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CASE: Aerocomp is in the busines of computing and computers. They have made decent money in the recent past. John Christer, CEO of Aerocomp has

CASE:

Aerocomp is in the busines of computing and computers. They have made decent money in the recent past. John Christer, CEO of Aerocomp has informed the Board of Director of Aerocomp that the company has extra cash of about $2.5 million. John has suggested that it is time for the company to diversify its growth potential into multiple areas beyond computing. Mark Zuber, the executive assistant to the CEO of Aerocomp, has proposed three alternative investments which are described as under:

Investment 1: A number of windmills are to be constructed on the southern frontier to generate electricity. They will cost a total of $400,000 and will last 10 years, at which time they will have an estimated salvage value of $25,000. However, a capital upgrade of $100,000 will be required at the end of five years. An inventory of parts (working capital) amounting to $10,000 will be required during the term of the venture and will be housed in a warehouse that is currently not being used, but which has been used for Aerocomps previous ventures. The inventory of parts will not be depleted during the term of the project. The warehouse could be rented out at $5,000 per year.

This enterprise is expected to generate revenues of $150,000 a year for 10 years. The federal experts on wind will impose their new tax on the wind, and that will cost the venture $7,500 a year. This new tax will be a deduction for income tax purposes and will be known as the BWT (Big Wind Tax).

Tax rate = 25%

CCA rate = 5%

Cost of capital = 20%

Investment 2: Aerocomp is considering building a pipeline from a remote source of gas with only a 10-year supply of reserves. This qualifies the pipeline for a CCA rate of 20 percent rather than the normal 4 percent. The pipeline will cost $1 million; accompanying buildings will cost another $200,000. The buildings are Class 1 with a CCA rate of 4 percent.

Aerocomp will use land it acquired eight years ago to assemble this project. The land was purchased for $500,000, and it is now worth $2 million. Annual cash flows before amortization from the pipeline and taxes for the 10-year period are estimated at $625,000.

In 10 years the buildings and pipeline will be worthless, but the land will be worth $4.5 million. Environmental clean-up costs at the end of the project are expected to be $1.2 million.

Aerocomp has a tax rate of 30 percent, and its cost of capital is 14 percent. Capital gains are taxed at 50 percent of the gain.

Investment 3: Aerocomp is considering investing into Swiss Ventures Inc. The details of the project are as follows:

Capital outlays on the project are expected to occur over the next two years, and the project, which will produce widgets for the wireless communication business, will be a unique entity to the Swiss Ventures family of projects. An immediate outlay of $600,000 will be required for the land to house the specialized building that will be constructed over the next year. Final payment on the building will amount to $1.1 million inclusive and will be due in exactly one year. Payment for the machinery to produce the widgets will amount to $175,000 and will be due after the initial test period, which will take to the end of the second year.

After the testing period, cash flows will begin in the third year. It is assumed that the revenues and expenses will be acknowledged at the end of each year. Beginning in the third year, revenues are expected to amount to $875,000 until the 12th year. Expenses are projected at $325,000 to the 12th year from the third year. These estimates are the averages of estimates obtained from the marketing staff and the production department. The expected values have been determined through preliminary work by Aerocomp.

In 12 years everything will end, as the market for the widget will be gone. The building will be scrapped for $225,000, and the machinery will be sold for $50,000. It is anticipated that the land will appreciate in value by 9 percent a year

The following additional information is available:

CCA rate: building 4%

machinery 30%

Corporate tax rate 30%

Cost of capital 15%

Capital gain 50% of gain taxable

REQUIREED:

Norman Windsor, CMA, CPA, has recently joined Aerocomp as Senior Financial Analyst. It is Friday morning. John met Norman while he was buying the morning coffee before he starts his work for the day. John tells him about the company plan and shares with him three proposals that the Board is considering. The Board members do not have any experience in financial analysis. Before the Board decides on the projects, John asks Norman to prepare the financial viability of three alternative investments. John asks Norman to do the following:

  1. Identify cash inflows and cash outflows for each project, and how these cash flows will be treated in the calculations of financial indicators.
  2. Calculate for each project the four indicators of financial viability, e.g.,
    1. Net Present Value
    2. IRR
    3. Payback period
    4. Profitability Index

and document them in a table.

  1. John emphasizes the role of sensitivity in evaluating these proposals. John asks Norman to increase/ decrease the key cash inflows (mainly the revenues or cost savings) by 10%, and analyze the impact on four indicators of financial viability (NPV, IRR, Payback Period, and Profitability Index). Document the results in a table.
  2. Analyze your results from a, b and c and make recommendations using a brief report to the CEO. You must include in your analysis any qualitative factors that might play an important role in making the final decision.

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