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56 Case 14 $51,000 each, and the additional business would bring in almost $700,000 in new sales in the first two years alone. (See Figure 4 for details). In her mind, Emily quickly went over the evaluation methods she had used in the past: payback, 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 favored the net present value 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 company was growing too fast and had piled up Figure 1 Financial analysis of Project A: Add a twin-jet to the company's fleet Year 1 Year 2 Year 3 Year 4 Initial Expenditures $300,000 Year 5 S43,000 11,250 45.000 (13,250) $76,800 11,250 Net cost of new plane... Additional revenue.. Additional operating costs. Depreciation.... Net increase in income. Less: Tax at 33%... Increase in aftertax income Add back depreciation Net change in cash flow. 66,000 $112,300 11,250 63,000 38,050 12.557 S_25.494 $63,000 88,494 (450) O (S_450) $66,000 65,550 $225,000 11,250 63,000 150,750 49,748 s101.003 63,000 164,003 $168,750 11,250 63.000 94,500 31.185 $ 63,315 $63,000 126,315 (513,250) $45,000 31,750 ($300,000) Year 5 Figure 2 Financial analysis of Project B: Diversify into copy machines Initial Expenditures Year 1 Year 2 Year 3 Year 4 Net cost of new franchise. $700,000 Additional revenue.. $ 87,500 $175,000 $262,500 $393,750 Additional operating costs 26,250 26,250 26,250 26,250 Amortization. 17.500 17.500 17.500 17.500 Net increase in income. 43,750 131,250 218,750 350,000 Less: Tax at 33%... 14.438 43.313 72,188 115.500 Increase in aftertax income $ 29,313 S 87,938 $146,563 $234,500 Add back depreciation S 17,500 S 17,500 S 17,500 $ 17,500 Net change in cash flow..... (S700,000) 46,813 105,438 164,063 252,000 $325,000 26,250 17.500 481,250 158.813 $322,438 $ 17,500 339,938 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 financial analysis, but she would listen to sensible arguments. Emily only hoped her financial analysis sounded sensible! Figure 3 Year 5 Net cost of helicopter Additional revenue. Additional operating costs. Depreciation. Net increase in income.. Less: Tax at 33%. Increase in aftertax income Add back depreciation Net change in cash flow.. Financial analysis of Project C: Add a helicopter to the company's fleet Initial Expenditures Year! Year 2 Year 3 Year 4 $800,000 $100,000 $200,000 $300,000 $450,000 40,000 40,000 40,000 40,000 120.000 176.000 168,000 168,000 (60,000) (16,000) 92,000 242,000 O 30.360 79.860 ($ 60.000) ($ 16,000) $ 61.640 $162,140 $120,000 $176,000 $168,000 $168,000 (5800,000) 60,000 160,000 229,640 330, 140 $600,000 40,000 168,000 392,000 129.360 $262.640 $168,000 430,640 Year 5 Figure 4 Financial analysis of Project D: Add fleet of trucks Initial Year Year 2 Year 3 Expenditures Year 4 Net cost of new trucks................ $510,000 Additional revenue... $382,500 $325,125 $ 89,250 $76,500 Additional operating costs 19,125 19,125 25,500 31,875 Depreciation 76,500 112.200 107.100 107.100 Net increase in income. 286,875 193,800 (43,350) (62,475) Less: Tax at 33%..... 94.669 63.954 0 0 Increase in aftertax income $192 206 $129.846 (S_43.350) (S_62.473) Add back depreciation $76,500 $112,200 $107,100 107,100 Net change in cash flow.......... (5510,000) 268,706 242,046 63,750 44,625 $51,000 38,250 107,100 (94,350) 0 ($94.350) $107,100 12,750 6. a. According to the IRR method, which project should be chosen? b. What is the major disadvantage of the IRR method that occurs when HIGH IRR projects are selected? C. Can you think of another disadvantage of the IRR method? (Hint: Look over the four alternatives and compare the sizes of the projects. Ask yourself whether you would prefer to make a large percent return on a small amount of money or a small percent gain on a large amount of money.) d. Do the NPV and IRR both reject the same projects - Why? 7. a. According to the Productivity Index, which project should be chosen? b. Explain why people use the Productivity Index. C. Explain why a Productivity Index so closely correlates with the results of NPV. 56 Case 14 $51,000 each, and the additional business would bring in almost $700,000 in new sales in the first two years alone. (See Figure 4 for details). In her mind, Emily quickly went over the evaluation methods she had used in the past: payback, 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 favored the net present value 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 company was growing too fast and had piled up Figure 1 Financial analysis of Project A: Add a twin-jet to the company's fleet Year 1 Year 2 Year 3 Year 4 Initial Expenditures $300,000 Year 5 S43,000 11,250 45.000 (13,250) $76,800 11,250 Net cost of new plane... Additional revenue.. Additional operating costs. Depreciation.... Net increase in income. Less: Tax at 33%... Increase in aftertax income Add back depreciation Net change in cash flow. 66,000 $112,300 11,250 63,000 38,050 12.557 S_25.494 $63,000 88,494 (450) O (S_450) $66,000 65,550 $225,000 11,250 63,000 150,750 49,748 s101.003 63,000 164,003 $168,750 11,250 63.000 94,500 31.185 $ 63,315 $63,000 126,315 (513,250) $45,000 31,750 ($300,000) Year 5 Figure 2 Financial analysis of Project B: Diversify into copy machines Initial Expenditures Year 1 Year 2 Year 3 Year 4 Net cost of new franchise. $700,000 Additional revenue.. $ 87,500 $175,000 $262,500 $393,750 Additional operating costs 26,250 26,250 26,250 26,250 Amortization. 17.500 17.500 17.500 17.500 Net increase in income. 43,750 131,250 218,750 350,000 Less: Tax at 33%... 14.438 43.313 72,188 115.500 Increase in aftertax income $ 29,313 S 87,938 $146,563 $234,500 Add back depreciation S 17,500 S 17,500 S 17,500 $ 17,500 Net change in cash flow..... (S700,000) 46,813 105,438 164,063 252,000 $325,000 26,250 17.500 481,250 158.813 $322,438 $ 17,500 339,938 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 financial analysis, but she would listen to sensible arguments. Emily only hoped her financial analysis sounded sensible! Figure 3 Year 5 Net cost of helicopter Additional revenue. Additional operating costs. Depreciation. Net increase in income.. Less: Tax at 33%. Increase in aftertax income Add back depreciation Net change in cash flow.. Financial analysis of Project C: Add a helicopter to the company's fleet Initial Expenditures Year! Year 2 Year 3 Year 4 $800,000 $100,000 $200,000 $300,000 $450,000 40,000 40,000 40,000 40,000 120.000 176.000 168,000 168,000 (60,000) (16,000) 92,000 242,000 O 30.360 79.860 ($ 60.000) ($ 16,000) $ 61.640 $162,140 $120,000 $176,000 $168,000 $168,000 (5800,000) 60,000 160,000 229,640 330, 140 $600,000 40,000 168,000 392,000 129.360 $262.640 $168,000 430,640 Year 5 Figure 4 Financial analysis of Project D: Add fleet of trucks Initial Year Year 2 Year 3 Expenditures Year 4 Net cost of new trucks................ $510,000 Additional revenue... $382,500 $325,125 $ 89,250 $76,500 Additional operating costs 19,125 19,125 25,500 31,875 Depreciation 76,500 112.200 107.100 107.100 Net increase in income. 286,875 193,800 (43,350) (62,475) Less: Tax at 33%..... 94.669 63.954 0 0 Increase in aftertax income $192 206 $129.846 (S_43.350) (S_62.473) Add back depreciation $76,500 $112,200 $107,100 107,100 Net change in cash flow.......... (5510,000) 268,706 242,046 63,750 44,625 $51,000 38,250 107,100 (94,350) 0 ($94.350) $107,100 12,750 6. a. According to the IRR method, which project should be chosen? b. What is the major disadvantage of the IRR method that occurs when HIGH IRR projects are selected? C. Can you think of another disadvantage of the IRR method? (Hint: Look over the four alternatives and compare the sizes of the projects. Ask yourself whether you would prefer to make a large percent return on a small amount of money or a small percent gain on a large amount of money.) d. Do the NPV and IRR both reject the same projects - Why? 7. a. According to the Productivity Index, which project should be chosen? b. Explain why people use the Productivity Index. C. Explain why a Productivity Index so closely correlates with the results of NPV