Financial Management Accounting

The Dilemma at Day-Pro

Class Case #5
November 10, 2018

Submitted to:
Felix D. Cena, CPA, PhD

Submitted by:
Feria, Hanah

Saturday, 2:00PM – 5:00 PM

 1. Calculate the Payback Period of each project. Explain what argument Mike should make
to show that the Payback Period is not appropriate in this case.

SYNTHETIC RESIN EPOXY RESIN

Year Cash Flow Cumulative CF Year Cash Flow Cumulative CF
0 (1,000,000.00) (1,000,000.00) 0 (800,000.00) (800,000.00)
1 350,000.00 (650,000.00) 1 600,000.00 (200,000.00)
2 400,000.00 (250,000.00) 2 400,000.00 200,000.00
3 500,000.00 250,000.00 3 300,000.00 500,000.00
4 650,000.00 900,000.00 4 200,000.00 700,000.00
5 700,000.00 1,600,000.00 5 200,000.00 900,000.00

SYNTHETIC RESIN EPOXY RESIN

Cash Flow Cash Flow
Payback Payback
= n + Cumulative Cash = n + Cumulative Cash
Period Period
Flow Flow
Payback 250,000.00 Payback 200,000.00
= 2 + = 1 +
Period 500,000.00 Period 400,000.00
Payback Payback
= 2 + 0.5 = 1 + 0.5
Period Period
Payback Payback
= 2.5 years = 1.5 years
Period Period

The payback period is the length of time required to recover the cost of an
investment. The payback period of a given investment or project is an important
determinant of whether to undertake the position or project, as longer payback periods
are typically not desirable for investment positions. Epoxy Resin project has a payback
period of 1.5 years while Synthetic Resin has a longer payback period of 2.5 years. On the
basis of this methodology we will choose to invest in Epoxy Resin. As the 2 projects have
different initial investment, it’s not appropriate to use the payback period method. The
smaller the amount, the faster the recovery. Also, it cannot measure the whole investor’s
wealth for it is only focusing on the time the initial cost of capital was recovered.
 2. Calculate the Discounted Payback Period (DPP) using 10% as the discount rate. Should Mike ask the Board to use DPP as the
deciding factor? Explain.
SYNTHETIC RESIN EPOXY RESIN
Year Cash Flow PV of Cash Flow Cumulative CF Year Cash Flow PV of Cash Flow Cumulative CF
0 (1,000,000.00) (1,000,000.00) 0 (800,000.00) (800,000.00)
1 350,000.00 318,181.82 (681,818.18) 1 600,000.00 545,454.55 (254,545.45)
2 400,000.00 330,578.51 (351,239.67) 2 400,000.00 330,578.51 76,033.06
3 500,000.00 375,657.40 24,417.73 3 300,000.00 225,394.44 301,427.50
4 650,000.00 443,958.75 468,376.48 4 200,000.00 136,602.69 438,030.19

5 700,000.00 434,644.93 903,021.40 5 200,000.00 124,184.26 562,214.45

SYNTHETIC RESIN EPOXY RESIN

Discounted Cash Flow Discounted Cash Flow
= n + = n +
Payback Period Cumulative Cash Flow Payback Period Cumulative Cash Flow
Discounted 351,239.67 Discounted 254,545.45
= 2 + = 1 +
Payback Period 375,657.40 Payback Period 330,578.51
Discounted Discounted
= 2 + 0.935 = 1 + 0.77
Payback Period Payback Period
Discounted Discounted
= 2.94 years = 1.77 years
Payback Period Payback Period

The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A
discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by
discounting future cash flows and recognizing the time value of money. Based on the computations above, Epoxy Resin is the
most viable project. It is vital for Tim to weigh the cost and the benefits of the two proposals and the payback methods cannot
simply do this to an extent in which it can maximize the company's wealth.
3. If management prefers to have a 40% accounting rate of return, which project would be
accepted? What is wrong with this decision?
SYNTHETIC RESIN EPOXY RESIN
Last Cumulative Cash Flow Last Cumulative Cash Flow
EAT = EAT =
n n
1,600,000.00 700,000.00
EAT = EAT =
5 5
EAT = 320,000.00 EAT = 140,000.00

EAT EAT
ARR = ARR =
Ave. Investment Ave. Investment
320,000.00 140,000.00
ARR = ARR =
500,000.00 400,000.00
ARR = 64.00% ARR = 35.00%

ARR for Synthetic Resin is 64% and 45% for Epoxy Resin. Since the acceptable ARR
for both projects is 40% it may be difficult for Tim to make the right decision as both will
be generating wealth. Also, ARR does not consider the time value of money or cash
flows, which can be an integral part of maintaining the business.
 4. Calculate the two projects’ IRR. How should Mike convince the Board that the IRR measure could be misleading?
SYNTHETIC RESIN
Year Cash Flow Discounted 10% PV Factor @ 30% PV @ 30% PV Factor @ 40% PV @ 40%
1 350,000.00 318,181.82 0.769 269,230.77 0.714 250,000.000
2 400,000.00 330,578.51 0.592 236,686.39 0.510 204,081.633
3 500,000.00 375,657.40 0.455 227,583.07 0.364 182,215.743
4 650,000.00 443,958.75 0.350 227,583.07 0.260 169,200.333
5 700,000.00 434,644.93 0.269 188,530.35 0.186 130,154.102
Cash Inflow 1,903,021.40 1,149,613.65 935,651.81
Cash Outflow 1,000,000.00 1,000,000.00 1,000,000.00
NPV 903,021.40 149,613.65 (64,348.19)

SYNTHETIC RESIN
discounted NPV
IRR = discount rate + ( ) ( PV rate - discount rate )
discounted NPV - present value
903,021.40
IRR = 10% + ( ) ( 40% - 10% )
903,021.40 - (64,348.19)
903,021.40
IRR = 10% + ( ) ( 30% )
967,369.59

IRR = 10% + ( 0.93 ) ( 30% )

IRR = 10% + 28%

IRR = 38.00%
 EPOXY RESIN
Year Cash Flow Discounted 10% PV Factor @ 40% PV @ 40% PV Factor @ 45% PV @ 45%
1 600,000.00 545,454.55 0.714 428,571.43 0.690 413,793.103
2 400,000.00 330,578.51 0.510 204,081.63 0.476 190,249.703
3 300,000.00 225,394.44 0.364 109,329.45 0.328 98,405.019
4 200,000.00 136,602.69 0.260 52,061.64 0.226 45,243.687
5 200,000.00 124,184.26 0.186 37,186.89 0.156 31,202.543
Cash Inflow 1,362,214.45 831,231.03 778,894.05
Cash Outflow 800,000.00 800,000.00 800,000.00
NPV 562,214.45 31,231.03 (21,105.95)

discounted NPV
IRR = discount rate + ( ) ( PV rate - discount rate )
discounted NPV - present value
562,214.45
IRR = 10% + ( ) ( 45% - 10% )
562,214.45 - (21,105.95)
562,214.45
IRR = 10% + ( ) ( 35% )
583,320.40

IRR = 10% + ( 0.96 ) ( 35% )

IRR = 10% + 34%

IRR = 43.73%

The IRR for Synthetic project is 38%, and the Epoxy project is 43.73%. The NVP for Synthetic project is 903,021.40, and the Epoxy
project is 562,214.45, so even though Synthetic project has a lower IRR than Epoxy Resin project, NPV contradicts this and thus we
must analyze this even further. IRR is not equal to annual rate of return. Assumptions of IRR are not always reasonable and rational.
IRR itself may produce misleading results.
 5. Calculate the NPV profiles for the two projects and explain the relevance of the crossover point. How should Mike convince the Board that
the NPV method is the way to go?

SYNTHETIC RESIN EPOXY RESIN

Year Cash Flow NPV Year Cash Flow NPV
350,000.00 600,000.00
1 350,000.00 318,181.82 1 600,000.00 545,454.55
(1+ 10%)1 (1+ 10%)1
400,000.00 400,000.00
2 400,000.00 330,578.51 2 400,000.00 330,578.51
(1+ 10%)2 (1+ 10%)2
500,000.00 300,000.00
3 500,000.00 375,657.40 3 300,000.00 225,394.44
(1+ 10%)3 (1+ 10%)3
650,000.00 200,000.00
4 650,000.00 443,958.75 4 200,000.00 136,602.69
(1+ 10%)4 (1+ 10%)4
700,000.00 200,000.00
5 700,000.00 434,644.93 5 200,000.00 124,184.26
(1+ 10%)5 (1+ 10%)5
Total NPV 1,903,021.40 Total NPV 1,362,214.45
Investment (1,000,000.00) Investment (800,000.00)
NPV 903,021.40 NPV 562,214.45

Year Synthetic Resin Epoxy Resin Difference

0 (1,000,000.00) (800,000.00) (200,000.00)
1 350,000.00 600,000.00 (250,000.00)
2 400,000.00 400,000.00 -
3 500,000.00 300,000.00 200,000.00
4 650,000.00 200,000.00 450,000.00
5 700,000.00 200,000.00 500,000.00
IRR 38.00% 43.73% 29.17%
NPV 903,021.40 562,214.45
 Crossover Point
1,600,000.00
1,400,000.00
1,200,000.00
1,000,000.00
800,000.00
600,000.00
400,000.00
200,000.00
-
(200,000.00) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46
(400,000.00)

NPV Synthetic NPV Epoxy

Discount Rate NPV Synthetic NPV Epoxy Difference Discount Rate NPV Synthetic NPV Epoxy Difference
1% 1,514,611.35 859,844.08 654,767.28 24% 318,355.63 254,179.10 64,176.54
2% 1,433,277.03 821,314.75 611,962.27 25% 287,616.00 237,056.00 50,560.00
3% 1,355,757.75 784,324.30 571,433.45 26% 257,988.56 220,441.39 37,547.17
4% 1,281,830.82 748,790.73 533,040.10 27% 229,421.89 204,314.41 25,107.48
5% 1,211,288.85 714,637.37 496,651.48 28% 201,867.39 188,655.24 13,212.15
6% 1,143,938.50 681,792.46 462,146.03 29% 175,279.12 173,445.08 1,834.04
7% 1,079,599.45 650,188.80 429,410.65 29% 170,852.05 170,902.71 (50.66)
8% 1,018,103.36 619,763.37 398,340.00 30% 149,613.65 158,666.07 (9,052.42)
9% 959,293.01 590,457.08 368,835.94 31% 124,829.84 144,301.22 (19,471.38)
10% 903,021.40 562,214.45 340,806.95 32% 100,888.78 130,334.40 (29,445.62)
11% 849,151.04 534,983.39 314,167.65 33% 77,753.59 116,750.25 (38,996.66)
12% 797,553.22 508,714.90 288,838.33 34% 55,389.32 103,534.14 (48,144.82)
13% 748,107.40 483,362.91 264,744.49 35% 33,762.85 90,672.16 (56,909.31)
 14% 700,700.56 458,884.04 241,816.51 36% 12,842.75 78,151.04 (65,308.29)
15% 655,226.73 435,237.46 219,989.27 37% (7,400.79) 65,958.15 (73,358.94)
16% 611,586.46 412,384.66 199,201.80 38% (26,996.09) 54,081.43 (81,077.52)
17% 569,686.34 390,289.34 179,397.00 39% (45,970.04) 42,509.38 (88,479.42)
18% 529,438.60 368,917.23 160,521.37 40% (64,348.19) 31,231.03 (95,579.22)
19% 490,760.73 348,235.98 142,524.75 41% (82,154.82) 20,235.91 (102,390.74)
20% 453,575.10 328,215.02 125,360.08 42% (99,413.04) 9,514.01 (108,927.05)
21% 417,808.65 308,825.46 108,983.18 43% (116,144.83) (944.24) (115,200.58)
22% 383,392.53 290,039.97 93,352.56 44% (132,371.09) (11,147.98) (121,223.11)
23% 350,261.91 271,832.68 78,429.23 45% (148,111.74) (21,105.95) (127,005.80)

Crossover rate is the cost of capital at which the net present values of two projects are equal. It is the point at which the NPV
profile of one project crosses over (intersects) the NPV profile of the other project. Crossover rate is useful in capital budgeting
analysis because it tells the investing company about the cost of capital at which both of the mutually-exclusive projects are equally
good. If the company's cost of capital crosses the crossover rate, the relative attractiveness of mutually-exclusive projects changes. For
example, if Synthetic Resin is preferable at a discount rate below the crossover rate, Epoxy Resin becomes feasible as soon as the cost
of capital crosses the crossover rate.

Mike should tell the board that NPV is the best method to use to decide between Synthetic and Epoxy Resins. NPV is the single best
criterion because it provides a direct measure of the value the projects adds to the shareholders’ wealth. Also, it accounts the time
value of money and can be used to compare investment alternatives that are similar. The NPV relies on a discount rate of return that
may be derived from the cost of the capital required to make the investment, and any project or investment with a negative NPV should
be avoided.
 6. Explain how Mike can show that the Modified Internal Rate of Return is the more realistic measure to use in the case of manually
exclusive projects.

SYNTHETIC RESIN
Year Cash Flow FV Factor FV 1
( )
0 (1,000,000.00) MIRR = FV of Cash Flows n
( ) -1
1 350,000.00 1.464 512,435.000 PV of Cash Flows
2 400,000.00 1.331 532,400.000 1
( )
3 500,000.00 1.210 605,000.000 MIRR = 3,064,835.000 5
( ) -1
4 650,000.00 1.100 715,000.000 1,000,000.000
5 700,000.00 700,000.000
( 0.2 )
3,064,835.000 MIRR =
( 3.065 ) -1

0.2
MIRR =
( 3.065 ) -1

MIRR = 25.11%
 EPOXY RESIN
Year Cash Flow FV Factor FV 1
( )
0 (800,000.00) MIRR = FV of Cash Flows n
( ) -1
1 600,000.00 1.464 878,460.000 PV of Cash Flows
2 400,000.00 1.331 532,400.000 1
( )
3 300,000.00 1.210 363,000.000 MIRR = 2,193,860.000 5
( ) -1
4 200,000.00 1.100 220,000.000 800,000.000
5 200,000.00 200,000.000
( 0.2 )
2,193,860.000 MIRR =
( 2.742 ) -1

0.2
MIRR =
( 2.742 ) -1

MIRR = 22.36%

Mutually exclusive projects refer to a sect of projects out of which only one project can be selected for investment. MIRR is
predominantly more accurate for these kind of projects. Modified internal rate of return (MIRR) assumes that positive cash flows are
reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. By contrast, the traditional
internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR. The MIRR more accurately reflects the
cost and profitability of a project. Since Synthetic Resin and Epoxy Resin are projects of unequal size, the MIRR is best used to rank
investments or projects. The calculation is a solution to two major problems that exist with the popular IRR calculation. The first main
problem with IRR is that multiple solutions can be found for the same project. The second problem is that the assumption that positive
cash flows are reinvested at the IRR is considered impractical in practice. With the MIRR, only a single solution exists for a given project,
and reinvestment rate of positive cash flows is much more valid in practice. Assuming that we used the 10% rate still if the cash flows
will be deposited at the bank, Synthetic’s MIRR is 25.11% and Epoxy’s is 22.36%. Given the rates, Mike should consider also the total
amount of return in the project and the return rate of the re-investment.
 7. Calculate the Profitability Index for each proposal. Can this measure help to solve the dilemma? Explain.
SYNTHETIC RESIN EPOXY RESIN
Year Cash Flow PV of Cash Flow Cumulative CF Year Cash Flow PV of Cash Flow Cumulative CF
0 (1,000,000.00) (1,000,000.00) 0 (800,000.00) (800,000.00)
1 350,000.00 318,181.82 (681,818.18) 1 600,000.00 545,454.55 (254,545.45)
2 400,000.00 330,578.51 (351,239.67) 2 400,000.00 330,578.51 76,033.06
3 500,000.00 375,657.40 24,417.73 3 300,000.00 225,394.44 301,427.50
4 650,000.00 443,958.75 468,376.48 4 200,000.00 136,602.69 438,030.19
5 700,000.00 434,644.93 903,021.40 5 200,000.00 124,184.26 562,214.45
1,903,021.40 1,362,214.45

SYNTHETIC RESIN EPOXY RESIN

Profitability PV of Future Cash Flows Profitability PV of Future Cash Flows
= =
Index Investment Index Investment
Profitability 1,903,021.40 Profitability 1,362,214.45
= =
Index 1,000,000.00 Index 800,000.00
Profitability Profitability
= 1.90 = 1.70
Index Index

A profitability index attempts to identify the relationship between the costs and benefits of a proposed project. A PI
greater than 1.0 indicates that profitability is positive, while a PI of less than 1.0 indicates that the project will lose money. As
values on the profitability index increase, so does the financial attractiveness of the proposed project. As both projects have a
PI greater than 1, this does not help solve the dilemma.
8. 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 your analysis?

Cash flow changes during the initial periods of the project is very critical in using
the NPV. A higher cash flow in the opening periods with a low discount rate leads to a
higher NPV. If we use the previous NPV calculations which use a discount rate of 10% we
can see that Synthetic Resin has a higher NPV than Epoxy Resin. If we will consider a
discount rate higher than 10%, the Epoxy Resin will generate a higher NPV than the
Synthetic Resin.

9. In looking over the documentation prepared by the two project teams, it appears to you
that the Synthetic Resin Technology would require extensive development before it could
be implemented whereas the Epoxy Resin Technology is available off-the-shelf.” What
impact might this have on your analysis?

When we look at the payback period, we look at the initial outlay and cash flows.
Synthetic resin is likely to incur additional costs due to its extensive development. This
could mean that its initial outlay will be greater than expected, thus the figures that we
have now may not be accurate once we started with the project. In that case, the payback
period will be affected. From 2.5 years it can be longer to 3.61 years if the initial outflow
is 1,500,000 and not 1,000,000. Since the epoxy resin is available off-the-shelf, its initial
outlay maybe lower than the expected initial investment of 800,000. So the recovery
period can be shorter than the expected period of 1.5 years. The Discount rate which is
being used also effects the true value of the 2 projects. Epoxy being readily available
anytime could imply that there is less risk involved. Also, at the current rate of 10%, this
could mean that it's too high, which makes it okay for the company. On the other hand,
the synthetic resin require extensive development. It means that it has a greater risk, and
at only 10% can be seen to be too low. All in all, it can be concluded that the
implementation of the 2 projects would greatly affect the analysis made.