Microsoft Word - Harding Plastic Molding Company

Harding Plastic Molding Company

On January 11, 2003, the finance committee of Harding Plastic Molding Company (HPMC) met to consider eight capital budgeting projects. Present at the meeting were Robert L. Harding, president and founder; Susan Jorgensen, comptroller; and Chris Woelk, head of research and development. Over the past five years, this committee has met every month to consider and make a final judgment on all proposed capital outlays brought up for review during the period.

Harding Plastic Molding Company was founded in 1982 by Robert L. Harding to produce plastic parts and molding for the Detroit automakers. For the first 10 years of operations, HPMC has worked solely as a subcontractor for the automakers, but since then the company has made strong efforts to diversify in order to avoid the cyclical problems faced by the auto industry. By 1998, this diversification attempt had led HPMC into the production of over 1,000 different items, including kitchen utensils, camera housings, and photographic and recording equipment. It had also led to an increase in sales 500 percent during the period 1992-2002. As this dramatic increase in sales was paralleled by a corresponding increase in production volume, HPMC was forced, in late 2001, to expand production facilities. This plant and equipment expansion involved capital expenditures of approximately $10.5 million and resulted in an increase of production capacity of about 40 percent. Because of this increased production capacity, HPMC has made a concerted effort to attract new business and, consequently, has recently entered into contracts with a large toy firm and a major discount department store chain. Still, non-auto- related business represents only 32 percent of HPMC?s overall business. Thus, HPMC has continued to solicit nonautomotive business, and as a result of this effort and its internal research and development, the firm has four sets of mutually exclusive projects to consider at this month?s finance committee meeting.

Over the past 10 years, HPMC?s capital budgeting approach has evolved into a somewhat elaborate procedure in which new proposals are categorized into three areas: profit, research and development, and safety. Projects falling into the profit or research and development area are evaluated using present value technique, assuming a 10 percent discount rate; those falling into the safety classification are evaluated in a more subjective framework. Bedsides the requirement that research and development projects receive favorable results from the present value criteria, a total dollar limit is assigned to projects of this category ? typically about $750,000 per year. This limitation was imposed by Harding primarily because of the limited availability of quality researchers in the plastics industry. He felt that if more funds than this were allocated, ?we simply couldn?t find the manpower to administer them properly.? The benefits derived from safety projects, on the other hand, are not measured in terms of cash flows; hence, present value methods are not used in their evaluation. Evaluating safety projects is a pragmatically difficult task requiring quantifying the benefits from these projects into dollar terms. Thus, safety projects are subjectively evaluated by a management-worker committee with a limited budget. All eight projects to be evaluated in January are classified as profit projects.

The first set of projects listed on the meeting?s agenda for examination involves the utilization of HPMC?s precision equipment. Project A calls for the production of vacuum containers for thermos bottles produced for a large discount hardware chain. The containers would be manufactured in five different size and color combinations. This project would be carried out over a three-year period. Project B involves the manufacture of inexpensive photographic equipment for a national photography outlet. Although HPMC currently has excess

plant capacity, each of these projects would utilize precision equipment whose excess capacity is limited. Thus, adopting either project would tie up all precision facilities. In addition, the purchase of new equipment would be both prohibitively expensive and involve a time delay of approximately two years, thus making projects A and B mutually exclusive. (The cash flows associated with projects A and B are given in Exhibit 1.)

EXHIBIT 1 Harding Plastic Molding Company

Year

0 1 2 3

Cash Flows Project A

$-75,000 10,000 30,000 100,000

Project B

$-75,000 43,000 43,000 43,000

EXHIBIT 2 Harding Plastic Molding Company

Year

0 1

Cash Flows Project C

$-8,000 11,000

Project D

$-20,000 25,000

The second set of projects involves the renting of computer facilities over a one-year period to aid in customer billing and perhaps inventory control. Project C entails the evaluation of a customer billing system proposed by Advanced Computer Corporation. Under this system, all the bookkeeping and billing presently being done by HPMC?s accounting department would now be done by Advanced. In addition to saving bookkeeping costs, Advanced would provide a more efficient billing system and do a credit analysis of delinquent customers, which could be used in the future for in-depth credit analysis. Project D is proposed by International Computer Corporation and includes a billing system similar to that offered by Advanced, as well as an inventory control system that will keep track of all raw materials and parts in stock and reorder when necessary, thereby reducing the likelihood of material stockouts, which has become more and more frequent over the past there years. (The cash flows for projects C and D and given in Exhibit 2.)

The third decision that faces the financial directors of HPMC involves a newly developed and patented process for molding hard plastic. HPMC can either manufacture and market the equipment necessary to mold such plastics or it can sell the patent rights to Polyplastics, Inc., the world?s largest producer of plastics products. (The cash flows for projects E and F are shown in Exhibit 3.) At present, the process has not been fully tested, and if HPMC is going to market it itself, it will be necessary to complete this testing and begin production of plant facilities immediately. On the other hand, the selling of these patent rights to Polyplastics would involve only minor testing and refinements, which could be completed within the year. Thus, a decision between the two courses of action is necessary immediately.

EXHIBIT 3 Harding Plastic Molding Company

Cash Flows Year Project E

1. 0 $-30,000
2. 1 210,000

2 3

4 5 6 7 8 9 10

Project F

$-271,500 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000

The final set of projects up for consideration concerns the replacement of some of the machinery. HPMC can go into one of two directions: project G suggests the purchase and installation of moderately priced and extremely efficient equipment with an expected life of 5 years; while project H advocates the purchase of a similarly priced, although less efficient, machine with a life expectancy of 10 years. (The cash flows for these alternatives are shown in Exhibit 4.)

EXHIBIT 4 Harding Plastic Molding Company

Cash Flows Year Project G

1. 0 $-500,000
2. 1 225,000
3. 2 225,000
4. 3 225,000
5. 4 225,000
6. 5 225,000

6

7 8 9 10

Project H

$-500,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000

As the meeting opened, debate immediately centered on the most appropriate method for evaluating all projects. Harding suggested that since the projects to be considered were mutually exclusive, perhaps their usual capital budgeting criterion of net present value was inappropriate. He felt that, in examining these projects, they should be more concerned with some measure of relative profitability. Both Jorgensen and Woelk agreed with Harding?s point of view, with Jorgensen advocating a profitability index approach and Woelk preferring to use the internal rate of return. Jorgensen argued that the use of profitability index would provide a benefit-cost ratio,

directly implying relative profitability, so that they would merely need to rank the projects and select those with the highest profitability index. Woelk suggested that the calculation of an internal rate of return would also give a measure of profitability and perhaps be somewhat easier to interpret. To settle the issue, Harding suggested that they calculate all three measures, as they would undoubtedly yield the same ranking.

From here the discussion turned to an appropriate approach to the problem of differing lives among mutually exclusive projects E and F, and G and H. Woelk argued that there really was no problem here, since all cash flows from these projects could be determined, any of the discounted cash flow methods of capital budgeting would work well. Jorgensen argued that this was true, but felt that some compensation should be made for the fact that the projects being considered did not have equal lives.

QUESTIONS

1. Was Harding correct in stating that the NPV, PI, and IRR necessarily will yield the same ranking order? Under what situations might the NPV, PI, and IRR methods provide different rankings? Why is this possible?
2. What are the NPV, PI, and IRR for projects A and B? What has caused the ranking conflicts? Should project A or B be chosen? Calculate Modified IRR assuming 10% reinvestment rate. Does Modified IRR support NPV or IRR? Why?
3. Now assume that projects A and B are independent, however you cannot start both projects immediately. One of the projects must be delayed and it must start only in year 2 (the initial outlay will occur in year 2) and will go until year 5. In this case, which project should be delayed, A or B?
4. What are the NPV, PI, and IRR for projects C and D? Should project C or D be chosen? Does your answer change if these projects are considered under a capital constraint? Calculate Modified IRR. Does it support NPV or IRR? Why? Now calculate Incremental IRR. Does it support NPV or IRR? Why?
5. What are the NPV, PI, and IRR for projects E and F? Are these projects comparable even though they have unequal lives? Why? Which project should be chosen? Assume that these projects are not considered under a capital constraint.
6. What are the NPV, PI, and IRR for projects G and H? Are these projects comparable even though they have unequal lives? Why? Which project should be chosen? Assume that these projects are not considered under a capital constraint.

Harding Plastic Molding Company On January 11, 2003, the finance committee of Harding Plastic Molding Company (HPMC) met to consider eight capital budgeting projects. Present at the meeting were Robert L. Harding, president and founder; Susan Jorgensen, comptroller; and Chris Woelk, head of research and development. Over the past five years, this committee has met every month to consider and make a final judgment on all proposed capital outlays brought up for review during the period. Harding Plastic Molding Company was founded in 1982 by Robert L. Harding to produce plastic parts and molding for the Detroit automakers. For the first 10 years of operations, HPMC has worked solely as a subcontractor for the automakers, but since then the company has made strong efforts to diversify in order to avoid the cyclical problems faced by the auto industry. By 1998, this diversification attempt had led HPMC into the production of over 1,000 different items, including kitchen utensils, camera housings, and photographic and recording equipment. It had also led to an increase in sales 500 percent during the period 1992-2002. As this dramatic increase in sales was paralleled by a corresponding increase in production volume, HPMC was forced, in late 2001, to expand production facilities. This plant and equipment expansion involved capital expenditures of approximately $10.5 million and resulted in an increase of production capacity of about 40 percent. Because of this increased production capacity, HPMC has made a concerted effort to attract new business and, consequently, has recently entered into contracts with a large toy firm and a major discount department store chain. Still, non-autorelated business represents only 32 percent of HPMC's overall business. Thus, HPMC has continued to solicit nonautomotive business, and as a result of this effort and its internal research and development, the firm has four sets of mutually exclusive projects to consider at this month's finance committee meeting. Over the past 10 years, HPMC's capital budgeting approach has evolved into a somewhat elaborate procedure in which new proposals are categorized into three areas: profit, research and development, and safety. Projects falling into the profit or research and development area are evaluated using present value technique, assuming a 10 percent discount rate; those falling into the safety classification are evaluated in a more subjective framework. Bedsides the requirement that research and development projects receive favorable results from the present value criteria, a total dollar limit is assigned to projects of this category - typically about $750,000 per year. This limitation was imposed by Harding primarily because of the limited availability of quality researchers in the plastics industry. He felt that if more funds than this were allocated, \"we simply couldn't find the manpower to administer them properly.\" The benefits derived from safety projects, on the other hand, are not measured in terms of cash flows; hence, present value methods are not used in their evaluation. Evaluating safety projects is a pragmatically difficult task requiring quantifying the benefits from these projects into dollar terms. Thus, safety projects are subjectively evaluated by a management-worker committee with a limited budget. All eight projects to be evaluated in January are classified as profit projects. The first set of projects listed on the meeting's agenda for examination involves the utilization of HPMC's precision equipment. Project A calls for the production of vacuum containers for thermos bottles produced for a large discount hardware chain. The containers would be manufactured in five different size and color combinations. This project would be carried out over a three-year period. Project B involves the manufacture of inexpensive photographic equipment for a national photography outlet. Although HPMC currently has excess plant capacity, each of these projects would utilize precision equipment whose excess capacity is limited. Thus, adopting either project would tie up all precision facilities. In addition, the purchase of new equipment would be both prohibitively expensive and involve a time delay of approximately two years, thus making projects A and B mutually exclusive. (The cash flows associated with projects A and B are given in Exhibit 1.) EXHIBIT 1 Harding Plastic Molding Company Cash Flows Year Project A Project B 0 1 2 3 $-75,000 10,000 30,000 100,000 $-75,000 43,000 43,000 43,000 EXHIBIT 2 Harding Plastic Molding Company Cash Flows Year 0 1 Project C Project D $-8,000 11,000 $-20,000 25,000 The second set of projects involves the renting of computer facilities over a one-year period to aid in customer billing and perhaps inventory control. Project C entails the evaluation of a customer billing system proposed by Advanced Computer Corporation. Under this system, all the bookkeeping and billing presently being done by HPMC's accounting department would now be done by Advanced. In addition to saving bookkeeping costs, Advanced would provide a more efficient billing system and do a credit analysis of delinquent customers, which could be used in the future for in-depth credit analysis. Project D is proposed by International Computer Corporation and includes a billing system similar to that offered by Advanced, as well as an inventory control system that will keep track of all raw materials and parts in stock and reorder when necessary, thereby reducing the likelihood of material stockouts, which has become more and more frequent over the past there years. (The cash flows for projects C and D and given in Exhibit 2.) The third decision that faces the financial directors of HPMC involves a newly developed and patented process for molding hard plastic. HPMC can either manufacture and market the equipment necessary to mold such plastics or it can sell the patent rights to Polyplastics, Inc., the world's largest producer of plastics products. (The cash flows for projects E and F are shown in Exhibit 3.) At present, the process has not been fully tested, and if HPMC is going to market it itself, it will be necessary to complete this testing and begin production of plant facilities immediately. On the other hand, the selling of these patent rights to Polyplastics would involve only minor testing and refinements, which could be completed within the year. Thus, a decision between the two courses of action is necessary immediately. EXHIBIT 3 Harding Plastic Molding Company Cash Flows Year Project E Project F 0 1 2 3 4 5 6 7 8 9 10 $-30,000 210,000 $-271,500 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 The final set of projects up for consideration concerns the replacement of some of the machinery. HPMC can go into one of two directions: project G suggests the purchase and installation of moderately priced and extremely efficient equipment with an expected life of 5 years; while project H advocates the purchase of a similarly priced, although less efficient, machine with a life expectancy of 10 years. (The cash flows for these alternatives are shown in Exhibit 4.) EXHIBIT 4 Harding Plastic Molding Company Cash Flows Year Project G Project H 0 1 2 3 4 5 6 7 8 9 10 $-500,000 225,000 225,000 225,000 225,000 225,000 $-500,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 As the meeting opened, debate immediately centered on the most appropriate method for evaluating all projects. Harding suggested that since the projects to be considered were mutually exclusive, perhaps their usual capital budgeting criterion of net present value was inappropriate. He felt that, in examining these projects, they should be more concerned with some measure of relative profitability. Both Jorgensen and Woelk agreed with Harding's point of view, with Jorgensen advocating a profitability index approach and Woelk preferring to use the internal rate of return. Jorgensen argued that the use of profitability index would provide a benefit-cost ratio, directly implying relative profitability, so that they would merely need to rank the projects and select those with the highest profitability index. Woelk suggested that the calculation of an internal rate of return would also give a measure of profitability and perhaps be somewhat easier to interpret. To settle the issue, Harding suggested that they calculate all three measures, as they would undoubtedly yield the same ranking. From here the discussion turned to an appropriate approach to the problem of differing lives among mutually exclusive projects E and F, and G and H. Woelk argued that there really was no problem here, since all cash flows from these projects could be determined, any of the discounted cash flow methods of capital budgeting would work well. Jorgensen argued that this was true, but felt that some compensation should be made for the fact that the projects being considered did not have equal lives. QUESTIONS 1. Was Harding correct in stating that the NPV, PI, and IRR necessarily will yield the same ranking 2. 3. 4. 5. 6. order? Under what situations might the NPV, PI, and IRR methods provide different rankings? Why is this possible? What are the NPV, PI, and IRR for projects A and B? What has caused the ranking conflicts? Should project A or B be chosen? Calculate Modified IRR assuming 10% reinvestment rate. Does Modified IRR support NPV or IRR? Why? Now assume that projects A and B are independent, however you cannot start both projects immediately. One of the projects must be delayed and it must start only in year 2 (the initial outlay will occur in year 2) and will go until year 5. In this case, which project should be delayed, A or B? What are the NPV, PI, and IRR for projects C and D? Should project C or D be chosen? Does your answer change if these projects are considered under a capital constraint? Calculate Modified IRR. Does it support NPV or IRR? Why? Now calculate Incremental IRR. Does it support NPV or IRR? Why? What are the NPV, PI, and IRR for projects E and F? Are these projects comparable even though they have unequal lives? Why? Which project should be chosen? Assume that these projects are not considered under a capital constraint. What are the NPV, PI, and IRR for projects G and H? Are these projects comparable even though they have unequal lives? Why? Which project should be chosen? Assume that these projects are not considered under a capital constraint