As she headed toward her bosss office, Emily Hamilton, chief operating officer for the

Aerocomp Corporationa computer services firm that specialized in airborne support

wished she could remember more of the training in financial theory that she had been

exposed to in college. Emily had just completed summarizing the financial aspects of four

capital investment projects that were open to Aerocomp 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 favour the project that promised the

highest gain in reported net income. Emily knew that selecting projects purely on that

basis would be incorrect, but she wasnt sure of her ability to convince Kay, who tended

to assume financiers thought up fancy methods just to show how smart they were.

As she prepared to enter Kays office, Emily pulled her summary sheets from her

briefcase and quickly reviewed the details of the four projects, all of which she considered

to be equally risky.

A. A proposal to add a jet to the companys 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 Table 1 for details.)

B. A proposal to diversify into copy machines. The franchise was to cost $700,000,

which would be amortized over a 40year 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 Table 2 for details.)

C. 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 versatility that the helicopter was expected to provide would

generate over $1.5 million in additional revenue, and it would give the company

access to a wider market as well. (See Table 3 for details.)

D. A proposal to begin operating a fleet of trucks. Ten could be bought for only $51,000

each, and the additional business would bring in almost $700,000 in new sales in the

first two years alone. (See Table 4 for details.)

In her mind, Emily quickly went over the evaluation methods she had used in the past:

payback period, internal rate of return, and net present value. Emily knew that Kay would

add a fourth, size of reported earnings, but she hoped she could talk Kay out of using it

this time. Emily herself favoured the NPV method, but she had always had a tough time

getting Kay to understand it.

One additional constraint that Emily had to deal with was Kays insistence that no

outside financing be used this year. Kay was worried that the company was growing too

fast and had piled up 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 Kays 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 wasnt 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 Kays 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!

a. Refer to Tables 1 through 4. Add up the total increase in aftertax income for each

project. Given what you know about Kay Marsh, to which project do you think she

will be attracted?

b. Compute the payback period, IRR, and NPV of all four alternatives based on cash

flow. Use 10 percent for the cost of capital in your calculations. For the payback

period, merely indicate the year in which the cash flow equals or exceeds the initial

investment. You do not have to compute midyear points.

c. i. According to the payback method, which project should be selected?

ii. What is the chief disadvantage of this method?

iii. Why would anyone want to use this method?

d. i. According to the IRR method, which project should be chosen?

ii. What is the major disadvantage of the IRR method that occurs when high IRR

projects are selected?

iii. Can you think of another disadvantage of the IRR method?

iv. If Kay had not put a limit on the size of the capital budget, would the IRR

method allow acceptance of all four alternatives? If not, which one(s) would be

rejected and why?

e. i. According to the NPV method, which project should be chosen? How does this

differ from the answer under the IRR?

ii. If Kay had not put a limit on the size of the capital budget, under the NPV

method which projects would be accepted? Do the NPV and IRR both reject the

same project(s)? Why?

iii. Given all the facts of the case, are you more likely to select project A or C?

f. i. According to the PI method, which project should be chosen?

ii. Does your answer conflict with the NPV method? Why? Which method suggests

the best project?

Initial Expenditures $300,000 Year 1 Year 2 Year 3 Year 4 Year 5 Net cost of new plane Additional revenue Additional operating costs Amortization Net increase in income Less: Tax at 33%. Increase in aftertax income Add back amortization Net change in cash flow $43,000 $76,800 $112,300 11,250 11,250 11,250 45,000 66,000 63,000 (13,250) (450) 38,050 0 0 12,557 ($13,250) ($ 450) $ 25,494 $45,000 $66,000 $ 63,000 31,750 65,550 88,494 $225,000 $168,750 11,250 11,250 63,000 63,000 150,750 94,500 49,748 31,185 $101,003 $ 63,315 $ 63,000 $ 3,000 164,003 126,315 ($300,000) Initial Expenditures $700,000 Year 1 Year 2 Year 3 Year 4 Year 5 Net cost of new franchise Additional revenue Additional operating costs Amortization ..... Net increase in income Less: Tax at 33% Increase in aftertax income Add back amortization Net change in cash flow $87,500 $175,000 26,250 26,250 17,500 17,500 43,750 131,250 14,438 43,313 $29,313 $ 87,938 $17,500 $ 17,500 46,813 105,438 $262,500 26,250 17,500 218,750 72,188 $146,563 $ 17,500 164,063 $393,750 $525,000 26,250 26,250 17,500 17,500 350,000 481,250 115,500 158,813 $234,500 $322,438 $ 17,500 $ 17,500 252,000 339,938 (700,000) Table 2 Financial analysis of project B: Diversify into copy machines Initial Expenditures $800,000 Year 1 Year 2 Year 3 Year 4 Year 5 Net cost of helicopter Additional revenue Additional operating costs Amortization ..... Net increase in income Less: Tax at 33% Increase in aftertax income Add back amortization Net change in cash flow $100,000 $200,000 $300,000 40,000 40,000 40,000 120,000 176,000 168,000 (60,000) (16,000) 92,000 0 0 30,360 ($60,000) ($16,000) $ 61,640 $120,000 $176,000 $168,000 60,000 160,000 229,640 $450,000 $600,000 40,000 40,000 168,000 168,000 242,000 392,000 79,860 129,360 $162,140 $262,640 $168,000 $168,000 330,140 430,640 (800,000) Table 3 Financial analysis of project C: Add a helicopter to the company's fleet Year 2 Year 3 Year 4 Year 5 Net cost of new trucks. Additional revenue Additional operating costs Amortization ... Net increase in income Less: Tax at 33%.. Increase in aftertax income Add back amortization Net change in cash flow Initial Expenditures Year 1 $510,000 $382,500 19,125 76,500 286,875 94,669 $192,206 $ 76,500 (510,000) 268,706 $325,125 19,125 112,200 193,800 63,954 $129,846 $112,200 242,046 $ 89,250 $76,500 $51,000 25,500 31,875 38,250 107,100 107,100 107,100 (43,350) (62,475) (94,350) 0 0 0 ($ 43,350) ($ 62,475) ($ 94,350) $107,100 $107,100 $107,100 63,750 44,625 12,750 Table 4 Financial analysis of project D: Add fleet of trucks Initial Expenditures $300,000 Year 1 Year 2 Year 3 Year 4 Year 5 Net cost of new plane Additional revenue Additional operating costs Amortization Net increase in income Less: Tax at 33%. Increase in aftertax income Add back amortization Net change in cash flow $43,000 $76,800 $112,300 11,250 11,250 11,250 45,000 66,000 63,000 (13,250) (450) 38,050 0 0 12,557 ($13,250) ($ 450) $ 25,494 $45,000 $66,000 $ 63,000 31,750 65,550 88,494 $225,000 $168,750 11,250 11,250 63,000 63,000 150,750 94,500 49,748 31,185 $101,003 $ 63,315 $ 63,000 $ 3,000 164,003 126,315 ($300,000) Initial Expenditures $700,000 Year 1 Year 2 Year 3 Year 4 Year 5 Net cost of new franchise Additional revenue Additional operating costs Amortization ..... Net increase in income Less: Tax at 33% Increase in aftertax income Add back amortization Net change in cash flow $87,500 $175,000 26,250 26,250 17,500 17,500 43,750 131,250 14,438 43,313 $29,313 $ 87,938 $17,500 $ 17,500 46,813 105,438 $262,500 26,250 17,500 218,750 72,188 $146,563 $ 17,500 164,063 $393,750 $525,000 26,250 26,250 17,500 17,500 350,000 481,250 115,500 158,813 $234,500 $322,438 $ 17,500 $ 17,500 252,000 339,938 (700,000) Table 2 Financial analysis of project B: Diversify into copy machines Initial Expenditures $800,000 Year 1 Year 2 Year 3 Year 4 Year 5 Net cost of helicopter Additional revenue Additional operating costs Amortization ..... Net increase in income Less: Tax at 33% Increase in aftertax income Add back amortization Net change in cash flow $100,000 $200,000 $300,000 40,000 40,000 40,000 120,000 176,000 168,000 (60,000) (16,000) 92,000 0 0 30,360 ($60,000) ($16,000) $ 61,640 $120,000 $176,000 $168,000 60,000 160,000 229,640 $450,000 $600,000 40,000 40,000 168,000 168,000 242,000 392,000 79,860 129,360 $162,140 $262,640 $168,000 $168,000 330,140 430,640 (800,000) Table 3 Financial analysis of project C: Add a helicopter to the company's fleet Year 2 Year 3 Year 4 Year 5 Net cost of new trucks. Additional revenue Additional operating costs Amortization ... Net increase in income Less: Tax at 33%.. Increase in aftertax income Add back amortization Net change in cash flow Initial Expenditures Year 1 $510,000 $382,500 19,125 76,500 286,875 94,669 $192,206 $ 76,500 (510,000) 268,706 $325,125 19,125 112,200 193,800 63,954 $129,846 $112,200 242,046 $ 89,250 $76,500 $51,000 25,500 31,875 38,250 107,100 107,100 107,100 (43,350) (62,475) (94,350) 0 0 0 ($ 43,350) ($ 62,475) ($ 94,350) $107,100 $107,100 $107,100 63,750 44,625 12,750 Table 4 Financial analysis of project D: Add fleet of trucks