EXTENDING YOUR KNOWLEDGE EYK12-1. Business Decision Case New Haven Corporation recently identified an investment oppon involving the purchase of a patent that will permit the company to modify its line of CD recorden The patent's 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 Haven's treasurer has recommended to the company's capital budgeting committee that the investment be rejected. Brad Decker, chairperson of the capital budgeting committee, finds it diffi cult to accept the treasurer's analysis because he feels intuitively that the investment is attractive. For this reason, he has retained you to review the treasurer's analysis and recommendation. You are provided with the following data and summary of the treasurer's 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 $ 620,000 560,000 400,000 250,000 200,000 $2,030,000 Cash Expenses $240,000 200,000 170,000 80,000 50,000 $740,000 3. 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. - vapauugeting 517 4. Income taxes: New Haven has an overall income tax rate of 30%. 5. Treasurer's analysis: $2,030,000 $740,000 720,000 Average cost of capital (8% + 9% + 10%)/ 3 9 % Total cash revenue.. Total cash expenses.. Total amortization .... Total operating expenses.. Projected net income over five years Average annual income. Present value of future returns. Required investment.... Negative net present value. 1,460,000 $ 570,000 $ 114,000 $ 443,420 720,000 $ (276,580) Recommendation: Reject investment because of insufficient net present value. Required a. Review the treasurer's analysis, identifying any questionable aspects and briefly comment on the apparent effect of each such item on the treasurer's analysis. 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%. 1 b Weighted average cost of capital Proportion Cost rate 8% Bonds Stocks Retained earnings 970 10% 30% 60% 100% 10% Weighted cost 0.80% 2.70% 6.00% 9.50% 2.50% 12.00% "Buffer" margin Cutoff rate After-tax cash flows: Tax rate (1 - tax rate) 3076 Year 2 NOTE: enter adjusted amounts, expenses are negative Revenue Expenses Taxes $ 560,000 $ (200,000) Year 3 400,000 (170.000) 620,000 (240,000 5 $ 250,000 (H0,000) 200,000 150,000 380,000 $ 360,000 S 210,000 $ 170,000 $ 150,000 Present value calculations: Year (N) After tax cash flow (FV) 309,200 295,200 204 200 162,200 0.89286S 0.79720 0.71180 0.63550 0.56740 Present value (PV) 276,072 215,332 145, 146 103,081 84,093 843,924 720,000 123,922 148,200 12% Total present value Investment required Net present value Recommendation The NPV is positive, its recommended for investing in the project romat Poster B B A E Merge Center $ % no Formatting Car Table Styles - Select 57e Sensitivity analysis Present value calculations: Year (N) After tax cash flow (FM 558.000 Revenue reduction Revised cash flow Total present value Investment required SSRESESERA838 38 38 85 28 NOTE: Because the PV tables only include discount rates up to 12%, this requirement will require the use of a calculator or Excel Present value calculation Year (N) After tax cash flow (V) 720.000 Investment required Net prevent value NPV will be negative and its not recommended to invest in the project EXTENDING YOUR KNOWLEDGE EYK12-1. Business Decision Case New Haven Corporation recently identified an investment oppon involving the purchase of a patent that will permit the company to modify its line of CD recorden The patent's 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 Haven's treasurer has recommended to the company's capital budgeting committee that the investment be rejected. Brad Decker, chairperson of the capital budgeting committee, finds it diffi cult to accept the treasurer's analysis because he feels intuitively that the investment is attractive. For this reason, he has retained you to review the treasurer's analysis and recommendation. You are provided with the following data and summary of the treasurer's 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 $ 620,000 560,000 400,000 250,000 200,000 $2,030,000 Cash Expenses $240,000 200,000 170,000 80,000 50,000 $740,000 3. 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. - vapauugeting 517 4. Income taxes: New Haven has an overall income tax rate of 30%. 5. Treasurer's analysis: $2,030,000 $740,000 720,000 Average cost of capital (8% + 9% + 10%)/ 3 9 % Total cash revenue.. Total cash expenses.. Total amortization .... Total operating expenses.. Projected net income over five years Average annual income. Present value of future returns. Required investment.... Negative net present value. 1,460,000 $ 570,000 $ 114,000 $ 443,420 720,000 $ (276,580) Recommendation: Reject investment because of insufficient net present value. Required a. Review the treasurer's analysis, identifying any questionable aspects and briefly comment on the apparent effect of each such item on the treasurer's analysis. 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%. 1 b Weighted average cost of capital Proportion Cost rate 8% Bonds Stocks Retained earnings 970 10% 30% 60% 100% 10% Weighted cost 0.80% 2.70% 6.00% 9.50% 2.50% 12.00% "Buffer" margin Cutoff rate After-tax cash flows: Tax rate (1 - tax rate) 3076 Year 2 NOTE: enter adjusted amounts, expenses are negative Revenue Expenses Taxes $ 560,000 $ (200,000) Year 3 400,000 (170.000) 620,000 (240,000 5 $ 250,000 (H0,000) 200,000 150,000 380,000 $ 360,000 S 210,000 $ 170,000 $ 150,000 Present value calculations: Year (N) After tax cash flow (FV) 309,200 295,200 204 200 162,200 0.89286S 0.79720 0.71180 0.63550 0.56740 Present value (PV) 276,072 215,332 145, 146 103,081 84,093 843,924 720,000 123,922 148,200 12% Total present value Investment required Net present value Recommendation The NPV is positive, its recommended for investing in the project romat Poster B B A E Merge Center $ % no Formatting Car Table Styles - Select 57e Sensitivity analysis Present value calculations: Year (N) After tax cash flow (FM 558.000 Revenue reduction Revised cash flow Total present value Investment required SSRESESERA838 38 38 85 28 NOTE: Because the PV tables only include discount rates up to 12%, this requirement will require the use of a calculator or Excel Present value calculation Year (N) After tax cash flow (V) 720.000 Investment required Net prevent value NPV will be negative and its not recommended to invest in the project