Unformatted text preview: CASE 14 Aerocomp, Inc. As she headed toward her boss’s ofﬁce, Emily Hamilton, chief operating A. A proposal to add a jet to the :9 ofﬁcer for the Aerocomp Corporation—a computer services ﬁrm that specialized in airborne support—wished she could remember more of her training in ﬁnancial theory that she had been exposed to in college. Emily had just completed summarizing the ﬁnancial company’s ﬂeet. The plane was only six years old and was considered a good buy at $300,000. In return, the plane would bring over $600,000 in additional revenue during the next ﬁve years with only about $56,000 in operating costs. (See Figure l for aspects of four capital investment projects that were open to Aerocomp B. during the coming year, and she was faced with the task of recommending which should be selected. What concerned her was the knowledge that her boss, Kay Marsh, a “street smart” chief executive, with no background in ﬁnancial theory, would immediately favor the project that promised the C. highest gain in reported net income. Emily know that selecting projects purely on that basis would be incorrect; but she wasn’t sure of her ability to convince Kay, who tended to assume ﬁnanciers thought up fancy methods just to show (a how smart they were. , ’ As she prepared to enter Kay’s ofﬁce, Emily pulled her summary sheets ﬁ'orn her briefcase and quickly reviewed the details of the four projects, all of which D. she considered to be equally risky. details.) A proposal to diversify into copy machines. The franchise was to cost $700,000, which would be amortized over a 40-year period. The new business was expected to generate over $1.4 million in sales over the next ﬁve years, and over $800,000 in aftertax earnings. (See Figure 2 for details.) A proposal to buy a helicopter. The machine was expensive and, counting additional training and licensing requirements, would cost $40,000 a year to operate. However, the versa- tility that the helicopter was expected to provide would generate over $1.5 a“ million in additional revenue, and it would give the company access to a wider market as well. (See Figure 3 for details.) A proposal to begin operating a ﬂeet of trucks. Ten could be bought for only a» . 56 Case 14 ev‘ $51,000 each, and the additional business would bring in almost $700,000 in new sales in the ﬁrst two years alone. (See Figure 4 for details). In her mind, Emily quickly went over the evaluation methods she had used in the past: payback, internal rate of return, and net present value. Emily knewthat Kay would add a fourth, size of reported earnings, but she hoped she could talk Kay out of using it this time. Emily herself favored the net present value method, but she had always had a tough, time getting Kay to understand it. One additional constraint that Emily had to doal «with was Kay’s insistence that no outside ﬁnancing be used this year. Kay was worried that the company was growing too fast and had piled up Figure 1 Financial analpis of Project A: Add a twin-jet to the company's ﬂeet EK— Explégzianlares Year I Year 2 Year 3 Year 4 Year 5 Net cost of new plane ................. $300,000 Additional revenue ..................... $43,000 $76,800 $1 12,300 $225,000 $168,750 Additional operating costs ......... 11,250 11,250 11,250 11,250 11,250 Depreciation ............................... 45,000 M 63,0_OQ M M Net increase in income ............... (13,250) (450) 38,050 150,750 94,500 Less: Tax at 33% .................... 0 9 12,557 42,74§ 31,185 Increase in aﬁertax income ........ M) M) #542 m Saw Add back depreciation ............... $45,000 $66,000 $63,000 63,000 $63,000 Net change in cash ﬂow ............. ($300,000) 31,750 65,550 88,494 164,003 126,315 ﬁ—‘ﬁ—ﬁ— Flgura 2 Financial analysis of Project B: Divarslfy Into copy machines ( M Wiggins Year I Year 2 Year 3 Year 4 Year 5 Net cost of new franchise ........... $700,000 Additional revenue ............... .. $ 87,500 $175,000 $262,500 $393,750 $525,000 Additional operating costs ......... 26,250 26,250 26,250 26,250 26,250 Amortization .............................. 17.5%} 1 7,599 17.5%! 1 2,500 12,500 I Net increase in income ............... 43,750 131,250 218,750 350,000 481,250 1 Less: Tax at 33% .................... 14,438 43,313 72,188 115,509 158,813 Increase in aﬁertax income ........ M m m m m Add back depreciation ............... $ 17,500 $ 17,500 5 17,500 $ 17,500 $ 17,500 Net change in cash ﬂow ............. ($700,000) 46,813 105,438 164,063 252,000 339,938 m enough debt for the time being. She was also against a stock issue for fear of diluting earnings and her control over the ﬁrm. As a result of Kay's prohibition of outside ﬁnancing, the size of the capital budget this year was limited to $800,000, which meant that only one of the four projects under consideration could be chosen. Emily wasn’t too happy about that, either, but she had decided to accept it for now, and concentrate on selecting the best of the four. As she closed her briefcase and walked toward Kay’s door, Emily reminded herself to have patience; Kay might not trust ﬁnancial analysis, but she would listen to sensible arguments. Emily only hoped her ﬁnancial analysis sounded sensible! ”mmmnmm.ummmmwnmnm"awe“,mnmm.‘ WWW—mm Aerocomp, Inc. 57 Figure 3 Flnanclal analysis of Project c: Add a hellcopter to the company’s ﬂeet ————*_________—_ Initial Expert (11' lures Year I Year 2 Year 3 Year 4 Year 5 Net cost of helicopter ................. $800,000 Additional revenue ..................... $100,000 $200,000 $300,000 $450,000 $600,000 Additional operating costs ......... 40,000 40,000 40,000 40,000 40,000 Depreciation ............................... .1194!!! M m m M Net increase in income ...... (60,000) (16,000) 92,000 242,000 392,000 Lees: Tax at 33% .................... 0 9 M _Z2,8_6_Q 422,169 Increase in aﬁertax income ........ (M) M) M M am Add back depreciation ........... $120,000 $176,000 $168,000 $168,000 $168,000 Net change in cash ﬂow.... ..... ($800,000) 60,000 160,000 229,640 330,140 430,640 Figure 4 Financial analysis of Project D: Add fleet of trucks wfggm Year 1 Year2 Year3 mu Year5 Net cost of new trucks ................ $510,000 Additional revenue ............. $382,500 $325,125 $ 89,250 $76,500 $51,000 Additional operating costs ......... 19,125 19,125 25,500 31,875 38,250 Depreciation ............................... 16,500 1 izgoo M m M Net increase in income... 286,875 193,800 (43,350) (62,475) (94,350) Less: Tax at 33% .................... M 61,255 9 Q 0 Inminﬁemxincm -------- am mm W) 6.62425.) (184.108.40.206) Add back depreciation ............... $76,500 $1 12,200 $107,100 107,100 $107,100 Net change in cash ﬂow ............. ($510,000) 268,706 242,046 63,750 44,625 12,750 Required 1. Refer to Figures 1 through 4. Add up the total increase in aﬁertax income for each project. Given what you know about Kay Marsh, to which project do you think she will be attracted? 2. Compute the payback period, internal rate of return (IRR), and net present value (NPV) of all four alternatives based on cash ﬂow. Use 10 percent for the cost of capital in your calculations. For the payback method, merely indicate the year in which the cash ﬂow equals or exceeds the initial investment. You do not have to compute midyear points. 3. a. According to the payback method, which project should be selected? What is the chief disadvantage of this method? Why would anyone want to use this method? According to the IRR method, which project should be chosen? What is the major disadvantage of the IRR method that occurs when high IRR projects are selected? Can you think of another disadvantage of the IRR method? (Hint: Look over the four alternatives and compare the sizes of the projects. Ask yourself whether you would prefer to make a large percent return on a small amount of money or a small percent gain on a large amount of money.) .A Framer D NPV method whichdpro‘j'ects would be accepted? Do the NPV and IRR both reject the é’ame project(s)? Why? Given all the facts of the case, are you more likely to select Project A or C? (I, ...
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Case study on capital budgeting with solution
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Case study on capital budgeting with solution
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