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Aerocomp, Inc. As she headed toward her boss's office, Emily Hamilton, chief operating officer for the Aerocomp 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 Aerocomp during the coming year, and she was faced with the task of recommending which should be selected. What concemed 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 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. 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 Figure 1 for details.) 6. 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 altertax 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 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 Figure 3 for details.) 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 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 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! Figure 1 Financial analysis of Project A: Add a twin-Jet to the company's fleet Initial Expenditures $300,000 Year 1 Year 2 Year Year 4 Years Net cost of new plane... Additional revenue Additional operating costs Depreciation Net increase in income $ 43,000 $76,800 $112,300 11,250 11,250 11.250 45.000 65.000 63.000 (450) 38,050 (13,250) 0 112.55Z (913.250) (050) 25.494 $225,000 $168,750 11,250 11,250 62.000 63.000 150,750 94,500 Less Tax at 33% 49.248 31185 101.003 63.315 Increase in aftertax income Add back depreciation.. Net change in cash flow. ($300,000) $ 45,000 $66,000 31,750 65,550 63,000 38,494 63,000 $63,000 154,003 126,315 Figure 2 Financial analysis of Project B: Diversify into copy machines Year! Year 2 Year 3 Year 4 Years Initial Expenditures $700,000 Net cost of new franchise $ 87,500 Additional revenue.. 26,250 Additional operating costs.. Amortization $175,000 $262.500 $393,750 $525.000 26,250 26,250 26,250 26,250 17.500 17.500 17.500 17.500 131,250 218,750 350,000 481,250 43.313 228 115.500 17.500 43,750 Net increase in income L! Taxat 33% COOPER Less: Tax at 33% 43,313 ZBB 115.500 158.013 Increase in aftertax income. 14.438 $29.313 $.87.938 S146.563 5204,500 $322.438 Add back depreciation... Net change in cash flow. ($700,000) $ 17,500 46,813 $ 17,500 105,438 $ 17,500 164,063 $ 17,500 $ 17,500 252,000 339,938 Figure 3 Financial analysis of Project C: Add a helicopter to the company's fleet Initia Expenditures Year 1 Year 2 Year Year Year 5 5800,000 Net cost of helicopter... Additional revenue... Additional operating costs. Depreciation..... *** Net increase in income... Less Tax at 33%......... $100,000 $$300,000 $450,000 $600,000 200,000 40,000 40,000 40,000 40,000 40,000 120.000 176.000 168.000 163.000 168.000 (60,000) (16,000) 92,000 242,000 392,000 0 0 20,160 79,860 129,360 (5 ( 51.640 5162.140 262.640 60.000) 16.000) $ $120,000 176,000 $168,000 $168,000 $168.000 60,000 160,000 229,640 330,140 430,640 Increase in aftertax income.. Add back depreciation... Net change in cash flow. ($800,000) Figure 4 Financial analysis of Project D: Add fleet of trucks Initial Expenditures Year 1 Year 2 Year 3 Year 4 Year 5 $510,000 Net cost of new trucks Additional revenue... $ 89,250 $382,500 $325, 125 Year! Year 2 Year Year Year 5 Figure 4 Financial analysis of Project Di Add fleet of trucks Toitia Expenditures Net cost of new tracia $510,000 Additional revenue Aditional operating costs Depreciation Net therease in income 382,500 $325,125 2.250 76,500 51.000 19.125 19,125 25 500 1.675 20 76.500 1.200 10710 02.100 1024100 206,875 191.1 (4.150) 7677475) (94,350) 91.00 3.354 0 1192.20 LS 13 05 5 43.21 A25 94332) 76.500 $112,200 107,100 107,100 310,100 2017 249.46 61,750 44,035 12.750 Less Taxat Increase in atertax com Add back depreciation Het change throw (6510,000) Required 1. Refer to Figures 1 through 4. Add up the total increase in aftertax income for each project. Given what you know about kay Marih, to which project do you think she will be attracted? Briefly explain your reasoning? 2. Compute the payback period, internal rate of return (IRR), and net present value (NPV) of all four alternatives based on cash flow. Use 10 percent for the cost of capital in your calculations. For the payback method, merely indicate the year in which the cash flow equals or exceeds the initial Investment. You do not have to compute midyear points. 3. a. According to the payback method, which project should be selected? Aerocomp, Inc. As she headed toward her boss's office, Emily Hamilton, chief operating officer for the Aerocomp 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 Aerocomp during the coming year, and she was faced with the task of recommending which should be selected. What concemed 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 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. 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 Figure 1 for details.) 6. 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 altertax 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 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 Figure 3 for details.) 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 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 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! Figure 1 Financial analysis of Project A: Add a twin-Jet to the company's fleet Initial Expenditures $300,000 Year 1 Year 2 Year Year 4 Years Net cost of new plane... Additional revenue Additional operating costs Depreciation Net increase in income $ 43,000 $76,800 $112,300 11,250 11,250 11.250 45.000 65.000 63.000 (450) 38,050 (13,250) 0 112.55Z (913.250) (050) 25.494 $225,000 $168,750 11,250 11,250 62.000 63.000 150,750 94,500 Less Tax at 33% 49.248 31185 101.003 63.315 Increase in aftertax income Add back depreciation.. Net change in cash flow. ($300,000) $ 45,000 $66,000 31,750 65,550 63,000 38,494 63,000 $63,000 154,003 126,315 Figure 2 Financial analysis of Project B: Diversify into copy machines Year! Year 2 Year 3 Year 4 Years Initial Expenditures $700,000 Net cost of new franchise $ 87,500 Additional revenue.. 26,250 Additional operating costs.. Amortization $175,000 $262.500 $393,750 $525.000 26,250 26,250 26,250 26,250 17.500 17.500 17.500 17.500 131,250 218,750 350,000 481,250 43.313 228 115.500 17.500 43,750 Net increase in income L! Taxat 33% COOPER Less: Tax at 33% 43,313 ZBB 115.500 158.013 Increase in aftertax income. 14.438 $29.313 $.87.938 S146.563 5204,500 $322.438 Add back depreciation... Net change in cash flow. ($700,000) $ 17,500 46,813 $ 17,500 105,438 $ 17,500 164,063 $ 17,500 $ 17,500 252,000 339,938 Figure 3 Financial analysis of Project C: Add a helicopter to the company's fleet Initia Expenditures Year 1 Year 2 Year Year Year 5 5800,000 Net cost of helicopter... Additional revenue... Additional operating costs. Depreciation..... *** Net increase in income... Less Tax at 33%......... $100,000 $$300,000 $450,000 $600,000 200,000 40,000 40,000 40,000 40,000 40,000 120.000 176.000 168.000 163.000 168.000 (60,000) (16,000) 92,000 242,000 392,000 0 0 20,160 79,860 129,360 (5 ( 51.640 5162.140 262.640 60.000) 16.000) $ $120,000 176,000 $168,000 $168,000 $168.000 60,000 160,000 229,640 330,140 430,640 Increase in aftertax income.. Add back depreciation... Net change in cash flow. ($800,000) Figure 4 Financial analysis of Project D: Add fleet of trucks Initial Expenditures Year 1 Year 2 Year 3 Year 4 Year 5 $510,000 Net cost of new trucks Additional revenue... $ 89,250 $382,500 $325, 125 Year! Year 2 Year Year Year 5 Figure 4 Financial analysis of Project Di Add fleet of trucks Toitia Expenditures Net cost of new tracia $510,000 Additional revenue Aditional operating costs Depreciation Net therease in income 382,500 $325,125 2.250 76,500 51.000 19.125 19,125 25 500 1.675 20 76.500 1.200 10710 02.100 1024100 206,875 191.1 (4.150) 7677475) (94,350) 91.00 3.354 0 1192.20 LS 13 05 5 43.21 A25 94332) 76.500 $112,200 107,100 107,100 310,100 2017 249.46 61,750 44,035 12.750 Less Taxat Increase in atertax com Add back depreciation Het change throw (6510,000) Required 1. Refer to Figures 1 through 4. Add up the total increase in aftertax income for each project. Given what you know about kay Marih, to which project do you think she will be attracted? Briefly explain your reasoning? 2. Compute the payback period, internal rate of return (IRR), and net present value (NPV) of all four alternatives based on cash flow. Use 10 percent for the cost of capital in your calculations. For the payback method, merely indicate the year in which the cash flow equals or exceeds the initial Investment. You do not have to compute midyear points. 3. a. According to the payback method, which project should be selected