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the invest- er its 5-year asure for a Chapter 6 Alternate Measures of Capital Investment Desirability 189 6-19. Compute the modified internal rates of return for the two production methods described in problem 18. Does the modified internal rate of re- turn help you to make a choice? 6-20. You are considering the purchase of a rental property for $100,000, with a $20,000 down payment. Cash flows after loan payments will be as follows. af cash in- quires an vs shown ied prof- YEAR 1 2 $2,120 3 $2,000 Cash flow 4 $2,240 5 7-10 $2,360 $2,480 6 $2,600 $2,720 SH FLOW 25,000 0,000 5,000 The loan balance will be $70,000 at the end of 10 years. For what price must you sell the property at the end of 10 years to provide an effective annual return of 15 percent? (Assume year-end cash flows.) 2,000 ,000 nitial e end avage d re- . re- be ent met En CASE PROBLEM Dash Buildings, Inc. Ann Smith is the president of Dash Build- ings, Inc. (DBI), a subsidiary of Dash, Inc., force leading the conversion to net pres- one of the new long-distance telephone that led to her eventual promotion to ent value was the source of recognition deregulation of long-distance telephone sis had allowed DBI to acquire newer, companies that sprang up as a result of president of DBI. Net present value analy- service in the United States. DBI is respon- larger, and more modern buildings. This sible for purchasing and managing real es had led to a dramatic decrease in com- tate used by the various units of Dash. DBI plaints about buildings and greater overall acts like a private real estate investment employee satisfaction. firm-acquiring properties, managing Oversight of capital budgeting at Dash those properties, and providing space to was the responsibility of the treasurer. The the other divisions of Dash. DBI occasion- prior treasurer had allowed each operat- ally rents space to other tenants when it ac- ing unit to use its own capital investment quires a building that has more space than analysis methods, with some choosing net is needed by Dash. DBI does not, however, present value, some choosing internal rate purchase buildings for the express purpose of return, and some even choosing ac- of renting to non-Dash tenants. counting rate of return. The new treas- DBI is a corporation rather than a de- urer, who comes from a background in in- partment only for reasons of legal conven- vestment banking, wants to standardize ience. DBI acts like any other department analysis so proposals can be compared within Dash. DBI does not raise its own from one unit to the other. While the funds but receives them from the corpo- treasurer has not issued a formal policy, it rate treasury. is clear that he is leaning toward internal When Smith first joined Dash as a prop rate of return. DBI has been formally evaluated as a erty manager, internal rate of return was the primary tool for project analysis. This profit center, being credited with revenue often forced DBI to acquire smaller, older, equal to the estimated cost of renting less efficient buildings. Her role on a task space of the same type in the local market. 190 Part Two Capital Investment Choice based on the profit of DBI. Bonuses at and would grow 5 percent a year there DBI had been quite small in the early after. It was estimated that the building Smith and her employees receive bonuses flow would be $1.1 million the first year years, but rising rents along with some would be worth $12 million after tax alive real end of the 10-year planning horizon. well-imed purchases at the bottom of a profitable enough to bring it up to the Gestate depression made the division maximum allowable bonus. She is there- satisfaction, which she believes to be the source of any further career advancement. on other investments similar to the risk of The after tax cash flow return available the DBI division (real estate) is estimated return available on investments with risk similar to the other divisions of Dash fore, able to concentrate on maximizing to be 12 percent. The after tax cash flow turn will force her to return to acquiring is not earning its opportunity cost of capi. Smith is concerned that internal rate of re- (telecommunications) is 15 percent. Dash less desirable office space. Dissatisfaction tal, and its stock price is low, so manage and complaints about building quality could derail her career. DBI is currently working on additional bonuses at all because of low profitability space for for Sun City. The alternatives ment is under pressure to improve prof. itability. Most units are not earning office in Sun City are typical of those in most Questions 1. Compute the net present value, inter other locations. An older building could nal rate of return, profitability index be acquired for $7 million. Imputed rent and payback period for each of the al savings from ownership would be $1.5 mil- ternatives. For present value calcula lion the first year, and would then grow tions, assume midyear cash flows ex- percent a year. After deduction of oper- cept for initial outlay and terminal ating cost and taxes from imputed rent value. savings, net cash flow would be $1 million the first year and would grow 3 percent a 2. Recommend the alternative that year thereafter. It is estimated that the should be chosen. after tax sale price at the end of the 10- 3. Prepare a presentation to the treas- year planning horizon required by Dash urer explaining how the company would be $5 million. would benefit from using net present Alternately, DBI could construct a new value instead of internal rate of building of the same size at a cost of $10.1 million. Because the space would be return. 4. Comment on the company's methods for evaluating and rewarding success. optimal capital investments in DBI more luxurious, imputed rent savings would be $1.8 million and would be ex- pected 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 Does the reward structure encourage and the rest of the company? 5. Would you recommend that there ward structure be changed in any way