Business Decision Case New Haven Corporation recently identified an investment opportunity

involving the purchase of a patent that will permit the company to modify its line of CD recorders.

The patents purchase price is $720,000 and the legal protection it provides will last for five more

years; there is no salvage value. However, after preparing the capital expenditure analysis below,

New Havens treasurer has recommended to the companys capital budgeting committee that the

investment be rejected. Brad Decker, chairperson of the capital budgeting committee, finds it diffi-

cult to accept the treasurers analysis because he feels intuitively that the investment is attractive.

For this reason, he has retained you to review the treasurers analysis and recommendation. You

are provided with the following data and summary of the treasurers analysis:

1. Required investment: $720,000 cash for the patent to be amortized on a straight-line basis,

five-year useful life, with a zero salvage value.

2. Projected cash revenue and operating expenses:

Year Cash Revenue Cash Expenses

1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 620,000 $240,000

2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560,000 200,000

3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 170,000

4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 80,000

5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 50,000

$2,030,000 $740,000

Source of capital: New Haven plans to raise 10% of the needed capital by issuing bonds, 30%

by issuing stock, and the balance from retained earnings. For these sources, the capital cost

rates are 8%, 9%, and 10%, respectively. New Haven has a policy of seeking a return equal

to the weighted average cost of capital plus 2.5 percentage points as a buffer margin for the

uncertainties involved.

Solution 12.1

Capital budgeting is the planning of major plant and equipment investments. These investments are im-

portant because they involve long-term commitments of significant amounts of capital and the decisions

cannot be easily reversed.

4. Income taxes: New Haven has an overall income tax rate of 30%.

5. Treasurers analysis:

Average cost of capital

(8% 1 9% 1 10%)/3 5 9%

Total cash revenue .............................. $2,030,000

Total cash expenses ............................. $740,000

Total amortization ............................... 720,000

Total operating expenses ......................... 1,460,000

Projected net income over five years ................ $ 570,000

Average annual income .......................... $ 114,000

Present value of future returns ..................... $ 443,420

Required investment............................. 720,000

Negative net present value........................ $ (276,580)

Recommendation: Reject investment because of insufficient net present value.

Required

a. Review the treasurers analysis, identifying any questionable aspects and briefly comment on

the apparent effect of each such item on the treasurers analysis.

b. Prepare your own analysis of the investment, including a calculation of the proper cost of

capital and hurdle rates, a net present value analysis of the project, and a brief recommenda-

tion to Decker regarding the investment (round amounts to nearest dollar).

c. Because of his concern for the uncertainties of the CD recorder business, Decker also has

asked you to provide analyses supporting whether or not your recommendation would change

1. If estimates of projected cash revenue were reduced by 10%.

2. If the buffer margin were tripled from 2.5% to 7.5%