mini case of the vegetrons CFO calls again. question 1. Are the book rates return period in table 5.1 and 5.2 useful inputs for the capital investment decision?

question 2

Vegetron's CFO Calls Again (The first episode of this story was presented in Section 5-1) Later that afternoon, Vegetron's CFO bursts into your office in a state of anxious confusion. The problem, he explains, is a last-minute proposal for a change in the design of the fermentation tanks that Vegetron will build to extract hydrated zirconium from a stockpile of powdered ore. The CFO has brought a printout (Table 5.1) of the forecasted revenues, costs, income, and book rates of return for the standard, low-temperature design. Vegetron's engineers have just proposed an alternative high-temperature design that will extract most of the hydrated zirconium over a shorter period, five instead of seven years. The forecasts for the high-temperature method are given in Table 5.2.1 A shadow price is the marginal change in the objective for a marginal change in the constraint. Forsmplicaty we have ignored taxes. There will be plenty about taxes in Chapter 6 Part One Value CFO Why do these engineers always have a bright idea at the last minute? But you 've got to admit the high-temperature process looks good We'll get a faster payback, and the rate of return beats Vegetron's 9% cost of capital in every year except the first. Let's see, income is $30,000 per year Average investment is half the $400.000 capital outlay, or $200.000, so the average rate of return is 30.000/200,000, or 19%--a lot better than the 9% hurdle rate. The average rate of return for the low-temperature process is not that good, only 28,000/200,000, or 14%. Of course we might get a higher rate of return for the low-temperature proposal if we depreciated the investment faster -do you think we should try that Vegetron or its investors. Book rates of return don't measure the true rate of return report to investors. You: Let's not fixate on book accounting numbers. Book income is not the same as cash flow to CFO But people use accounting numbers all the time. We have to publish them in our annual You: Accounting numbers have many valid uses, but they're not a sound basis for capital invest ment decisions. Accounting changes can have big effects on book income or rate of return, even when cash flows are unchanged Here's an example. Suppose the accountant depreciates the capital investment for the low temperature process over six years rather than seven Then income for years I to 6 goes down. because depreciation is higher ncome for year 7 goes up because the depreciation for that year becomes zero But there is no effect on year-to-year cash flows, because depreciation is not a cash outlay It is simply the accountant's device for spreading out the "recovery" of the up front capital outlay over the lale of the project. CFO So how do we get cash flows? You: In these casesit's easy, Depreciation is the only noncash entry in your spreadsheets (Tables 5.1 and 5.2), so we can just leave it out of the calculation. Cash flow equals revenue minus operat- CFO: In effect you're adding back depreciation,beause depreciation is a noncash accounting espense. Cash flow net income + depreciation-3080 110, or $110,000 ing costs. For the high-temperature process, annual cash flow iss revenue operating cost 180 70 110,or $110,000 You: Right. You could also do it that way CFO: Of course. I remember all this now, but book returns seem important when someone shoves them in front of your nose. Year 1. Revenue 2. Operating costs 3. Depreciatioe 4 Net income .Start-of-year bock value 400 343 286 229 171 114 57 6.Bookrateofreturn (4-5) 7% 82% 98% 12.2% 16.4% 246% 411% 140 140 140 140 140 140 140 57 57 28 57 28 TABLE 5.1 Income statement and book rates of retum for low-temperature extraction of hydrated zirconium ($ thousands). Bounded. Staijght-Ine depreciatisn cver arven years is 4007-57.1, or $$7,140pr yex Cap tal Inwestment is $400,000 in year . per yeu. Chapter 5 Net Present Value and Other Investment Criteria Year 2 1 Revenue 2. Operating costs . Depreciatior 4. Net income 5. Start-of-year book vake 180 70 80 30 180 180 180 70 180 70 80 70 70 80 30 30 40 320 160 & Book rate of reburn (4+ 5) 75% 125% la 75% 37.5% D TABLE 5.2 Income statement and book rates of retun for high-temperature extraction of hydrated zirconium ($ thousands). Stagmane depreciatin aer sve years is 4005 , S80,000 per year. Capital investment is $400,000 n year d You: It's not clear which project is better. The high-temperature process appears to be less effi- t. It has higher operating costs and generates less total revenue over the life of the project of the project but of course it generates more cash flow in years 1 to 5 cFO: Maybe the processes are equally good from a financial point of view. If so we'll stick with the low-temperature process rather than switching at the last minute. You: We'll have to lay out the cash flows and calculate NPV for each process. CFO: OK, do that. I'll be back in a half hour-and I also want to see each project's true, DCF rate of return. Calculate NPV and IR to the CFO. 2. R for each process. What is your recommendation? Be ready to explain