Patagonia, Inc. was founded in May, 2000 by Lawrence Rollins, who was employed f
ID: 2383013 • Letter: P
Question
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 WORKER, learned good capital budgeting techniques in his finance classes at XXXXX,
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.
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.
Hint: Read page 193 “Investments of Unequal Lives: The Equivalent Annual Cost Method” in the textbook.
Table 2 for Questions 7:
Cash Flow Projections for Process 2
0 1 2 3 4 5 6
EBIT 733,333 400,000 291,667 66,667 66,667 100,000
Depreciation 160,000 160,000 160,000 160,000 160,000 -
Initial Investment (800,000)
Explanation / Answer
1191890 NPV
1191890
From above table, PBP lies between years 2 & 3.
So, PBP = 2 + (Absolute cumulative CFAT of year 2 / CFAT for year 3)
=2=(-50000=660000)=2.75
Discounted PBP lies between years 2 & 3.
So, PBP = 2 + (Absolute cumulative discounted CFAT of year 2 / Discounted CFAT for year 3)
=2+(-0.195)=2.195
8) If only PBP is chosen, process 2should be chosen since it has a lower PBP
because it is very big quetion some parts of answer might be missed
-942142
year investment EBIAT depreciation CAFT Discountfactor@9.75 DiscontedCAFT 0 -1000000 -1000000 1 -1000000 1 250000 200,000 450000 0.9112 410040 2 400000 200,000 600000 0.8302 492180 3 460000 200,000 660000 0.7565 499290 4 400000 200,000 600000 0.6893 413580 5 400000 200,000 600000 0.628 376800 21918901191890 NPV
year CAFT cumulativeCAFT Discouted CAFT CumulativeCAFT 0 -1000000 -1000000 1 450000 -650000 410040 -589960 2 600000 -50000 492180 -97780 3 660000 610000 499290 401510 4 600000 670000 413580 815090 5 600000 730000 3768001191890