Case Problem
Dash Buildings, Inc.
Ann Smith is the president of Dash Buildings, Inc. (DBI), a subsidiary of Dash, Inc., one of the new long-distance telephone companies that sprang up as a result of deregulation of long-distance telephone service in the United States. DBI is responsible for purchasing and managing real estate used by the various units of Dash. DBI acts like a private real estate investment firm - acquiring properties, managing those properties, and providing space to the other divisions of Dash. DBI occasionally rents space to other tenants when it acquires a building that has more space than is needed by Dash. DBI does not, however, purchase buildings for the express purpose of renting to non-Dash tenants. DBI is a corporation rather than a department only for reasons of legal convenience. DBI acts like any other department within Dash. DBI does not raise its own funds but receives them from the corporate treasury. When Smith first joined Dash as a property mananger, internal rate of return was the primary tool for project analysis. This often forced DBI to acquire smaller, older, less efficient buildings. Her role on a task force leading the conversion to net present value was the source of recognition that led to her eventual promotion to president of DBI. Net present value analysis had allowed DBI to acquire newer, larger, and more modern buildings. This has led to a dramatic decrease in complaints about buildings and greater overall employee satisfaction. Oversight of capital budgeting at Dash was the responsibility of the treasurer. The prior treasurer had allowed each operating unit to use its own capital investment analysis methods, with some choosing net present value, and some even choosing accounting rate of return. The new treasurer, who comes from a background in investment banking, wants to standardize analysis so proposals can be compared from one unit to the other. While the treasurer has not issued a formal policy, it is clear that he is leaning toward internal rate of return. DBI has formally evaluated as a profit center, being credited with revenue equal to the estimated cost of renting space of the same type in the local market. Smith and her employees receive bonuses based on the profit of DBI. Bonuses at DBI had been quite small in the early years, but rising rents along with some well-timed purchases at the bottom of a real estate depression made the division profitable enough to bring it up to the maximum allowable bonus. She is, therefore, able to concentrate on maximizing satisfaction, which she believes to be the source of any further career advancement. Smith is concerned that internal rate of return will force her to return to acquiring less desirable office space. Dissatisfaction and complaints about building quality could derail her career. DBI is currently working on additional office space for Sun City. The alternatives in Sun City are typical of those in most other locations. An older building could be acquired for $7 million. Imputed rented savings from ownership would be $1.5 million the first year, and would then grow 3 percent a year. After deduction of operating cost and taxes from imputed rent savings, net cash flow would be $1 million the first year and would grow 3 percent a year thereafter. It is estimated that the after tax sale price at the end of the 10-year planning horizon required by Dash would be $5 billion. Alternatively, DBI could construct a new building of the same size at a cost of $10.1 million. Because the space would be more luxurious, imputed rent savings would be $1.8 million and would be expected to grow 5 percent a year because of the excellent location of the building. After deduction of operating cost and taxes from imputed rent savings, net cash flow would be $1.1 million the first year and would grow 5 percent a year thereafter. It was estimated that the building would be worth $12 million after tax at the end of the 10-year planning horizon. The after tax cash flow return available on other investments similar to the risk of the DBI division (real estate) is estimated to be 12 percent. The after tax cash flow return available on investments with risk similar to the other divisions of Dash (telecommunications) is 15 percent. Dash is not earning its opportunity cost of capital, and its stock price is low, so management is under pressure to improve profitability. Most units are not earniing bonuses at all because of low profitability.
Questions:
1. Compute the net present value, internal rate of return, profitability index, and payback period for each of the alternatives. For present value calculations, assume midyear cash flows except for initial outlay and terminal value.
2. Recommend the alternative that should be chosen.
3. Prepare a presentation to the treasurer explaining how the company would benefit from using net present value instead of internal rate of return.
4. Comment on the company's methods for evaluating and rewarding success. Does the reward structure encourage optimal capital investments in DBI and the rest of the company?
5. Would you recommend that the reward structure be changed in any way?