1. Net present value (CMA adapted) (LO 3) "Maybe I should have stuck with teaching high school art. No matter what I try, I can't seem to turn that Roanoke plant around." That's how the meeting between Warren Wingo, CEO of clothing manufacturer Wingo Designs, and Angie Tillery, vice president of corporate lending at First National Bank, ended. Wingo and Tillery had just concluded that the Roanoke plant was draining corporate cash flow and income, and should be closed on December 31, 2011.

When he returned to his office, Wingo summoned corporate controller Ron Wright to tell him the bad news. "Ron, I wish there were some way to turn this situation around. We've had so many bad things happen lately-the fire in Lexington, the strike in Pulaski, and now this. Why didn't I stay at Cave Spring High?"

"Warren, it may not be as bad as it seems," Ron replied. "Let's put our heads together and do some investigating. We've got some great folks working here, and I bet if we asked them to think about it, they could come up with some options." With that encouragement, Warren sent Ron out to find some way of disposing of the Roanoke facility.

Early Monday morning, Ron ran into Warren's office waving a legal pad. "We've done it, Warren. We've got three good options for the Roanoke plant. One of them even has us keeping the plant." Warren listened intently as Ron laid out the three options his staff had developed:

Option 1

Sell the plant immediately to Tinsley Togs for $9,000,000.

Option 2

Lease the plant for four years to Star City Mills (one of Wingo's suppliers). Under the lease terms, Star City would pay Wingo $2,400,000 in rent each year and would grant Wingo a 10% discount on fabric purchased by another of its plants. The fabric normally sells for $2 per yard, and Wingo expects to purchase 2,370,000 yards of it each year. Star City would cover all the plant's ownership costs, including property taxes. At the end of the lease, Wingo would sell the plant for $2,000,000.

Option 3

Use the plant for four years to make souvenir 2014 Winter Olympic jackets. Fixed overhead, before equipment upgrades, is estimated at $200,000 a year. The jackets are expected to have a variable cost of $33 per unit and to sell for $42 each. Estimated unit sales are as follows; annual production would equal sales.

Year Jacket Sales in Units
2012 200,000
2013 300,000
2014 400,000
2015 100,000

To manufacture the jackets, some of the plant's equipment would have to be replaced at an immediate cost of $1,500,000. The equipment would have a useful life of four years. Because of the upgraded equipment, Wingo could sell the plant for $3,000,000 at the end of four years.

Required

a. Calculate the cash flows for years one through four for each option.
b. Calculate the net present value of each of each option. Assume a 12% discount rate.
c. Use Excel or another spreadsheet application to determine the discount rate that equates options 1 and 2. Do the same for options 1 and 3.
d. What should Wingo do?

2. Net present value (LO 3) AutoQuest has been selling auto parts to the general public for over 70 years. It has built a reputation for outstanding customer service, becoming the third largest auto parts retailer in the Southwest. Hoping to expand its sales to other regions, managers have decided to establish an online retail presence. Dan Jennings, CIO of AutoQuest, is charged with the task of evaluating how the company should implement this strategy.

One of the first things Dan needs to determine is how to acquire the network servers the company will need. He knows the vendor he wants to use, but is uncertain whether he should buy or lease the servers. If he buys the servers for $4.3 million, AutoQuest will incur annual maintenance costs of $50,000 over their five-year life. If he leases the servers for five years, AutoQuest will make lease payments of $1.2 million in each of the first three years and of $1 million in each of the last two years. Annual maintenance costs under the lease will be $80,000.

Required

a. Which option will cost the company less to implement, assuming a 12% discount rate?
b. What salvage value would AutoQuest need to receive on the purchased servers at the end of year 5 so that the purchase option is essentially equal to the lease option? Assume a 12% discount rate.
c. What annual cash inflow from the new online sales would be necessary for the lease option to be financially acceptable? Assume a 12% discount rate.
d. What nonfinancial issues might Dan Jennings consider in deciding whether to purchase or lease the servers?

3. Net present value, profitability index (LO 3) Bill Zimmerman is evaluating two new business opportunities. Each of the opportunities shown below has a ten-year life. Bill uses a 10% discount rate.

Required
a. Calculate the net present value of the two opportunities.
b. Calculate the profitability index of the two opportunities.
c. Which option should Bill choose? Why?