INTRODUCTION

Background Egret Printing and Publishing Company is a family owned specialty printing business. It was found by John and Keith Belford in 1956. It operates mainly as a full range printer of high quality, four colors offset advertising material, calendars, specialty tabloids, business printing and some books. Belford brothers follow conservative approach as they avoid use of debt, since their father had struggled under the burden of debts during the Great Depression of the 1930s. Patrick Hill does not disagree with this philosophy, but he considers an all-equity capital structure to be overly conservative. Hill is occupied with the detailed analysis of four major capital investment proposals identified by Belfords brother. The description of each proposals are as follows: Project A: Major Plant Expansion Project A has been designed to alleviate the capacity problem by constructing a new wing of the main plant due to rising volume of order monthly. The expansion would make it possible to work on several jobs simultaneously, to hold a greater variety of paper stock in inventory and to reposition its various presses for a more efficient work flow. The new expansion would also include a new bindery room and extra space for the Special Services Department that specializes in low volume custom book printing and binding. It will have computerized selection and retrieval system tied directly to a computer typesetter and printing press. Project B: Alternative Plan for Plant Expansion Project B is an alternative to plant expansion i.e. project A. Egret can gain extra storage room and more efficiently arrange the printing equipment by moving some non-load bearing walls and rearranging some of the operations in the present printing plant. This project has the same cost as project A as the modifications required are extensive and businesses will be lost during the renovation. This alternative can be finished more quickly and allow Egret to take up major printing jobs in the years to come that can go to the hands of their competitors. Project C: Purchase of New Press Project C would acquire the latest equipment designed for printing functions i.e., printing of high quality color calendars program. This project can be incorporated in the business with projects A or B. The profitability of the expansion programs will not be affected by the acceptance or rejection of this project. However, project C would not be feasible in the case when both projects A and B are rejected. Project D: Upgrade of Egrets Video Text Service Project D is targeted at upgrading the Video Text Service that will ensure reliability of their service. It is also targeted at reducing the customers complaints and to attract new subscriber.

ANALYSIS OF CASE
Question 1 Determine the payback, net present value (NPV) and internal rate of return (IRR) for each project, using both 15 and 21% discount rates. Rank the investment proposals considering the capital budget of $1.5 million. Which projects should the company choose and why? Which discount rate is more appropriate? (Note that project A and B are mutually exclusive). Solution Project A B C D Regular Payback Period 3.14 years 1.48 years 3.09 years 2.86 years Table 1: table showing PBP, NPV and IRR Discounted Payback NPV Period 15% 21% 15% 21% 3.53 years 3.75 years 164,578.00 70,907.60 1.87 years 2.11 years 156,038.00 100,333.00 4.48 years 5.53 years 621,137.00 309,765.00 4.00 years 4.82 years 86,775.00 . 12,050.00

IRR 26.72% 35.01% 29.94% 22.11%

Fig 1: Regular and Discounted Payback Period

Regular & Discounted Payback Period

6 5 4 Years Regular Payback Period 3 2 1 0 Project A Project B Project C Project D

Discounted Payback Period (15%)

Discounted Payback Period (21%)

Fig 2: NPV at 15% and 21%

NPV @ 15% and 21%

700,000 600,000 500,000 400,000 NPV (15%) 300,000 200,000 100,000 0 Project A Project B Project C Project D NPV (21%) $

Fig 3: IRR of different projects

IRR
40.00%
35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% IRR

Project A

Project B

Project C

Project D

The table below shows the rank of investment proposals: Table 2: Ranking of the projects Rank Regular Payback Discounted NPV period Payback Period Regular 15% 21% 15% 21% IV II II II III I I I III II III IV IV I I II III III IV IV

Project A B C D

IRR III I II IV

Analyzing regular payback period, Project B is preferable as it provide return of investment in 1.48 years. Analyzing discounted payback period, project B is preferable in both 15% and 21% discount rate, as it provide return of investment in 1.87 years and 2.11 years respectively. Analyzing Net Present Value (NPV), project C is preferable in both 15% and 21% discount rate, as it provide highest return among other project i.e., Rs 621,137 and Rs 309,765 respectively. Analyzing Internal Rate of Return (IRR), accepting project B provides higher rate of return i.e., 35.01%, so project B is preferable to other.

After analyzing all capital budgeting technique of four different projects, project C is preferable as its NPV is higher than that of other project. (Note that, when there are different capital budgeting techniques, we prefer NPV than that of other because it considers time value of money.) The method that will help us to evaluate the best combination of projects is profitability index. It is the ratio of present value of benefits to present value of cost.

Profitability Index: Table 3: PI at 15% discount rate

Combinations A and C A and D B and C B and D Initial Investment 1.5 million 1 million 1.5 million 1 million NPV (164,578 + 621,137) = $785,715 (164,578 + 86,775) = $251,353 (156,038 + 621,137) = $777,175 (156,038 + 86,775) = $242,813 PV (66,4578+ 1,621,137) =2,285,715 (66,4578+586,775) =1,251,352.60 (656,038+1,621,137) =2,277,175.00 (656,038+586,775) =1,242,813.00 Profitability Index 1.523 1.25 1.518 1.24 Rank 1st 3rd 2nd 4th

Decision criteria The combination of project with the highest PI is selected i.e., combination of project A and C is preferable than that of other as its profitability index is highest that of other at discount rate of 15%. Table 4: PI at 21% discount rate
Combinations A and C A and D B and C B and D Initial Investment 1.5 million 1 million 1.5 million 1 million NPV (70,907.60 + 309,765) = 380,672.60 (70,907.60 + 12,050) = 82,957.60 (100,333 + 309,765) = 410,098 (100,333 + 12,050) = 112,383 PV (570,907.60+1,309,765) = 1,880,672.60 (570,907.60+512,050) =1,072,107.60 (600,333+1,309,765) =1,809,844.00 (600,333+512,050) =1,001,279.00 Profitability Index 1.25 1.07 1.21 1.00 Rank 1st 3rd 2nd 4th

Decision criteria The combination of project with the highest PI is selected i.e., combination of project A and C is preferable than that of other as its profitability index is highest that of other at discount rate of 21%. Conclusion Considering the capital budget of $1.5 million, the different possible combinations of the project that the company can undertake is as follows: A and C A and D B and C B and D 5

Among the different viable combination of projects, we suggest the company to choose the project A and C as the profitability index of these projects is greater than the profitability index of other combination of projects. From the table below we see that at both 15% and 21% project the company should choose project A and C.

Working Notes
For Project A: Table 5: Computation of ordinary Payback Period for project A Particular Cash Flows Cumulative Cash Flow Original Investment -5,00,000 -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 The computation of cumulative cash flows shows that the firm can recover the investment in 3 to 4 years. The exact payback period may be computed as follows: Payback period = 3 + (92,000 / 6, 18,800) = 3.14 years Table 6: Computation of Discounted Payback Period of project A (with Net Present Value)
Year 0 1 2 3 4 Cash Flow -5,00,000.00 136,000.00 136,000.00 136,000.00 618,800.00 PVIF @ 15% 1.000 0.870 0.756 0.658 0.572 NPV = PV @ 15% -500,000 118,320 102,816 89,488 353,954 164,578 Cumulative PV -500,000 -381,680 -278,864 -189,376 164,578 PVIF @ 21% 1.000 0.826 0.683 0.564 0.467 NPV = PV @ 21% -500,000.00 112,336.00 92,888.00 76,704.00 288,979.60 70,907.60 Cumulative PV -500,000.00 -387,664.00 -294,776.00 -218,072.00 70,907.60

At discount rate 15% The computation of cumulative cash flows shows that the firm can recover the investment in 3 to 4 years. The exact payback period may be computed as Discounted payback period = 3 years + (189,376 / 353,954) = 3.53 years At discount rate 21% The computation of cumulative cash flows shows that the firm can recover the investment in 3 to 4 years. The exact payback period may be computed as Discounted payback period = 3 years + (218,072 /288,979.60) = 3.75 years

Table 7: Computation of Internal Rate of Return for project A PVIF @ 26% PV @ 26% PVIF @ 27% PV @ 27% 1.000 -500,000.00 1.000 -500,000.00 0.794 107,984.00 0.787 107,032.00 0.630 85,680.00 0.620 84,320.00 0.500 68,000.00 0.488 66,368.00 0.397 245,663.60 0.384 237,619.20 TPV= 507,297.60 TPV= 495,339.20 NPV = 7,327.60 NPV = -4,660.80

IRR= = 26 + [(507297.60-500,000.00)/ (507297.60- 495339.20)] * 1 = 26.61% For Project B: Table 8: Computation of Payback Period for project B Particular Cash Flows Cumulative Cash Flow 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 The computation of cumulative cash flows shows that the firm can recover the investment in 1 to 2 years. The exact payback period may be computed as follows: Payback period = 1 + (1, 30,000 / 2, 70,000) = 1.48 years

Table 9: Computation of Discounted Payback Period of project B

Year 0 1 2 3 4 Cash Flow -500,000.00 370,000.00 270,000.00 155,000.00 49,000.00 PVIF @ 15% 1.000 0.870 0.756 0.658 0.572 NPV = PV @ 15% 500,000.00 321,900.00 204,120.00 101,990.00 28,028.00 156,038.00 Cumulative PV -500,000.00 -178,100.00 26,020.00 128,010.00 156,038.00 PVIF @ 21% 1.000 0.826 0.683 0.564 0.467 NPV = PV @ 21% 500,000.00 305,620.00 184,410.00 87,420.00 22,883.00 100,333.00 Cumulative PV -500,000.00 -194,380.00 -9,970.00 77,450.00 100,333.00

At discount rate 15% The computation of cumulative cash flows shows that the firm can recover the investment in 1 to 2 years. The exact payback period may be computed as: Discounted payback period = 1 year + (178,100 /204,120) = 1.87 years At discount rate 21% The computation of cumulative cash flows shows that the firm can recover the investment in 2 to 3 years. The exact payback period may be computed as: Discounted payback period = 2 years + (9,970 /87,420) = 2.11 years Table 10: Computation of Internal Rate of Return for project B PVIF @ 34% PV @ 34% PVIF @ 37% PV @ 37% 1.000 -500,000.00 1.000 -500,000.00 0.746 276,020.00 0.730 270,100.00 0.557 150,390.00 0.533 143,910.00 0.416 64,480.00 0.389 60,295.00 0.310 15,190.00 0.284 13,916.00 TPV = 506,080.00 TPV = 488,221.00 NPV = 6,080.00 NPV = -11,779.00 IRR = 34 + [(506080.00-500,000.00)/ (506080.00- 488221.00)] * 3 = 35.02%

For Project C: Computation of Payback period of Project C Since the cash flows are even, the payback period can be calculated as Payback Period = Original investment / Annual Cash Flow = 1,000,000 / 323,000 = 3.09 years

Table 11: Computation of Discounted Payback Period of project C

Year 0 1 2 3 4 5 6 7 8 9 10 Cash Flow 1,000,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 PVIF @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247 NPV = PV @ 15% 1,000,000.00 281,010.00 244,188.00 212,534.00 184,756.00 160,531.00 139,536.00 121,448.00 105,621.00 91,732.00 79,781.00 621,137.00 Cumulative PV -1,000,000.00 -718,990.00 -474,802.00 -262,268.00 -77,512.00 83,019.00 222,555.00 344,003.00 449,624.00 541,356.00 621,137.00 PVIF @ 21% 1.000 0.826 0.683 0.564 0.467 0.386 0.319 0.263 0.218 0.180 0.149 NPV = PV @ 21% 1,000,000.00 266,798.00 220,609.00 182,172.00 150,841.00 124,678.00 103,037.00 84,949.00 70,414.00 58,140.00 48,127.00 309,765.00 Cumulative PV 1,000,000.00 -733,202.00 -512,593.00 -330,421.00 -179,580.00 -54,902.00 48,135.00 133,084.00 203,498.00 261,638.00 309,765.00

At discount rate 15% The computation of cumulative cash flows shows that the firm can recover the investment in 4 to 5 years. The exact payback period may be computed as: Discounted payback period = 4 years + (77,512/ 160,531) = 4.48 years At discount rate 21% The computation of cumulative cash flows shows that the firm can recover the investment in 5 to 6 years. The exact payback period may be computed as: Discounted payback period = 5 years + (54,902/103,037) = 5.53 years

Table 12: Computation of Internal Rate of Return for Project C PVIF @ 30% PV @ 30% PVIF @ 28% PV @ 28% 1.00 -1,000,000.00 1.00 -1,000,000.00 0.769 248,387.00 0.781 252,263.00 0.592 191,216.00 0.610 197,030.00 0.455 146,965.00 0.477 154,071.00 0.350 113,050.00 0.373 120,479.00 0.269 86,887.00 0.291 93,993.00 0.207 66,861.00 0.227 73,321.00 0.159 51,357.00 0.178 57,494.00 0.123 39,729.00 0.139 44,897.00 0.094 30,362.00 0.108 34,884.00 0.073 23,579.00 0.085 27,455.00 TPV = 998,393.00 TPV = 105,5887.00 NPV = -1,607.00 NPV = 55,887.00 IRR = 28 + [(1055887.00-1,000,000.00)/ (1055887.00- 998393.00)] * 2 = 29.94% For Project D: Since the cash flows are even, the payback period can be calculated as Payback Period = Original investment / Annual Cash Flow = 500,000 / 175,000 =2.86 years Table 13: Computation of Discounted Payback Period of project D
Year 0 1 2 3 4 5 Cash Flow -500,000.00 175,000.00 175,000.00 175,000.00 175,000.00 175,000.00 PVIF @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 NPV = PV @ 15% -500,000.00 152,250.00 132,300.00 115,150.00 100,100.00 86,975.00 86,775.00 Cumulative PV -500,000.00 -347,750.00 -215,450.00 -100,300.00 -200.00 86,775.00 PVIF @ 21% 1.000 0.826 0.683 0.564 0.467 0.386 NPV = PV @ 21% -500,000.00 144,550.00 119,525.00 98,700.00 81,725.00 67,550.00 12,050.00 Cumulative PV -500,000.00 -355,450.00 -235,925.00 -137,225.00 -55,500.00 12,050.00

At discount rate 15% The computation of cumulative cash flows shows that the firm can recover the investment in 4 to 5 years. The exact payback period may be computed as: Discounted payback period = 4 years + (200 / 86,975) = 4 years 10

At discount rate 21% The computation of cumulative cash flows shows that the firm can recover the investment in 4 to 5 years. The exact payback period may be computed as: Discounted payback period = 4 years + (55,500/67,550) = 4.82 years Table 14: Computation of IRR for Project D PV @ 22% PVIF @ 24% -500,000.00 1.00 143,442.62 0.806 117,575.92 0.650 96,373.71 0.524 78,994.84 0.423 64,749.87 0.341 501,136.96 TPV = 1,136.96 NPV =

PVIF @ 22% 1.00 0.820 0.672 0.551 0.451 0.370 TPV = NPV =

PV @ 24% -500,000.00 141,050.00 113,750.00 91,700.00 74,025.00 59,675.00 480,200.00 -19,800.00

IRR = 22 + [(501136.96-500,000.00)/ (501136.96- 480200.00)] * 2 = 22.11%

Question 2 Do you find anything wrong in choosing the projects based on pay back, NPV and IRR as stated above? What suggestions can be made to the company? How should be the projects with unequal lives dealt with? Determine equivalent annuity (EAA) for each project, and based on the calculations, which projects should Egret printing and publishing company accept for the coming year and why? Solution To suggest the company on choosing the project based on payback, NPV and IRR, we need to analyze each of them. They are as follows: 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 =

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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. It has serious limitations like: 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. Assumes the investment that is made have the same level of risk throughout the entire time horizon which may not be possible. 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 12

It has serious limitations like: 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. It is based on unrealistic 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. Not Helpful for comparing two mutually exclusive investments

Suggestions to the Company

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. 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. Account for time: 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 firms equity will change as a result of undertaking the project. 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. How should be the projects with unequal lives dealt with? 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. 13

There are two methods used to make the adjustments between two unequal life projects: 1. Replacement-chain (common life) approach Suppose a certain company is evaluating installation of either a cement factory or a sugar factory. It has to choose between these two projects, that is, it is not in a position to undertake both of the projects. Thus they are mutually exclusive projects. The relevant information regarding the said projects may be seen as under:

Table 15: Cement factory (Project C)

Time 0 1 2 3 4 5 6 Cash Flow -18,000 3,000 4,000 5,000 4,000 5,000 6,000

NPVC at 10% = Rs 1,013; IRR= 11.7%

Table 16: Sugar Factory (Project S)

Time 0 1 2 3 Cash Flow -9,000 4,000 4,500 3,000

NPVS at 10%= Rs 609; IRR =14.1% The above shows that Project C, when discount at 10% cost of capital has higher NPV and thus appears to be better project. Although the NPV suggests that Project C should be selected, our analysis is incomplete, and the decision to choose this project is actually incorrect. If we choose Project S, we will have an opportunity to make a similar investment in 3 years, and if cost and revenue conditions continue as shown above, this second investment will also be profitable. However, if we choose Project C, we give up option to make this second investment. Therefore, to make a proper comparison between Projects C and S, replacement chain approach should be applied. It means to say that one should find the NPV of Project C, which also has a life of six years. In order to do so, we must add in a second project to extend the overall life of the combined projects to six years.

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Table 17: Revised cash flow table of Sugar Company

Time 0 1 2 3 4 5 6 Cash Flow -9,000 4,000 4,500 3,000-9,000 = -6,000 4,000 4,500 3,000

We assume that the Project Ss cost, annual cash flows, and cost of capital will not change if the project is repeated in three years. We obtain the following results: NPV at 10% = Rs. 1,067; IRR= 14.1% The NPV of this extended Project S is Rs. 1,067, and its IRR is 14.1%. As the NPV of extended Project S over the common life of 6 years is Rs. 1,067, which is greater than the NPV of Project C. Thus the Project S should be selected. 2. Equivalent annual annuity The EAA method is an alternative to the Replacement Chain method, for use in evaluating projects with unequal lives. The EAA model derives a dollar value of the project that represents the same financial value of the NPV, except that the dollar value of the EAA is for payments or benefits that are equally spread over the life of the project (an annuity). The annual annuity can be compared between projects, and the project with the highest annuity should be chosen over lower annuity. The EAA method is clarified by the below given illustrations and calculations Determine equivalent annuity (EAA) for each project, and based on the calculations, which projects should Egret printing and publishing company accept for the coming year and why? Referring to the case we have the following table i.e. computation of EAA for all the projects A, B, C and D. Here, EAA = NPV / PVIFA (k%, n years) Table 18: Equivalent annuity (EAA) for each project Projects Computation at K = 15% EAA A 164577.6/PVIFA (15%, 4yrs) 57645 B 156038/PVIFA (15%, 4yrs) 54654 C 621137/PVIFA (15%, 10yrs) 123757 D 86775/PVIFA (15%, 5yrs) 25887 From the above table it is seen that project C has the highest EAA as compared to other projects. Since it higher EAA, it also has higher NPV therefore project C should be accepted. 15

Question 3 Draw a graph of NPV versus discount rate for projects A and B (a present value profile) using, in part, your answers for the IRR and NPV in question 1. Determine the crossover rate and discuss which project appears to be superior? Why? Table 19: calculation of PV at different rate of Project A Project A PV @ 0% PVIF @5% 1 0.952 0.907 0.8638 0.8227 PVIF PV @ 5% @ 10% -500,000 129,472 123,352 117,477 509,087 379,387 1 0.909 0.826 0.751 0.683 PV @ 10% -500,000 123,624 112,336 102,136 422,640.4 260,736.4 PVIF @ 20% 1 0.833 0.694 0.579 0.482 PV @ 20% -500,000 113,288 94,384 78,744 298,261. 6 84,677.6 PVIF @25 % 1 0.80 0.64 0.512 0.4096 PV @ 25% 500000 108800 87040 69632 253460 18932

-500,000 -500,000 136,000 136,000 136,000 618,800 136,000 136,000 136,000 618,800 526,800

Table 20: calculation of PV at different rate of Project B Project B PV @ 0% PVIF @ 5% 1 0.952 0.907 0.8638 0.8227 PVIF PV @ 5% @ 10% -500,000 352,240 244,890 133,889 40,312.3 271,331.3 1 0.909 0.826 0.751 0.683 PV @ 10% -500,000 336,330 223,020 116,405 33,467 209,222 PVIF @ 20% 1 0.833 0.694 0.579 0.482 PV @ 20% -500,000 308,210 187,380 89,745 23,618 108,953 PVIF @ 25% 1 0.80 0.64 0.512 0.4096 PV @ 25% 500000 296000 172800 79360 20070 68230

-500,000 -500,000 370,000 270,000 155,000 49,000 370,000 270,000 155,000 49,000 344,000

Project A has higher NPV at low discount rate as compared to cross over rate whereas Project B has high NPV at high discount rate compared to cross over rate. The figure shows that the NPV of Project A and Project B decline as the discount rate increases. Also, the NPV of project A is more sensitive to changes with discount rate as compared to that of project B.

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Table 21: Cross over Rate Calculation

Year 0 1 2 3 4 Total Project A (500000) 136000 136000 136000 618800 Project B (500000) 370000 270000 155000 49000 Difference 0 (234000) (134000) (19000) 569800 PVIF@ 15% 1 0.869 0.756 0.657 0.571 PV@ 15% 0 (203346) (101304) (12483) 325355.8 8222.8 PVIF@ 17% 1 0.855 0.731 0.624 0.534 PV@ 17% 0 (200070) (97954) (11856) 304273.2 (5606.8)

Crossover Rate=

Fig 4: cross-over rate

600000 500000 400000 300000 200000 NPV Project A NPV Project B

100000
0 0% -100000 -200000 10% 20% 30%

IRR=35.02%
40% IRR=26.61%

Crossover Rate= 16.19% which means that at 16.19% the decision remains neutral. This indicates that when the cost is less than crossover rate, we will select project A and if the cost is more than crossover rate, we will select project B. In this case, Project B is better than project A as the payback period, discounted payback period and IRR is favorable for project B. Also, at higher cost of capital, Project B seems to provide more return.

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Table 22: Decision regarding superiority of projects

Discount rate (k) 15% Comparison with crossover rate (16.19%) k<16.19% NPV of project A will be greater than NPV of project B 21% k>16.19% NPV of project B will be greater than NPV of project A Project A will be superior Project B will be superior Result Decision

Hence, project A will be superior at discount of 15% and project B will be superior at a discount rate of 21%.

Question 4 Now suppose that hill made a mistake in the projected cash flows for project D- they should have been $195,000 per year. Determine the effect of this change would have on capital budgeting. Would this situation bear on the decision about the mutually exclusive projects? Explain. Solution Calculations for Project D based on the Corrected Cash flows: I. Regular payback period

Since the cash flows are even every year, the payback period can be calculated as: Payback Period = Original investment / Annual Cash Flow = 500,000 / 195,000 = 2.56 years II. Discounted Payback Period Table 23: cash flow at discount rate of 15% Year 0 1 2 3 4 5 Cash Flow -500,000 195,000 195,000 195,000 195,000 195,000 PVIF @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 18 PV @ 15% -500,000 169,650 147,420 128,310 111,540 96,915 NPV Cumulative PV -500,000 -330,350 -182,930 -54,620 56,920 153,835 153,835.00

The payback period may be computed as: Discounted payback period = 3 + (54,620 / 111,540) = 3.49 years The computation of cumulative cash flows shows that the firm will be able to recover the investment in 3 to 4 years. Table 24: cash flow t discount rate of 21% Year 0 1 2 3 4 5 Cash Flow -500,000 195,000 195,000 195,000 195,000 195,000 PVIF @ 21% 1.000 0.826 0.683 0.564 0.467 0.386 PV @ 21% -500,000 161,070 133,185 109,980 91,065 75,270 NPV Cumulative PV -500,000 -338,930 -205,745 -95,765 -4,700 70,570 70,570

The payback period may be computed as: Discounted payback period = 4 + (4,700 / 75,270) = 4.06 years The computation of cumulative cash flows at discount rate @ 21% shows that the firm will be able to recover the investment in 4 to 5 years.

III. PVIF @ 27% 1.00 0.787 0.620 0.488 0.384 0.303 PV NPV

Table 25: calculation of Internal Rate of Return (IRR) PV @ 27% -500,000 153,465 120,900 95,160 74,880 59,085 503,490 3490 PVIF @ 29% 1.00 0.775 0.601 0.466 0.361 0.280 PV NPV PV @ 29% -500,000 151,125 117,195 90,870 70,395 54,600 484,185 -15,815

IRR = Lower rate + PV at lower rate-Original Investment PV at lower rate PV at higher rate = 27 + [(503,490 -500,000)/ (503,490-484,185)] * 2 = 27.36

(High rate-Lower Rate)

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Table 26: Changes on Project D after correction in class flows Project D (cash flow of Rs.175,000 Criterion each year) Project D (cash flow of Rs. 195,000 each year) Changes Remarks

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 Discounted payback period @ 15% Discounted payback period @ 21%

22.11

27.36

(5.25)

Increase in IRR

4.02

3.48

0.54

Decrease discounted payback

in

4.82

4.05

0.77

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Table 27: Comparison of Different Projects Project A Project B Project C -500,000.00 136,000.00 136,000.00 136,000.00 618,800.00 -500000 370000 270000 155000 49000 Project D -

1,000,000.00 500,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 323,000.00 195,000.00 195,000.00 195,000.00 195,000.00 195,000.00

NPV @ 15% NPV @ 21% IRR Payback period Discounted payback period @ 15% Discounted payback period @ 21%

$164,577.60 $71,043.60 26.61% 3.15 years

$156,038 $100,488 35.02% 1.48 years

$621,137 $310,088 29.94% 3.1 years

$153,835 $70,765 27.36% 2.56 years

3.54 years

1.87 years

4.48 years

3.48 years

3.75 years

2.11 years

5.53 years

4.05 years

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Fig 5: Comparison of Payback Period (years), IRR (%) and Discounted payback period at different rates of Project D, after changes in Cash Flows
30.00 25.00 20.00 15.00 10.00 5.00 Payback IRR Discounted Discounted payback period payback period @ 15% @ 21% Project D (cash flow of Rs.175,000 each year)

Project D (cash flow of Rs. 195,000 each year)

Fig 6: Comparison of NPV at different rates of Project D, after changes in Cash Flows
180,000 160,000

140,000
120,000 100,000 80,000 60,000 40,000 20,000 NPV @ 15 % NPV @ 21% Project D (cash flow of Rs.175,000 each year) Project D (cash flow of Rs. 195,000 each year)

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Fig 7: Comparison of Different Projects (after change in Cash Flows of Project D)

700000 600000 500000 Project A 400000 300000 200000 100000 0 NPV @ 15% NPV @ 21% Project B Project C Project D (Rs. 195,000) Project D (Rs. 175,000)

Fig 8: Comparison of IRR of all the projects, after changes in Cash Flows of Project D
40 35 30 25 20 15 10 5 0 IRR Project A Project B Project C Project D (Rs. 195,000) Project D (Rs. 175,000)

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Fig 9: Comparison of Different Projects (after change in Cash Flows of Project D)

6

5
4 3 2 1 0 Payback period Discounted payback period @ 15% Discounted payback period @ 21%

Project A Project B Project C Project D (Rs. 195,000) Project D (Rs. 175,000)

Even though the Cash Flows for Project D change, the combination of Project B and Project C is still a good option. Whereas, Project C has the highest NPV compared to other projects and higher IRR. The company should choose Project B because it has good NPV with highest IRR among the four alternative projects. Thus, even with the change in Cash Flows, the decision on the mutually exclusive projects remains the same.

Question 5 Assuming that the return on project A is representative of investment opportunities generally found on the printing industry, would it be reasonable for Mr. Hill to claim that Project B would generate a return of approximately 35% over its four-year life? Explain in terms of available reinvestment rates. Solution The IRR of project A is approximately 27%. Since project As 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. 24

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. Table 28: Calculation of MIRR Year 1 2 3 4 Cash Inflows $370,000.00 $270,000.00 $155,000.00 $49,000.00 Terminal Value of Cash Inflows FVIF @ 27% 2.0348 1.6057 1.2672 1 FV of Inflows $752876.00 $433539.00 $196416.00 $49,000.00 $1,431831.00

MIRR is calculated to determine the rate at which the present value of a projects outflow equals the terminal value of the projects inflows.

PV of costs Or, 500000

= terminal value/ [1 + MIRR] ^n = 1431831/[1 + MIRR]^4

Or, [1 +MIRR] ^4 = 2.8636 Or, MIRR = 0.30085 = 30.085% An MIRR of 30.085% 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 30.085%, 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.

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Question 6

If Mr. Hill is confident that he will be able to generate more and better projects in the years to come, but relatively doubtful that he will be able to persuade the Belford brothers to employ debt financing, how might this influence his recommendations? Could there ever be a situation in which Project D would be advisable? Explain. Solution Decision Criteria: Cost of capital > Rate of return; Reject the project Cost of capital < Rate of return; Accept the project Project D could be advisable in certain situations. This has been explained below: If Egret borrows (Debt) $500,000 at an interest rate of 12% then the new WACC would be as follows: Table 29: change in capital structure after addition of debt Capital Weighted Amount/Proportion Weights Cost (in %) Structure average 1,500,000/ 2,000,000 11.25 Equity 1,500,000 15 = 0.75 500,000/ 2,000,000 12(1-0.46) 1.62 Debt 500,000 = 0.25 =6.48 12.87 Total 2,000,000 As mentioned in the case, market rate of debt is 12% with tax rate of 46%. Thus, the new capital structure which employs 25% debt has weighted average cost of capital of 12.87%. Therefore, use of debt financing decreases the cost of capital and hence ensures better cash flows in the project. The reduction in the WACC also prevents from losing the personal security holdings of Belford Brothers through improved current net present value. So, Belford brothers can invest in Project D with use of additional debt that generates more cash flows. Earlier the company was able to invest in project A and C with the minimum proportion equity but now with the use of the increased amount of funds, it will be able to invest even in those projects which were not viable before. The additional funds increases by Rs 500,000 which implies that it now have 2 million of investable funds. So, the company can easily make use of the additional funds in project D. It can also invest in the new combination of project A, C and D or project B, C and D.

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Question 7 If the Belfords agree to Hills 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 terms of future returns to the Belford families, what would the impact be from using this debt financing or what would be the extra value addition in the present values of the selected projects? (Revise your computations using a new discount rate and conclude about the project to be chosen). Solution The new capital structure as assumed by Hill: Table 30: calculation of WACC Type of capital Long term debt Preferred stock Common equity Amount ($) 500,000 0 1,500,000 Weight 0.25 0 0.75 1 After tax cost 6.48 % 0 15% Percent 1.62 0 11.25 12.87%

Weighted average cost of capital

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 27

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: Table 31: calculation of PV and PI after debt financing Discount rate Combination of Projects Initial Investment NPV 1,082,366. 12.87% A, C & D 2 million 738 1,057,027. 12.87% B, C & D 2 million 073 PV of Inflow 3,082,366 .74 3,057,027 .07 1.52 1.54 Profitability Index(PI)

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

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The impact of using this debt financing is shown by the extra value addition in present values of selected project: Table 32: table showing extra value addition by use of debt financing Particulars Amount

Net present value of selected projects after inclusion of debt in capital $1,082,366.738 structure (A) Less: Net present value of selected projects before inclusion of debt in capital $786,714 structure. (B) 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: Table 33: cash flow of Project A Project A Year 0 1 2 3 4 Cash Flow -500000 136000 136000 136000 618800 1 0.886 0.785 0.6954 0.6161 Total PV of Inflows NPV PVIF@12.87 -500000 120496 106760 94574.4 381242.68 703073.08 203073.08 PV

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Table 34: cash flow of Project B Project B Year 0 1 2 3 4 Cash Flow -500000 370000 270000 155000 49000 1.000 0.886 0.785 0.695 0.616 TPV of Inflows NPV PVIF@12.87 -500000 327810.756 211936.967 107794.381 30191.3116 677733.415 177733.415 PV

Table 35: cash flow of Project C Project C Year 0 1 2 3 4 5 6 7 8 9 10 Cash Flow -1000000 323000 323000 323000 323000 323000 323000 323000 323000 323000 323000 1 0.886 0.785 0.695 0.616 0.546 0.484 0.428 0.380 0.336 0.298 TPV of Inflows NPV PVIF@12.87 -1000000 286169.93 253539.408 224629.581 199016.197 176323.378 156218.107 138405.34 122623.673 108641.511 96253.6643 1,761,820 761820.79 PV

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Table 36: cash flow of Project D Project D Year 0 1 2 3 4 5 Cash Flow -500000 175000 175000 175000 175000 175000 1.000 0.886 0.785 0.695 0.616 0.546 TPV of Inflows NPV PVIF@12.87 -500000 155045.628 137366.552 121703.333 107826.113 95531.2419 617472.868 117472.868 PV

Question 8

Assuming that the $1.5 million of internal funds available to finance new investment is after paying a dividend of $300,000 and represents an average addition to retained earnings; do you consider the use of $500,000 of debt to increase the risk to the Belfords by very much? Explain by considering times interest earned ratio. Solution We are given that the $1.5 million of internal funds is available to the company after paying $300,000 dividend, and it represents an average addition to retained earnings. The financing can be either equity financing or debt financing. Even though the company had had a bad experience with debt financing, going ahead with equity financing is not a good choice since it allows the lender to have partial control over the business. And the interest on debt finance is tax deductible which overshadows all the merits of equity financing. So we recommend the company to use $500,000 of debt which would help the company to get higher returns. To establish right mix of capital in the business, the company should follow a targeted debt level. And to monitor the debt level, the company should keep checking coverage ratio.

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Coverage ratios are mostly calculated using Times Interest Earned (TIE) Ratio. Times Interest Earned Ratio = EBIT / Interest Expense The times interest earned ratio indicates the extent of which earnings are available to meet interest payments. Table 37: Calculation of Times Interest Earned Ratio Particulars EBIT Less: Interest EBT Less: Tax @ 46% Net Income Less: Dividend Retain Earnings Times Interest Earned Ratio = EBIT/Interest Expense = 56.55 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 companys 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. Amount $ 3,393,333 60,000 3,333,333 1,533,333 1,800,000 300,000 1,500,000

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Question 9 The case stated that Project C would be feasible unless either Project A or B was also accepted. What is the implication of this statement on the current capital budgeting analysis? Do you think that the way Project C is handled earlier in the case is valid? Why or Why not? Solution As stated in the case, projects A and B are a mutually exclusive project which implies that only one project will be accepted from a set of projects at a time and the other project cannot be undertaken. Thus, when choosing between mutually exclusive projects, more than one project may satisfy the capital budgeting criterion. However, only one project would be selected among them. Project C would be feasible unless either project A or B is accepted. It refers that either with Project A or with Project B, Project C has to be carried out together making it a contingent project. If Egret Printing and Publishing Company selects project C then it provides them the option to choose optimal combination of projects. The possible combinations would occur as follows:

Project A ($ 0.5 million) $1.5 million Project B ($ 0.5 million)

Project C ($ 1 million)

Project C ($ 1 million)

The company has internal fund of $1.5 million. When all equity capital financing is used, the combinations of projects were obtained as of Projects A and C or Projects B and C. So, selection of the projects and investment is entirely based on increasing the value of the enterprise and maximizing the shareholders wealth. The independent project is chosen on the basis of considerable management practices and judgmental skills to incorporate the outcomes of these processes into the project analysis. Hence the way project C is handled earlier in the case is valid as it was the optimal project, which was combined with either project A or B.

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Question 10 Do you think that the quantitative measures alone are important in capital budgeting evaluation? What qualitative factors could also be important in capital budgeting evaluation? Solution Capital budgeting decisions are crucial to a firms success. So, while evaluating the projects, effective measures need to be carried out. If the decision is made entirely on the basis of quantitative factors alone then it has indirect impact on the management in the effective utilization of investment opportunities. The use of only those quantitative factors is not only sufficient for making judgments and evaluating decisions. Besides the quantitative factors, there are various qualitative factors which also need to be undertaken while making capital budgeting decisions. The quantitative factors include payback period, NPV and IRR. So, the management needs to make use of those quantitative factors along with the qualitative ones for making better decisions in selection of a project.

Importance of Qualitative factors in Capital Budgeting Evaluation Qualitative factors refer to those which have an impact on the project but the assessment of the accuracy of measurement is impossible to analyze and evaluate in monetary terms. Whenever a project passes through the quantitative analysis test, qualitative factors are taken into consideration for further evaluation. There are various factors that effect on the decision criteria as to accept or reject the project but they are quite difficult to measure. Such factors include:

Relationship with and commitment to suppliers Strategic consequences of consumption of scarce raw material Relationship with the labor unions( positive or negative) Environmental impact of the project Possible positive or negative governmental political attitudes towards the project Long term effect on profitability Effect on customers( Present and future) Effect of investment on the quality of products and services Suitability of market to carry out other project

As most of the projects are strategic and not just financial in nature, various dynamic and competitive environmental factors have to be considered. In order to analyze the feasibility of the project, the future innovation and the advantages that could be derived from the project should be assessed.

34

CONCLUSION
While making a choice between projects NPV should be the factor that should be taken as the decision criteria over other IRR, payback period and EAA. Positive NPV value guarantees maximization of shareholders wealth which other factors dont guarantee. Debt financing broadens the choices for selecting projects. So a firm that uses debt financing has more choices towards acceptance of projects when compared to a firm using equity financing. With the increased number of choices between projects, the company can select the project that gives higher returns. So projects which were not feasible with equity financing become viable under debt financing. Using optimal amount of debt in the companys capital structure is extremely significan t. However, few managerial personnel might not use the optimal amount and use a lesser amount instead because of increased risk in bankruptcy and higher levels of debt.

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