Case Study – Alliance Industries, Inc. – Capital Budgeting

Case Study – Alliance Industries, Inc. – Capital BudgetingThe Alliance Industries, Inc., established in 1995, has managed to earn a consistently high rate of return on its investments. The secret of its success has been the strategic and timing development, manufacturing, and marketing of innovative products that have been used in various industries. Currently, the management of the company is considering the manufacture of a special polymer to be used in the energy industry. The company’s research and development teams have come up with two alternatives (1) polymer A which has a lower startup cost, and a polymer B which costs more to produce initially, but would have greater economies of scale. At the initial presentation, the project leaders of both teams presented their cash flow projections and provided sufficient documentation in support of their proposals. However, since the products are mutually exclusive, the firm can only fund one proposal.In order to resolve this dilemma, Craig Stewart, the company’s CFO has been assigned the task of analyzing the costs and benefits of the two proposals and presenting his findings to the board of directors. Craig knows this will be an uphill battle, since the board members are not all on the same page when it comes to financial concepts. The board has historically has a strong preference for using rate of return as its decision criteria. On occasions it has also used the payback period approach to decide between competing projects. However, Craig is convinced that the net present value (NPV) method is least flawed and when used correctly will always add the most value to the company’s wealth.After obtaining the cash flow projections for each project (see Tables 1 and 2), and crunching our the numbers, Craig realizes that the hill is going to be steeper than he thought. The various capital budgeting techniques, when applied to the tow series of cash flows, provide inconsistent results. The project with the higher NPV has a longer payback period as well as a lower Account Rate of Return (ARR) and Internal Rate of “Return (IRR). Craig scratches his head, wondering how he can convince the board that the IRR and ARR, and Payback Period can often lead to incorrect decision.1. Calculate the Payback Period of each project. Explain what argument Craig should make to show that the Payback Period is not appropriate in this case.2. Calculate the Discount Payback Period (DPP) using 10% as the discount rate. Should Craig ask the board to use the DPP as the deciding factor? Explain.3. Calculate the two projects’ IRR. How should Craig convince the board that the IRR measure could be misleading?4. Calculate the NPV profile for the two projects and explain the relevance of the crossover point. How should Craig convince the board that the NPV method is the way to go?5. Explain how Craig can show that the Modified Internal Rate of Return (MIRR) is the more realistic measure to use in the case of mutually exclusive projects.6. Calculate the Profitability Index for each proposal. Can this measure help to solve the dilemma? Explain.7. In looking over the documentation prepared by the two project teams, it appears to you that the polymer B team has been somewhat more conservative in its revenue projections than the polymer A term. What impact might this have on your analysis?8. In looking over the documentation prepared by the two project teams, it appear to you that the polymer B technology would require extensive development before it could be implemented where as the polymer A technology is available “off-the-shelf”. What impact might this have on your analysis??Table 1Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Polymer A Net income 440,000 240,000 140,000 40,000 40,000Depreciation (Straight Line) 160,000 160,000 160,000 160,000 160,000Net Cash Flow ($800,000) 600,000 400,000 300,000 200,000 200,000Table 2Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Polymer B Net income 150,000 200,000 300,000 450,000 500,000Depreciation (Straight Line) 200,000 200,000 200,000 200,000 200,000Net Cash Flow (1,000,000) 350,000 400,000 500,000 650,000 700,000