WATERTOWN, INCCapital Budgeting Decision RulesWatertown, Inc. was founded in May, 2000 by Lawrence R

WATERTOWN, INCCapital Budgeting Decision RulesWatertown, Inc. was founded in May, 2000 by Lawrence Rollins, who was employed forthe last 20 years as a river rafting guide. Mr. Rollins received an unexpectedinheritance of $2,000,000 in January, 2000. Soon after, he decided to leave his lifelongcareer in river rafting and use his inheritance as seed capital for Watertown. During thefirst few years of its existence, Watertown experienced steady sales growth, althoughthe company has only recently shown positive net income.It is March, 2012 and the company is considering two alternative processes formanufacturing 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,2012 and expects any cash flows associated with the project to arrive yearly, beginningat the end of April, 2013.The first manufacturing process has a higher start-up cost than the second, but greatereconomies of scale. The expected cash flows associated with this process arepresented below in Table 1.Table 1Cash Flow Projections for Process 101234*EBIAT150,000200,000300,000470,000Depreciation200,000200,000200,000200,000Initial Investment(1,000,000)*EBIAT is “Earnings Before Interest and After-Taxes†(i.e. EBIT*(1-tax rate).5500,000200,000The 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 cashflows associated with this process are presented in Table 2 below.Table 2Cash Flow Projections for Process 201EBIAT440,000Depreciation160,000Initial Investment(800,000)2240,000160,0003175,000160,000440,000160,000540,000160,000After careful assessment of the risk associated with this project, you conclude that theappropriate cost of capital for both processes is 9.75%.At the initial presentation, project leaders of both teams presented their cash flowprojections. However, since the processes are mutually exclusive, the firm can only accept oneproposal.You have been asked to evaluate the two production processes and present your findingsto the board of directors. Your CEO Charlie, a loyal Beaver, learned good capital budgetingtechniques in his finance classes at OSU, and you are confident that he is able to distinguishamong 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 financeclass. In fact, he is a self-made man who does not have a college degree. He prefers the secondprocess because it costs less money up-front. In addition, several influential old-timers on theboard are intrigued with the payback decision rule. It is your job to compute several decisionmetrics, clearly articulate the relative merits of each, and make a recommendation tomanagement about which process is preferred.GUIDELINES FOR ANALYSISThe case is intended to be worked on by either an individual or with one other person (thegroup). You may use online resources, your textbook, lecture notes, and any additional assignedreadings to aid you in the completion of this case. You may discuss the case with classmates, buteach group must submit an individual case that strictly reflects that group’s work.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. Introduction2. Analysis3. ConclusionThe introduction sets the stage for the work to follow and should consist of a short paragraph ofthe key problem(s) or issue(s) that your analysis addresses. The analysis will constitute the bulkof 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. Theconclusion should be a short paragraph or two that summarizes the key points of the analysis.Your report should not exceed five pages of double-spaced text with 1 inch margins at thesides, top, and bottom of the page. This does not include exhibits of your computations. Youmay submit one Excel Spreadsheet that contains all your exhibits, clearly labeled, andappropriately referenced in the text of your report.Your case is intended for the senior management of Watertown. As such, it should be written in aprofessional manner, easily followed, and free from typographical and grammatical errors.Finally, the questions on the next page are intended to provide you guidelines of the topics todiscuss. Do not simply enumerate the questions and write answers, nor should you write thequestions verbatim in your report. Rather, incorporate the questions into the normal writing ofthe document.Specific Tasks for the Case Write-UpYour analysis of “Watertown, Inc.†case should include answers to the questions below. Do notwrite the questions verbatim in your report. Instead, write a brief introductory statement thatsummarizes the question before you proceed with your analysis.1. Compute the Net Present Value, Internal Rate of Return, Incremental IRR, ProfitabilityIndex, 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. Besure to include a discussion of your computations in the text of your report and provideadditional exhibits to show all of your intermediate steps.Process 1Process 2Net Present Value (NPV)Internal Rate of Return (IRR)Profitability IndexPayback PeriodDiscounted Payback Period2. Which process would management choose if they used only payback as the decisioncriteria? What argument(s) would you make to convince the board that the paybackperiod is not an appropriate decision rule? Should the board use discounted payback asthe deciding factor? Explain why or why not.3. Which process would management choose if they used IRR as the decision criteria? Whatarguments would you make to show the board that the IRR measure could be misleadingin this case? Is the modified IRR a helpful measure in this case? Explain why or why not.4. Plot the NPV profiles for the two projects and present the graph as an Exhibit in yourreport (see figure 5.3 on page 109 of the BMA textbook for an example of how to dothis). Explain the relevance of the crossover point. How would you convince the boardthat the NPV method is best?5. Is the profitability index helpful in this case? Explain why or why not.

 

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