PLEASE ANSWER THE HIGHLIGHTED QUESTIONS

Open with Google Docs CASE 14 Aerocomp, Inc. As she headed toward her boss's office, Emily Hamilton, chief operating officer for the Aerocomp Corporation - 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 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 favor the project that promised the highest gain in reported net income. Emily know 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. The plane was only six years old and was considered a good buy at $300,000. In retum, the plane would bring over $600,000 in additional revenue during the next five years with only about $56,000 in operating costs. (See Figure 1 for details.) 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 Figure 2 for details.) 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 versa- tility 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 Figure 3 for details.) D. A proposal to begin operating a fleet of trucks. Ten could be bought for only Page 1 / 4 + 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 Initial Year / Expenditures Year 2 Year 3 Year 4 Net cost of new plane. $300,000 Additional revenue.... $43,000 $76,800 $112,300 $225,000 $168,750 Additional operating costs......... 11,250 11,250 11,250 11,250 11,250 Depreciation...... 45,000 66.000 63.000 63.000 63.000 Net increase in income.. (13,250) (450) 38,050 150,750 94,500 Less: Tax at 33%... 0 12.557 49.748 _31.185 Increase in aftertax income ..... ($13.250) ( S450) S. 25.494 $101.003 $63.315 Add back depreciation.. $45,000 $66,000 $63,000 63,000 $63,000 Net change in cash flow.. (5300,000) 31,750 65,550 88,494 164,003 126,315 Year 5 Figure 2 Year 5 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. Financial analysis of Project B: Diversify into copy machines Initial Expenditures Year / Year 2 Year 3 Year 4 5700,000 $ 87,500 $175,000 $262,500 $393,750 26,250 26,250 26,250 26,250 17.500 17.500 17.500 17.500 43,750 131,250 218,750 350,000 14.438 43.313 72,188 115.500 29,313 $ 87,938 $146,563 $234,500 $ 17,500 $ 17,500 $ 17,500 $ 17,500 (5700,000) 46,813 105,438 164,063 252,000 $525,000 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! Aerocomp, Inc. 57 Years Figure Financial analysis of Project C: Add a helicopter to the company's fleet Initial Expedie Tear Year 2 Year 3 Year Netcost of helicopter $300,000 Additional revenue $100,000 $200,000 $300,000 $450,000 Additional operating costs 40,000 40,000 40,000 40,000 Depreciation 120.000 176.000 168.000 168.000 Net increase in income (60,000) (16,000) 242,000 Less: Taxat 33%. 29.250 Increase in ateriax income ($_60.000) 15. 16.000) 5.61.640 $162.140 Add back depreciation $120,000 $176,000 $168,000 $168,000 Net change in cash flow (5800,000) 60,000 160,000 229,640 330,140 93,000 5600,000 40,000 168.00 392,000 129.390 5262.640 $168,000 430,640 Year 5 Netcost of new trucks. Additional revenue Additional operating costs Depreciation Net increase in income.. Less: Taxat 33% Increase in aftertax income Add back depreciation Net change in cash flow Figure 4 Financial analysis of Project D: Add fleet of trucks Initial Year Expenditures Year 2 Year 3 Year 5510,000 5382,500 $325,125 $ 89,250 576,500 19,128 19.125 25,500 31,875 76,500 112.200 107.100 107.100 286,875 193,800 (43,350) (62,475) 94,662 63.954 0 $192.206 $129.846 (5.43.350) (562475) 576,500 $112,200 $107,100 107,100 (5510,000) 258,706 242,046 63,750 44,625 $51,000 38.250 107.100 (94,350) ($14.350) S107,100 12,750 Required: Open with Google Docs 1. Refer to Figures 1 through 4. Add up the total increase in after-tax income for each project. Given what you know about Kay Mash, to which project do you think she will be attracted? 2. Computer the Payback Period, Discounted Payback Period, Net Present Value, Internal Rate of Return (IRR), and Productivity Index of all four alternatives based on cash flow. User 10 percent for the cost of capital in your calculations. For the Payback Period and for the Discounted Payback Period, compute to the midyear points as discussed in class. 3. a. According to the payback method, which project should be selected? b. What is the chief disadvantage of this method? c. Why would anyone want to use this method? 4. a. According to the Discounted Payback method, which project should be selected? b. What is the chief disadvantage of this method? C. Why would anyone want to use this method? 5. a. According to the Net Present Value method, which project should be selected? b. What are the major advantages of the Net Present Value method? C. What are any disadvantages of the Net Value lethod? d. If Kay had not put a limit on the size of the capital budget, under the NPV method which projects would have been accepted? 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. Page 4 4 + Open with Google Docs CASE 14 Aerocomp, Inc. As she headed toward her boss's office, Emily Hamilton, chief operating officer for the Aerocomp Corporation - 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 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 favor the project that promised the highest gain in reported net income. Emily know 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. The plane was only six years old and was considered a good buy at $300,000. In retum, the plane would bring over $600,000 in additional revenue during the next five years with only about $56,000 in operating costs. (See Figure 1 for details.) 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 Figure 2 for details.) 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 versa- tility 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 Figure 3 for details.) D. A proposal to begin operating a fleet of trucks. Ten could be bought for only Page 1 / 4 + 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 Initial Year / Expenditures Year 2 Year 3 Year 4 Net cost of new plane. $300,000 Additional revenue.... $43,000 $76,800 $112,300 $225,000 $168,750 Additional operating costs......... 11,250 11,250 11,250 11,250 11,250 Depreciation...... 45,000 66.000 63.000 63.000 63.000 Net increase in income.. (13,250) (450) 38,050 150,750 94,500 Less: Tax at 33%... 0 12.557 49.748 _31.185 Increase in aftertax income ..... ($13.250) ( S450) S. 25.494 $101.003 $63.315 Add back depreciation.. $45,000 $66,000 $63,000 63,000 $63,000 Net change in cash flow.. (5300,000) 31,750 65,550 88,494 164,003 126,315 Year 5 Figure 2 Year 5 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. Financial analysis of Project B: Diversify into copy machines Initial Expenditures Year / Year 2 Year 3 Year 4 5700,000 $ 87,500 $175,000 $262,500 $393,750 26,250 26,250 26,250 26,250 17.500 17.500 17.500 17.500 43,750 131,250 218,750 350,000 14.438 43.313 72,188 115.500 29,313 $ 87,938 $146,563 $234,500 $ 17,500 $ 17,500 $ 17,500 $ 17,500 (5700,000) 46,813 105,438 164,063 252,000 $525,000 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! Aerocomp, Inc. 57 Years Figure Financial analysis of Project C: Add a helicopter to the company's fleet Initial Expedie Tear Year 2 Year 3 Year Netcost of helicopter $300,000 Additional revenue $100,000 $200,000 $300,000 $450,000 Additional operating costs 40,000 40,000 40,000 40,000 Depreciation 120.000 176.000 168.000 168.000 Net increase in income (60,000) (16,000) 242,000 Less: Taxat 33%. 29.250 Increase in ateriax income ($_60.000) 15. 16.000) 5.61.640 $162.140 Add back depreciation $120,000 $176,000 $168,000 $168,000 Net change in cash flow (5800,000) 60,000 160,000 229,640 330,140 93,000 5600,000 40,000 168.00 392,000 129.390 5262.640 $168,000 430,640 Year 5 Netcost of new trucks. Additional revenue Additional operating costs Depreciation Net increase in income.. Less: Taxat 33% Increase in aftertax income Add back depreciation Net change in cash flow Figure 4 Financial analysis of Project D: Add fleet of trucks Initial Year Expenditures Year 2 Year 3 Year 5510,000 5382,500 $325,125 $ 89,250 576,500 19,128 19.125 25,500 31,875 76,500 112.200 107.100 107.100 286,875 193,800 (43,350) (62,475) 94,662 63.954 0 $192.206 $129.846 (5.43.350) (562475) 576,500 $112,200 $107,100 107,100 (5510,000) 258,706 242,046 63,750 44,625 $51,000 38.250 107.100 (94,350) ($14.350) S107,100 12,750 Required: Open with Google Docs 1. Refer to Figures 1 through 4. Add up the total increase in after-tax income for each project. Given what you know about Kay Mash, to which project do you think she will be attracted? 2. Computer the Payback Period, Discounted Payback Period, Net Present Value, Internal Rate of Return (IRR), and Productivity Index of all four alternatives based on cash flow. User 10 percent for the cost of capital in your calculations. For the Payback Period and for the Discounted Payback Period, compute to the midyear points as discussed in class. 3. a. According to the payback method, which project should be selected? b. What is the chief disadvantage of this method? c. Why would anyone want to use this method? 4. a. According to the Discounted Payback method, which project should be selected? b. What is the chief disadvantage of this method? C. Why would anyone want to use this method? 5. a. According to the Net Present Value method, which project should be selected? b. What are the major advantages of the Net Present Value method? C. What are any disadvantages of the Net Value lethod? d. If Kay had not put a limit on the size of the capital budget, under the NPV method which projects would have been accepted? 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. Page 4 4 +