, this is different from our first analysis where Machine A was chosen given its greater NPV.

* The IRR of Machine A remains 8.3%.

* The IRR of Machine B remains 15.5%.

This analysis indicates that Machine B, with the greater IRR, should be the project chosen.

With the cash flows adjusted with the replacement-chain method, both the NPV and the IRR arrive at the same conclusion. With this adjusted analysis, Machine B (project 2), should be the project accepted.

2. Equivalent-Annual-Annuity Approach

This is the procedure for determining EAA:

* Determine the projects’ NPVs.

* Find each project’s EAA, the expected payment over the project’s life, where the future value of the project would equal zero.

* Compare the EAA of each project and select the project with the highest EAA.

From our example, the NPV of each project is as follows:

NPV of Machine A is equal to $2,926.

NPV of Machine B is equal to $1,735.

To determine each project’s EAA, it is best to use your financial calculator.

-For, Machine A (project 1), our assumptions are as follows:

I = 8.4%

n = 6

PV = NPV = -2,926

FV = 0

Find for PMT

For Machine A, the EAA (the calculated PMT) is $640.64.

For Machine B (project 2), our assumptions are as follows:

I = 8.4%

n = 3

PV = NPV = -1,735

FV = 0

Find for PMT

For Machine B, the EAA (the calculated PMT) is $678.10.

Machine B should be the project chosen as it has the highest EAA, which is $678.10, relative to Machine A whose EAA is $640.64.

Calculation of Equivalent Annual Annuity (EAA) for each project

Project A

NPV @ 15%=164577.6

Rate=15%

N=4 years

Find for PMT

PMT= NPV/PVIFA15%, 4years

PMT= 164577.6/2.855

PMT=US$ 57645.39

For NPV @ 21%,

NPV= 71043.6

PMT=NPV/PVIFA21%, 4years

PMT= 71043.6/2.540

PMT=US$ 27969.92

Project B

NPV @15% =156038

N= 4years

Find for PMT

PMT= NPV/PVIFA15%, 4years

PMT= 156038/2.855

PMT= US$ 54654.29

For NPV @21%

NPV=100488

PMT=NPV/PVIFA21%, 4years

PMT= 100488/2.540

PMT= US$ 39562.2

Project C

NPV @15%=621137

N=10years

Find for PMT

PMT=NPV/PVIFA15%, 10years

PMT=621137/5.091

PMT= $122006.87

For NPV @21%

NPV=310088

PMT=NPV/PVIFA21%, 10years

PMT=310088/4.054

PMT= $76489.39

Project D

NPV @15%=86775

N=5years

PMT=NPV/PVIFA15%, 5years

PMT=86775/3.352

PMT= $25887.53

For NPV @21%=12225

PMT=NPV/PVIFA21%, 5years

PMT=12225/2.926

PMT= $4178.06

EAA @15% | 57645.39 | 54654.29 | 122006.87 | 25887.53 |

EAA @21% | 27969.92 | 39562.2 | 76489.39 | 4178.06 |

| | | | |

A and C | $179652.26 | 1 | $104,459.31 | 2 |

B and C | $176661.16 | 2 | $116051.59 | 1 |

C and D | $147894.4 | 3 | $80667.45 | 3 |

A and D | $83532.92 | 4 | $32147.98 | 5 |

B and D | $80541.82 | 5 | $43740.26 | 4 |

At 15% A and C’s combination is the best as highest EAA is achieved.

At 21% B and C’s combination is the best

4. ————————————————-

ANSWER NO. 3

Calculation for the Graph (Project A)

Project A | PVIF @0% | PV @ 0% | PVIF @ 10% | PV @ 10% | PVIF @ 20% | PV @ 20% | PVIF @ 30% | PV @30% | PVIF @ 40% | PV @ 40% |

-500000 | 1 | -500000 | 1 | -500000 | 1 | -500000 | 1 | -500000 | 1 | -500000 |

136000 | 1 | 136000 | 0.909 | 123624 | 0.833 | 113288 | 0.769 | 104584 | 0.714 | 97104 |

136000 | 1 | 136000 | 0.826 | 112336 | 0.694 | 94384 | 0.592 | 80512 | 0.51 | 69360 |

136000 | 1 | 136000 | 0.751 | 102136 | 0.579 | 78744 | 0.455 | 61880 | 0.364 | 49504 |

618800 | 1 | 618800 | 0.683 | 422640.4 | 0.482 | 298261.6 | 0.35 | 216580 | 0.26 | 160888 |

| | 526800 | | 260736.4 | | 84677.6 | | -36444 | | -123144 |

Project B

Project B | PVIF @0% | PV @ 0% | PVIF @ 10% | PV @ 10% | PVIF @ 20% | PV @ 20% | PVIF @ 30% | PV @30% | PVIF @ 40% | PV @ 40% |

-500000 | 1 | -500000 | 1 | -500000 | 1 | -500000 | 1 | -500000 | 1 | -500000 |

370000 | 1 | 370000 | 0.909 | 336330 | 0.833 | 308210 | 0.769 | 284530 | 0.714 | 264180 |

270000 | 1 | 270000 | 0.826 | 223020 | 0.694 | 187380 | 0.592 | 159840 | 0.51 | 137700 |

155000 | 1 | 155000 | 0.751 | 116405 | 0.579 | 89745 | 0.455 | 70525 | 0.364 | 56420 |

49000 | 1 | 49000 | 0.683 | 33467 | 0.482 | 23618 | 0.35 | 17150 | 0.26 | 12740 |

| | 344000 | | 209222 | | 108953 | | 32045 | | -28960 |

Graph showing the Cross Over rate for Project A and Project B

Cross Over Rate=16.16%

The above figure shows that the NPV profiles of both Project A and Project B decline as the discount rate increases. It can be noted that, Project A has the higher NPV at low discount rate. Project B has the higher NPV if the discount rate is greater than the cross over rate. The project A’s NPV is more sensitive to changes in the discount rate as compared to project B’s NPV. In other words, Project A’s net present value has the steeper slope. It indicates that a given change in discount rate has larger effect on the net present values.

Calculation of Cross Over Rate

0 | (500000) | (500000) | 0 | 1 | 0 | 1 | 0 |

1 | 136000 | 370000 | (234000) | 0.862 | (201708) | 0.855 | (200070) |

2 | 136000 | 270000 | (134000) | 0.743 | (99562) | 0.731 | (97954) |

3 | 136000 | 155000 | (19000) | 0.641 | (12179) | 0.624 | (11856) |

4 | 618800 | 49000 | 569800 | 0.552 | 314529.6 | 0.534 | 304273.2 |

Total | | | | | 1080.6 | | (5606.8) |

Therefore,

Crossover Rate= Lower Rate+NPV of LRNPV of LR-NPV of HR(HR-LR)

= 16+1080.61080.6-(-5606.8)1

Crossover Rate= 16.16%

This means that, we are indifferent between Project A and Project B when the cost if 16.35%.

Hence, when the cost in less than crossover rate, we will select project A and if the cost is more than crossover rate, we will select project B.

In our case, Project B seems to be more superior as, it is good in all the aspect when compared to project A. the payback period and discounted payback period, both supports project B. IRR for Project B is also more when compare to project A. At higher cost of capital, Project B will provide with more return than project A. Therefore, in all, project B seems to be superior to Project A.

5. ————————————————-

ANSWER NO. 4

Project D (After correction in Cash Flows)

a) Ordinary Payback Period

| | |

| Cash Flows | Cumulative Cash Flows |

Original Investment | -500,000 | -500,000 |

Year 1 | 195,000 | -305,000 |

Year 2 | 195,000 | -110,000 |

Year 3 | 195,000 | 85,000 |

Year 4 | 195,000 | 200,000 |

Year 5 | 195,000 | 375,000 |

| | |

Payback Period = | 500,000 | |

| 195,000 | |

= | 2.56 | Years |

b) Discounted Payback Period

Project D @ 15 % discount rate | | |

0 | -500,000 | 1 | -500,000 | -500,000 |

1 | 195,000 | 0.87 | 169,650 | -330,350 |

2 | 195,000 | 0.756 | 147,420 | -182,930 |

3 | 195,000 | 0.658 | 128,310 | -54,620 |

4 | 195,000 | 0.572 | 111,540 | 56,920 |

5 | 195,000 | 0.497 | 96,915 | 153,835 |

| | | NPV | 153,835 |

| | | | |

Discounted Payback Period= | 3 + 54,620 | | |

| | 111,540 | | |

| = | 3.48 | years | |

| | | | |

Project D @ 21 % discount rate | | |

0 | -500,000 | 1 | -500,000 | -500,000 |

1 | 195,000 | 0.826 | 161,070 | -338,930 |

2 | 195,000 | 0.683 | 133,185 | -205,745 |

3 | 195,000 | 0.565 | 110,175 | -95,570 |

4 | 195,000 | 0.467 | 91,065 | -4,505 |

5 | 195,000 | 0.386 | 75,270 | 70,765 |

| | | NPV | 70,765 |

| | | | |

Discounted Payback Period= | 4 + 4,505 | | |

| | 75,270 | | |

| = | 4.05 | years | |

c) IRR

0 | -500,000 | 1 | -500,000 | -500,000 |

1 | 195,000 | 0.787 | 153,465 | -346,535 |

2 | 195,000 | 0.62 | 120,900 | -225,635 |

3 | 195,000 | 0.488 | 95,160 | -130,475 |

4 | 195,000 | 0.384 | 74,880 | -55,595 |

5 | 195,000 | 0.303 | 59,085 | 3,490 |

| | | NPV | 3,490 |

| | | | |

0 | -500,000 | 1 | -500,000 | -500,000 |

1 | 195,000 | 0.781 | 152,295 | -347,705 |

2 | 195,000 | 0.61 | 118,950 | -228,755 |

3 | 195,000 | 0.477 | 93,015 | -135,740 |

4 | 195,000 | 0.373 | 72,735 | -63,005 |

5 | 195,000 | 0.291 | 56,745 | -6,260 |

| | | NPV | -6,260 |

| | | | |

IRR = | Lower Rate + | NPV of lower Rate | (diff in rates) |

| | NPV lower rate – NPV higher rate | |

| | | | |

= | 27% + | 3,490 | (28 – 27) |

| | (3490 – (-) 6260) | |

| | | | |

= | 27% + | 0.357948718 | | |

| | | | |

= | 27.36 | |

| | | | |

IRR = 27.36 % | | | |

Changes on Project D, after correction in class flows | | |

Payback | 2.86 | 2.56 | 0.30 | Decrease in payback |

NPV @ 15 % | 86,775 | 153,835 | (67,060.00) | Increase in NPV |

NPV @ 21% | 12,225 | 70,765 | (58,540.00) | |

IRR | 22.11 | 27.36 | (5.25) | Increase in IRR |

Discounted payback period @ 15% | 4.02 | 3.48 | 0.54 | Decrease in discounted payback |

Discounted payback period @ 21% | 4.82 | 4.05 | 0.77 | |

Comparison of Different Projects

| -500,000.00 | -500000 | -1,000,000.00 | -500,000.00 |

| 136,000.00 | 370000 | 323,000.00 | 195,000.00 |

| 136,000.00 | 270000 | 323,000.00 | 195,000.00 |

| 136,000.00 | 155000 | 323,000.00 | 195,000.00 |

| 618,800.00 | 49000 | 323,000.00 | 195,000.00 |

| | | 323,000.00 | 195,000.00 |

| | | 323,000.00 | |

NPV @ 15% | $164,577.60 | $156,038 | $621,137 | $153,835 |

NPV @ 21% | $71,043.60 | $100,488 | $310,088 | $70,765 |

IRR | 26.61% | 35.02% | 29.94% | 27.36% |

Even with the change in the Cash Flows for Project D, it still seems the combination of Project B and Project C is a good option. Project C has the highest NPV than other projects with very much acceptable IRR. The company should also choose Project B because it has good NPV with highest IRR among the alternative projects. Thus, even with the change in Cash Flows, the decision on the mutually exclusive projects remains the same.

Changes on Project D, after correction in class flows

Fig: Comparison of Payback Period (years), IRR (%) and Discounted payback period at different rates of Project D, after changes in Cash Flows

Fig: Comparison of NPV at different rates of Project D, after changes in Cash Flows

Comparison of Different Projects – (after change in Cash Flows of Project D)

Fig: Comparison of NPV at different rates of all the projects, before and after changes in Cash Flows of Project D

Fig: Comparison of IRR of all the projects, before and after changes in Cash Flows of Project D

Comparison of Different Projects – (after change in Cash Flows of Project D)

Fig: Comparison of Payback period and Discounted payback period at different rates of all the projects, before and after changes in Cash Flows of Project D

6. ————————————————-

ANSWER NO. 5

The IRR of project A is approximately 27%. Since project A’s IRR is equal to reinvestment rate, reinvestment rate would be 27% as well. Similarly, the IRR of project B is 35%.

It would be unreasonable for Mr. Hill to claim that project B will generate a return of approximately 35 percent over its four-year life because the return of 35% is far higher compared to the actual reinvestment rate in the market.

Reinvestment at the cost of capital is generally a better assumption because it is closer to reality. Even if the MIRR is calculated, an expected return of 35% would be still high. It can be demonstrated through the following calculation for Project B.

Year | Cash Inflows | FVIF @ 27% | FV of Inflows |

1 | $370,000.00 | 2.0483 | $757,871.00 |

2 | $270,000.00 | 1.6129 | $435,483.00 |

3 | $155,000.00 | 1.27 | $196,850.00 |

4 | $49,000.00 | 1 | $49,000.00 |

| Terminal Value of Cash Inflows | | $1,439,204.00 |

MIRR is calculated to determine the rate at which the present value of a project’s outflow equals the terminal value of the project’s inflows. Trying at 35% and 25%, we get

| | PVIF @ 35% | PV @ 35% | PVIF @ 25% | PV@ 25% |

Present Value of Terminal Cash Inflow | $1,439,204 | 0.3011 | $433,344.32 | 0.4096 | $589,497.96 |

Present Value of Outflow | $500,000 | 1 | $500,000 | 1 | $500,000 |

NPV | | | $(66,655.68) | | $89,497.96 |

MIRR= 25% + 89,497.96/ (89497.96+66,655.68) * (35-25)

= 30.73%

An MIRR of 30.73% is lower by around 5% compared to the 35% IRR of project B. Although NPV is the best method to use, MIRR is also an acceptable one. Since MIRR is superior to IRR, and the MIRR obtained for project B is 30.73%, this is the most that Mr. Hill can claim that the project will generate over the next five years. Anything above the MIRR rate would be uncertain and risky.

7. ————————————————-

ANSWER NO. 6

Egret Printing and Publishing Company, owned by the Belford brothers who posses extreme conservative nature which was the outcome of the fact that their father had to struggle under a crushing burden of debt during the Great Depression of 1930. It was mainly due to this that the Belford brothers vowed never to get deeply into debt. However, Patrick Hill who was responsible for managing the internal as well as the external financial operations of the company has been trying to change the firm’s policy of not using any debt. He puts forward a proposal to the Belford brothers in which he states that he would complete the current task of carrying out a detailed analysis of four major capital investments using the existing capital structure but lowering the cost of capital, by including long term debt in the capital structure. He even discusses the issue with the company’s bank which then provides him with certain information as to how much could the company borrow, at what rate of interest which in turn would help Egret to lower the weighted average cost of capital.

Patrick Hill is somehow confident of the fact that he will be able to persuade the Belford brothers to make use of some amount of debt in their financial operations which would help the firm to lower the cost of capital. The decision of whether to accept or reject the project totally depends upon the comparison between the cost of capital and the return of the project .He considers the use of debt financing to be extremely beneficial for the projects and he is sure that it will help the company to be able to generate more and better projects in the coming years. However, he also seems to be a bit confused about the fact that whether he will be able to persuade the Belford brothers to employ debt financing. Hence, in order to be able to convince them completely Patrick Hill needs to have strong and genuine support to his idea about debt financing. He needs to support his idea by providing them with the advantages of debt financing. Hill has estimated that the total amount of fund needed for the new project has to come from the Belford brothers and also that if they do not make use of debt financing, the Belford brothers would have to liquidate their personal security holdings. As the use of equity results in higher cost of capital Mr. Hill will advise only those projects which have higher rate of return than cost of capital, and thus are more risky.

Earlier when the company did not make use of debt, it could only invest in Projects A & C, but if the company takes debt, it would increase the funds that would be available with the company and which would further allow the company to invest in those projects that were not feasible earlier. It is also stated that if the company has to make use of additional funds beyond $1.5 million, the Belford Brothers would have to liquidate their personal security and the company would have to pay 21% as the cost of capital for this. But by making use of debt financing the cost of capital would only be 12% and this would help in lowering the WACC which in turn would improve the company’s current NPV.

Hence, this proves that the use of debt financing is beneficial to the company which would help in lowering the cost of capital and improve the cash flows in the business. Use of debt would increase the level of investments by $500,000 and this would further make it possible for the company to invest in project D. Now the company would have a total of 2 million of investable fund which would allow the company to invest either in Project A, C and D or Project B, C and D.

8. ————————————————-

ANSWER NO. 7

If the Belfords agree to Hill’s proposal to use a modest amount of debt to finance the projects this year, what would be its implication on the present capital structure and the cost of capital? In term of future returns to the Belford families, what would be the impact be from using this debt financing or what would be the extra value addition in present values of the selected projects

Hill has been trying to change the philosophy of internal financing exercised by Belford brothers to avoid the circumstance as their father faced. Hill considered all equity capital structure to be overly conservative. If Belford’s agree to Hills proposal to use debt financing, they will use $500000 debt at 12% interest rate. So, the company has now, $ 2 million to invest in the projects and can choose three projects.

The new capital structure as assumed by Hill:

Long term debt | 500,000 | 0.25 | 6.48 % | 1.62 |

Preferred stock | 0 | 0 | 0 | 0 |

Common equity | 1,500,000 | 0.75 | 15% | 11.25 |

Weighted average cost of capital | 1 | | 12.87% |

Calculation of kdt:

Interest rate of debt (kd) = 12%

After tax cost of debt (kdt) = kd*(1-tax rate)

=12*(1-0.46)

=6.48%

Also,

Weight of debt = 500000 /2000000 =0.25

Weight of equity= 1500000 /2000000= 0.75

From the investment of 2,000,000 we can select three projects, we can choose A, C and D or B, C and D as Project A and Project B are mutually exclusive.

Now,

With debt and equity financing at 12.87% cost of capital

Net present value of project A, C & D = NPV of Projects (A + C +D)

= $(203073.08+ 761820.79+ 117472.868)

=$ 1,082,366.738

Net present value of project B, C & D = NPV of Projects (B + C +D)

= $(177733.415+ 761820.79+ 117472.868)

=$ 1,057,027.073

To find the profitability index of the projects:

12.87% | A, C & D | 2 million | 1,082,366.738 | 3,082,366.74 | 1.54 |

12.87% | B, C & D | 2 million | 1,057,027.073 | 3,057,027.07 | 1.52 |

From this table we can select projects A, C and D when the company takes the debt financing with 12.87% cost of capital.

When 15% cost of capital was taken as discounting factor, the combined NPV of project A& C reveals higher value. So, this was selected as the best combination. Also, there was internal financing through retained earnings and excluded external financing through debt.

With all Equity financing at 15% cost of Capital:

Net present value of project A & C = NPV of Projects (A + C)

= $(164,577.6+621,137)

=$ 785,714

The impact of using this debt financing is shown by the extra value addition in present values of selected project:

Particulars | Amount |

Net present value of selected projects after inclusion of debt in capital structure (A)Less: Net present value of selected projects before inclusion of debt in capital structure. (B) | $1,082,366.738$786,714 |

Extra value additional due to use of debt financing (A-B) | $ 295652.738 |

This shows that when debt financing is used the company can yield more NPV as debt financing helps to leverage the capital structure. Debt financing is relatively cheaper financing method as the company can utilize capital with lower rate. Therefore, instead of using the combination of projects A & C, the combination of A, C & D should be selected taking into consideration the profitability index which is calculated on the basis of NPV and Total PV of inflows.

Working Note:

Project A | | | |

Year | Cash Flow | [email protected] | PV |

0 | -500000 | 1 | -500000 |

1 | 136000 | 0.886 | 120496 |

2 | 136000 | 0.785 | 106760 |

3 | 136000 | 0.6954 | 94574.4 |

4 | 618800 | 0.6161 | 381242.68 |

| | Total PV of Inflows | 703073.08 |

| | NPV | 203073.08 |

Project B | | | |

Year | Cash Flow | [email protected] | PV |

0 | -500000 | 1.000 | -500000 |

1 | 370000 | 0.886 | 327810.756 |

2 | 270000 | 0.785 | 211936.967 |

3 | 155000 | 0.695 | 107794.381 |

4 | 49000 | 0.616 | 30191.3116 |

| | TPV of Inflows | 677733.415 |

| | NPV | 177733.415 |

| | | |

Project C | | | |

Year | Cash Flow | [email protected] | PV |

0 | -1000000 | 1 | -1000000 |

1 | 323000 | 0.886 | 286169.93 |

2 | 323000 | 0.785 | 253539.408 |

3 | 323000 | 0.695 | 224629.581 |

4 | 323000 | 0.616 | 199016.197 |

5 | 323000 | 0.546 | 176323.378 |

6 | 323000 | 0.484 | 156218.107 |

7 | 323000 | 0.428 | 138405.34 |

8 | 323000 | 0.380 | 122623.673 |

9 | 323000 | 0.336 | 108641.511 |

10 | 323000 | 0.298 | 96253.6643 |

| | TPV of Inflows | 1,761,820 |

| | NPV | 761820.79 |

Project D | | | |

Year | Cash Flow | [email protected] | PV |

0 | -500000 | 1.000 | -500000 |

1 | 175000 | 0.886 | 155045.628 |

2 | 175000 | 0.785 | 137366.552 |

3 | 175000 | 0.695 | 121703.333 |

4 | 175000 | 0.616 | 107826.113 |

5 | 175000 | 0.546 | 95531.2419 |

| | TPV of Inflows | 617472.868 |

| | NPV | 117472.868 |

9. ————————————————-

ANSWER NO. 8

EBIT | $3,393,333.33 |

Less: Interest (12%) | $60,000.00 |

EBT | $3,333,333.33 |

Less: Tax @ 46% | $1,533,333.33 |

EAT | $1,800,000.00 |

Less: Dividends | $300,000.00 |

Retained Earnings | $1,500,000.00 |

Times Interest Earned= EBIT / Interest Expense

= $ 3,393,333.33/60,000

= 56.5555 times

The use of debt amounting to $500,000 does not represent a significant risk to the company. The times interest earned ratio calculated above demonstrates that the company has more than sufficient earnings to meet the cost of debt. The company’s EBIT is 56.5555 times the interest expense to be paid for the debt capital. This is a very healthy times interest earned ratio which represents a low amount of debt capital used by the company and small portion of EBIT to be used for payment of cost of debt i.e. interest.

The use of debt would be risky if the times interest earned ratio had been dangerously low; which would be a ratio of one or close to one.

10. ————————————————-

ANSWER NO. 9

The implication of the statement that Project C would not be feasible unless either Project A or B was also accepted is that the company has to invest a minimum of $ 1.5 million if it wants to invest in project C. In this case Projects A and B are mutually exclusive projects which implies that only one project can be chosen at a particular point of time. It also states that Project C cannot be feasible unless Projects A or B is accepted. Project C should be carried out together with either project A or B which makes it a dependent project. Project C is a contingent project whose acceptance or rejection is dependent on the decision to accept or reject Project A or B.

The way Project C has been handled earlier in the case is valid. Project is about purchase of new printing equipment and press. Obviously, the purchase of new equipments would require larger space requirements. Project A and B both deal with expansion of storage areas. Hence, the mutually exclusive projects A and B can provide a suitable precondition for the implementation of Project C.

Another important implication in the earlier case is that a project combination of C and D could never be used. Although a project combination of C and D requires $1,500,000, however, for C to be implemented, further $500,000 needs to be invested in either Project A or B. This would take the total investment to $2 million which the firm does not have when it is not using the debt capital.

Hence, the primary implication of above statement to the capital budgeting is that investment of $ 1 million in project C would require further investment of $ 500,000 in either project A or project B . This would mean that to only the project combinations of A and C or B and C or A and D or B and D are possible considering the budget available. So, if Project C is to choose, Project D could never be chosen as well.

11. ————————————————-

ANSWER NO. 10

The decision solely based on the quantitative measures may not be accurate, since in selecting the projects various factors play an important role. The factors such as societal impact, working environmental conditions, political and legal issues, company’s reputation and image, policies etc also can change the decision in capital budgeting evaluation. Even though these qualitative factors can influence the decision making process, it is quite difficult or impossible to accurately estimate these qualitative factors. However, a careful analysis of the situation, experience and proper judgment skills might support the management in decision making process. Thus, considering both quantitative and qualitative measures can give a better decision in selecting a project rather depending only on quantitative or qualitative factors.

Important qualitative Factors in capital budgeting evaluation:

Before making a final decision about investing on a project, quite often a project is selected if it has acceptable IRR, NPV or other quantitative factors. In deciding for the projects for Egret Printing and Publishing Company we have only considered the quantitative factors. The decisions are exclusively based on IRR, NPV and other numerical calculations. Decision based on quantitative factors may not be enough, various qualitative factors also are considered as they can have a major impact on the business. The various important qualitative factors that must be answered before making the decision for the project are as follows:

1. Is the organization capable of carrying out the project in terms of human resource, availability of raw materials and suppliers?

2. What relationship exists between the project and the firm?

3. Is the market suitable to carry out the project?

4. What and who can be the competitors for the project which might make labor and capital scarce?

5. What are the Macro environmental elements and the project?

6. Does this investment effects the quality of products and services offered?

There are three basic assumptions related to the NPV analysis, but however they do not consider the three qualitative factors that have been mentioned in the paragraph above. This analysis also states that the decisions that are made by the company do not affect the competitors and the ways the competitors react in turn do not affect the profitability of the firm. However it is also assumed that the various macro environmental forces will continue to be the same even in the future and it will not affect the decision criteria for the project. This is not a right method but a very essential component of most of the financial models such as the NPV analysis. The NPV is calculated as a combination of quantitative as well as qualitative factors and this serves as the basis of the decision support information. The information from this is then made use of by the analysts in order to make certain recommendations and also to take a major decision as to whether accept or reject a project.

There are also other factors such as the various dynamic and competitive environment factors that need to be considered, since most of the projects are strategic and not just financial in their nature. But in certain situations only the quantitative factors such as NPV is considered, but this might lead them to miss on some of the best investing opportunities. Looking at NPV alone will lead the managers to take bad decisions. It should be seen to it that the project that the company is investing in should be beneficial and innovative even in the future. That project should lead the company to growth and help the company attain a better strategic position

PROJECT A: Major Plant Expansion

PROJECT B: Alternative Plan for Plant Expansion

PROJECT C: Purchase of New Press

Project D: Upgrade of Egret’s Video Text Service

Similar Papers