Patagonia, Inc. was founded in May, 2000 by Lawrence Rollins, who was employed for the last 20 years as a river rafting guide. Mr. Rollins received an unexpected inheritance of $2,000,000 in January, 2000. Soon after, he decided to leave his lifelong career in river rafting and use his inheritance as seed capital for Patagonia. During the first few years of its existence, Patagonia experienced steady sales growth, although the company has only recently shown positive net income. It is March, 2016 and the company is considering two alternative processes for manufacturing inflatable tubes to service demand in a rapidly growing market. Management intends to make the initial investment in the project at the end of April, 2016 and expects any cash flows associated with the project to arrive yearly, beginning at the end of April, 2017. 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 1 0 1 2 3 4 5 EBIT 250,000 400,000 460,000 400,000 400,000 Depreciation 200,000 200,000 200,000 200,000 200,000 Initial Investment (1,000,000) 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. Table 2: Cash Flow Projections for Process 2 0 1 2 3 4 5 EBIT 733,333 400,000 291,667 66,667 66,667 Depreciation 160,000 160,000 160,000 160,000 160,000 Initial Investment (800,000) The marginal tax rate for the company is 40% and after careful assessment of the risk associated with this project, you conclude that the appropriate cost of capital for both processes is 9.75%. 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 Islander, learned good capital budgeting techniques in his finance classes at TAMUCC, and you are confident that he 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 taken a finance class. In fact, he is a self-made man who 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. It is your job to compute several decision metrics, clearly articulate the relative merits of each, and make a recommendation to management about which process is preferred. Guidelines for Case Analysis The following aids are permitted for this analysis: You may use internet sources, books, all posted materials (including Discussion Board Q&A), and your notes. Any other aids are unauthorized and their use constitutes a violation of academic integrity. This includes face-to- face or electronic correspondence concerning the specific details of the case with any other person that is not a member of your assigned group, whether or not they have current or past affiliation with Texas A&M Corpus Christi University. The case is due on the date indicated on the course schedule. Late papers may be accepted with a reasonable excuse, but will be assessed a 20% grade reduction penalty. Cases should be typed in 12-point font, double-spaced, with a minimum of 1 inch margins. The case report should be written according to the following format: 1. Introduction 2. Analysis 3. Conclusion The introduction sets the stage for the work to follow and should consist of a short paragraph of the key problem(s) or issue(s) that your analysis addresses. The analysis will constitute the bulk of the written presentation and will be a direct response to the questions below. Use clear, concise, and complete sentences. Do not use bullet points or numbered paragraphs. The conclusion should be a short paragraph that summarizes the key points of the analysis. Your report should not exceed 5 pages of double-spaced text with 1 inch margins at the sides, top, and bottom of the page. This does not include exhibits of your computations. You may submit one Excel spreadsheet that contains all your exhibits, clearly labeled, and appropriately referenced in the text of your report. Your analysis of Patagonia, Inc. case should include answers to the questions below. Do not write the questions verbatim in your report. Instead, write a brief introductory statement that summarizes the question before you proceed with your analysis. 1. Compute the Net Present Value, Internal Rate of Return, Incremental IRR, Profitability Index, Payback Period, and Discounted Payback Period for each of the two processes. Fill in the table below with your answers and include it as Exhibit 1 of your report. Be sure to include a discussion of your computations in the text of your report and provide additional exhibits to show all of your intermediate steps. Process 1 Process 2 Net Present Value (NPV) Internal Rate of Return (IRR) Incremental IRR Profitability Index Payback Period Discounted Payback Period 2. Which process would management choose if they used only payback as the decision criteria? What argument(s) would you make to convince the board that the payback period is not an appropriate decision rule? Should the board use discounted payback as the deciding factor? Explain why or why not. 3. Which process would management choose if they used IRR as the decision criteria? What arguments would you make to show the board that the IRR measure could be misleading in this case? Is the modified IRR a helpful measure in this case? Explain why or why not. 4. Explain the meaning of the incremental IRR. Based on the incremental IRR, which process should you choose? Should the board use incremental IRR as a decision rule? Explain why or why not. 5. Plot the NPV profiles for the two projects and present the graph as an Exhibit in your report (see figure 5.6 on page 153 of the RWJ text for an example of how to do this). Explain the relevance of the crossover point. How would you convince the board that the NPV method is best? 6. Is the profitability index helpful in this case? Explain why or why not. 7. If for some reason the management of Patagonia, Inc. is able to extend the life of process 2 for an extra year (Year 6) and have an EBIT of $100,000 would your decision based on NPV change? What argument(s) would you make to convince the board that the total NPV is not an appropriate decision rule anymore? Should the board use the Equivalent Annual Cost (also known as Annual NPV) as the deciding factor? Explain why or why not.