Smith and her employees receive bonuses based on the profit of DBI. Bonuses at DBI had...

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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, there- fore, 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 re- turn 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 rent savings from ownership would be $1.5 mil- lion the first year, and would then grow 3 percent a year. After deduction of oper- ating 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 million. Alternately, 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 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 flow would be $1.1 million the first year and would grow 5 percent a year there. after. 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 capi- tal, and its stock price is low, so manage- ment is under pressure to improve prof- itability. Most units are not earning bonuses at all because of low profitability. Questions 1. Compute the net present value, inter- nal rate of return, profitability index, and payback period for each of the al- ternatives. For present value calcula- tions, assume midyear cash flows ex- cept for initial outlay and terminal value. 2. Recommend the alternative that should be chosen. 3. Prepare a presentation to the treas- urer 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 re- ward structure be changed in any way? 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, there- fore, 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 re- turn 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 rent savings from ownership would be $1.5 mil- lion the first year, and would then grow 3 percent a year. After deduction of oper- ating 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 million. Alternately, 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 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 flow would be $1.1 million the first year and would grow 5 percent a year there. after. 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 capi- tal, and its stock price is low, so manage- ment is under pressure to improve prof- itability. Most units are not earning bonuses at all because of low profitability. Questions 1. Compute the net present value, inter- nal rate of return, profitability index, and payback period for each of the al- ternatives. For present value calcula- tions, assume midyear cash flows ex- cept for initial outlay and terminal value. 2. Recommend the alternative that should be chosen. 3. Prepare a presentation to the treas- urer 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 re- ward structure be changed in any way?

Answer rating: 100% (QA)

1 Net Present Value NPV Internal Rate of Return IRR Profitability Index PI and Payback Period a Alternative 1 Acquire an older building Initial Outlay ... View the full answer