What  is  the projects NPV? Explain  the  economic rationale behind the NPV.  could  the NPV  of this  particular  project  be  different  for Lone  star Petroleum company than for one  of Chicago valves other potential customers? explain.

1.The following inputs would be used to calculate the net present value (NPV), for Lone Star Petroleum’s proposed valve system:

  • Year 0, net investment, which is the price of the valve system plus $12,500 installation cost. Tax savings are not applicable.
  • The depreciation tax savings in each year of the project’s economic life, which would be calculated using the Modified Accelerated Cost Recovery System (MACRS) method and the 5-year class life of the equipment.
  • The project’s incremental cash flows, which would be the annual operating cost savings of $60,000 for each year of the project’s 8-year economic life.
  1. The project’s NPV is calculated by taking the present value of the future cash flows, minus the initial investment. The economic reasoning behind NPV, is that it takes into account both the cost of capital and the risks associated with the project. Lone Star Petroleum’s NPV could differ from that of another customer because of differences in cost, tax rate, or other factors that might affect cash flow.
  2. To calculate the project’s internal rate of return (IRR), we would need to determine the net cash flows of the project over its life, and the initial investment. IRR stands for the discount rate which makes the net cash flows equal in value to zero. The rationale behind using the IRR is that it provides a measure of a project’s profitability and is useful for comparing projects with different lives and cash flow patterns. Due to the differences in net cash flows, the IRR of this project might be different for Lone Star than for another customer.

4. a. The payback period of Lone Star’s valve system would be calculated by taking the total cost ($200,000), and dividing it by the annual operating savings ($60,000). We would get a 3.33 year payback.

b. Payback can be used as a method to quickly determine the project’s time to return its original investment. You can use this information to help you compare different projects, and decide which project will return the most investment.

As a method for capital budgeting, c.Payback suffers from several flaws. Payback only takes into consideration the amount of time required to recover the original investment. It does not consider future cash flows. Also, the payback calculation does not take into consideration the cost of the project and the future cash flows.

The d.Payback method provides useful data regarding capital budgeting, including the amount of time required for projects to recover their initial investments. It should not be considered alone as it is subject to limitations.

e. Payback periods may prove more effective as sales tools for certain types of equipment than other. Chicago Valve might have a product that has a low life expectancy, but also has an affordable cost. This could make it a selling point. Customers looking for a fast return on their investment may be less interested in products with a longer life expectancy or higher cost.

f. Using the payback’s reciprocal as an estimate of the project’s rate of return would not be appropriate as it does not take into account the time value of money or the projects risk. For projects with short life expectancies, it would be less appropriate.

  1. The cash flow for each year and cost of capital are required to calculate the MIRR. The MIRR refers to the ratio at which future cash flows are valued today and equals initial investment. There is a difference between IRR and MIRR. MIRR assumes all cash flows will be reinvested at cost capital. IRR doesn’t. The MIRR decision is more reliable as it considers the reinvestment rates of projects and takes less into consideration the sign and size of cash flows.
  2. We would divide the current value of the cash flows by our initial investment to calculate the Profitability Index. Lone Star’s Profitability Index (PI) would be calculated using the exact cash flow and capital cost calculations. PI calculates future cash flows and the current value of the original investment to give an indicator of project profitability.
  3. If they have the same value and sign, NPV and IRR can lead to the same acceptance/rejection decision. If the signs and values of the different methods differ, conflict can result. In this case, the method that should be used would depend on the specific circumstances and the decision maker’s priorities.
  4. The ITC of 10% would be accepted if Congress reinstated the Investment Tax Credit (ITC). ITC will reduce overall project cost, make it more economically attractive and increase its profitability.

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