MINI CASE Aerocomp Corporation As she headed toward her boss's office, Emily Hamilton, chief operating officer for the Aerocomp Corporationa computer services firm that specialized in airborne support- wished she could remember more of the 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 Aerocomp 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 favour the project that promised the highest gain in reported net income. Emily knew that selecting projects purely on that basis would be incorrect, but she wasn't 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. plane was only six years 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.) Inice Expenditures 5200,000 Year 1 Year 2 Year 3 Year 4 Years $225,000 11,250 Netcost of new plane Additional revenue Additional operating costs Amortization Net Increase in income Less: Taxat 33%. Increase in aftertax income Add back amortation Net change in cash flow $43,000 11,250 45,000 (13.250) 0 ($13.250) 45 31,750 $76,100 $112,300 11.250 11,250 65,000 63,00 (450) 38,050 12,557 (5 450) $25,494 966.000 $ 6,00 65,550 82,494 63,000 150,750 49,748 5101,003 $ 63,000 164,000 $168,750 11,250 53,000 94,500 31,185 $ 63,315 $3,000 126,315 (5200,000) B. Table 1 Financial analysis of project A: Add a twin-jet to the company's fleet 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.) Intal Year 1 Year 2 Year 3 Year 4 Year 5 Expenditures $700,000 Net cost of new franchise Additional revenue Additional operating costs Amortization Net increase in income Less: Taxat 33%... Increase in aftertax income Add back amostration Net change in cash flow $87.500 26,250 17.500 43,750 14:41 $29,313 $17.500 45,813 $175,000 26.250 17.500 131,250 43.313 $ 87,938 $ 17,500 106.438 5262,500 26,250 17,500 218,750 72,188 $146,553 $ 17.00 164,063 $393,750 26,250 17,500 350,000 115,500 $234,500 $17.500 252,000 $525,000 26,250 17.500 481,250 150 313 $322.438 $ 17,500 339,900 (700,000) Table 2 Financial analysis of project B: Diversify into copy machines 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.) Year 2 Year 3 Year 4 Year 5 Netcost of helicopter Additional revenue Additional operating costs Amortization Net Increase in income Less Tax at 33% Increase in aftertax income Add back amortation Net change in cash flow Initial Expenditures Year 1 $800,000 $100,000 40,000 120,000 (50,000) 0 (580,000) $120,000 (800,000) 60,000 5200,000 40,000 176,000 (16,000) 0 ($16.000) $176.000 160.000 $300,000 40,000 168,000 92,000 30,20 $ 61,640 $168,000 229,640 $450,000 40,000 168,000 242,000 79,850 5600,000 40,000 168,000 392,000 129,360 $262.640 $153,000 430,540 5162,140 S16,000 330,140 Table 3 Financial analysis of project C. Add a helicopter to the company's fleet D. A proposal to begin operating a fleet of trucks. Ten could 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.) Year 2 Year 3 Year 4 Year 5 Net cost of new trucis Additional revenue Additional operating costs Amortization Initial Expenditures Year 1 $510,000 5282,500 19,125 76,500 286,875 94,569 5192,206 $ 89,250 25,500 107,100 (43,250) 575,500 31.1075 107.100 (62.475) $51,000 38,250 107,100 (94,350) Net increase in Income $325,125 19.125 112.200 193.800 63.954 $129,846 $112.200 242.046 Less Taxat 33%... Increase in aftertax income Add hack amortation Net change in cash flow (5 43,350) (5 62.475) (5 94,350) $107,100 $107,100 $107,100 63,750 44,625 12,750 $ 76,500 258,706 (510,000) Table 4 Financial analysis of project D: Add fleet of trucks In her mind, Emily quickly went over the evaluation methods she had used in the past payback period, 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 favoured the NPV 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 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. a. c. 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? b. Compute the payback period, IRR, and NPV of all four alternatives based on cash flow. Use 10 percent for the cost of capital in your calculations. For the payback period, merely indicate the year in which the cash flow equals or exceeds the initial investment. You do not have to compute midyear points. i. According to the payback method, which project should be selected? ii. What is the chief disadvantage of this method? iii. Why would anyone want to use this method? d. i. According to the IRR method, which project should be chosen? ii. What is the major disadvantage of the IRR method that occurs when high IRR projects are selected? iii. Can you think of another disadvantage of the IRR method? iv. 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? e. i. According to the NPV method, which project should be chosen? How does this differ from the answer under the IRR? ii. 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? iii. Given all the facts of the case, are you more likely to select project A or C? f. i. According to the PI method, which project should be chosen? ii. Does your answer conflict with the NPV method? Why? Which method suggests the best project? MINI CASE Aerocomp Corporation As she headed toward her boss's office, Emily Hamilton, chief operating officer for the Aerocomp Corporationa computer services firm that specialized in airborne support- wished she could remember more of the 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 Aerocomp 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 favour the project that promised the highest gain in reported net income. Emily knew that selecting projects purely on that basis would be incorrect, but she wasn't 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. plane was only six years 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.) Inice Expenditures 5200,000 Year 1 Year 2 Year 3 Year 4 Years $225,000 11,250 Netcost of new plane Additional revenue Additional operating costs Amortization Net Increase in income Less: Taxat 33%. Increase in aftertax income Add back amortation Net change in cash flow $43,000 11,250 45,000 (13.250) 0 ($13.250) 45 31,750 $76,100 $112,300 11.250 11,250 65,000 63,00 (450) 38,050 12,557 (5 450) $25,494 966.000 $ 6,00 65,550 82,494 63,000 150,750 49,748 5101,003 $ 63,000 164,000 $168,750 11,250 53,000 94,500 31,185 $ 63,315 $3,000 126,315 (5200,000) B. Table 1 Financial analysis of project A: Add a twin-jet to the company's fleet 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.) Intal Year 1 Year 2 Year 3 Year 4 Year 5 Expenditures $700,000 Net cost of new franchise Additional revenue Additional operating costs Amortization Net increase in income Less: Taxat 33%... Increase in aftertax income Add back amostration Net change in cash flow $87.500 26,250 17.500 43,750 14:41 $29,313 $17.500 45,813 $175,000 26.250 17.500 131,250 43.313 $ 87,938 $ 17,500 106.438 5262,500 26,250 17,500 218,750 72,188 $146,553 $ 17.00 164,063 $393,750 26,250 17,500 350,000 115,500 $234,500 $17.500 252,000 $525,000 26,250 17.500 481,250 150 313 $322.438 $ 17,500 339,900 (700,000) Table 2 Financial analysis of project B: Diversify into copy machines 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.) Year 2 Year 3 Year 4 Year 5 Netcost of helicopter Additional revenue Additional operating costs Amortization Net Increase in income Less Tax at 33% Increase in aftertax income Add back amortation Net change in cash flow Initial Expenditures Year 1 $800,000 $100,000 40,000 120,000 (50,000) 0 (580,000) $120,000 (800,000) 60,000 5200,000 40,000 176,000 (16,000) 0 ($16.000) $176.000 160.000 $300,000 40,000 168,000 92,000 30,20 $ 61,640 $168,000 229,640 $450,000 40,000 168,000 242,000 79,850 5600,000 40,000 168,000 392,000 129,360 $262.640 $153,000 430,540 5162,140 S16,000 330,140 Table 3 Financial analysis of project C. Add a helicopter to the company's fleet D. A proposal to begin operating a fleet of trucks. Ten could 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.) Year 2 Year 3 Year 4 Year 5 Net cost of new trucis Additional revenue Additional operating costs Amortization Initial Expenditures Year 1 $510,000 5282,500 19,125 76,500 286,875 94,569 5192,206 $ 89,250 25,500 107,100 (43,250) 575,500 31.1075 107.100 (62.475) $51,000 38,250 107,100 (94,350) Net increase in Income $325,125 19.125 112.200 193.800 63.954 $129,846 $112.200 242.046 Less Taxat 33%... Increase in aftertax income Add hack amortation Net change in cash flow (5 43,350) (5 62.475) (5 94,350) $107,100 $107,100 $107,100 63,750 44,625 12,750 $ 76,500 258,706 (510,000) Table 4 Financial analysis of project D: Add fleet of trucks In her mind, Emily quickly went over the evaluation methods she had used in the past payback period, 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 favoured the NPV 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 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. a. c. 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? b. Compute the payback period, IRR, and NPV of all four alternatives based on cash flow. Use 10 percent for the cost of capital in your calculations. For the payback period, merely indicate the year in which the cash flow equals or exceeds the initial investment. You do not have to compute midyear points. i. According to the payback method, which project should be selected? ii. What is the chief disadvantage of this method? iii. Why would anyone want to use this method? d. i. According to the IRR method, which project should be chosen? ii. What is the major disadvantage of the IRR method that occurs when high IRR projects are selected? iii. Can you think of another disadvantage of the IRR method? iv. 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? e. i. According to the NPV method, which project should be chosen? How does this differ from the answer under the IRR? ii. 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? iii. Given all the facts of the case, are you more likely to select project A or C? f. i. According to the PI method, which project should be chosen? ii. Does your answer conflict with the NPV method? Why? Which method suggests the best project