Business Decision Case New Haven Corporation recently identified an investment opportunity involving the purchase of a patent that will permit the company to modify its line of CD recorders. The patent’s purchase price is $720,000 and the legal protection it provides will last for five more years; there is no salvage value. However, after preparing the capital expenditure analysis below, New Haven’s treasurer has recommended to the company’s capital budgeting committee that the investment be rejected. Brad Decker, chairperson of the capital budgeting committee, finds it difficult to accept the treasurer’s analysis because he “feels intuitively” that the investment is attractive. For this reason, he has retained you to review the treasurer’s analysis and recommendation. You are provided with the following data and summary of the treasurer’s analysis:
1. Required investment: $720,000 cash for the patent to be amortized on a straight-line basis, ?ve-year useful life, with a zero salvage value.
2. Projected cash revenue and operating expenses:
Year Cash Revenue Cash Expenses
1 620,000 240,000
2 560,000 200,000
3 400,000 170,000
4 250,000 80,000
5 200,000 50,000
Total 2,030,000 740,000
3. Source of capital: New Haven plans to raise 10% of the needed capital by issuing bonds, 30% by issuing stock, and the balance from retained earnings. For these sources, the capital cost rates are 8%, 9%, and 10%, respectively. New Haven has a policy of seeking a return equal to the weighted average cost of capital plus 2.5 percentage points as a “buffer margin” for the uncertainties involved.
4. Income taxes: New Haven has an overall income tax rate of 30%.
5. Treasurer’s analysis:
Average cost of capital
(8% + 9% + 10%) / 3 = 9%
Total cash revenue 2,030,000
Total cash expenses 740,000
Total amortization 720,000
Total operating expenses 1,460,000
Projected net income over five years 570,000
Average annual income 114,000
Present value of future returns 443,420
Required investment 720,000
Negative net present value (276,580)
Recommendation: Reject investment because of insufficient net present value.
Required
a. Review the treasurer’s analysis, identifying any questionable aspects and briefly comment on the apparent effect of each such item on the treasurer’s analysis.
b. Prepare your own analysis of the investment, including a calculation of the proper cost of capital and cutoff rates, a net present value analysis of the project, and a brief recommendation to Decker regarding the investment (round amounts to nearest dollar).
c. Because of his concern for the uncertainties of the CD recorder business, Decker also has asked you to provide analyses supporting whether or not your recommendation would change
1. If estimates of projected cash revenue were reduced by 10%.
2. If the “buffer margin” were tripled from 2.5% to 7.5%.