RUNNING HEAD: CAPE CHEMICAL CASE

Julio Ramos, Terryann Bodden-Bravo, and Opal Ruiz

Accounting for Executives

International College of the Cayman Islands

Professor Dr. Alicia Law

September 9th, 2017

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Abstract

Capital budgeting is needed for almost any business entity. As such, knowing how to

apply such financial calculations to proposed investments will greatly compliment a business.

This paper closely examines a case study of a company called Cape Chemical. The company is

faced with a capital budgeting issue in which they have to decide to purchase new or old

equipment. As the discussion ensues, the team will delve into the various capital budgeting

methods that can be utilized. The capital budgeting methods that will be examined for the

purpose of this paper include the net present value (NPV), the internal rate of return (IRR),

modified internal rate of return (MIRR), cash payback method and the discounted cash pay back

method. Each of these methods analyzes cash flows in relation to each investment alternative.

Calculations will be done and the team will then determine what investment decision will be the

best alternative for Cape Chemical.

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1) Using examples from your textbook on information regarding capital budgeting,

explain to Clarkson why it is important for her company to have a capital budget.

The decisions for competitiveness strategy for product markets and prices are made in

line with a companys investment and physical resources or capacity to meet the objectives of a

companys strategy. One of the decisions that are required by a firm for the long-run

competitiveness is deciding on creating a Capital Budget. As reported by Marshall, McManus, &

Viele (2014), Capital Budgeting is the process that is used to analyze a proposed capital

expenditure or investment in plant, equipment, products and also investment that may be worth

pursuing (Marshall et al., 2014). The objective of the process is to determine whether the

proposed capital project in its life time will generate the relevant cash inflows and outflows that

will meet the companys target or benchmark. Capital budgeting is described as a process, and

within that process, various methods and techniques can assist management to identify

alternatives that will contribute to the future profitability of the company. Lastly, a capital budget

is described as a blue print that helps firms meet its long-term growth and profitability objectives

(Marshall et al., 2014).

Below are general needs for Capital Budgeting.

1. Essential Task By having to pledge significant capital into a project that will influence a

firms profitability and objectives are enough to emphasize that Capital Budgeting is important.

2. Long Term Commitment As most capital projects are extended for long periods it is only

appropriate that proper steps are taken to address any concerns before entering into a long-term

commitment.
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3. Investment Decision Are based on profitability and how these will be realized. Capital

Budgeting can assist in determining what the required mix of investment is to achieve the desired

return.

4. Mitigating Risk Capital projects and investment are long-termed and have a higher

implication of risk. The design of Capital Budgeting decisions is in line with identifying the

associated risks.

WACC is the acronym for weighted average cost of capital.

2) Calculate Cape Chemical's weighted average cost of capital (WACC). Note: round to

the nearest whole number. Discuss the theory used by Clarkson to determine Cape

Chemical's optimum target capital structure (30% debt and 70% equity). Show your

results. Since the used equipment will be financed with internal capital and the new

equipment with a bank loan, should the same discount rate be used to evaluate each

alternative? Explain.

WACC is the acronym for weighted average cost of capital. The WACC is a financial

calculation that helps to determine the viability of a project. With WACC the options of equity

and debt are also considered to the point of having a mixed structure of both options. Ideally,

when a company value has been maximized, its because the WACC has been minimized.

Cape Chemicals WACC Calculation:

Cape Chemical has opted to consider debt financing as it results in low-cost and lower

risk when compared to the option of equity. The lower cost of debt financing is attributed to the

fact the commitment of principal and interest are a legal obligation that in turns makes the
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arrangement less risky when compared to equity financing. As obligations that need to be paid

carry higher risks in regards to financial leverage and financial risk, this is a disadvantage of

Debt financing. The key to capital budgeting is to maintain a structure of debt and equity that

will provide the lowest cost that will maximize a companys performance and thereby achieve its

objectives. The WACC for Cape Chemical was calculated to be 15% (Appendix 1).

3) Explain why an accurate WACC is important to a firm's long-term success. Using

Exhibit 5-4 on page 164 of your textbook, provide an inventory cost flow exhibit to

determine the ending inventory amount using August 31, 2016 and the cost of goods

sold for the year then ended, using the WACC, FIFO, and LIFO cost flow assumptions

for the above discussed old and new equipment. Ending inventory will be the old

equipment.

Explain why an accurate WACC is important to a firm's long-term success

A common use of the WACC is the discounting rate method for evaluating capital

projects within a company. Deciding to accept or reject a project that is obviously designed to

provide the best returns for its stakeholders is the primary goal. As the decisions on capital

projects are long termed, it is important that the WACC calculations are accurate, to avoid

having to make mistakes that will not be easy to rectify on locked commitment. An inaccurate

WACC will lead a company make the wrong decision on a capital project.

4) Evaluate the strengths and weaknesses of the Cash Payback Period, Discounted Cash

Payback Period, NPV, IRR and MIRR capital expenditure budgeting *Remember, you

have seven years you are looking at.

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Cash Payback Period

Brigham and Ehrhardt (2014), describe the cash payback period as the number of years

that are needed to recover a project's cost. Additionally, the cash payback period can also be

defined as the number of years that are required to recoup funds that have been invested in a

project via its operating cash flows (Brigham et al., 2014). One weakness of the cash payback

period is that funds received in different years are all given the same weight, which means that it

does not consider the time value of money (Brigham et al., 2014)., 2014). Two significant

disadvantages of the cash payback period are that it does not have an explicit acceptance rule and

cash flows that extend past the payback period are not taken into consideration regardless of how

large these cash flows might be (Brigham et al., 2014). Another disadvantage of the cash

payback period is that unlike NPV or IRR it does not measure how much wealth is derived from

a project or how much a project's rate of return is greater than the cost of capital (Brigham et al.,

2014). As mentioned by Brigham et al. (2014), the cash payback period merely indicates how

long it will take to regain the funds initially invested into the project (Brigham & Ehrhardt,

2014). The strengths of the cash payback period it is that it is easy to explain and calculate

(Brigham et al., 2014). Marshall, McManus, and Viele (2014), also supports this notion and

advises that a distinct advantage of the cash payback period is that it is easy to calculate and

understand. Moreover, another benefit of the cash payback period is that provides insights on the

projects liquidity and risk factors as it indicates the period in which the invested capital will be

tied up (Brigham et al., 2014).

Discounted Cash Payback Period

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As mentioned by Brigham et al. (2014), the discounted cash payback was designed to

improve one of the flaws of the cash payback period which is concerning the time value of

money. In the discounted cash payback period, cash flows are discounted at the weighted

average cost of capital, and the discounted cash flows are utilized to determine the payback

(Brigham et al., 2014). As indicated by Brigham et al. (2014), one of the benefits of the

discounted cash payback period is that it considers the time value of money. Additional

advantages of the discounted cash payback period are that it factors in capital cost and it also

provides information about liquidity and risks (Brigham et al., 2014). However, a major

weakness of the discounted cash payback period is that like the cash payback period; the

discounted cash payback period ignores cash flows that extend past the payback period (Brigham

et al., 2014). According to Brigham et al. (2014), the discounted cash period considers capital

costs; however, it does not take into consideration cash flows from poor management decisions.

Lastly, as reported by Brigham and Ehrhardt (2014), in using the discounted cash payback period

there is no way to determine how short the payback period should be to justify accepting a

project and hence there is no particular method for deciding whether a project should be accepted

or rejected.

Internal Rate of Return (IRR)

According to Brigham et al. (2014), a project's IRR or internal rate of return is the

discount rate that forces cause the present value of the expected future cash flows to be

equivalent to the initial cash flow. Additionally, this is equal to forcing the NPV to be equal to

zero (Brigham et al., 2014). Therefore, in capital budgeting, IRR is used to estimate the expected

rate of return for a project (Brigham et al., 2014). As stated by Bringham and Ehrhardt (2014), if

the anticipated return is greater than the costs used to finance the project, then the excess
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funds/difference goes to the firm's stockholders. Conversely, if the IRR is less than the cost of

capital, this is unfavorable as the company's shareholders will need to make up the shortfall

(Brigham et al., 2014). Hence, if the IRR is greater than the firm's weighted average cost of

capital then the project should be accepted (Brigham et al., 2014). Therefore, if the IRR is less

than the firm's weighted average cost of capital, then the project should be rejected. This view is

also supported by Marshall et al. (2014), who advises that if the IRR is greater than the cost of

capital, then the investment is recommended. However, if the IRR is less than the cost of capital,

then the investment should not be supported (Marshall et al., 2014).

As stated by Brigham et al. (2014), the internal rate of return, which is also known as

IRR, is a capital budgeting method which calculates the time-adjusted rate of return on

investment over the life of a project. Additionally, the IRR method solves for the actual rate of

return which is expected to be derived from the potential investment (Marshall et al., 2014).

Moreover, this is also the discount rate in which the present value of cash flows from the project

will be equivalent to the amount of the investment (Marshall et al., 2014). According to

Ivanovic, Nasti, & Bekic (2015), the examination of the effectiveness the IRR method is done by

comparing the discount rate with the calculated IRR rate. Also, dissimilar to the NPV, which

indicates the absolute effectiveness of investments, the IRR is a representation of a relative

indicator which is measured as a percentage (Ivanovic et al., 2015). Additionally, although the

discount rate is a representation of the required rate of the project, the IRR exhibits the actual

interest rate of the project (Ivanovic et al., 2015). Nonetheless, the IRR also has some

weaknesses and limitations (Ivanovic et al., 2015)

As stated by Marshall et al. (2014), one of the weaknesses of the IRR is that it's hard to

calculate as it may require numerous calculations utilizing several different discount rates.
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Furthermore, Mott (2010) reaffirms this as he states that it can be challenging to calculate the

IRR. Additionally, the IRR can be misguiding when there is no initial significant outflow of cash

(Mott, 2010). According to Brigham et al. (2014), one of the disadvantages of using the IRR is

that if the project's cash flow does not have a normal cash flow pattern; but rather has a non-

normal cash flow pattern, this means that the project is expected to have some years of cash

outflows as opposed to cash inflows which result in multiple IRRs. Likewise, the IRR capital

budgeting technique also has its advantages (Brigham et al., 2014). As mentioned by Brigham et

al. (2014), advantages of the IRR method are that it recognizes the time value of money and it

considers all the anticipated cash flows of a project. Additionally, this view is also supported by

Mott (2010), who states that one of the strengths of the IRR is that it takes the time value of

money into consideration. Furthermore, additional advantages of the IRR technique are that it

places emphasis on the expected future cash flows of an investment and it does not require the

use of the firm's weighted average cost of capital (Brigham et al., 2014).

Net Present Value (NPV)

Brigham et al. (2014), describe the net present value which is commonly referred to as

the NPV as the current value of a project's anticipated cash flows (including its initial cost)

discounted at the applicable risk-adjusted rate. Furthermore, as mentioned by Marshall et al.

(2014), the NPV method calculates the present value of the anticipated cash flows from a project.

It is computed by using the cost of capital as the discount rate, and then by comparing the total

present value of the cash flows to the amount of investment that is required for the project

(Marshall, et al., 2014). As mentioned by Marshall et al. (2014), one of the advantages of the

NPV is that it focuses on future expected cash flows and it has an accept or reject rule.

Another benefit of the NPV process for evaluating investments is that it recognizes the time
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value of money (Marshall et al., 2014). Furthermore, additional strengths of utilizing the net

present value are that it takes into consideration all of the cash flows of the potential project and

also recognizes that cash flow is reinvested according to the firm's average weighted cost of

capital (Brigham et al., 2014). These advantages are further supported by Mott (2010), who

advises some benefits of using NPV is that the time value of money is considered, and the NPV

accounts for all cash flows over the duration/life of the investment.

According to Brigham et al. (2014), the NPV is beneficial in measuring the amount of

wealth that projects provide to shareholders. The net present value method utilizes the cost of

capital as the discount rate to determine the variance between the present value of the future cash

flows from the amount that is invested (Marshall et al., (2014). According to Marshall et al.

(2014), when the net present value is either positive or zero, the return on investment for the

proposed investment is equal to or higher than the cost of capital, which means that the

investment is appropriate/acceptable. The main disadvantages of the NPV are that it is quite

complicated and can be difficult to understand and calculate (Brigham et al., 2014). Also,

another issue of utilizing the NPV approach to capital budgeting is that it requires knowledge of

the company's average weighted cost of capital to calculate which adds to the complexity of the

technique (Brigham et al., 2014). Furthermore, Mott (2010), also support this as he states that

one of the disadvantages of the NPV is that one is required to know the cost of capital to

calculate the net present value of the project/investment.

Modified Internal Rate of Return (MIRR)

According to Brigham et al. (2014), the modified internal rate of return which is also

known as MIRR is similar to the regular IRR. However, the MIRR assumes that cash flows are
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reinvested at the weighted average cost of capital or some other explicit rate which is a more

accurate assumption (Brigham et al., 2014). Hence a key strength of the MIRR is that it uses the

assumption that firms should reinvest cash flows at the cost of capital (Brigham et al., 2014).

Additional advantages of the MIRR are that it takes the time value of money into consideration

and it does not require knowledge of the firm's WACC (Brigham et al., 2014). Furthermore, the

MIRR focuses on future cash flows and is typically a more accurate indicator of the rate of return

on the reinvested cash flows as well as the project (Brigham et al., 2014). As mentioned by

Brigham and et al. (2014), another advantage of MIRR is that it can be compared with the cost of

capital when determining whether a project should be accepted or rejected. According to

Ivanovic et al. (2015), the MIRR was developed based on the assumption that any net cash flows

that are produced are reinvested according to the cost of capital. Additionally, it is of the view

that the MIRR has substantial advantages as it relates to the traditional method of calculating the

IRR and hence is a more efficient measurement of the actual rate of return (Ivanovic et al.,

2015).

As mentioned by Ivanovic et al. (2015), the MIRR was developed to solve inefficiencies

of the IRR as it relates to multiple IRRs. According to Brigham et al. (2014), dissimilar to the

IRR, the MIRR technique will not result in more one modified IRR. Furthermore, the MIRR

works by solving for the terminal value of cash inflows, and then compounding these cash

inflows as per the company's cost or capital (Brigham et al., 2014). After that, the MIRR

determines the relevant discount rate which forces the present value of the terminal value to the

equivalent present value of the cash outflows (Brigham et al., 2014). Therefore, the MIRR,

assumes the cash flows from projects are reinvested at the company's WACC as opposed to the

project's IRR (Brigham et al., 2014). As a consequence, the modified internal rate of return is a
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more accurate measure of a project's actual level of profitability (Brigham et al., 2014). One of

the disadvantages of the MIRR is that is relatively complex and difficult to comprehend

(Brigham et al., 2014). As mentioned by Mott (2010), another weakness of the MIRR method of

capital budgeting is related to determining the actual reinvestment rate.

5) Prepare a recommendation for Stewart regarding the capital budgeting method or

methods to use in evaluating the expansion alternatives. Support your answer.

It is proposed for Cape Chemical to utilize a combination of the four capital budgeting

techniques to evaluate its decision in purchasing the used or new equipment. Hence, a

combination of capital budgeting techniques will be utilized to assess the expansion alternatives

comprehensively. Therefore, the following capital budgeting techniques will be used to evaluate

the alternative equipment purchases: methods such as the Cash Payback Period, the Discounted

Cash Payback Period, the Net Present Value (NPV), the Internal Rate of Return (IRR), and the

Modified Internal Rate of Return (MIRR). According to Marshall et al. (2014), the cash payback

period is widely used by firms, in particular, as it relates to equipment replacement decisions.

Furthermore, the extensive use of the cash payback period is as a result of the clarity of its

meaning and also because the period in which a firm requires an investment is vital (Marshall et

al., 2014). Moreover, in evaluating the anticipated return from a project, it would be beneficial

to use the MIRR over the IRR as the rates derived from the MIRR are more likely going to be

that rates that the project would earn if the cash flows are reinvested in future projects (Brigham

et al., 2014).

According to Marshall et al. (2014), there are some advantages to using the NPV

technique to measure proposed capital expenditure. Most managers prefer to use both the IRR
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and the NPV methods are they are more comfortable knowing the actual rate of return (Marshall

et al., 2014). However, the net present value (NPV) is recommended as the preferred capital

budgeting technique for evaluating the alternatives. As stated by Brigham et al. (2014), in

determining which project to accept, the net present value is typically viewed as the best single

criterion. Nonetheless, many managers and analysis utilize the results of the cash payback period

and the discounted cash payback period along with the results of the net present value (NPV) and

the internal rate of return (IRR) (Marshall et al., 2014). As mentioned by Marshall et al. (2014) if

the NPV of the proposed project is positive or zero, it means that the return on investment is

higher than the cost of capital. Hence the investment should be accepted. However, the NPV is

more efficient than both the MIRR and IRR when deciding between competing projects

(Brigham et al., 2014). Therefore, the net present value (NPV) is recommended as the preferred

capital budgeting technique in evaluating among alternative projects as is the case of the Cape

Chemical.

6) Calculate the Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and

MIRR for each alternative. For the calculations, assume a WACC of 15%. Based on the

results of these methods, should either option be selected? Why? Solution requires

preparation of a spreadsheet.

Cape Chemicals is considering making a capital investment to increase its production to

meet growing demand from the market (Kunz & Benjamin, 2010). The company is evaluating if

it would be a better capital investment for them to purchase used or new equipment. However,

these two projects are mutually exclusive projects. As stated by Brigham et al. (2014), mutually

exclusive projects are projects that cannot be pursued simultaneously. Hence in mutually
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exclusive projects, a firm must choose either project A or B, or, the company may reject both

alternatives if they are not feasible (Brigham et al., 2014). However, the firm cannot accept both

projects (Brigham et al., 2014). According to Brigham et al. (2014), the rules for mutually

exclusive projects state that the project with the highest NPV should be accepted. It also states

that if both projects have a negative NPV, both should be rejected (Brigham et al. 2014). In

calculating the NPVs for both projects via excel spreadsheets, it is determined that the NPV for

the used equipment is $24,391.00 and the NPV for the new equipment is $45,895.00. Based on

these calculations and the rule for mutually exclusive projects, the new equipment should be

accepted as it has a higher NPV than the used equipment.

Stewart is concerned that the projected annual sales growth rate of 15% for incremental

blended material may be optimistic. Recalculate the Cash Payback Period, Discounted

Cash Payback Period, NPV, IRR and MIRR for each alternative assuming the annual sales

growth rates of 10% and 5%. Assume a WACC of 15%. Does the change in growth rate

alter the recommendation made in question 5? Solution requires preparation of

spreadsheets. Explain.

The results of the alternatives for the used equipment are as follows:

- For the 15% Sales Growth Rates, the used equipment has a net present value of $24,391

(appendix 2).

- For the 10% Sales Growth Rates, the used equipment has a net present value of $19,571

(appendix 3).
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- For the 5% Sales Growth Rates, the used equipment has a net present value of $14,894

(appendix 4).

The results of the alternatives for the new equipment are as follows:

- For the 15% Sales Growth Rates, the new equipment has a net present value of $45,895

(appendix 2).

- For the 10% Sales Growth Rates, the new equipment has a net present value of ($8,433)

(appendix 3).

- For the 5% Sales Growth Rates, the new equipment has a net present value of ($54,392)

(appendix 4).

Upon reviewing the outcome of each evaluation method, the used equipment is the best

investment opportunity for the company as it has a higher NPV. The used equipment meets

investment conditions with all growth rates. The new equipment has the higher NPV of $$45,895

with the 15% growth rate. However, it results in negative NPVs with the utilization of growth

rates of 10% and 5%. The way to be effective with either alternative is based on the accuracy of

the estimated increase in blended package material. None the less, it is necessary to bear in mind

that it is highly unlikely that the volume of sales in the future will be exactly in line with

projected sales.

8) The projected cash flow benefits of both projects did not include the effects of inflation.

Future cash flows were determined using a constant selling price and operating costs (real

cash flows). The cash flows were then discounted using a WACC that included the impact
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of inflation (nominal WACC). Discuss the problem with using real cash flows and a

nominal WACC when calculating a project's Discounted Payback Period, NPV, IRR and

MIRR.

Cash flows are described as the rates at which money comes into a company. Cash flow

is crucial as it illustrates a businesss ability to meet its expenses and financial obligations in the

future. A business can have a high net worth but still have poor cash flow which can cause them

critical financial issues just to the fact that they do not have access to the cash they need to

operate (The Finance Base, n.d.). Nominal and real cash flows use different calculations to

determine the value of cash. Real cash flow uses a basic measurement in its calculation which

counts all cash flows for the future at its present value. Nominal cash flow considers the impact

of inflation which affects the prices of goods by adjusting the value of a particular currency.

Nominal cash flow is considered a more precise measurement of the value of cash flows (The

Finance Base, n.d.).

If consideration is not given to growth in prices and costs when forecasting cash flows,

more than likely the value of the project will be underestimated. This is because the projects

weighted average cost of capital (WACC) includes the effect of inflation (Brigham et al., 2014).

What this means is that the estimated cash flows will be too low in comparison to the WACC.

Therefore, the estimated net present value (NPV) will also be too low when compared to the to

the true NPV (Brigham et al., 2014). The weighted average cost of capital has cost of equity and

cost of debt components included in the calculation. The cost of debt has an inflation premium

attached to it. Therefore, the WACC calculation accounts for the impact of inflation. As such,

the estimated cash flows must also account for the impact of inflation (Brigham et al., 2014).
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The precise effect of combining "real" cash flows and a "nominal" discount rate can only be

ascertained by taking away the inflation factor from the discount rate or adding it to future cash

flows (Brigham et al., 2014).

The NPV and IRR are most common methods used to determine payback periods.

However, in the past, the primary approach used was the payback period (Brigham et al., 2014).

The regular payback period uses real cash flows and does not consider the cost of capital.

Therefore, it does not give the true payback period (Brigham et al., 2014). The discounted

payback period is discounted using the WACC and the resulting cash flows are used to calculate

the payback period. Because the discounted payback period uses the WACC percentage, it gives

a more accurate payback period for each alternative investment (Brigham et al., 2014). The IRR

overstates return expected from future cash flows as the cash flows do not take the cost of capital

into consideration. The MIRR on the other hand projects estimated future cash flows using the

weighted average cost of capital percentage (WACC). As such, cash flows under the MIRR

method will account for inflation in the future and therefore provide a more accurate result

(Brigham et al., 2014).

9) What other issues should Stewart and Clarkson considered before a final decision

regarding the expansion alternatives is made?

The growth rate factor is vital to the analysis. Hence, before a decision can be made, it is

necessary for the growth rate factors to be looked at again. It appears that Stewart understands

this criterion and requested further examination based on an annual growth that was lower than

the 15% given by the marketing department. Integrating the component about future inflation
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rates would also improve the outcome of this analysis. In summary, the financial analysis is a

part of the decision-making process.

Conclusion

Working together to solve this case has proved to be very beneficial for the team of MBA

students. The team is now more familiar with the capital budgeting techniques and will be able

to apply calculations to real life financial decisions. Capital budgeting is by far the most vital

apparatus to make financial decisions. The team has applied various capital budgeting methods

to solve the Cape Chemicals case and reviewed the results to make an important investment

decision. The Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and MIRR,

WACC, were all utilized to solve a pertinent investment decision. Capital budgeting techniques

aided in this analysis as it provided various methods that could be used to help the company

decide which investment alternative to choose.

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References

Bringham E. F. & Ehrhardt M. C. (2014). Financial Management Theory & Practice (14th ed.).

South Western, Cengage Learning

Ivanovic, S., Nastic, L., & Bekic, B. (2015). POSSIBILITIES OF MIRR METHOD

APPLICATION FOR EVALUATION OF INVESTMENTS IN AGRICULTURE: AN

EXAMPLE OF PIGS FATTENING 1. Ekonomika Poljoprivrede, 62(2), 325-333.

Retrieved from https://search-proquest-com.ezp-

01.lirn.net/docview/1766260440?accountid=158672

Kunz, David A., and Benjamin L. Dow, III. "Cape Chemical: capital budgeting issues." Journal

of the International Academy for Case Studies 16.5 (2010): 133+. Business Insights:

Global. Web. 5 July 2017.

Marshall, D. H., McManus, W. W., & Viele, D. F. (2014). Accounting: what the numbers mean

(10th ed.). New York, NY: McGraw-Hill Education.

Mott, L. (2010). Cost-benefit analysis: A primer. The Bottom Line, 23(1), 31-36.

doi:http://dx.doi.org.ezp-01.lirn.net/10.1108/08880451011049687

The Finance Base (n.d.) Retrieved from http://thefinancebase.com/nominal-vs-real-cash-flow-

4415.html
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Appendix 1
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Appendix 2
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Appendix 3
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Appendix 4
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