Question

Dillon Hall, Inc. (DHI) operates a warehousing business that operates in the southern USA. It warehouses temperature sensitive inventory for its customers. The inventory that it warehouses must be kept in climate controlled environments to prevent spoiling or damage. The HVAC unit at DHI’s Virginia facility is at the end of its duty cycle and must be replaced or its highly profitable Virginia warehouse must be shut down. Because of rigid climate controlled specifications, DHI must install one of two HVAC options that meet its climate control specifications. The installation of either HVAC unit will allow DHI to maintain contracts with existing customers. The installation of a new HVAC unit will not cause DHI’s revenues to increase or decrease, so DHI faces a capital budgeting decision that consists of choosing a unit that has the least lifetime cost to DHI.

OPTION ONE is a “capital intensive HVAC unit” that has a high up-front cost, but low yearly operating costs.

OPTION TWO is an “operating intensive HVAC unit” that has a lower up-front cost, but higher yearly operating costs.

DHI expects both HVAC units to have operating lives of 5 years.

DHI’s weighted average cost of capital (WACC) is 7%.

Relevant HVAC cash flows appear below:

Year                                              0                    1                  2                        3                       4                         5

AFTER-TAX CASH FLOWS:                       |------------------|------------------|------------------|------------------|------------------|

Capital intensive HVAC unit            ($600,000)      ($50,000)          ($50,000)         ($50,000)         ($50,000)         ($50,000)

Operating intensive HVAC unit      ($100,000)    ($175,000)        ($175,000)       ($175,000)      ($175,000)       ($175,000)

TASKS: Please -

Calculate and interpret the “net present value” (NPV) capital budgeting metric for each of the HVAC units. Document TVM calculations and keystrokes.

If DHI’s controller asked you to calculate the IRRs and MIRRs of the two projects, what message would you deliver about the use of IRRs and MIRRs in this case?

Suppose that DHI’s WACC rose to 15%. Provide TVM calculations and a new “management recommendation memo” that indicates your recommendation and the logic behind your recommendation.

Answer 1

		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=WACC=7%=0.07
		N=Year of Cash Flow
		CAPITAL INTENSIVE UNIT
	N	Year	0	1	2	3	4	5
	A	After tax Cash Flow	($600,000)	($50,000)	($50,000)	($50,000)	($50,000)	($50,000)	SUM
	PV=A/(1.07^N)	PV of after tax cash flow	$       (600,000)	$    (46,729)	$   (43,672)	$    (40,815)	$      (38,145)	$     (35,649)	$ (805,010)
	NPV	Net Present Value of Costs	$          805,010
		OPERATING INTENSIVE UNIT
	N	Year	0	1	2	3	4	5
	A	After tax Cash Flow	($100,000)	($175,000)	($175,000)	($175,000)	($175,000)	($175,000)	SUM
	PV=A/(1.07^N)	PV of after tax cash flow	$       (100,000)	$ (163,551)	$ (152,852)	$ (142,852)	$   (133,507)	$ (124,773)	$ (817,535)
	NPV	Net Present Value of Costs	$          817,535
		Lifetime cost is Lower for Capital intensive unit
		Hence, Capital Intensive unit is recommended
		IRR gives the required rate of return at which NPV is zero
		MIRR is a modified IRR which gives the rate of return of investment required to equal future value of cash inflows
		Both are related to return on investment
		In this case , there is no saving , the investment does not generate any direct return
		Hence, IRR and MIRR are not applicable
		If WACC =15%
		Present Value (PV) of Cash Flow=(Cash flow)/(1.15^N)
		N=Year of cash flow
		CAPITAL INTENSIVE UNIT
	N	Year	0	1	2	3	4	5
	A	After tax Cash Flow	($600,000)	($50,000)	($50,000)	($50,000)	($50,000)	($50,000)	SUM
	PV=A/(1.15^N)	PV of after tax cash flow	$       (600,000)	$    (43,478)	$   (37,807)	$    (32,876)	$      (28,588)	$     (24,859)	$ (767,608)
	NPV	Net Present Value of Costs	$          767,608
		OPERATING INTENSIVE UNIT
	N	Year	0	1	2	3	4	5
	A	After tax Cash Flow	($100,000)	($175,000)	($175,000)	($175,000)	($175,000)	($175,000)	SUM
	PV=A/(1.15^N)	PV of after tax cash flow	$       (100,000)	$ (152,174)	$ (132,325)	$ (115,065)	$   (100,057)	$     (87,006)	$ (686,627)
	NPV	Net Present Value of Costs	$          686,627
		Lifetime cost is Lower for Operating   intensive unit
		Hence, Operating Intensive unit is recommended