Capital Budgeting: Ranking Problems Presented in the Harding Plastic Molding Company - Assignment Example

Capital Budgeting: Ranking Problems Presented in the Harding Plastic Molding Company Abstract Capital budgeting is one great task that needs careful study before considering the final decision as this involves a company’s money matters which could either increase or decrease its wealth. Considering capital budgeting in financial management, this paper focuses on the Net Profit Value (NPV), Profitability Index (PI) and Internal Rate of Return (IRR) taking into account their importance in a company’s decision making to avoid loses in terms of money and time. The data provided by Harding Plastic Molding Company (HPMC) will basically be the information used in this paper to make a clear presentation of our objectives, critically reflecting on the results. Computing through the aforementioned techniques to consider the acceptance or rejection of a project, we will be considering the different aspects affecting the result of the decision with the eight given projects namely, projects A-H. Charts presenting the computed NPV, PI and IRR will also be included for a clearer visual understanding of what will be discussed, answering the questions given in considering the projects. Moreover, the said projects will be scrutinized comparing their advantages or disadvantages over the other. In connection to the comparisons, we will be looking into which project will be taken over the other and the reason behind each decision. Assuming certain circumstances like capital constraint, we will also be reflecting the acceptance or rejection of a project. In addition, a literature review is included in this paper where we critically evaluate the Net Present Value, Profitability Index and Internal Rate of Return taking into account their definitions, assumptions, advantages and limitations to fully understand the concept in financial marketing. Likewise, there would be a discussion of the advantages and disadvantages of the real options methodology compared to the investment appraisal techniques mentioned earlier. Question 1: In ranking projects to decide on whether to take a project or not or which project to take, there are certain factors that need to be considered so that computing for the NPV, PI and IRR is necessary. With that, I do not see Harding Plastic Molding Company to be correct in stating that these factors would yield the same ranking. These factors would include situations when there is a great difference in the cash flow like in the case of projects A and B where A had uneven cash flows ranging from $10,000-100,000 while project B had an even cash flow of $43,000 per year. The size of the projects is another factor to consider which could largely affect the IRR computation resulting to a wrong decision (Rosen, 1195, p. 244). Along with size disparity, we also need to consider time disparity and unequal lives because these ranking problems would also affect the results of the three appraisal techniques (Rosen, 1195, p. 244). For instance, projects A and B exemplify time disparity showing a difference in the payback period while projects C and D clearly have a great difference between the cash flows or size, and projects E and F have unequal lives as project E is short-lived compared to project F with a life span of ten years. Question 2 Looking at Illustrations A and B, project A has a NPV of $12,037, PI of 1.16 and an IRR of 32.92% while project B has a NPV = $15,578.7, PI = 1.21 and IRR = 32.92%. Obviously, time disparity caused the ranking conflicts with a great difference in the cash flows. Comparing the results for the investment appraisal techniques, both projects can be accepted as NPV is higher than 0, PI is greater than one and the IRR is higher than the rate of return. However, HPMC should invest on project B because it has higher results than that of project A which means the company will benefit more from project B. Illustration A Project A Rate of Return (assumed)_1 20%       Year 0 1 2 3   -75,000 10,000 30,000 100,000 Discount factors 1 0.8333 0.6944 0.5787 PV cash flows -75,000.0 8,333.3 20,833.3 57,870.4 NPV 12,037.0 PI= 1.16 IRR(Excel) 27.19% Illustration B Project B Rate of Return (assumed)_1 20%       Year 0 1 2 3   - 75,000 43,000 43,000 43,000 Discount factors 1 0.8333 0.6944 0.5787 PV cash flows - 75,000.0 35,833.3 29,861.1 24,884.3 NPV 15,578.7 PI = 1.21 IRR(Excel) 32.92% Assuming the discount rate is 12%, with the results of the techniques shown in illustrations C and D, yes the favored investment should be on project A and not B because the results change with the NPV, PI and IRR of project A higher than that of B. Illustration C Project A Rate of Return (assumed)_1 12%       Year 0 1 2 3   - 75,000 10,000 30,000 100,000 Discount factors 1 0.8929 0.7972 0.7118 PV cash flows - 75,000.0 8,928.6 23,915.8 71,178.0 NPV 29,022.4 IRR(Excel) 27.19% Illustration D Project 1 Rate of Return (assumed)_1 12%       Year 0 1 2 3   - 75,000 43,000 43,000 43,000 Discount factors 1 0.8929 0.7972 0.7118 PV cash flows - 75,000.0 38,392.9 34,279.3 30,606.6 NPV 28,278.7 IRR(Excel) 32.92% Considering a 12% discount rate, it is logical to assume that the IRR for project B of approximately 33% is a correct calculation for ranking purposes because as seen in illustration E, the IRR 32.92% which is very near the rate of 33%. Illustration E Project B Rate of Return (assumed) 12%       Year 0 1 2 3   - 75,000 43,000 43,000 43,000 Discount factors 1 0.8929 0.7972 0.7118 PV cash flows - 75,000.0 38,392.9 34,279.3 30,606.6 NPV 28,278.7   IRR 27.47% Question 3 The NPV, PI, and IRR of project C are $1,166.7; 1.1458 and 37.5% respectively while project D has a NPV of $833.3, PI of 1.0417 and an IRR of 25%. Thus, project C should be chosen over project D because of the higher values for NPV, PI and IRR. If the projects were to be considered under capital constraint, the answer will not change because project C has a lower capital than D. The $12,000 margin not used in project C is a considerable amount to weigh in choosing this project over the other including the fact that with $8,000; there is a $3,000 return of investment compared to $5,000 with a capital of $20,000. Thus, project C would be chosen because it yields a higher return of the investment (Compare illustrations F & G). Illustration F Project C Rate of Return (assumed)_1 20%   Year 0 1   - 8,000 11,000 Discount factors 1 0.8333 PV cash flows - 8,000.0 9,166.7 NPV 1,166.7 PI= 1.1458 IRR(Excel) 37.50% Illustration G Project D Rate of Return (assumed)_1 20%   Year 0 1   - 20,000 25,000 Discount factors 1 0.8333 PV cash flows - 20,000.0 20,833.3 NPV 833.3 PI= 1.0417 IRR(Excel) 25.00% Question 4 The NPV, PI and IRR of project E are 160,908.9, 6.3636 and 600% while F has 342,954, 2.26, 35%, respectively. Since projects E and F are mutually exclusive projects which have unequal lives, they are not comparable with the use of NPV, PI or IRR. With this condition, we would need to compute the Equivalent Annual Annuity (EAA) for us to be able to compare the two projects, using the equation: , where r is the rate and n is the number of years. Thus, we get the and . Having this result, we can now choose project F over project E despite an IRR of 600% and a PI of 6.3636 compared to the IRR of project F which is just 35% and a PI of 2.26. Illustration G Project E Rate of Return (assumed) 10%   Year 0 1   - 30,000 210,000 Discount factors 1 0.90909 PV cash flows - 30,000.0 190,908.9 NPV 160,908.9 PI=6.3636 IRR(Excel) 600% EAA= $26,187 Illustration H Project F Rate of Return (assumed) 10%                     Year 0 1 2 3 4 5 6 7 8 9 10   - 271,500 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 Discount factors 1 0.90909 0.82644 0.75131 0.68301 0.62092 0.56447 0.51316 0.46651 0.42409 0.38554 PV cash flows - 271,500.0 90,909 82,644 75,131 68,301 62,092 56,447 51,316 46,651 42,409 38,554 NPV 342,954 PI=2.26 EAA= $55,815 IRR(Excel) 35% Question 5 Illustration I Project G Rate of Return (assumed) 20%             Year 0 1 2 3 4 5     -500,000 225,000 225,000 225,000 225,000 225,000 Discount factors 1 0.8333 0.6944 0.5787 0.4823 0.4019 PV cash flows -500,000.0 187,492 156,240 130,208 108,518 90,428   NPV 172,886 PI= 1.3458 IRR(Excel) 34.94% EAA= 57,809 Illustration H Project H Rate of Return (assumed) 20%                     Year 0 1 2 3 4 5 6 7 8 9 10   - 500,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 Discount factors 1 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349 0.2791 0.2326 0.1938 0.1615 PV cash flows - 500,000.0 124,995 104,160 86,805 72,345 60,285 50,235 41,865 34,890 29,070 24,225 NPV 128,875 PI=1.26 IRR(Excel) 22.31% EAA= 30, 739 Looking at illustrations I and J, the NPV, PI, IRR as well as the EAA of project G is higher than that of project H. Yes, the two projects are comparable because their NPV difference is not so great not like projects E and F. HMPC should choose project G as this will increase the wealth of the company. Question 6 So far, we have seen how the three investment appraisal techniques can be applied in deciding on a project. We remember that we accept the project when NPV>0; PI>1 or IRR>Rate of Return or ROR but reject it if NPV1 but when NPV Read More