Question

Dash Buildings, Inc.

Ann Smith is the president of Dash Buildings Inc. (DBI), a subsidiary of Dash, Inc., one of the new long distance telephone companies that sprang up as a result of deregulation of long distance telephone service in the United States. DBI is responsible for purchasing and managing real estate used by various units of Dash. DBI acts like a private real estate investment firm – acquiring properties, managing those properties, and providing space to the other divisions of Dash. DBI occasionally rents space to other tenants when it acquires a building that has more space that is needed by dash. DBI does not, however. Purchase building for the express purpose of renting to non-Dash tenants.

DBI is a corporation rather than a department only for reasons of legal convenience. DBI acts like any other department within Dash. DBI does not raise it owns funds but receives them from the corporate treasury.

When smith first joined dash as a property manager, internal rate of return was the primary tool for project analysis. This often forced DBI to acquire smaller, older, less efficient buildings. Her role on a task force was leading the conversion to net present value was the source of recognition led to her eventual promotion to president of DBI. Net present value analysis has allowed DBI to acquire newer, larger, and more modern buildings. This had led to a dramatic decrease in complaints about buildings and greater overall employee satisfaction.

Oversight of capital budgeting at Dash was the responsibility of the treasurer. The prior treasurer had allowed each operating unit to use its own capital investment analysis methods, with some choosing net present value, some choosing internal rate of return, and some even choosing account rate of return. The new treasurer, who comes from a background of investment banking, wants to standardize analysis so proposals can be compared from one unit to the other. While the treasurer has not issued a formal policy. It is clear that he is leaning toward internal rate of return.

DBI has been formally evaluated as a profit center. Being credited with revenue equal to the estimate cost of renting space of the same type in the local market. 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 the real estate depression made the division profitable enough to bring it up to the maximum allowable bonus. She is, therefore, able to concentrate on maximizing satisfaction, which she believes to be the source of many further career advancement. Smith is concerned that internal rate of return will force her to return to acquiring less desirable office space. Dissatisfaction and complaints about building quality could derail her career.

BDI is currently working on additional office space for Sun City. The alternatives in Sun City are typical of those in most other location. An older building could be acquired for $7 million. Imputed rent savings from ownership would be $1.5 million the first year, and would grow 3 percent a year. After deduction of operating 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 savins would be $1.8 million and would be expected 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 thereafter. It is 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 division of Dash (telecommunications) is 15 percent. Dash is not earning its opportunity cost of capital, and its stock price is low, so management is under pressure to improve profitability. Most units are not earning bonuses at all because of low profitability.

Questions –

Compute net present value, internal rate of return profitability index, and payback period for each of the alternatives. For present value calculation, assume midyear cash flow except for initial outlay and terminal value. (with formulas)

Recommend the alternative that should be chosen.

Prepare a presentation to the treasurer explain how the company would benefit from using net present value instead of internal rate of return.

Comment on the company’s method of evaluating and rewarding success. Does the reward structure encourage optimal capital investments in DBI and the rest of the company?

Would you recommend that the reward structure be changed in any way?

Answer 1

Please find below net cash flow along with scheduled dates [Based on mid year cash flows exception being initial investment and terminal flows)

Oldbulding cash flow growth rates @ 3 % - As given

and New building cash flow growth rates @ 5% - As given

Cash Flow dates	1/1/2020	6/30/2020	6/30/2021	6/30/2022	6/30/2023	6/30/2024	6/30/2025	6/30/2026	6/30/2027	6/30/2028	6/30/2029	12/31/2029
Cash Flows Old building	-7	1	1.03	1.0609	1.092727	1.12550881	1.159274074	1.194052297	1.229873865	1.266770081	1.304773184	5
Cash flows of new building	-10.1	1.1	1.155	1.21275	1.2733875	1.337056875	1.403909719	1.474105205	1.547810465	1.625200988	1.706461038	12

NPV :-

Consider expected rate of return @ 12 % , which is after cash flow returns of a division with same risk profile as that DBI (Real Estate)

Using XNPV in Excel for different schedule dates

NPV of old building = 1.28142

NPV of New Building = 1.67174

IRR

Using XIRR in Excel for different schedule dates

IRR of Old building = 15.65 %

IRR of new building = 14,83 %

Payback Periods

Old Building

Cash Flow dates	1/1/2020	6/30/2020	6/30/2021	6/30/2022	6/30/2023	6/30/2024	6/30/2025	6/30/2026	6/30/2027	6/30/2028	6/30/2029	12/31/2029
Cash Flows Old building	-7	1	1.03	1.0609	1.092727	1.12550881	1.159274074	1.194052297	1.229873865	1.266770081	1.304773184	5
Cummulated cash flows		1	2.03	3.0909	4.183627	5.30913581	6.468409884	7.662462181	8.892336046	10.15910613	11.46387931	16.463879

Calculate cummulative cash periods in each year and by the end of 5.5 Years cash flows are 6.468

Fraction of time to reach 7 , which is an initial investment is (7-6.468)/(7.66-6.468) = 0.445 year

Payback period is 5.5 + 0.445 = 5.945 years

New Building

Cash Flow dates	1/1/2020	6/30/2020	6/30/2021	6/30/2022	6/30/2023	6/30/2024	6/30/2025	6/30/2026	6/30/2027	6/30/2028	6/30/2029	12/31/2029
Cash flows of new building	-10.1	1.1	1.155	1.21275	1.2733875	1.337056875	1.403909719	1.474105205	1.547810465	1.625200988	1.706461038	12
Cummulative cash flows		1.1	2.255	3.46775	4.741138	6.0781944	7.4821041	8.9562093	10.50402	12.129221	13.835682	25.83568

Calculate cummulative cash periods in each year and by the end of 6.5 Years cash flows are 8.956

Fraction of time to reach 7 , which is an initial investment is (10.1-8.956)/(10.50402-8.956) = 0.739 year

Payback period is 6.5 + 0.739 = 7.239 yeare years

Prepare a presentation to the treasurer explain how the company would benefit from using net present value instead of internal rate of return.

Critial point here is reinvestment rate.NPV assumes that cashflows are reinvested as cost of capital over the time , which is more closer to practicalilties.

IRR assumes that reinvestment occurs as IRR of a related project over the time,Its not closer to practicalities and related project / Hurdle Rate might fluctuate during time horizon of 10 years.

Hence NPV is most suiltable approach

Comment on the company’s method of evaluating and rewarding success. Does the reward structure encourage optimal capital investments in DBI and the rest of the company?Would you recommend that the reward structure be changed in any way?

Rewards are linked to net profits , which are calculated on imputed rentals near local market minus expenses of DBI.It motivates employees to chose a location which offers more future expected rentals.Obviously , more rental increase is possible in a location which has good infrastructure and other amenities.In addition to this , net profilt motivates employee to look for a property , which is available at economical prices (not cheaper) , as it might decrease DBIs expenses and increase net profit.

Thus reward structure is promoting better net profits , which means NPV method.Hence I recommend to continue existing incentive structure alligned to NPV method.