Part I
Critical Questions
Q1. Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Manama and Dubai. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store.
Which of the following should be included as part of the incremental earnings for the proposed new retail store?
a. The cost of the land where the store will be located.
b. The cost of demolishing the abandoned warehouse and clearing the lot.
c. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead.
d. The $10,000 in market research spent to evaluate customer demand.
e. Construction costs for the new store.
f. The value of the land if sold.
g. Interest expense on the debt borrowed to pay the construction costs.
Answer:
Q2. Explain the similarities and differences between Net Present Value (NPV), Profitability Index (PI), and Economic Value Added (EVA).
Answer:
Q3. In your view, if the payback period method is used in conjunction with the NPV method, should it be used before or after the NPV evaluation?
Answer:
Q4. What effect would a decrease in the interest rate have on the future value of a deposit? What effect would an increase in the holding period have on future value?
Answer:
Q5. What effect does compounding interest more frequently than annually have on (a) future value and (b) the effective annual rate (EAR)? Why?
Answer:
Q6. Mini Cases
Case #1: Investment Decision
Manama Tool, a large machine shop, is considering replacing one of its lathes with either of two new lathes—lathe A or lathe B. Lathe A is a highly automated, computer-controlled lathe; lathe B is a less expensive lathe that uses standard technology. To analyze these alternatives, Mohamed Jassim, a financial analyst, prepared estimates of the initial investment and incremental (relevant) cash inflows associated with each lathe. These are shown in the following table.
Year Lathe A Lathe B
0 -$660,000 -$360,000
1 128,000 $88,000
2 182,000 120,000
3 166,000 96,000
4 168,000 86,000
5 450,000 207,000
Note that Mohamed plans to analyze both lathes over a 5-year period. At the end of that time, the lathes would be sold, thus accounting for the large fifth-year cash inflows. Mohamed believes that the two lathes are equally risky and that the acceptance of either of them will not change the firm’s overall risk. He therefore decides to apply the firm’s 13% cost of capital when analyzing the lathes. Manama Tool requires all projects to have a maximum payback period of 4.0 years.
Required:
a. Use the payback period to assess the acceptability and relative ranking of each lathe.
b. Assuming equal risk, use the following sophisticated capital budgeting techniques to assess the acceptability and relative ranking of each lathe:
(1) Net present value (NPV).
(2) Internal rate of return (IRR).
c. Summarize the preferences indicated by the techniques used in parts a and b. Do the projects have conflicting rankings?
d. Draw the net present value profiles for both projects on the same set of axes, and discuss any conflict in rankings that may exist between NPV and IRR. Explain any observed conflict in terms of the relative differences in the magnitude and timing of each project’s cash flows.
e. Use your findings in parts a through d to indicate, on both (1) a theoretical basis and (2) a practical basis, which lathe would be preferred. Explain any difference in recommendations.
Good Luck!
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