Case Study

As business owners, we constantly strive to ensure the profitability of our company by working hard to generate a high rate of return on both short and long term investments. In chapter 7 we discussed how we manage working capital to maintain liquidity and to meet our short-term obligations. We pointed out that excess cash should be invested temporarily in short-term marketable securities to generate a more positive return on our investment without too much risk. We also mentioned that we invest in assets that are expected to result in cash returns for a period of 1 year or more. These investments in capital expenditures (assets having a useful life of 1 year or more) are expected to help generate increased revenues that make our firm more profitable in the future. Our business must constantly make decisions about whether to purchase new equipment or expand operations with the addition of new buildings. The method we use to make these determinations is referred to as capital budgeting.??Please read the accompanying information about Northeast Studios. This company has experienced tremendous growth in the past few years and is nearing the capacity of their two current recording facilities. Northeast Studios is considering expanding the company and purchasing a turnkey studio facility, "Studio C" from their current competitor.

Northeast Studios is in the process of deciding whether or not to expand and purchase Studio C from their competitor, Noah Gigliotti. If Northeast would purchase Studio C, it would cost $400,000 at the time of the purchase. Northeast is projecting that the new facility will be able to generate an additional $100,000 in positive cash flow per year for five (5) years.

Northeast Studios will use a collateralized equipment loan to finance the expansion. The company has been approved to for a $300,000, five-year loan at an 8% annual interest rate from Chase Manhattan that will start on January 1, 2011 and will be paid off by December 31, 2015. To finance the remaining $100,000, Northeast will divert cash from their savings at an opportunity cost of 4%.

The facility's "David Smith Massenberg GML Console" is valued at $210,000 and has an estimated salvage value of $60,000 after its five (5) year depreciable lifespan. The other recording equipment has an estimated value of $90,000 with a three (3) year depreciable lifespan and no ($0) salvage value. The building has an estimated value of $100,000 and a 25-year depreciable lifespan and an assumed $0 salvage value.

Please answer the following questions:

1. (a) Using the straight-line method, calculate the annual depreciation for each of the following three assets: The "Massenberg GML Console", the "other recording equipment", and the building. (b) What is the total annual depreciation for the first year?

2. (a) Using an amortization schedule calculator, calculate the annual interest expense for the equipment loan obtained from Chase Manhattan beginning on January 1, 2011 for each of the five years of the loan. (b) Explain the difference between the interest expense and the loan payments made to the bank for each year of the loan.

3. Using the payback method, determine the length of time that will be required to recoup the $400,000 investment in the new facility.

4. Calculate the company's Weighted Average Cost of Capital using the loan and the cash from savings to finance the expansion.

5. (a) Calculate the net present value of the investment in the new facility. (b) Calculate the profitability index of the investment. (c) Should Northeast Studios proceed with the investment? Why or why not?

6. Suppose the company's weighted average cost of capital rose 3% higher than the rate that was originally calculated in question #5. (a) Calculate the net present value and (b) profitability index using the revised cost of capital. (c) Should Northeast Studios still proceed with the investment? Why or why not?

7. Explain the relationship between the net present value and the profitability index.

8. (a) Calculate the accounting rate of return. (b) What are the advantages and disadvantages of this type of calculation?

9. Identify and explain some of the specific assets that YOUR OWN Company will need to own in order to operate in the capacity you have assumed, to have the capability to produce its products or services, or otherwise make those products or services available for sale. In other words, what assets (equipment) will your company need?

10. From Rich Dad, Poor Dad, what is Rich Dad's "Rule One"? Why is it so important?