Watertown, 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 Watertown. During the first few years of its existence, Watertown 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
EBIAT*		150,000	200,000	300,000	470,000	500,000
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
EBIAT*		440,000	240,000	175,000	40,000	40,000
Depreciation		160,000	160,000	160,000	160,000	160,000
Initial Investment	(800,000)

*EBIAT is Earnings Before Interest and After Tax (i.e., EBIT x (1-tax rate))

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 learned good capital budgeting techniques 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 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.

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.

	Process 1	Process 2
Net Present Value (NPV)
Internal Rate of Return (IRR)
Incremental IRR
Profitability Index
Payback Period
Discounted Payback Period

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.

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.

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.

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?

Is the profitability index helpful in this case? Explain why or why not.