Question:

Yoland Research Institute

Programming

Data Provided: Cash Flows ($) _______

Economic Life (years) _________

Net Investment Amount ($) Purchase Price _________ Disposal/Sell of old equip. _________

__________

Interest Rate _________

1. Calculate the NPV: (Please show calculations or formula) NPV = (CF x pvf) - I _____________

pvf = I / CF ____________

2. Calculate Pay Back Period: (Please show calculations or formula) PB = I / CF __________

Yoland Research Institute Case Study:

He wants what? Or hell do what? If we keep this up well all be out of a job. How can I possibly take another one of his requests to the board next week?

Brooke Russell, Executive Director of Yoland Research Institute, was reacting to a proposal that her CFO had brought to her. Submitted by Dr. Russ Roberts, director of the Nutrition Studies Department, the request was for the purchase of some new equipment to perform operations currently being performed on similar equipment. The purchase price was $400,000 delivered and installed. Ms. Russell continued:

Correct me if Im wrong, but this new equipment doesnt do anything from a research perspective that his existing equip- ment doesnt already do. And whats this about selling vitamins? Were not a pharmacy! His credibility is pretty low at this point. And now hes threatening to take his research projects to another institute where hell get better support if we dont buy the stuff. Hes got to be kidding! Maybe wed be better off letting him go.

BACKGROUND

Yoland Research Institute was a nonprofit, university-affiliated organization, specializing in research in a wide variety of fields. In large part, its activities were determined by a combination of the faculty affiliated with it and their research interests, although most of its projects tended to be of a basic, rather than applied, nature. As such, it was constantly involved in projects that were attempting to advance the state of the art in the particular field of in- vestigation. One such area was nutrition, where much of the work required sophisticated equipment, and where Dr. Roberts research had resulted in some major scientific discoveries, contributing to Yolands growing international reputation as an institute on the leading edge of nutritional research.

Sometimes the purchase of this equipment was funded by a particular research grant or contract. Unfortunately, in the case of Dr. Roberts request, this was not the case. Nevertheless, Dr. Roberts had worked closely with the equipment manufacturer to determine the potential benefits of the new equipment, and he had estimated that it would allow him to develop some vitamin supplements that the institute could sell for about $100,000 a year at a cost of about $40,000. He argued that the resulting $60,000 would help to cover some of the institutes overhead expenses which he knew were quite high. He also had told Yolands CFO that if the institute bought this equip- ment for him, his needs would be met for the next ten years.

COMPLICATING FACTORS

There were several complications associated with Dr. Roberts request. The first was that, although the present equipment was in good working order and would probably last, physically, for at least 10 more years, it was being depreciated at a straight-line rate of 10 percent per year. As such, it had a book value of $144,000 (cost $240,000; accumulated depreciation, $96,000). It had a very low resale value, however. Dr. Roberts commented:

Im pretty sure that we can find someone to remove it and pay us about $30,000 for it. Theres a market for this sort of stuff in other countries, and there are always people who will buy it for pennies on the dollar and then sell if for a small profit in some other country. Maybe we could do that ourselves, but we dont have the connections, and, besides, its a big hassle. We certainly couldnt sell it to anyone around here for more than $30,000 though.

The second complication was that the Institute had had some recent controversy on the board concerning the ap- propriate discount rate to use for its capital investment decision making. As one board member had put it:

Last years balance sheet [Exhibit 1 makes it pretty clear that well over half of our capital structure is in the form of equity. In my company [a multinational conglomerate] that equity represents our shareholders stake in the enterprise. If we dont give them a reasonable return, theyll sell their stock. When we make decisions like this, we use a minimum of 15 percent for our equity. In good years, when we have lots of attractive investment opportunities, we might even use a higher figure.

Another board member had been equally vociferous in his opposition:

Thats the for-profit world, but this is not. We dont even call it equity here, and we certainly have no shareholders to account to. My expectation as a member of this board is that well do cutting edge research, and anything needed to support that is justifiable. In fact, if you look at the sources of those net assets, youll see that most of them are unrestricted. Weve been earning large surpluses over the past few years and we now have an obligation to plow those back into the institute. The temporarily restricted are from research contracts and the permanently restricted are from donations and other gifts that were basically free. Why should we try to earn money on those? I think the donors would be outraged if we did. What I dont understand is why we dont have that $39 million in cash. Where is it anyway?

The first board member amplified on her earlier comments:

I realize that were nonprofit, but I dont agree that that means we can be fiscally irresponsible. If we told the donors that we were attempting to preserve the purchasing power of their gifts and donations, I think theyd be delighted. Besides, those gifts werent free. We spent a lot of staff and board time cultivating those relationships in order to get the gifts, and that has a real cost. Even the temporarily restricted funds had an expensegrant and contract writing and such.

As far as the unrestricted funds go, plowing them back into the institute is exactly what were doing, but were trying to do so in a way that lets us remain viable over the long term, and that means making wise investments. Im not suggesting we go for huge returns, but I think an interest rate on our equity of 10 percent would be a pretty good approximation of its cost to us; thats about what weve been earning on our portfolio over the past 20 years or so. Sure, we can have an investment or two that dont meet the hurdle rate, but we cant have very many of those or well be out of business before you know it.

It was in the context of this debate that Ms. Russell needed to frame her response to Dr. Roberts request.

Assignment

Where is the $39 million of equity that the second board member wondered about? Why isnt it in cash?

What is the appropriate discount rate to use?

Is Dr. Roberts proposal financially feasible?

If the Institute decides to purchase the new equipment for Dr. Roberts, what should it do with the existing equipment? What might be done to avoid similar mistakes in the future?

Assuming Dr. Roberts project is financially feasible, should the Institute buy the equipment for him? Why or why not?

____________________________________________________________________________________________________________ 

Yoland Research Institute July 2014 2 of 3

ASSETS Current Assets

Cash and cash equivalents (1) $10,500

Accounts receivable (net) 400

Inventories 1,350 Investments at market (1) 9,500 $21,750

Fixed Assets

Property plant, and equipment $83,000

Accumulated depreciation (36,400) 46,600

Total Assets $68,350

LIABILITIES AND NET ASSETS

Current liabilities

Accounts payable $2,050 Salaries and wages payable 1,290 Current portion of mortgage payable (5.5%) 410 $3750

Long-term liabilities

Notes payable (7.2%) $8,000

Mortgage payable (5.5%) 17,500 25,500

Net Assets (2)

Unrestricted $24,400

Temporarily restricted 6,700

Permanently restricted 8,000 39,100

Total Liabilities and Net Assets Notes: $68,350

Investments earned about 10 percent a year. Cash and cash equivalents (which are more liquid than investments) earned about 5 percent a year.

The term net assets in a nonprofit organization is equivalent to the term equity in a for-profit organization. It comprises per- manently restricted, temporarily restricted, and unrestricted funds.

With permanently restricted funds, the organization is not permitted to spend the principal amount; it must invest the principal, and may only spend the earnings on its investments (or a portion of the earnings). Some earnings come about as a result of ap- preciation in the share prices of stocks, others as a result of dividend payments from companies in which the organization owns stock, and others as a result of interest earnings on an investment, such as a bond. As indicated in footnote 1, Yoland was earn- ing an average of about 10 percent on its investments.

With temporarily restricted funds, the principal may be spent but only after some agreed-upon conditions have been met. They typically are associated with grants and contracts. Once the activities specified in the grant or contract have been completed, the funds are released and may be spent. Depending on the language of the grant or contract, the funds can be released incrementally, as certain grant conditions are met, or they can be retained until the entire project has been completed. In many instances, the funds are released weekly or monthly as people who work on the grant or contract receive their salaries.

With unrestricted funds, as the name suggests, there are no restrictions on use. Some of these funds are created because a dona- tion is made to the organization and the donor does not require that the donation itself (the principal) be retained intact (which would mean having the donation be permanently restricted. The money coming from annual fund drives or alumni contributions typically are unrestricted. The remainder of the funds are created when the organization earns a surplus, i.e., an excess of revenues over expenses. The surplus becomes part of the unrestricted net assets. Similarly, a deficit reduces the unrestricted funds.