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1. Refer to Figures 1 through 4. Add up the total increase in aftertax income for each project. Given what you know about April Harrington, to which project do you think she will be attracted?

2. Compute the payback period, internal rate of return (IRR), and net present value (NPV) of all four alternatives based on cash flows. Use 10% (ten percent) for the cost of capital in your calculations. For the payback method, 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?

b. What is the main disadvantage of this method?

c. Why would anyone want to use this method?

4.

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. If April 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?

5.

a. According to the NPV method, which project should be chosen? How does this differ from the

answer under the IRR?

b. If April 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?

c. Given all the facts of the case, are you more likely to select Project A or C?

Airbound Corporation As she headed toward her boss's office, Eliza Washington, chief operating officer for the Airbound Corporation - computer services firm that specializes in airborne support-wished she could remember more of her training in financial analysis that she had been exposed to in college. Eliza had just completed summarizing the financial aspects of four capital investment projects that were open to Airbound 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, April Harrington, a "street smart" chief executive, with no background in financial theory and analysis, would immediately favor the project that promised the highest gain in reported net income. Eliza knew that selecting projects purely on that basis would be incorrect; but she wasn't confident in her ability to convince April, who tended to assume financiers thought up fancy methods just to show how smart they were As she prepared to enter April's office, Eliza 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 flect. 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.) 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 after-tax 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, Eliza quickly went over the evaluation methods she had used in the past: payback, internal rate of return, and net present value. Eliza knew that April would add a fourth, size of reported earnings, but she hoped she could talk April out of using it this time. Eliza herself favored the net present value method, but she had always had a tough time getting April to understand it One additional constraint that Eliza had to deal with was April's insistence that no outside financing be used this year. April 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 April'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 Eliza 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 April's door, Eliza reminded herself to have patience; April might not trust financial analysis, but she would listen to sensible arguments. Eliza only hoped her financial analysis sounded sensible! Figure 1 Financial analysis of Project A: Add a twin-jet to the company's fleet Initial Expenditur Year 1 Year 2 Year 3 Year 4 Year 5 es $300,000 $43,000 $76,800 $112,300 $225,000 $168,750 11,250 11.250 11.250 11,250 11,250 66,000 Net cost of new plane Additional revenue Additional operating costs Depreciation Net increase in income Less: Tax at 33% Increase in aftertax income Add back depreciation Net change in cash flow 45,000 -13,250 0 -450 63.000 38,050 12,557 63.000 150,750 49.748 63.000 94,500 31. 185 0 (513,250) $45,000 31,750 (3 450) 566,000 65,550 S 25.494 563,000 88,494 $101.003 63,000 $ 63.315 $63,000 ($300,000) 164,003 126,315 Figure 2 Financial analysis of Project B: Diversify into copy machines Initial Expenditur Year 1 Year 2 Year 3 Year 4 Year 3 es new $700,000 $ 87,500 $262,500 $525,000 $175,000 26250 26,250 26,250 26,250 Net cost of 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 $393,750 26,250 17.500 350,000 115 500 17.500 43,750 14438 S 29313 17500 131.250 43.313 $ 87938 17500 218,750 72188 17300 481,250 158.813 $146563 $234 500 $322438 $ 17,500 $17.500 $ 17.500 S 17.500 S 17.500 (5700,000) 46,813 105,438 164,063 252,000 339938 Figure 3 Financial analysis of Project C: Add a helicopter to the company's fleet Initial Expenditur Year 1 Year 2 Year 3 Year 4 Year 5 es Net cost of helicopter $800,000 Additional revenue $100,000 $200,000 $300,000 $450,000 $600,000 Additional operating 1 40,000 40,000 40,000 40,000 40,000 costs Depreciation 120,000 176,000 168,000 168,000 168,000 Net increase in income -60,000 -16,000 92,000 242,000 392,000 Less: Tax at 33% 30,360 79,860 129,360 Increase in aftertax ($ 60,000 (S 16.000 income $ 61.640 $162.140 $262.640 Add back depreciation $120,000 $176,000 $168,000 $168,000 $168,000 Net change in cash flow (5800,000) 60,000 160,000 229,640 330,140 430,640 Figure 4 Financial analysis of Project D: Add fleet of trucks Initial Expenditur Year 1 Year 2 Year 3 Year 4 Year 5 es $510,000 $382,500 $325,125 $ 89,250 $76,500 $51,000 19,125 19,125 25,500 31,875 38,250 Net cost of new trucks Additional revenue Additional operating costs Depreciation Net increase in income Less: Tax at 33% Increase in aftertax income Add back depreciation Net change in cash flow 76,500 286,875 94,669 112,200 193,800 63.954 107,100 -43,350 0 107,100 -62,475 0 107,100 -94,350 0 S129.846 S192.206 $76,500 268,706 ($_43350) $107,100 (5 62475 107,100 (S 94350 $107,100 $112,200 242,046 (5510,000) 63,750 44,625 12,750 REQUIRED 2 Refer to Figures 1 through 4. Add up the total increase in aftertax income for each project. Given what you know about April Harrington, to which project do you think she will be attracted? Compute the payback period, internal rate of return (RR), and net present value (NPV) of all four alternatives based on cash flows. Use 10% (ten percent) for the cost of capital in your calculations. For the payback method, indicate the year in which the cash flow equals or exceeds the initial investment. You do not have to compute midyear points. According to the payback method, which project should be selected? 3 a. b. What is the main disadvantage of this method? C. 4 a. b. C. Why would anyone want to use this method? According to the IRR method, which project should be chosen? What is the major disadvantage of the IRR method that occurs when high IRR projects are selected? 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.) April 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? According to the NPV method, which project should be chosen? How does this differ from the answer under the IRR? April 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? c. Given all the facts of the case, are you more likely to select Project A or C? d. 5 a. b Remember to explain all of your answers and show ALL calculations. I will award partial credit if I can see where you err in your calculations (if you do err). You will be graded not only on the calculation component of your answers but on the critical thinking components of the questions as well. Do not simply present your calculations, but explain your calculations as well. Be sure to review the cases Airbound Corporation As she headed toward her boss's office, Eliza Washington, chief operating officer for the Airbound Corporation - computer services firm that specializes in airborne support-wished she could remember more of her training in financial analysis that she had been exposed to in college. Eliza had just completed summarizing the financial aspects of four capital investment projects that were open to Airbound 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, April Harrington, a "street smart" chief executive, with no background in financial theory and analysis, would immediately favor the project that promised the highest gain in reported net income. Eliza knew that selecting projects purely on that basis would be incorrect; but she wasn't confident in her ability to convince April, who tended to assume financiers thought up fancy methods just to show how smart they were As she prepared to enter April's office, Eliza 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 flect. 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.) 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 after-tax 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, Eliza quickly went over the evaluation methods she had used in the past: payback, internal rate of return, and net present value. Eliza knew that April would add a fourth, size of reported earnings, but she hoped she could talk April out of using it this time. Eliza herself favored the net present value method, but she had always had a tough time getting April to understand it One additional constraint that Eliza had to deal with was April's insistence that no outside financing be used this year. April 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 April'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 Eliza 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 April's door, Eliza reminded herself to have patience; April might not trust financial analysis, but she would listen to sensible arguments. Eliza only hoped her financial analysis sounded sensible! Figure 1 Financial analysis of Project A: Add a twin-jet to the company's fleet Initial Expenditur Year 1 Year 2 Year 3 Year 4 Year 5 es $300,000 $43,000 $76,800 $112,300 $225,000 $168,750 11,250 11.250 11.250 11,250 11,250 66,000 Net cost of new plane Additional revenue Additional operating costs Depreciation Net increase in income Less: Tax at 33% Increase in aftertax income Add back depreciation Net change in cash flow 45,000 -13,250 0 -450 63.000 38,050 12,557 63.000 150,750 49.748 63.000 94,500 31. 185 0 (513,250) $45,000 31,750 (3 450) 566,000 65,550 S 25.494 563,000 88,494 $101.003 63,000 $ 63.315 $63,000 ($300,000) 164,003 126,315 Figure 2 Financial analysis of Project B: Diversify into copy machines Initial Expenditur Year 1 Year 2 Year 3 Year 4 Year 3 es new $700,000 $ 87,500 $262,500 $525,000 $175,000 26250 26,250 26,250 26,250 Net cost of 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 $393,750 26,250 17.500 350,000 115 500 17.500 43,750 14438 S 29313 17500 131.250 43.313 $ 87938 17500 218,750 72188 17300 481,250 158.813 $146563 $234 500 $322438 $ 17,500 $17.500 $ 17.500 S 17.500 S 17.500 (5700,000) 46,813 105,438 164,063 252,000 339938 Figure 3 Financial analysis of Project C: Add a helicopter to the company's fleet Initial Expenditur Year 1 Year 2 Year 3 Year 4 Year 5 es Net cost of helicopter $800,000 Additional revenue $100,000 $200,000 $300,000 $450,000 $600,000 Additional operating 1 40,000 40,000 40,000 40,000 40,000 costs Depreciation 120,000 176,000 168,000 168,000 168,000 Net increase in income -60,000 -16,000 92,000 242,000 392,000 Less: Tax at 33% 30,360 79,860 129,360 Increase in aftertax ($ 60,000 (S 16.000 income $ 61.640 $162.140 $262.640 Add back depreciation $120,000 $176,000 $168,000 $168,000 $168,000 Net change in cash flow (5800,000) 60,000 160,000 229,640 330,140 430,640 Figure 4 Financial analysis of Project D: Add fleet of trucks Initial Expenditur Year 1 Year 2 Year 3 Year 4 Year 5 es $510,000 $382,500 $325,125 $ 89,250 $76,500 $51,000 19,125 19,125 25,500 31,875 38,250 Net cost of new trucks Additional revenue Additional operating costs Depreciation Net increase in income Less: Tax at 33% Increase in aftertax income Add back depreciation Net change in cash flow 76,500 286,875 94,669 112,200 193,800 63.954 107,100 -43,350 0 107,100 -62,475 0 107,100 -94,350 0 S129.846 S192.206 $76,500 268,706 ($_43350) $107,100 (5 62475 107,100 (S 94350 $107,100 $112,200 242,046 (5510,000) 63,750 44,625 12,750 REQUIRED 2 Refer to Figures 1 through 4. Add up the total increase in aftertax income for each project. Given what you know about April Harrington, to which project do you think she will be attracted? Compute the payback period, internal rate of return (RR), and net present value (NPV) of all four alternatives based on cash flows. Use 10% (ten percent) for the cost of capital in your calculations. For the payback method, indicate the year in which the cash flow equals or exceeds the initial investment. You do not have to compute midyear points. According to the payback method, which project should be selected? 3 a. b. What is the main disadvantage of this method? C. 4 a. b. C. Why would anyone want to use this method? According to the IRR method, which project should be chosen? What is the major disadvantage of the IRR method that occurs when high IRR projects are selected? 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.) April 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? According to the NPV method, which project should be chosen? How does this differ from the answer under the IRR? April 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? c. Given all the facts of the case, are you more likely to select Project A or C? d. 5 a. b Remember to explain all of your answers and show ALL calculations. I will award partial credit if I can see where you err in your calculations (if you do err). You will be graded not only on the calculation component of your answers but on the critical thinking components of the questions as well. Do not simply present your calculations, but explain your calculations as well. Be sure to review the cases

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