The Dilemma At Day Pro.docx

THE DILEMMA AT DAY-PRO

1. Calculate the Payback Period of each project. Explain what argument Tim should make to show that the Payback Period is not appropriate in this case.

Payback Synthetic Resin Year 1

350,000

-650,000

2

400,000

-250,000

3

500,000

250,000

4

650,000

5

700,000

PBP – 2 = 0 – (-250,000) 3–2

250,000 – (-250,000)

PBP – 2 = 250,000 1

500,000

= 2.5 years #

Payback Epoxy Resin Year 1

600,000

-200,000

2

400,000

200,000

3

300,000

4

200,000

5

200,000

PBP – 1 = 0 – (-200,000) 2–1

200,000 – (-200,000)

PBP – 1 = 200,000 1

400,000

= 1.5 years #

Payback period is the length of time required for an investment to recover its initial outlays in terms of profits or savings. The lesser the time taken is the better. So in this project is better to choose the Epoxy Resin compare to Synthetic Resin since the Payback Period for Epoxy Resin is 1.5 years while the Synthetic Resin is 2.5 years.

2. Calculate the Discount Payback Period (DPP) using 10% as the discount rate. Should Tim ask the Board to use DPP as the deciding factor? Explain.

Payback Synthetic Resin Year 0

-1,000,000

-1,000,000

-1,000,000

1

350,000

318,185

-681,815

2

400,000

330,560

-351,255

3

500,000

375,650

24,395

4

650,000

5

700,000

Discounted Payback 2 + 351,255 375,650

= 2.94 years #

Payback Epoxy Resin Year 0

-800,000

-800,000

-800,000

1

600,000

545,460

-254,540

2

400,000

330,560

76,020

3

300,000

4

200,000

5

200,000

Discounted Payback 1 + 254,540 330,560

= 1.77 years #

Discounted Payback period is the amount of time that its take for the initial cost of a project to equal to discounted value of expected cash flows, or the time it takes to break even from an investment. It is the period in which the cumulative NPV of a project equals zero. The lesser the amount of time taken is the better. So in this project is better to choose the Epoxy Resin compare to Synthetic Resin since the Payback Period for Epoxy Resin is 1.77 years while the Synthetic Resin is 2.94 years.

3. If management prefers to have 40% accounting rate of return, which project would be accepted? What is wrong with this decision?

Synthetic Resin Net income: 150,000 + 200,000 + 300,000 + 450,000 + 500,000 = 1,600,000

Average profit: 1,600,000 = 320,000 / year 5 years

Average investment: 1,000,000 = 500,000 2

Accounting Rate of Return: 320,000 x 100% = 64% 500,000

Epoxy Resin Net income: 440,000 + 240,000 + 140,000 + 40,000 + 40,000 = 900,000

Average profit: 900,000 = 180,000 / year 5 years

Average investment: 800,000 = 400,000 2

Accounting Rate of Return: 180,000 x 100% = 45% 400,000

Accounting Rate of Return is built to evaluate profit and it can be easily manipulate with changes in depreciation method. It disregards the time factor in term of time value of money or risk for long term investment. Since the management prefers to have a 40% accounting rate of return, both project is exceed more than 40% so both will be generate profit but there will be more profit generate if Synthetic Resin project being choose. 4. Calculate the two projects’ IRR. How should Tim convince the Board that the IRR measure could be misleading?

Synthetic Resin Year

Cash Flow

PVIF,40%,n

PVIF,10%,n

0

-1,000,000

1

1

-1,000,000

-1,000,000

1

350,000

0.7143

0.9091

250,000

318,185

2

400,000

0.5102

0.8264

204,080

330,560

3

500,000

0.3644

0.7513

182,200

375,650

4

650,000

0.2603

0.6830

169,195

443,950

5

700,000

0.1859

0.6209

130,130

434,630

935,605

1,902,975

-1,000,000

-1,000,000

-64,395

902,975

10%

IRR

40%

902,975

0

-64,395

IRR – 10% = 0 - 902,975 40% - 10% -64,395 – (902,975) IRR – 10% = - 902,975 30%

- 967,370

IRR – 10% = 0.9334 x 30% IRR = 28% + 10% IRR = 38%

Epoxy Resin Year

Cash Flow

PVIF,40%,n

PVIF,45%,n

0

-800,000

1

1

-800,000

-800,000

1

600,000

0.7143

0.6897

428,580

413,820

2

400,000

0.5102

0.4756

204,080

190,240

3

300,000

0.3644

0.3280

109,320

98,400

4

200,000

0.2603

0.2262

52,060

45,240

5

200,000

0.1859

0.1560

37,180

31,200

40%

IRR 0

31,220

831,220

778,900

-800,000

-800,000

31,220

-21,100

45% -21,100

IRR – 40% = 0 - 31,220 45% - 40% -21,100 – 31,220 IRR – 40% = - 31,220 5%

- 52,320

IRR – 40% = 0.5967 x 5% IRR = 2.984% + 40% IRR = 42.98% The Epoxy internal rate return is greater compare to Synthetic, therefore Epoxy Project should be chosen in this project. This is because internal rate return is a measure of an investment’s rate of return. The term internal refers to the fact that the internal rate exclude external factors. 5. Calculate the NPV profiles for the two projects and explain the relevance of the crossover point. How should Tim convince the Board that the NPV method is the way to go?

Synthetic Resin Year

Cash Flow

PVIF,38%,n

0

-1,000,000

1

-1,000,000

1

350,000

0.7246

253,610

2

400,000

0.5251

210,040

3

500,000

0.3805

190,250

4

650,000

0.2757

179,205

5

700,000

0.1998

139,860 972,965 -1,000,000 -27,035

Epoxy Resin Year

Cash Flow

PVIF,42.98%,n

0

-800,000

1

-800,000

1

600,000

0.6994

419,640

2

400,000

0.4892

195,680

3

300,000

0.3421

102,630

4

250,000

0.2393

47,860

5

200,000

0.1673

33,460 799,270 -800,000 -730

NPV should be 0, however in this case Synthetic Resin NPV is -27,035 while Epoxy Resin NPV is -730, the company should choose Epoxy Resin compare to Synthetic Resin since Epoxy is greater than -27,035