The Dilemma at Day-Pro Comparison of Capital Budgeting Techniques The Day-Pro Chemical Company, 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 chemical 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 Companyâs 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, Tim Palmer, the Assistant Treasurer and a recent MBA from Drexel 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. Tim 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, 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 companyâs wealth. The appropriate discount rate for the projects is a required rate of return of capital of 10% (opportunity cost of capital). After obtaining the cash flow projections for each project (see Tables 1 & 2), and crunching out the numbers, Tim realizes that the hill is going to be steeper 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 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. Table 1. Synthetic Resin Cash Flows Synthetic Resin Year 0 1 2 3 4 5 Net Income $150,000 $200,000 $300,000 $450,000 $500,000 Depreciation $200,000 $200,000 $200,000 $200,000 $200,000 Net Cash Flow $(1,000,000) $350,000 $400,000 $500,000 $650,000 $700,000 Table 2. Epoxy Resin Cash Flows Epoxy Resin Year 0 1 2 3 4 5 Net Income $440,000 $240,000 $140,000 $ 40,000 $ 40,000 Depreciation $160,000 $160,000 $160,000 $160,000 $160,000 Net Cash Flow $(800,000) $600,000 $400,000 $300,000 $200,000 $200,000 Questions: In looking over the documentation prepared by the two project teams, it appears to you that the synthetic resin team has been somewhat more conservative in its revenue projections than the epoxy resin team. What impact might this have on the Payback Period, NPV, and IRR calculations for the synthetic resin project? How does this complicate comparing the synthetic resin and epoxy resin projects? Is being conservative in revenue projections a good practice? What adjustments might be made? Comment
The Dilemma at Day-Pro Comparison of Capital Budgeting Techniques The Day-Pro Chemical Company, 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 chemical 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 Companyâs 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, Tim Palmer, the Assistant Treasurer and a recent MBA from Drexel 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. Tim 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, 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 companyâs wealth. The appropriate discount rate for the projects is a required rate of return of capital of 10% (opportunity cost of capital). After obtaining the cash flow projections for each project (see Tables 1 & 2), and crunching out the numbers, Tim realizes that the hill is going to be steeper 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 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. Table 1. Synthetic Resin Cash Flows Synthetic Resin Year 0 1 2 3 4 5 Net Income $150,000 $200,000 $300,000 $450,000 $500,000 Depreciation $200,000 $200,000 $200,000 $200,000 $200,000 Net Cash Flow $(1,000,000) $350,000 $400,000 $500,000 $650,000 $700,000 Table 2. Epoxy Resin Cash Flows Epoxy Resin Year 0 1 2 3 4 5 Net Income $440,000 $240,000 $140,000 $ 40,000 $ 40,000 Depreciation $160,000 $160,000 $160,000 $160,000 $160,000 Net Cash Flow $(800,000) $600,000 $400,000 $300,000 $200,000 $200,000 Questions: In looking over the documentation prepared by the two project teams, it appears to you that the synthetic resin team has been somewhat more conservative in its revenue projections than the epoxy resin team. What impact might this have on the Payback Period, NPV, and IRR calculations for the synthetic resin project? How does this complicate comparing the synthetic resin and epoxy resin projects? Is being conservative in revenue projections a good practice? What adjustments might be made? Comment
