Capital Budgeting – Case Study
As she headed toward her boss’s office, Sara James, chief operating officer for the Alpha Corporation—a computer services firm that specialized in airborne support—wished she could remember more of her training in financial management that she had been exposed to in college. Sara had just completed the following tasks:
• Analyzing the financial statements of its nearest competitor and their own performance. She was not quite pleased with their performance. The competitor was performing much better.
• Summarizing the financial aspects of four capital investment projects that were open to Alpha-Corp during the coming year, and she was faced with the task of recommending which should be selected.
Sara had to explain their financial performance in the previous year and convince her boss to agree on investing 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 financial theory, would immediately favor the project that promised the highest gain in reported net income. Sara knew that selecting projects purely on that basis would be incorrect; but she wasn’t sure of her ability to convince Sandra, who tended to assume financiers 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 minimum acceptable rate of return. The company uses a straight-line method for calculating 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 bring over $600,000 in additional revenue during the next five years with only about $56,000 in operating costs.
YR-0 YR-1 YR-2 YR-3 YR-4 YR-5
Initial investment (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 60,000 60,000 60,000 60,000 60,000
Proposal –B:
This proposal is to diversify into copy machines. The new business was expected to generate over $1.4 million in sales over the next five years.
YR-0 YR-1 YR-2 YR-3 YR-4 YR-5
Initial investment (700,000)
Additional Revenue 87,500 175,000 262,500 393,750 525,000
Additional operating 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 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.
YR-0 YR-1 YR-2 YR-3 YR-4 YR-5
Initial investment (800,000)
Additional Revenue 100,000 200,000 300,000 450,000 600,000
Additional operating 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 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.
YR-0 YR-1 YR-2 YR-3 YR-4 YR-5
Initial investment (510,000)
Additional Revenue 382,500 325,125 89,250 76,500 51,000
Additional operating costs 31,000 31,000 31,000 31,000 31,000
Depreciation 102,000 102,000 102,000 102,000 102,000
In her mind, Sara quickly went over the evaluation methods she had used in the past: payback, internal rate of return, and net present value. Sara herself favored the net present value method, but she had always had a tough time getting Sandra to understand it.
One additional constraint that Sara had to deal with was Sandra’s insistence that no outside financing be used this year. Sandra 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 Sandra’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. Sara 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 Sandra’s door, Sara reminded herself to have patience; Sandra might not trust financial analysis, but she would listen to sensible arguments. Sara only hoped her financial analysis sounded sensible!
Income Statements for the year ended Dec 31, 2XXX
(All 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: Selling and Admin. 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
Retained Earnings 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 financial 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 each of these four areas with suggestions for improvement.
Part B:
You will use MS-Excel to do the calculations 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 following for each of the proposals in the case
a. Payback period
b. Net Present value (NPV)
c. Internal rate of return (IRR)
d. What would happen if operating cost were 10% higher than expected?
e. What would happen if operating 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 include your complete financial analysis
b. Recommendation as to which proposal should be adopted and the reasons for your recommendation in order to address her concerns and convince her of your choice.
