# Question

Argile Textiles is evaluating a new product, a silk/wool blended fabric. Assume that you were recently hired as assistant to the director of capital budgeting, and you must evaluate the proposed project. The fabric would be produced in an unused building located adjacent to Argile’s Southern Pines, North Carolina, plant; Argile owns the building, which is fully depreciated. The required equipment would cost $200,000, plus an additional $40,000 for shipping and installation. With the new project, inventories would rise by $25,000, and accounts payable would increase by $5,000. All of these costs would be incurred at t = 0. By a special ruling, the machinery could be depreciated under the MACRS system as 3-year property.

The project is expected to operate for four years, and then be terminated. The cash inflows are assumed to begin one year after the project is undertaken, or at t = 1, and to continue to t = 4. At the end of the project’s life (t = 4), the equipment is expected to have a salvage value of $25,000.

Unit sales are expected to total 100,000 five-yard rolls per year, and the expected sales price is $2 per roll. Cash operating costs for the project (total operating costs excluding depreciation) are expected to amount to 60 percent of dollar sales. Argile’s marginal tax rate is 40 percent, and its required rate of return is 10 percent. Tentatively, the silk/wool blend fabric project is assumed to be of equal risk to Argile’s other assets. You have been asked to evaluate this project and to make an accept/reject recommendation. To guide you in your analysis, your boss has asked you to answer the following set of questions.

a. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?

b. What is the difference between independent and mutually exclusive projects? Between projects with conventional cash flows and projects with unconventional cash flows? Between replacement analysis and expansion analysis?

c. Draw a cash flow timeline that shows when the net cash inflows and outflows will occur with Argile’s proposed project, and explain how the timeline can be used to help structure the analysis.

d. Argile has a standard form that is used in the capital budgeting process; it is shown in Table IP13-1. Part of the table has been completed, but you must compute the missing values. Complete the table in the following steps:

(1) Complete the unit sales, sales price, total revenues, and operating costs (excluding depreciation) lines.

(2) Complete the depreciation line.

(3) Complete the table down to net income and then down to net operating cash flows.

(4) Fill in the blanks under Year 0 and Year 4 for the initial investment outlay and the terminal cash flows, respectively. Next, complete the cash flow timeline (net cash flow). Discuss the role of working capital. What would have happened if the machinery were sold for less than its book value?

e. (1) Argile uses debt in its capital structure, so some of the money used to finance the project will consist of debt. Given this fact, should you revise the projected cash flows to show projected interest charges? Explain.

(2) Suppose you learned that Argile had spent $50,000 to renovate the building last year, expensing these costs. Should this cost be reflected in the analysis? Explain.

(3) Suppose you learned that Argile could lease its building to another party and earn $25,000 per year. Should that fact be reflected in the analysis? If so, how?

(4) Assume that the silk/wool blend fabric project would take away profitable sales from Argile’s cotton/wool blend fabric business. Should that fact be reflected in your analysis? If so, how?

For the remainder of the questions, disregard all of the assumptions made in part (e) and assume there was no alternative use for the building over the next four years.

f. (1) What is the regular payback period and the discounted payback period for the project?

(2) What is the rationale for the payback? According to the payback criterion, should Argile accept the project if the firm’s maximum acceptable payback is two years?

(3) Explain the main difference between the regular payback and the discounted payback.

(4) What are the main disadvantages of the regular payback method? Is the payback method of any real usefulness in capital budgeting decisions?

g. (1) Define the term net present value. What is the proposed project’s NPV?

(2) What is the rationale behind the NPV method? Based on the results of your NPV analysis, should Argile accept the project?

(3) Would the NPV change if the required rate of return (WACC) changed? Explain.

h. (1) Define the term internal rate of return. What is the proposed project’s IRR?

(2) How is the IRR on a project related to the YTM on a bond?

(3) What is the logic behind the IRR method? Based on the results of your IRR analysis, should Argile accept the project?

(4) Would the project’s IRRs change if the required rate of return changed? Explain.

i. (1) Define the term modified internal rate of return. What is the project’s MIRR?

(2) What is the rationale behind the MIRR method? According to MIRR, should the project be accepted?

(3) Would the MIRR change if the required rate of return changed?

j. Draw the NPV profile for the proposed project. What information does the NPV profile provide?

k. If this project had been are placement rather than an expansion, how would the analysis have changed? In answering this question, think about the changes that would occur in the cash flow table, but do not perform any calculations.

l. Assume that inflation is expected to average 5 percent over the next four years, that this expectation is reflected in the required rate of return, and that inflation will increase variable costs and revenues by the same percentage. Does it appear that the analysis has properly dealt with inflation? If not, what should be done, and how would the required adjustment affect thedecision?

The project is expected to operate for four years, and then be terminated. The cash inflows are assumed to begin one year after the project is undertaken, or at t = 1, and to continue to t = 4. At the end of the project’s life (t = 4), the equipment is expected to have a salvage value of $25,000.

Unit sales are expected to total 100,000 five-yard rolls per year, and the expected sales price is $2 per roll. Cash operating costs for the project (total operating costs excluding depreciation) are expected to amount to 60 percent of dollar sales. Argile’s marginal tax rate is 40 percent, and its required rate of return is 10 percent. Tentatively, the silk/wool blend fabric project is assumed to be of equal risk to Argile’s other assets. You have been asked to evaluate this project and to make an accept/reject recommendation. To guide you in your analysis, your boss has asked you to answer the following set of questions.

a. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?

b. What is the difference between independent and mutually exclusive projects? Between projects with conventional cash flows and projects with unconventional cash flows? Between replacement analysis and expansion analysis?

c. Draw a cash flow timeline that shows when the net cash inflows and outflows will occur with Argile’s proposed project, and explain how the timeline can be used to help structure the analysis.

d. Argile has a standard form that is used in the capital budgeting process; it is shown in Table IP13-1. Part of the table has been completed, but you must compute the missing values. Complete the table in the following steps:

(1) Complete the unit sales, sales price, total revenues, and operating costs (excluding depreciation) lines.

(2) Complete the depreciation line.

(3) Complete the table down to net income and then down to net operating cash flows.

(4) Fill in the blanks under Year 0 and Year 4 for the initial investment outlay and the terminal cash flows, respectively. Next, complete the cash flow timeline (net cash flow). Discuss the role of working capital. What would have happened if the machinery were sold for less than its book value?

e. (1) Argile uses debt in its capital structure, so some of the money used to finance the project will consist of debt. Given this fact, should you revise the projected cash flows to show projected interest charges? Explain.

(2) Suppose you learned that Argile had spent $50,000 to renovate the building last year, expensing these costs. Should this cost be reflected in the analysis? Explain.

(3) Suppose you learned that Argile could lease its building to another party and earn $25,000 per year. Should that fact be reflected in the analysis? If so, how?

(4) Assume that the silk/wool blend fabric project would take away profitable sales from Argile’s cotton/wool blend fabric business. Should that fact be reflected in your analysis? If so, how?

For the remainder of the questions, disregard all of the assumptions made in part (e) and assume there was no alternative use for the building over the next four years.

f. (1) What is the regular payback period and the discounted payback period for the project?

(2) What is the rationale for the payback? According to the payback criterion, should Argile accept the project if the firm’s maximum acceptable payback is two years?

(3) Explain the main difference between the regular payback and the discounted payback.

(4) What are the main disadvantages of the regular payback method? Is the payback method of any real usefulness in capital budgeting decisions?

g. (1) Define the term net present value. What is the proposed project’s NPV?

(2) What is the rationale behind the NPV method? Based on the results of your NPV analysis, should Argile accept the project?

(3) Would the NPV change if the required rate of return (WACC) changed? Explain.

h. (1) Define the term internal rate of return. What is the proposed project’s IRR?

(2) How is the IRR on a project related to the YTM on a bond?

(3) What is the logic behind the IRR method? Based on the results of your IRR analysis, should Argile accept the project?

(4) Would the project’s IRRs change if the required rate of return changed? Explain.

i. (1) Define the term modified internal rate of return. What is the project’s MIRR?

(2) What is the rationale behind the MIRR method? According to MIRR, should the project be accepted?

(3) Would the MIRR change if the required rate of return changed?

j. Draw the NPV profile for the proposed project. What information does the NPV profile provide?

k. If this project had been are placement rather than an expansion, how would the analysis have changed? In answering this question, think about the changes that would occur in the cash flow table, but do not perform any calculations.

l. Assume that inflation is expected to average 5 percent over the next four years, that this expectation is reflected in the required rate of return, and that inflation will increase variable costs and revenues by the same percentage. Does it appear that the analysis has properly dealt with inflation? If not, what should be done, and how would the required adjustment affect thedecision?

## Answer to relevant Questions

Problem 13-35 contained the details of a new-project capital budgeting evaluation being conducted by Argile textiles. Although inflation was considered in the initial analysis, the riskiness of the project was not taken into ...Explain how a firm might shift its capital structure so as to change its weighted average cost of capital (WACC). What would be the impact on the value of the firm?The Scanlon Company’s optimal capital structure calls for 50 percent debt. The interest rate on its debt is a constant 10 percent; its cost of common equity from retained earnings is 14 percent; the cost of equity from new ...Now your boss wants you to evaluate the dividend policy of Information Systems, Inc. (ISI), which develops software for the health care industry. ISI was founded five years ago by Donald Brown and Margaret Clark, who are ...Describe the cash conversion cycle. How can a financial manager use knowledge of the cash conversion cycle to better manage the firm’s working capital?Post your question

0