EYK12-1. Business Decision Case New Haven Corporation recently identified an investment opportunity involving the purchase of a patent that will permit the company to modify its line of CD recorders. 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. 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. fi 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. b. 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%. Weighted average cost of capital Proportion Cost rate Weighted cost Bonds Stocks Retained earnings 0% 0.00% "Buffer" margin Cutoff rate 0.00% After-tax cash flows: Tax rate (1-tax rate) Year 1 Year 2 Year 3 Year 4 Year 5 NOTE: enter adjusted amounts, expenses are negative Revenue Expenses Taxes . S Present value calculations: Year (N) Factor After tax cash flow (FV) 1 $ 309,200 Present value (PV) 276,072 12% 0.89286 $ 21 $ 276,072 Total present value Investment required Net present value $ 276,072 Recommendation C Sensitivity analysis: Present value calculations: Year (N) After tax cash flow (FV) Revenue reduction Revised cash flow i/Y Factor Present value (PV) $ . Total present value Investment required Net present value $ . Recommendation NOTE: Because the PV tables only include discount rates up to 12%, this requirement will require the use of a calculator or Excel fx. Present value calculations: Year (N) After tax cash flow (FV) i/Y Factor Present value (PV) Total present value Investment required Net present value $ - Recommendation EYK12-1. Business Decision Case New Haven Corporation recently identified an investment opportunity involving the purchase of a patent that will permit the company to modify its line of CD recorders. 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. 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. fi 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. b. 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%. Weighted average cost of capital Proportion Cost rate Weighted cost Bonds Stocks Retained earnings 0% 0.00% "Buffer" margin Cutoff rate 0.00% After-tax cash flows: Tax rate (1-tax rate) Year 1 Year 2 Year 3 Year 4 Year 5 NOTE: enter adjusted amounts, expenses are negative Revenue Expenses Taxes . S Present value calculations: Year (N) Factor After tax cash flow (FV) 1 $ 309,200 Present value (PV) 276,072 12% 0.89286 $ 21 $ 276,072 Total present value Investment required Net present value $ 276,072 Recommendation C Sensitivity analysis: Present value calculations: Year (N) After tax cash flow (FV) Revenue reduction Revised cash flow i/Y Factor Present value (PV) $ . Total present value Investment required Net present value $ . Recommendation NOTE: Because the PV tables only include discount rates up to 12%, this requirement will require the use of a calculator or Excel fx. Present value calculations: Year (N) After tax cash flow (FV) i/Y Factor Present value (PV) Total present value Investment required Net present value $ - Recommendation