Midcity Center Inc. Case Study

Adapted from Capital Budgeting and Long-Term Financing Decisions, 4^th Edition

by Niel Seitz and Mitch Ellison

Midcity Center Inc. is located in a run-down part of an old industrial city. The center is a nonprofit corporation formed by a coalition of churches to serve the needs of the inner-city poor. Services provided by the center included temporary quarters for the homeless, hot meals once a day for the indigent, and the General Store. The General Store carried free used clothing and free nonperishable foods for the poor. In addition, the center housed a store called the Center Boutique which sold donated items to help cover the centers operating costs.

Midcity Center was funded by annual pledges from the coalition churches. The center also had an endowment fund as a result of several large bequests. The endowment fund was controlled by the centers board of trustees, who had complete discretion with regard to investment policy. The board had the authority to spend the entire endowment fund, but they had always maintained a strict policy of preserving the principle and spending on the income.

The endowment fund had a balance of $1.2 million invested entirely in corporate bonds. The average interest rate on the bonds was 7%, but many of the bonds were selling at a discount due to rising interest rates. Yields to maturity for bonds of this type were currently 10%.

The Board of Trustees had before it several options:

To counteract increased energy costs, install new thermally efficient windows. The building would need 68 new windows at a cost of $230 per window. Cost includes installation. Estimates are that the new windows would decrease heating costs by 20%.

To counteract increased energy costs, install a new high efficiency furnace. The furnace would cost $27,630 to install and make ready. It is estimated that this would decrease heat costs by 40%.

If both options are chosen, independent analysis has indicated that heating costs would decrease by 26%.

Question becomes do we do either the window project or the furnace project or both? Tied up with this decision is how to pay for the projects. Clearly money could be removed from the endowment (principal can be used recall). Another suggests borrowing from a local bank given their knowledge it seems a reasonable interest rate is 12% if borrowed for 10 years.

Complete an analysis of the options presented and develop a recommendation to the Board of Trustees. Heating costs for the past year were $14,230. The Center has no plans to move buildings and based on life expectancy of the windows, the furnace, and other factors, assume a 10 year operating plan. Heating costs are expected to continue rising, due to higher energy costs and continued wear and tear on the existing equipment at the center. For years 1 thru 4 assume a cost growth rate of 6%, for years 5 thru 7 a cost growth rate of 7.2%, and for years 8 thru 10 a cost growth rate of 8.8%.

Deliverables:

NPV analysis of project options (windows, furnace, both). You may do other analysis but not required.

Recommend to the Board how the project(s) chosen are funded.

As this is modeled on real world events, you are not limited to the black and white options here. You are welcome to get creative to solve the problem just be sure you can justify your decisions/recommendations.

Other Facts

It is often asked what interest rate you use for the bonds: 7% or 10%. Making an assumption that the bonds are staggered and rolling forward (as bonds mature, new ones are purchased at current rates), we can assume that over the life span of the projects, the YTM is a better measure of return on investment. Thus the interest rate on the bonds in your calculation should be 10%.

Heating costs are growing from base year 0, $14,230. Years 1 thru 4 have a growth rate of 6%, so this would be a 6% increase from year 0 to figure out year 1 projected costs. Year 2 projected cost is a further 6% increase from year 1.

Current Interest Earnings are already spoken for. Some students wish to use the existing interest earnings on the endowment for the projects. This money is already spoken for, as the Board of Trustees spends this money on existing operations. At an average interest rate of 7%, the earnings on the endowment fund then are some $84,000 for last year. Moving this to cover these projects would put an impossible burden on the Center, as the projects are optional existing operations are not. Said another way, youd would be robbing Peter to pay Paul money still has to come from somewhere to fund the gap!