Keiser University

FIN4443
Mini Case Capital Budgeting Processes and Techniques

Durango Cereal Co. is considering adding two new kinds of cereal to its product line--- one geared tower
children and the other toward adult. The company is currently at full capacity and will have to invest a
large sum in machinery and production space. However, given the nature of cereal production, the
investment in machinery will be mos costly for the children’s cereal (Poofy Puffs) than for the adult
cereal (Filling Fiber). The expected cash flow for the two cereals are:

Year Poofy Puffs Filling Fiber

0 -24,890,000 -13,500,000
1 12,950,000 7,230,000
2 10,923,000 8,100,000
3 8,231,000 8,629,000
4 7,242,000 5,238,900

Management requires a minimum return of 15% in order for the people to be acceptable. The discount
rate for project for this level of risk is 10%. Management requires projects with this type of risk a
payback of 1.75 years.

Assuming the projects are independent and ignoring the issue of scale, what should Durango Cereal do?
Include calculation for the payback method, the discounted payback method, Net Present value, IRR,
and profitability index in your analysis. Revisit the problem considering the scaling issue. Which project
should the company consider is any?
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FIN4443

One cereal for children (poofy Puffs).

One cereal for adults (Filling Fiber)

Children (poofy Puffs). Adults (Filling Fiber).

Year Cash Cumulative year Cash Cumulative
inflow cash inflow inflow cash inflow

0 24,890,000 0 -$13500000
$

1 12,950,000 12,950,000 1 7230000 7230000

2 10,923,000 23873000 2 8100000 15330000

3 8,231,000 32104000 3 8629000 23959000

4 7,242,000 39346000 4 5238900 29197900

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FIN4443
Children (poofy Puffs):

Payback period = 2 years + [24,890000-23873000] /8231000

=2+ 1,017000 /8231000

= 2 +0.1235 =2.1235 years.

Adults (Filling Fiber).

Payback period = 1 years + [13500,000-7230000] /8100000

= 1+ 6270000 /8100000

= 1 +0.774 =1.774 years.

a- What should Durango Cereal Company do?

It’s advisable management can select filling fiber as it pays back the initial investment
back less in possible time.

b- Net present Value [NPV]:

PROJECT X PROJECT Y

Year Cash flow P.V DCF Cash P.V DCF

factor@15% flow factor@15
%

1 12,890,000 0.870 11,214300 7,230,000 0.870 6,290,100

2 10,923,000 0.756 8,25,788 8,100,000 0.756 6,123,600

3 8,231,000 0.658 5,415,998 8,629,000 0.658 5,441,002

4 7,242,000 0.572 4,142,424 5,238,900 0.572 2,996,650

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FIN4443

PROJECT X PROJECT Y

Total Present Value = 29,030,510 20,851,752,8

Less initial investment - 24,890,000 - 13,500.000

NPV = 4,140,510 7,351,352


As the NPV of Project (Y) is higher than the NPV of Project (X) , then it is
recommended to select & develop project (Y).
c- Profitability Index:

Profitability Index of (Y) = (PV of Future Cash flow) / Initial Investment.

= (7,351,352) / 13,500,000. =0.544544

Profitability Index of (X) = (PV of Future Cash flow) / Initial Investment.

= (4,140,510) / 24890000 =0.166352

 Bothe Profitability Index for both projects(X, Y) are less than 1, therefore we
cannot take decision based on PI Index.

 Average Rate of Return:


PROJECT X PROJECT Y

Total cash 39,316 Total cash 29,197,900

flow flow
Less initial 24,890 Less initial 13,500,00
Invest Invest
Profit 14,426 Profit 15,697,900
Average 14,426 / 4 $ 3,606 Average 3,924,475
Profit Profit
Average 24,890,000 Average 13,500,000 /
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FIN4443

Investment /2 Investment 2
12,445,000 6,750,00
ARR 3,606,000 / ARR 3,924,475 /
12,44500 6,750,000
0.29 = 29 0.58 = 58%
%

 Conclusion: we select Y as it gives higher Account Rate of return.