Capital Budgeting Analysis As she headed toward her boss's office, Emily Hamilton, chief operating officer for the Aero tech Corporation - a computer services firm that specialized in airborne support - wished she could remember more of her training i n 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 Aero tech during the coming year, and she was faced with the task of recommending w hich 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 highest gain in reported net income. E mily knows that selecting projects purely on that basis would be incorrect; but she was not 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 Kay's 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 company's fleet. The plane was only six years old and was c onsidered 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 abo ut $56,000 in operating costs. (See Table 1 for details) Table 1 Financial analysis of Project A: Add a twin - j et to the company's fleet Initial Expenditures Year 1 Year 2 Year 3 Year 4 Year 5 Net cost of new plane $300,000 Additional revenue $43,000 $76,800 $112,300 $225,000 $168,750 Additional operating costs 11,250 11,250 11,250 11,250 11,250 Depreci ation 45,000 66,000 63,000 63,000 63,000 Net increase in income (13,250) (450) 38,050 150,750 94,500 Less: Tax at 33% 0 0 12,557 49,748 31,185 Increase in aftertax income ($13,250) ($450) $25,494 $101,003 $63,315 Add back depreciation $45,000 $6 6,000 $63,000 $63,000 $63,000 Net change in cash flow ($300,000) $31,750 $65,550 $88,494 $164,003 $126,315 B. 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 Table 2 for details) Table 2 Financial analysis of Project B: Diversify into copy machines Initial Expenditures Year 1 Year 2 Yea r 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 17,500 17,500 17,500 17,500 17,500 Net increase in i ncome 4 3, 7 50 131,2 50 21 8, 7 50 3 50, 00 0 4 81 , 2 50 Less: Tax at 33% 14,438 43,313 7 2, 188 115 , 500 158 ,8 13 Increase in aftertax income $ 29 , 313 $ 87,938 $ 146 , 563 $ 234 , 500 $3 22 , 438 Add back depreciation $17,500 $17,500 $17,500 $17,500 $17,500 Net change in cash flow ($700,000) $ 46 , 813 $ 10 5, 438 $ 164 , 063 $ 252 ,00 0 $ 339 , 938 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 acc ess to a wider market as well. (See Table 3 for details) Table 3 Financial analysis of Project C: Add a helicopter to the com pany's fleet Initial Expenditures Year 1 Year 2 Year 3 Year 4 Year 5 Net cost of new helicopter $ 8 00,000 Additional revenue $ 100 ,000 $ 200 , 0 00 $ 300 , 0 00 $ 4 5 0 ,000 $ 600 , 00 0 Additional operating costs 40,000 40,000 40,000 40,000 40,000 Depreciation 120,000 176,000 168,000 168,000 168,000 Net increase in income ( 60 , 00 0) ( 16,00 0) 92 ,0 0 0 242 , 00 0 3 9 2 , 0 00 Less: Tax at 33% 0 0 30,360 79,860 129,360 Increase in aftertax income ($ 60 , 00 0) ($ 16,000 ) $ 61 , 6 4 0 $1 62 , 140 $ 2 6 2 , 640 Add back depreciation $1 20,000 $176,000 $168,000 $168,000 $168,000 Net change in cash flow ($8 00,000) $ 60 , 00 0 $ 1 6 0 , 00 0 $ 229 , 6 4 0 $ 330 , 140 $ 430 , 640 D. A proposal to begin operating a fleet of trucks. Ten would be bought for only $51,000 each, and the additional business would brin g in almost $700,000 in new sales in the first two years alo ne. (See Table 4 for details) Table 4 Financial analysis of Project D: Add fleet of trucks Initial Expenditures Year 1 Year 2 Year 3 Year 4 Year 5 Net cost of new trucks $ 510 ,000 Additio nal revenue $3 82 , 5 00 $ 325 , 125 $ 89 , 25 0 $ 76 , 5 00 $ 51 , 00 0 Additional operating costs 1 9 , 1 25 1 9 , 1 25 25 ,5 0 0 3 1, 875 38 ,250 Depreciation 76,500 112,200 107,100 107,100 107,100 Net increase in income 286 , 875 193,800 (4 3, 3 50 ) (62 , 4 75 ) ( 94, 3 50 ) Less: Tax at 33% 94,669 63,954 0 0 0 Increase in aftertax income $192,206 $129,846 ($43,350) ($62,475) ($94,350) Add back depreciation $76,500 $112,200 $107,100 $107,100 $107,100 Net change in cash flow ($ 510 ,000) $ 268 ,70 6 $ 242 ,0 46 $ 63 , 750 $ 4 4, 625 $12, 7 5 0 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 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 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 deal with was Kay's insistence that no outside financing be used this y ear. 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 Kay's prohibition of outside financing, the size of the capital budget this year was limited to $800,000, which means that only one of the four projects under consideration could be chosen. Emily was not 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 financ ial analysis sounded sensible! Questions : 1. 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? 2. Compute the payback period, internal rate of return (IRR), net present value (NPV) , and profitability index of all four alternatives based on cash flow. Use 10% for the discount rate in your calculations. 3. a. According to the payback method, which project should be selected? b. Wha t are the disadvantage s of this method? 4. a. According to the IRR method, which project should be chosen? b. What are the major disadvantages of the IRR method? c. 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? 5. a. According to the NPV method, which project should be chosen? How does this differ from the answer under the IRR? b. 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? c. Given all the facts of the case, are you more likely to select Project A or C