Question

Brownie, LLC (“Brownie”) purchased property (land and a building) three years ago for $1.5 Million. Annual property tax is $25,000 and will not change in the foreseeable future. The property is currently rented for a net after-tax cash flow (inclusive of the aforesaid annual property tax) of $150,000 per year. Brownie is considering converting the property to a fitness center, and has estimated, the net aftertax cash flow of the fitness center will be $250,000 for the next five years. If Brownie converts the property to a fitness center it will no longer receive the aforesaid $150,000 cash flow from the rental of the property. To convert the property to a fitness center will require an initial capital investment of $250,000.00 at the beginning of year one, and an additional investment of $141,986.50 at the end of year two. Brownie’s required rate or return (or cost of capital) is 10%. Assume all cash flows, except for the initial capital investment of $250,000, are at the end of each year.

(a) Using at least two capital investment evaluation methods or other managerial accounting concepts studied in our course, recommend whether Brownie should go forward with the project, or not, and explain your reasoning for your conclusion.

(b) Explain and comment on the advantages and disadvantages of each investment evaluation method you considered in reaching your conclusion.

(c) Discuss the relevance of all cash flows and explain why each should or should not be included in your analysis.

Answer 1

(a) Capital investment evaluation methods using here are Net Present Value and Internal Rate of Return.

According to NPV:

Since the NPV of the project is more than $0, the project is acceptable.

Cash flows in Year 0 end, that is starting of Year 1 is initial investment of $250,000.

Cash flows at the end of Year 2, refers to additional investment of $141,986.50

Cash flows for 1 to 5 years of annual income is taken as $100,000 because $150,000 of opportunity cost is deducted to know the real profit.

According to IRR:

IRR = 12% - 2,713.15/(4,350.27+2,713.15)

= 12% - 0.3841

= 11.6159% (approx.)

Since IRR is more than the cost of capital, the project is acceptable according to IRR.

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(b) Advantage of NPV is, it considers time value of money. Disadvantage is, it is difficult to compute.

Advantage of IRR is, it considers time value of money, it perfectly uses time value of money. It gives importance to all the cash flows. Disadvantages of IRR is, it is difficult to understand.

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(c)

Historical cost of $1.5 million of purchased property is sunk cost and not to be used in decision making. Hence irrelevant.

Annual property tax, though is included in net income, we cannot exclude that amount stating that it is irrelevant for decision making, because of time value of money. We have made no adjustments regarding that following the same.

Net-after tax cash flow of rental property is considered as Opportunity cost as we would earn that amount every year if the property is not converted into fitness center. So it is a cost to fitness center and the fitness center should atleast earn that income.

Net after tax cash flow from fitness center is taken as cash inflow every year for next 5 years at $250,000

Initial capital investment and additional capital investment are considered as cash outflows.