Capital Budgeting
As a former college athlete, Mike Carpenter strongly believes in the benefits of being healthy and physically fit. He returned to his hometown in 2000 and opened the WeightsPlus Health Club the following year to enhance the lives of the individuals and families in his community through exercise. This member-based club focuses on providing a total workout experience which includes a full line of cardio equipment (treadmills, steppers, ellipticals, rowing machines, and stationary bicycles), free weights, a twenty-five meter lap pool and three indoor basketball courts. The club also offers group and individual fitness instruction to its members through its staff of personal trainers. Although Mike experienced high start-up costs and did not expect to generate a profit for the first four years of operation, the popularity of the club grew faster than anticipated, especially with active individuals over fifty years of age, and WeightsPlus had profits of $500,000 at the end of the third year.
Slowed by the economic downturn in 2009, Mike had to postpone major updates to WeightsPlus. During this time his membership dropped by twenty-five percent. To reduce operating expenses, he cut back on the club's hours of operation and he laid-off two members of his training staff. Although these were difficult steps to take, Mike was able to avoid the financial distress that many businesses in the community faced during this time.
Recently, the economy has begun to turn around. Membership rolls have increased by twenty percent. Mike has recently rehired the two personal trainers and is now looking to upgrade the club's facilities and to enhance the experience for its members. However, as concerns for the economic recovery still exist, Mike is cautious to only take on those projects that will add value to the business.
As his financial manager, Mike has asked you to evaluate two potential capital budgeting proposals. He has been able to secure sufficient external financing to implement both projects if they are both acceptable. Although each of these projects may ultimately result in increased membership, Mike wants your initial analysis to assume no increase in the membership rolls, i.e. 100,000 hours of exercise time per quarter. He has asked you to focus on the savings that are generated through a reduction in total operating expenditures - labor and/or overhead. Also, as all current financial information is provided on a quarterly basis, Mike prefers the analysis maintain the same quarter time periods.
The first proposal, Project Alpha, involves the addition of digital data capture equipment to WeightPlus's full line of cardio machines. This equipment will be able to transmit usage information for each client, by date and time into the club's personal fitness computer system. By providing enhanced monitoring of training programs this equipment will better meet the needs of its members and allow WeightPlus's personal trainers to be more effective in program design and implementation. In addition, the usage information will allow Mike to more efficiently manage maintenance of the equipment.
Project Alpha has a useful life of two-years, or eight quarters. After that time, technology is expected to change sufficiently to require a new data capture system. The project costs $528K and is able to be applied to a maximum of 100,000 hours of equipment usage per quarter (note that if your projected usage is less than 100,000 hours of exercise time per quarter you will have to adjust your analysis accordingly.) Project Alpha is expected to create overhead savings in reduced maintenance costs of $14,200 per quarter. Initial labor savings (in the first quarter of operation) are forecasted to be $0.70 per hour of exercise time. After the first quarter, as the club's personal trainers begin to realize the benefit of this system, the labor savings are forecasted to increase by $0.02 per quarter.
The second project, Project Beta, entails adding weight machines to WeightPlus's strength training facilities, to meet the changing needs of its members. These machines are expected to have a useful life of three years, or twelve quarters. The new weight machines will not create overhead savings for the club as they require greater maintenance and utility expenditures than the free weights, however, the personal training staff will be able to reduce its direct contact time with the clients and increase its overall efficiency. Labor savings are expected to diminish over time as more clients utilize the equipment for enhanced strength training, thereby requiring additional instructional time.
The new weight machines cost $542K and are able to be utilized a maximum of 120,000 hours per quarter (note that if your projected usage is less than 120,000 hours of exercise time per quarter you will have to adjust your analysis.) Project Beta will require new overhead expenditures, as noted, in the amount of $9,400 per quarter. Initial labor savings (in the first quarter of operation) are forecasted to be $0.90 per hour of exercise time. After the first quarter, as your clients begin to realize the benefit of the new equipment and require additional instruction, the labor savings are forecasted to decrease by $0.02 per hour of exercise time.
Mike has indicated that the WeightPlus's historical cost of financing is 3.97 percent per quarter; however, due to the recent credit tightening, he is able to secure new external financing at a weighted average cost of 4.50 percent per quarter. The business's current marginal federal plus state tax rate is 40 percent. Depreciation of all new equipment should be on a straight-line basis to a salvage value of $0.
To help structure the analysis and to ensure that he fully understands the evaluation process, Mike has provided you with the following questions. Please answer the questions in the required format of a memo, not a bullet list response.
Questions
1.Compute each project's base case NPV, IRR, and payback. Explain the rationale behind each of these capital budgeting methods and your accept/reject decisions based upon each method. Include a chart showing the NPV profile for both projects.
2.Is there any value in using MIRR in the evaluation of these two capital budgeting proposals? Explain.
3.How would your recommendations be impacted if the membership rolls over the projects' lives are ten percent lower than assumed? Ten percent greater than assumed? Base you sensitivity analysis on the impact on NPV relative to the base case.
4.How would your recommendations be impacted if the cost of external financing is one-half percent lower than assumed? One-half percent greater than assumed? Base you sensitivity analysis on the impact on NPV relative to the base case.
5.What is your final recommendation to Mike regarding these two capital budgeting proposals?