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William Johnson has recently graduated from a local community college in upstate New York. He is also the owner of Lawn-Pro, a landscaping and lawn-mowing
William Johnson has recently graduated from a local community college in upstate New York. He is also the owner of "Lawn-Pro", a landscaping and lawn-mowing business. During the first couple of years when the business was at its early stages, William used the money from the lawn service business to supplement his allowance from his parents. However, more recently, his business had grown to the point it generated enough income for him to become almost financially independent. This provided him the incentive to continue this business and pursue it on a full-time basis. The business operated for six months each year and by the end of each season it generated a net income of $40,000. Most of the income (80%) was generated from the landscaping portion of the business and the mowing service's contribution was secondary (20\%). Due to the prohibitive cost of new machinery, William had always used second- or third-hand equipment. However, lately his existing equipment appeared to have reached the end of its productive life. Its maintenance had increased dramatically both in frequency and cost. Consequently, William is now considering replacing the equipment with a new machine so he may have the benefits of a longer machineproductive life compared to that of the second-hand equipment he has been using in the past. After some brief research, he has identified two brands which he considers to be of high quality, John Deere and Ariens. The John Deere equipment costs $9,200, and the Ariens equipment costs $10,900. William could finance the equipment through a small business loan at 6% (which is his hurdle rate or cost of capital). One of the main differences between the machines is that the Ariens mower, although more expensive than the John Deere, has an overall lower maintenance cost. This will translate into higher projected future cash inflows for the Ariens and lower projected cash inflows for the John Deere mower. Based on his experience with various machines, Williams estimates the total useful life of both John Deere and Ariens lawn mowers to be five years. Williams also estimates the salvage value of these lawn mowers at the end of their estimated useful lives to be zero. With the help of his friend, Mr. CPA, Williams estimates the projected annual cash inflows generated by each machine and received at the end of each subsequent period/year as follows (see table below). Required: (Ignore income taxes.) a) (4 marks) For each of the alternatives, conduct NPV and IRR analyses. Based on these quantitative analyses, please advise William on which machine to select. (Note: ONLY IF you are using the present value tables for calculating IRR, as a simplifying assumption you can assume that the annual cash inflows for John Deere will be $8,142 equal per year. This assumption can be used only for John Deere IRR calculation and not for any other part of this question. If you are using Excel or your calculator, please proceed with the data given in the table above.) b) (5 marks) Briefly explain the limitations of NPV and IRR analyses each. Suggest a potential metric that mitigates these limitations (and explain how it mitigates any limitations of NPV and IRR). Calculate this metric for both the alternatives and advise William on which machine to select. c) (4 marks) Calculate and compare the Payback Period for both the alternatives. Based on this metric, please advise William on which machine to select. Explain briefly the pros and cons of using Payback Period to evaluate capital projects. d) (3 marks) Are there any other qualitative or not immediately quantifiable factors that could influence the capital budgeting analyses? Suggest at least three such factors that William should consider. e) (2 marks) William's sister (a third-year commerce student) happens to look over the capital budgeting metrics you have just calculated. She looks specifically at the impressive IRR for both the machines and says that: "With returns so good I almost feel like dropping out of college and pursuing lawncare as a full-time profession. Instead of one, I will buy 10 lawn mowers. With the help of friends and family, we can have a very successful business with returns that would be the envy of high flyers in the finance industry!!" Advise William's sister on whether dropping out of college based on William's IRR estimates is in her best interests. f) (2 mark) Mr. CPA recalls reading in the Wall Street Magazine about a recent government initiative that allows complete and immediate expensing of capital expenditure for tax reporting purposes by small businesses, to help spur capital investment activity in the U.S. But he also recalls his management accounting professor saying that how capital expenditure is allocated over future time periods (i.e., depreciation expense) for financial accounting purposes is not relevant. Can you help resolve Mr. CPA's confusion? William Johnson has recently graduated from a local community college in upstate New York. He is also the owner of "Lawn-Pro", a landscaping and lawn-mowing business. During the first couple of years when the business was at its early stages, William used the money from the lawn service business to supplement his allowance from his parents. However, more recently, his business had grown to the point it generated enough income for him to become almost financially independent. This provided him the incentive to continue this business and pursue it on a full-time basis. The business operated for six months each year and by the end of each season it generated a net income of $40,000. Most of the income (80%) was generated from the landscaping portion of the business and the mowing service's contribution was secondary (20\%). Due to the prohibitive cost of new machinery, William had always used second- or third-hand equipment. However, lately his existing equipment appeared to have reached the end of its productive life. Its maintenance had increased dramatically both in frequency and cost. Consequently, William is now considering replacing the equipment with a new machine so he may have the benefits of a longer machineproductive life compared to that of the second-hand equipment he has been using in the past. After some brief research, he has identified two brands which he considers to be of high quality, John Deere and Ariens. The John Deere equipment costs $9,200, and the Ariens equipment costs $10,900. William could finance the equipment through a small business loan at 6% (which is his hurdle rate or cost of capital). One of the main differences between the machines is that the Ariens mower, although more expensive than the John Deere, has an overall lower maintenance cost. This will translate into higher projected future cash inflows for the Ariens and lower projected cash inflows for the John Deere mower. Based on his experience with various machines, Williams estimates the total useful life of both John Deere and Ariens lawn mowers to be five years. Williams also estimates the salvage value of these lawn mowers at the end of their estimated useful lives to be zero. With the help of his friend, Mr. CPA, Williams estimates the projected annual cash inflows generated by each machine and received at the end of each subsequent period/year as follows (see table below). Required: (Ignore income taxes.) a) (4 marks) For each of the alternatives, conduct NPV and IRR analyses. Based on these quantitative analyses, please advise William on which machine to select. (Note: ONLY IF you are using the present value tables for calculating IRR, as a simplifying assumption you can assume that the annual cash inflows for John Deere will be $8,142 equal per year. This assumption can be used only for John Deere IRR calculation and not for any other part of this question. If you are using Excel or your calculator, please proceed with the data given in the table above.) b) (5 marks) Briefly explain the limitations of NPV and IRR analyses each. Suggest a potential metric that mitigates these limitations (and explain how it mitigates any limitations of NPV and IRR). Calculate this metric for both the alternatives and advise William on which machine to select. c) (4 marks) Calculate and compare the Payback Period for both the alternatives. Based on this metric, please advise William on which machine to select. Explain briefly the pros and cons of using Payback Period to evaluate capital projects. d) (3 marks) Are there any other qualitative or not immediately quantifiable factors that could influence the capital budgeting analyses? Suggest at least three such factors that William should consider. e) (2 marks) William's sister (a third-year commerce student) happens to look over the capital budgeting metrics you have just calculated. She looks specifically at the impressive IRR for both the machines and says that: "With returns so good I almost feel like dropping out of college and pursuing lawncare as a full-time profession. Instead of one, I will buy 10 lawn mowers. With the help of friends and family, we can have a very successful business with returns that would be the envy of high flyers in the finance industry!!" Advise William's sister on whether dropping out of college based on William's IRR estimates is in her best interests. f) (2 mark) Mr. CPA recalls reading in the Wall Street Magazine about a recent government initiative that allows complete and immediate expensing of capital expenditure for tax reporting purposes by small businesses, to help spur capital investment activity in the U.S. But he also recalls his management accounting professor saying that how capital expenditure is allocated over future time periods (i.e., depreciation expense) for financial accounting purposes is not relevant. Can you help resolve Mr. CPA's confusion
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