Tim can show that the payback period is not appropriate in the analysis of the projects for the following reasons. First, it does not properly account for the time value of money, risk financing and other important considerations such as opportunity cost and it does not consider the cost of capital. It does not specify any required comparison to other investments or even to not making an investment. The method is an indication of both the risk and the liquidity without considering the terms to maturity. Second, it ignores cash flows occurring after the payback period. An implicit assumption in the use of method is that returns to the investment continue after the payback period. Cash flows occurring within the payback period should not be weighted equally as they are. It violates the principle that investors desire more in the way of benefits rather than less. Lastly, the selection of maximum acceptable payback period is arbitrary.
2. Discounted Payback Period using 10% as the discount rate
Though Discounted Payback Period is more appropriate way of measuring the payback period since it considers the time value of money, Tim should not ask the Board to use DPP as the deciding factor because it produces conflicting rankings. With the Discounted Payback Period, investments that have a Positive Net Present Value (NPV) over the longer term will be rejected because of the fact that we have to set an arbitrary cut-off point. Since we determine a cut-off point, we are ignoring the possibility of growing cash flows thereafter. Thus, we are ignoring cash flows that are paid or received after the payback period.
3. 40% Accounting Rate of Returns
• If the ARR of a project is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Since Synthetic Resin has the higher ARR it should be accepted even though both exceed the preferred ARR, which is 40%, of the management.
Using ARR in deciding what project to choose should not be used at all because of the following reasons: cash flows are more important to investors and ARR is based on numbers that include non-cash items; ARR does not diminish with time as is the case with NPV and IRR; it does not adjust for the greater risk to longer term forecasts; there are better alternating which are not significantly more difficult to calculate; and it tends to favor high risk decisions.
4. IRR of the two Project:
Synthetic Resin = 36.63% Epoxy Resin = 42.91%
• In the case, these two projects are mutually exclusive. Since both projects have greater return than the cost of capital, then the project with a higher yield will be chosen and that is the Epoxy Resin.
Tim can convince the management that the IRR measure could be misleading for some reasons. First, it should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in. In addition, IRR overstates the annual equivalent rate of return for a project whose cash flows are reinvested at a rate lower than calculated IRR. There might be a possibility of multiple IRRs. Moreover, it assumes cash flows over the life of the project can be reinvested at the IRR. The IRR, as a measure of investment efficiency may give better insights in capital constrained situations. However, when comparing mutually exclusive projects, NPV is the appropriate measure.
5. NPV Profiles
|Cost Of Capital |Synthetic Resin |Epoxy Resin | |0% |$1 600 000 |$900 000 | |10% |903 021.4032 |562 214.4538 | |20% |453 575.1029 |328 215.0206 | |30% |149 613.6474 |158 666.067 | |40% |(64...