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Capital Budgeting Analysis As she headed toward her boss's office, Emily Hamilton, chief operating officer for the Aerotech Corporation - a computer services firm that specialized in airborne support - wished she could remember more of her training in financial theory that she had been exposed to in college. Emily had just completed summarizing the financial aspects of four capital investment projects that were open to Aerotech 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 \"street smart\" chief executive, with no background in financial theory, would immediately favor the project that promised the highest gain in reported net income. Emily knows that selecting projects purely on that basis would be incorrect; but she was not sure of her ability to convince Kay, 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 sheets from her briefcase and quickly reviewed the details of the four projects, all of which she considered to be equally risky. A. A proposal to add a jet to the company's fleet. The plane was only six years old and was considered a good buy at $300,000. In return, the plane would bring over $600,000 in additional revenue during the next five years with only about $56,000 in operating costs. (See Table 1 for details) Table 1 Financial analysis of Project A: Add a twin-jet to the company's fleet 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 Initial Expenditures $300,000 ($300,000) Year 1 $43,000 11,250 45,000 (13,250) 0 ($13,250) $45,000 $31,750 Year 2 $76,800 11,250 66,000 (450) 0 ($450) $66,000 $65,550 Year 3 Year 4 Year 5 $112,300 11,250 63,000 38,050 12,557 $25,494 $63,000 $88,494 $225,000 11,250 63,000 150,750 49,748 $101,003 $63,000 $164,003 $168,750 11,250 63,000 94,500 31,185 $63,315 $63,000 $126,315 B. A proposal to diversify into copy machines. The franchise was to cost $700,000, which would be amortized over a 40-year period. The new business was expected to generate over $1.4 million in sales over the next five years, and over $800,000 in aftertax earnings. (See Table 2 for details) Table 2 Financial analysis of Project B: Diversify into copy machines Net cost of new franchise Additional revenue Additional operating costs Amortization Net increase in income Less: Tax at 33% Increase in aftertax income Add back depreciation Net change in cash flow Initial Expenditures $700,000 ($700,000) Year 1 $87,500 26,250 17,500 43,750 14,438 $29,313 $17,500 $46,813 Year 2 Year 3 Year 4 Year 5 $175,000 26,250 17,500 131,250 43,313 $87,938 $17,500 $105,438 $262,500 26,250 17,500 218,750 72,188 $146,563 $17,500 $164,063 $393,750 26,250 17,500 350,000 115,500 $234,500 $17,500 $252,000 $525,000 26,250 17,500 481,250 158,813 $322,438 $17,500 $339,938 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 versatility that the helicopter was expected to provide would generate over $1.5 million in additional revenue, and it would give the company access to a wider market as well. (See Table 3 for details) Table 3 Financial analysis of Project C: Add a helicopter to the company's fleet Net cost of new 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 Initial Expenditures $800,000 ($800,000) Year 1 Year 2 Year 3 Year 4 Year 5 $100,000 40,000 120,000 (60,000) 0 ($60,000) $120,000 $60,000 $200,000 40,000 176,000 (16,000) 0 ($16,000) $176,000 $160,000 $300,000 40,000 168,000 92,000 30,360 $61,640 $168,000 $229,640 $450,000 40,000 168,000 242,000 79,860 $162,140 $168,000 $330,140 $600,000 40,000 168,000 392,000 129,360 $262,640 $168,000 $430,640 D. A proposal to begin operating a fleet of trucks. Ten would be bought for only $51,000 each, and the additional business would bring in almost $700,000 in new sales in the first two years alone. (See Table 4 for details) Table 4 Financial analysis of Project D: Add fleet of trucks Net cost of new trucks 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 Initial Expenditures $510,000 ($510,000) Year 1 $382,500 19,125 76,500 286,875 94,669 $192,206 $76,500 $268,706 Year 2 Year 3 Year 4 Year 5 $325,125 19,125 112,200 193,800 63,954 $129,846 $112,200 $242,046 $89,250 25,500 107,100 (43,350) 0 ($43,350) $107,100 $63,750 $76,500 31,875 107,100 (62,475) 0 ($62,475) $107,100 $44,625 $51,000 38,250 107,100 (94,350) 0 ($94,350) $107,100 $12,750 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 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 means that only one of the four projects under consideration could be chosen. Emily was not 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! Questions: 1. Refer to Tables 1 through 4. Add up the total increase in aftertax income for each project. Given what you know about Kay Marsh, to which project do you think she will be attracted? 2. Compute the payback period, internal rate of return (IRR), net present value (NPV), and profitability index of all four alternatives based on cash flow. Use 10% for the discount rate in your calculations. 3. a. b. According to the payback method, which project should be selected? What are the disadvantages of this method? 4. a. b. c. According to the IRR method, which project should be chosen? What are the major disadvantages of the IRR method? If Kay had not put a limit on the size of the capital budget, would the IRR method allow acceptance of all four alternatives? If not, which one(s) would be rejected and why? 5. a. According to the NPV method, which project should be chosen? How does this differ from the answer under the IRR? If Kay had not put a limit on the size of the capital budget, under the NPV method which projects would be accepted? Do the NPV and IRR both reject the same project(s)? Why? Given all the facts of the case, are you more likely to select Project A or C? b. c