Corporate Finance

Capital Budgetin" rel="nofollow">ing – Case Study As she headed toward her boss’s office, Sara James, chief operatin" rel="nofollow">ing officer for the Alpha Corporation—a computer services firm that specialized in" rel="nofollow">in airborne support—wished she could remember more of her train" rel="nofollow">inin" rel="nofollow">ing in" rel="nofollow">in fin" rel="nofollow">inancial management that she had been exposed to in" rel="nofollow">in college. Sara had just completed the followin" rel="nofollow">ing tasks: • Analyzin" rel="nofollow">ing the fin" rel="nofollow">inancial statements of its nearest competitor and their own performance. She was not quite pleased with their performance. The competitor was performin" rel="nofollow">ing much better. • Summarizin" rel="nofollow">ing the fin" rel="nofollow">inancial aspects of four capital in" rel="nofollow">investment projects that were open to Alpha-Corp durin" rel="nofollow">ing the comin" rel="nofollow">ing year, and she was faced with the task of recommendin" rel="nofollow">ing which should be selected. Sara had to explain" rel="nofollow">in their fin" rel="nofollow">inancial performance in" rel="nofollow">in the previous year and convin" rel="nofollow">ince her boss to agree on in" rel="nofollow">investin" rel="nofollow">ing in" rel="nofollow">in a project for future growth. What concerned her was the knowledge that her boss, Sandra Jones, a “street smart” chief executive, with no background in" rel="nofollow">in fin" rel="nofollow">inancial theory, would immediately favor the project that promised the highest gain" rel="nofollow">in in" rel="nofollow">in reported net in" rel="nofollow">income. Sara knew that selectin" rel="nofollow">ing projects purely on that basis would be in" rel="nofollow">incorrect; but she wasn’t sure of her ability to convin" rel="nofollow">ince Sandra, who tended to assume fin" rel="nofollow">inanciers thought up fancy methods just to show how smart they were. As she prepared to enter Sandra’s office, Sara 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 and therefore used 10% as the min" rel="nofollow">inimum acceptable rate of return. The company uses a straight-lin" rel="nofollow">ine method for calculatin" rel="nofollow">ing depreciation and the company’s tax rate is 33%. Proposal –A: This proposal is 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 brin" rel="nofollow">ing over $600,000 in" rel="nofollow">in additional revenue durin" rel="nofollow">ing the next five years with only about $56,000 in" rel="nofollow">in operatin" rel="nofollow">ing costs. YR-0 YR-1 YR-2 YR-3 YR-4 YR-5 Initial in" rel="nofollow">investment (300,000) Additional Revenue 43,000 76,800 112,300 225,000 168,750 Additional operatin" rel="nofollow">ing costs 11,250 11,250 11,250 11,250 11,250 Depreciation 60,000 60,000 60,000 60,000 60,000 Proposal –B: This proposal is to diversify in" rel="nofollow">into copy machin" rel="nofollow">ines. The new busin" rel="nofollow">iness was expected to generate over $1.4 million in" rel="nofollow">in sales over the next five years. YR-0 YR-1 YR-2 YR-3 YR-4 YR-5 Initial in" rel="nofollow">investment (700,000) Additional Revenue 87,500 175,000 262,500 393,750 525,000 Additional operatin" rel="nofollow">ing costs 26,250 26,250 26,250 26,250 26,250 Depreciation 17,500 17,500 17,500 17,500 17,500 Proposal—C: This proposal is to buy a helicopter. The machin" rel="nofollow">ine was expensive and, countin" rel="nofollow">ing additional train" rel="nofollow">inin" rel="nofollow">ing and licensin" rel="nofollow">ing 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" rel="nofollow">in additional revenue, and it would give the company access to a wider market as well. YR-0 YR-1 YR-2 YR-3 YR-4 YR-5 Initial in" rel="nofollow">investment (800,000) Additional Revenue 100,000 200,000 300,000 450,000 600,000 Additional operatin" rel="nofollow">ing costs 40,000 40,000 40,000 40,000 40,000 Depreciation 160,000 160,000 160,000 160,000 160,000 Proposal – D: This proposal is to begin" rel="nofollow">in operatin" rel="nofollow">ing a fleet of trucks. Ten could be bought for only $51,000 each, and the additional busin" rel="nofollow">iness would brin" rel="nofollow">ing in" rel="nofollow">in almost $700,000 in" rel="nofollow">in new sales in" rel="nofollow">in the first two years alone. YR-0 YR-1 YR-2 YR-3 YR-4 YR-5 Initial in" rel="nofollow">investment (510,000) Additional Revenue 382,500 325,125 89,250 76,500 51,000 Additional operatin" rel="nofollow">ing costs 31,000 31,000 31,000 31,000 31,000 Depreciation 102,000 102,000 102,000 102,000 102,000 In her min" rel="nofollow">ind, Sara quickly went over the evaluation methods she had used in" rel="nofollow">in the past: payback, in" rel="nofollow">internal rate of return, and net present value. Sara herself favored the net present value method, but she had always had a tough time gettin" rel="nofollow">ing Sandra to understand it. One additional constrain" rel="nofollow">int that Sara had to deal with was Sandra’s in" rel="nofollow">insistence that no outside fin" rel="nofollow">inancin" rel="nofollow">ing be used this year. Sandra was worried that the company was growin" rel="nofollow">ing too fast and had piled up enough debt for the time bein" rel="nofollow">ing. She was also again" rel="nofollow">inst a stock issue for fear of dilutin" rel="nofollow">ing earnin" rel="nofollow">ings and her control over the firm. As a result of Sandra’s prohibition of outside fin" rel="nofollow">inancin" rel="nofollow">ing, 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. Sara wasn’t too happy about that, either, but she had decided to accept it for now, and concentrate on selectin" rel="nofollow">ing the best of the four. As she closed her briefcase and walked toward Sandra’s door, Sara remin" rel="nofollow">inded herself to have patience; Sandra might not trust fin" rel="nofollow">inancial analysis, but she would listen to sensible arguments. Sara only hoped her fin" rel="nofollow">inancial analysis sounded sensible! Income Statements for the year ended Dec 31, 2XXX (All in" rel="nofollow">in ‘000) Gamma corporation Alpha Corporation Sales $ 985,000 $ 560,000 Less: Cost of sales 650,000 397,000 Gross profit 335,000 163,000 Less: Sellin" rel="nofollow">ing and Admin" rel="nofollow">in. Expenses 124,000 75,000 EBIT 211,000 88,000 Less: Interest 35,000 10,000 EBT 176,000 78,000 Less: Taxes 58,000 25,000 EAT 118,000 53,000 Balance Sheets as at Dec 31, XXX ASSETS Current Assets $ $ $ $ Cash 50,000 45,000 A/Receivable 170,000 395,000 Inventory 155,000 140,000 Total Current assets 375,000 580,000 Fixed Assets 765,000 410,000 Total assets 1,140,000 990,000 LIABILITIES Current Liabilities A/Payable 235,000 300,000 Other payables 130,000 125,000 Total Current Liabilities 365,000 425,000 Long term Debt 220,000 70,000 Total Liabilities 585,000 495,000 SHAREHOLDERS' EQUITY Common Stock 450,000 440,000 Retain" rel="nofollow">ined Earnin" rel="nofollow">ings 105,000 55,000 Total Shareholders' Equity 555,000 495,000 Total Liab. & Sh. Equity 1,140,000 990,000 Part A: (You can use MS-Excel to do the ratios) Analyze the fin" rel="nofollow">inancial statements of both Alpha & Gamma Corporations on the four key areas: 1. Liquidity 2. Asset Utilization 3. Debt Utilization 4. Profitability A detailed analysis is expected in" rel="nofollow">in each of these four areas with suggestions for improvement. Part B: You will use MS-Excel to do the calculations in" rel="nofollow">in this case. (Use a different worksheet for each of these proposals – Ex: Sheet 1 – Proposal A; Sheet 2 – Proposal B) 1. Calculate the Cash flows for each of the proposals. 2. Calculate the followin" rel="nofollow">ing for each of the proposals in" rel="nofollow">in the case a. Payback period b. Net Present value (NPV) c. Internal rate of return (IRR) d. What would happen if operatin" rel="nofollow">ing cost were 10% higher than expected? e. What would happen if operatin" rel="nofollow">ing costs were 10% lower than expected? 3. You will write a short report to Sandra Jones, Chief executive officer of Alpha Company. a. Your report should in" rel="nofollow">include your complete fin" rel="nofollow">inancial analysis b. Recommendation as to which proposal should be adopted and the reasons for your recommendation in" rel="nofollow">in order to address her concerns and convin" rel="nofollow">ince her of your choice.        

Sample Solution