# Case95QuestionsPalmer1

**Topics:**Net present value, Investment, Internal rate of return

**Pages:**9 (2198 words)

**Published:**April 17, 2015

1. Table 1 contains the complete cash flow analysis 6 on GP Manufacturing’s basic information. Explain the inputs into 1) the net initial investment outlay at year 0, 2) the depreciation tax savings in each year of the project’s economic life, and 3) the project’s incremental cash flows?

1) $302,040 net initial investment includes:

($285,000) delivered cost

($18,000) installation cost

($2,500) removal cost

$4,000 current market value

($1,440) tax on proceeds

2) For year 1 the new system depreciated by 20 percent. Multiply that by the net initial investment and you get the total amount depreciated after 1 year, equal to $60,588. With a 36 percent tax rate you get the depreciated tax savings of $21,812. Year 2- 32% depreciated

Year 3- 19% depreciated

Year 4- 12% depreciated

Year 5- 11% depreciated

Year 6- 6% depreciated

3) Incremental cash flows: add depreciation tax saving of each year and add after tax cost saving of each year. Year 8 has a cash flow that consist of after tax cost savings and salvage value of the system.

2. What is the project’s NPV? Explain the economic rationale behind the NPV. Could the NPV of this particular project be different for GP Manufacturing than for one of Chino Material Systems Inc.’s other potential customers? Explain. NPV = $20,578

NPV is a measure of profitability of an investment. If NPV is positive, the company should accept the project. The NPV would be the same for everyone if values were the same because it is just an estimate of future cash flows. The only way it could change is if they used a different cost of capital.

3. Calculate the proposed project’s IRR. Explain the rationale for using the IRR to evaluate capital investment projects. Could the IRR for this project differ for GP Manufacturing versus for another customer? IRR = 14.32%

The higher the rate, the better. IRR is a good indicator of whether a company should accept a long term investment. Ideally, you want the IRR to be greater than the required rate of return to accept the project. The IRR could be different if the initial investment and cash flows are different.

4. Suppose one of GP Manufacturing’s executives typically uses the payback as a primary capital budgeting decision tool and wants some payback information.

a. What is the project’s payback period?

4.29 years (cell B73)

b. What is the rationale behind the use of payback as a project evaluation tool?

The rationale behind payback as an evaluation tool is it gives investors an idea of when their initial investment will be paid back. This is the point where the project should start to profit.

c. What deficiencies does payback have as a capital budgeting decision method?

The disadvantage of using the payback is it ignores the time value of money. A majority of cash inflows may not be received for a long time. It also does not consider that some projects may receive cash flow long after the payback period. A good project could be ignored because the payback focuses mainly on short-term cash flows.

d. Does payback provide any useful information regarding capital budgeting decisions?

It provides a simple way for managers to make quick evaluations and is best used for small investments. It can also help accept project for companies that do not have much cash and need to recover as soon as possible.

e. Chino Material Systems Inc. has a number of different types of products: some that are relatively expensive, some that are inexpensive, some that have very long lives, and some with short lives. Strictly as a sales tool, without regard to the validity of the analysis, would the payback be of more help to the sales staff for some types of equipment than for others? Explain.

The payback method could be used as a sales tool to estimate the number of years for the investment to be recovered. The sales staff could use this information to explain to customers the quick investment recovery of some...

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