Centronics Corporation Case:

As she headed toward her boss's office, Emily Hamilton, Chief operating officer for the corporation - a 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 the college. Emily had just completed summarizing the financial aspects of four investment projects that were open to Centronics 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 "streetsmart" 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 wasn't sure of her abilityto convinceKay, 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 sheetsfrom her brief case and quickly reviewed the detailsof the fourprojects, all of which she considered to be equally risky.

Proposal A:

A proposal to add a jet to the company's fleet. The plane was only six years old and was considereda good buy at $300,000. In return, the plane would bring over $600,000in additional revenue during the next five years with only about $56,000 in operating costs. (See Exhibit 1 shows financial information of project A - adding twin-jet to the company's fleet).

Proposal B

A proposal to diversify into copy machines. The franchise was to cost $700,000, which would be amortized over 40-year period. The new business was expected to generate over $1.4 million in sales over the next five years, and $1,443,750 in additional revenue. See Exhibit 1 showing the financial information of project B to diversify into copy machines

Proposal 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 versatilitythat the helicopter was expected to provide would generate over 1.5 million in additional revenue, andit would give the company access to a wider market as well. See Exhibit 2 showing the financial information ofbuying a helicopter

Proposal 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 an additional $700,000 in new sales in the first two years alone. See Exhibit 2 for the financial information of operating a fleet of trucks.

Her first challenge is to calculate the net change in cash flow for each project. 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 Kay's insistence that no outside financing be used this year. Kay was worried that the companywas 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 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 the financial analysis provided, but she would listen to sensible arguments. Emily only hoped her financial analysis sounded sensible. She is planning to use NPV, IRR, Payback Period and Profitability Index to evaluate the four projects and suggest which project should be selected and why. She would highlight the pros and cons of each method and recommend a project that she believes will be the best analyzing all the four methods simultaneously with possible risks attached to each method.

Additional Information:Total market value of the company's stock is $200 million and total market value of debt of the company is $200 million. It is assumed that the company can borrow money in the market at 10% per annum.The return on company's common stock is 18%. The company is in the corporate tax bracket of 40%.

REQUIRED:

You assume the role of Emily and undertake appropriate financial analysis and determine the project that should be selected based on your analysis. Your report should be prepared in the form of a memo to Kay. Use the memo format to write the report. The memo should not exceed 1200 words and should be typed in double spaced with numerical work attached as an appendix. Please remember your memo should be precise and concise with no cluttering and use small paragraphs.The tables for projects A through D are attached.

You are required to work this case in MS WORD and attach the completed document for grading.

Grade Distribution:

MemoFormat = 5 marks

Memo contents = 7 marks

Numerical work = 8 marks

WACC = E/(D+E) x r_e+E/(D+E)x r_dx (1-T)

E= Market value of equity

D = Market value of debt

r_e= cost of equity

r_d= cost of debt

T = corporate tax rate

Exhibit 1:

PROPOSAL A

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

Amortization

$45,000

$66,000

$63,000

$63,000

$63,000

PROPOSAL B

Initial Expenditures

Year 1

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

$17,500

$17,500

$17,500

$17,500

$17,500

Exhibit 2:

PROPOSAL C

Initial Expenditures

Year 1

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

Amortization

$120,000

$176,000

$168,000

$168,000

$168,000

PROPOSAL D

Initial Expenditures

Year 1

Year 2

Year 3

Year 4

Year 5

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

Amortization

$76,500

$112,200

$107,100

$107,100

$107,100