EYK12-1. Business Decision Case

a. List at least three of the defects that appear in the treasurer's analysis: HINT: there are five altogether

b. Weighted average cost of capital:

Source Proportion Cost Rate Weighted Cost

Bonds 10% x 8% = 0.80% Check figure: Bonds percents are given for you

Stock x 9 =

Retained earnings x 10 =

Totals

Provide the "buffer margin" in the box

Cutoff rate for net present value analysis

We may compute the annual after-tax cash flows by computing and combining the individual after-tax cash effects. The individual effects are determined by multiplying both the cash revenue and cash expenses by 70% (1 - income tax rate) and multiplying the patent amortization by 30% (the income tax rate).

There are 3 steps to calculate After - Tax Cash Flow - I have provided Year 1 for you:

Year 1: $620,000 x 70% = $434,000

(240,000) x 70% = $(168,000)

144,000 x 30% = $43,200

After-tax cash flow $309,200

Year 2: $560,000 x 70% =

After-tax cash flow

Year 3: $400,000 x 70% =

After-tax cash flow

Year 4: $250,000 x 70% =

After-tax cash flow

Year 5: $200,000 x 70% =

After-tax cash flow

After-tax Present

Year (N) Cash Flows (FV) i/Yr Value Show your work here (first one provided for you)

1 $309,200 @ 12% = 276,071 PV = $309,200 x 0.89286 = $276,072 (difference due to rounding)

2 @ 12% =

3 @ 12% =

4 @ 12% =

5 @ 12% =

Total present value

Investment required

Net positive present value

What is the recommendation:

c - 1 Year (N) Original After Tax Cash Flows (10% Revenue Reduction) x 1 - Tax Rate) Revised After Tax Cash Flows (FV) i/Yr Present Value

1 $309,200 = (62,000 x 70%) = $265,800 @ 12% = $237,321

2 = = @ 12% =

3 = = @ 12% =

4 = = @ 12% =

5 = = @ 12% =

Total present value

Investment required

Net positive present value

What is the conclusion:

c - 2 Students do not have to complete C -2

DING YOUR KNOWLEDGE Business Decision Case New Haven Corporation recently identified an investment on involving the purchase of a patent that will permit the company to modify its line of CD record The patient's purchase price is $720,000 and the legal protection it provides will last for five years: there is no salvage value. However, after preparing the capital expenditure analysis belo New Haven's treasurer has recommended to the company's capital budgeting committee that the investment he rejected. Brad Decker, chairperson of the capital budgeting committee, finds it dit 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 Y 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 89.9%, and 10%, respectively. New Haven has a policy of seeking a return cqual to the weighted average cost of capital plus 2.5 percentage points as a "buffer margin" for the uncertainties involved. QUIWU Chapter 18 Capital Bugeting Income taxes New Haven has an overall income tax rate of 5. Treasurer's analysis tive 3740,000 720,000 Average cost of capital (0% 99% 100 T cash revera Total ca s es Total amortization Total operating expenses. Projected net income over five years Average arvual income Present value of future retums.... Required investment.... Negative not present value 1400.000 $570,000 1114.000 1443 420 720,000 (276,500) hted pital Recommendation: Reject investment because of insuficient net prevent 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 1. Prepare your own analysis of the investment, including calculation of the proper cost of capital and hurdle rates, a ne present value analysis of the project, and a brief recommenda tion to Decker regarding the investment (round amounts to nearest dollar). 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%. the m o ral Ceneral Company's cutting department, which pro- DING YOUR KNOWLEDGE Business Decision Case New Haven Corporation recently identified an investment on involving the purchase of a patent that will permit the company to modify its line of CD record The patient's purchase price is $720,000 and the legal protection it provides will last for five years: there is no salvage value. However, after preparing the capital expenditure analysis belo New Haven's treasurer has recommended to the company's capital budgeting committee that the investment he rejected. Brad Decker, chairperson of the capital budgeting committee, finds it dit 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 Y 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 89.9%, and 10%, respectively. New Haven has a policy of seeking a return cqual to the weighted average cost of capital plus 2.5 percentage points as a "buffer margin" for the uncertainties involved. QUIWU Chapter 18 Capital Bugeting Income taxes New Haven has an overall income tax rate of 5. Treasurer's analysis tive 3740,000 720,000 Average cost of capital (0% 99% 100 T cash revera Total ca s es Total amortization Total operating expenses. Projected net income over five years Average arvual income Present value of future retums.... Required investment.... Negative not present value 1400.000 $570,000 1114.000 1443 420 720,000 (276,500) hted pital Recommendation: Reject investment because of insuficient net prevent 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 1. Prepare your own analysis of the investment, including calculation of the proper cost of capital and hurdle rates, a ne present value analysis of the project, and a brief recommenda tion to Decker regarding the investment (round amounts to nearest dollar). 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%. the m o ral Ceneral Company's cutting department, which pro