Watertown, Inc. was founded in May, 2005 by Lawrence Rollins, who was employed for 20 years...

 

Transcribed Image Text:

Watertown, Inc. was founded in May, 2005 by Lawrence Rollins, who was employed for 20 years prior as a river rafting guide. Mr. Rollins received an unexpected inheritance of $2,000,000 in January, 2005. Soon after, he decided to leave his lifelong career in river rafting, and use his inheritance as seed capital for Watertown. Over the last few years, Watertown experienced rapid sales growth, although the company has only recently shown positive net income. The company is considering two alternative processes for manufacturing inflatable tubes to service demand in a rapidly growing market. The first manufacturing process has a higher start-up cost than the second, but greater economies of scale. The expected cash flows associated with this process are presented below in Table 1. Table 1: Cash Flow Projections for Process I EBIAT Depreciation Initial Investment (1,000,000) Table 2: Cash Flow Projections for Process 2 150,000 200,000 EBIAT Depreciation The second manufacturing process requires a smaller initial investment than the first, and because of this it is appealing to some members of the board. The expected cash flows associated with this process are presented in Table 2 below. 200,000 300,000 470.000 200,000 200,000 200,000 1 440,000 160,000 3 4 2 240,000 175,000 40,000 160,000 160,000 160,000 500,000 200,000 Initial Investment (800,000) *EBIAT is Earnings Before Interest and After Tax (i.e., EBIT x (1-tax rate)) 5 40,000 160,000 After careful assessment of the risk associated with this project, you conclude that the appropriate cost of capital for both processes is 14.25%. Based on other available capital investments, you believe that free cash flows generated by each project can be re-invested in other projects at a rate of at least 18%. At the initial presentation, project leaders of both teams presented their cash flow projections. However, since the processes are mutually exclusive, the firm can only accept one proposal. You have been asked to evaluate the two production processes and present your findings to the board of directors. Your CEO Charlie, a loyal Cougar, learned capital budgeting techniques in his finance classes at WSU, and you are confident that she is able to distinguish among competing investment decision rules and use the appropriate criteria for decision-making. However, the founder and Chairman of the Board, Lawrence Rollins has never been to business school, in fact he does not have a college degree. He prefers the second process because it costs less money up-front. In addition, several influential old-timers on the board are intrigued with the payback decision rule, which you believe contains significant shortcomings. It is your job to clearly articulate the relative merits of each investment decision criterion. Guidelines for Written Case Report Prepare a report intended for the board of directors of Watertown that contains an evaluation of the two production processes and a recommended course of action. Your report should contain answers to the following questions. 1. Compute the Net Present Value, Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), Incremental IRR, Profitability Index, and Payback Period, for each of the two processes. 2. Explain why the payback period is not an appropriate decision rule. Should you use discounted payback instead? Explain why or why not. 3. Why is the IRR measure potentially misleading? 4. Explain the concept of Incremental IRR. Is it helpful in making a decision in this situation? Explain why or why not. 5. Explain the concept of Modified IRR. Is it helpful in making a decision in this situation? Explain why or why not. 6. Explain the concept of profitability index. Is it helpful in making a decision in this situation? Explain why or why not. 7. How would you convince the board that the NPV method is the best decision rule to use? Watertown, Inc. was founded in May, 2005 by Lawrence Rollins, who was employed for 20 years prior as a river rafting guide. Mr. Rollins received an unexpected inheritance of $2,000,000 in January, 2005. Soon after, he decided to leave his lifelong career in river rafting, and use his inheritance as seed capital for Watertown. Over the last few years, Watertown experienced rapid sales growth, although the company has only recently shown positive net income. The company is considering two alternative processes for manufacturing inflatable tubes to service demand in a rapidly growing market. The first manufacturing process has a higher start-up cost than the second, but greater economies of scale. The expected cash flows associated with this process are presented below in Table 1. Table 1: Cash Flow Projections for Process I EBIAT Depreciation Initial Investment (1,000,000) Table 2: Cash Flow Projections for Process 2 150,000 200,000 EBIAT Depreciation The second manufacturing process requires a smaller initial investment than the first, and because of this it is appealing to some members of the board. The expected cash flows associated with this process are presented in Table 2 below. 200,000 300,000 470.000 200,000 200,000 200,000 1 440,000 160,000 3 4 2 240,000 175,000 40,000 160,000 160,000 160,000 500,000 200,000 Initial Investment (800,000) *EBIAT is Earnings Before Interest and After Tax (i.e., EBIT x (1-tax rate)) 5 40,000 160,000 After careful assessment of the risk associated with this project, you conclude that the appropriate cost of capital for both processes is 14.25%. Based on other available capital investments, you believe that free cash flows generated by each project can be re-invested in other projects at a rate of at least 18%. At the initial presentation, project leaders of both teams presented their cash flow projections. However, since the processes are mutually exclusive, the firm can only accept one proposal. You have been asked to evaluate the two production processes and present your findings to the board of directors. Your CEO Charlie, a loyal Cougar, learned capital budgeting techniques in his finance classes at WSU, and you are confident that she is able to distinguish among competing investment decision rules and use the appropriate criteria for decision-making. However, the founder and Chairman of the Board, Lawrence Rollins has never been to business school, in fact he does not have a college degree. He prefers the second process because it costs less money up-front. In addition, several influential old-timers on the board are intrigued with the payback decision rule, which you believe contains significant shortcomings. It is your job to clearly articulate the relative merits of each investment decision criterion. Guidelines for Written Case Report Prepare a report intended for the board of directors of Watertown that contains an evaluation of the two production processes and a recommended course of action. Your report should contain answers to the following questions. 1. Compute the Net Present Value, Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), Incremental IRR, Profitability Index, and Payback Period, for each of the two processes. 2. Explain why the payback period is not an appropriate decision rule. Should you use discounted payback instead? Explain why or why not. 3. Why is the IRR measure potentially misleading? 4. Explain the concept of Incremental IRR. Is it helpful in making a decision in this situation? Explain why or why not. 5. Explain the concept of Modified IRR. Is it helpful in making a decision in this situation? Explain why or why not. 6. Explain the concept of profitability index. Is it helpful in making a decision in this situation? Explain why or why not. 7. How would you convince the board that the NPV method is the best decision rule to use?

Answer rating: 100% (QA)

Watertown Production Process Evaluation for Inflatable Tubes Introduction This report evaluates two alternative production processes for Watertowns inflatable tubes We will analyze each process using ... View the full answer