Case Study
Carpe Diem Fund Management Ltd.
A successful fund and investment management company, by the name of Carpe Diem Fund Management Ltd., had a good track record of choosing the right investments – those that had positive returns – during the past number of years, through the middle of 2019. They were concerned about the stock market’s volatility and wanted to begin diversifying so they would not be as susceptible to swings in the market as they had been in the past, and to hedge against the economic uncertainty they faced during the latter part of 2019. Top management was a competent group that consisted of several long term investors and traders in the market, but two of them had not had much formal education and training in financial analytical techniques that were being employed in the industry to support investment decision-making – one of them frequently referred to his “gut” as the source of inspiration for making important decisions as in “my gut is telling me…”. However, they had decided to look at a number of direct investment opportunities, one of which they would purchase outright, to initiate the diversification strategy.
Monica Moneybags, one of the primary financial analysts at Carpe Diem Fund Management Ltd., knew her education, training, and experience had put her in a good position to lead discussions and analysis concerning potential investments for the company’s portfolio, but now she had to utilize some skills that she had not used since her finance courses in graduate school. Executive management at Carpe Diem had decided to make direct investments in a venture, rather than just purchasing stock or providing capital in other forms. They were looking at four different target acquisitions, and had to make decisions in the next several weeks. It was up to Monica to complete the analysis, share her work papers and justify her recommendations. This was going to be a challenge for her, because two of the top managers were “street savvy” but no formal training or education concerning a number of the financial analytical techniques that Monica was going to utilize. One of them, Albert Ross, focused almost entirely on net income gains and rates of increase, and would be difficult to convince if she were to use other analytical techniques, which he sometimes referred to as financial “hocus-pocus” and often would not listen to the rationale supporting the methodology.
She had pulled together the basic information about the four proposals that were under consideration, and summarized them as follows:
Proposal 1
This proposal was to purchase a company that rented and serviced mailing and office machines. The company had been in business for over 4 years and was well-run, but needed capital or a “white knight” to invest or purchase the operation. The initial cost totaled $600,000 and was to be depreciated over a period of 20 years (straight line). They projected sales of over $1.443 million during the next five years, and almost $775,000 in aftertax earnings. See Figure 1 below for the data to be used in the analysis.
Figure 1 Financial Analysis of Proposal 1 – Office Machines
| Proposal 1: Office Machines | ||||||
| Initial Invstmt | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Net cost of new business | $600,000 | |||||
| Incremental Revenue | 91000 | 170000 | 263000 | 394000 | 525750 | |
| Operating cost | 26500 | 27000 | 27500 | 28000 | 28500 | |
| Depreciation (straight line, 40 yrs) | 30000 | 30000 | 30000 | 30000 | 30000 | |
| Net increase in income | 34500 | 113000 | 205500 | 336000 | 467250 | |
| Less: Tax at 33 % | 11385 | 37290 | 67815 | 110880 | 154193 | |
| Increase in aftertax income | 23115 | 75710 | 137685 | 225120 | 313058 | |
| Add back depreciation | 30000 | 30000 | 30000 | 30000 | 30000 | |
| Net cash flow for the period | ($600,000) | 53115 | 105710 | 167685 | 255120 | 343058 |
Proposal 2
The second proposal was to purchase a small plane to be located at a small executive airport nearby, and to be used by small business owners who had travel requirements that commercial airlines could not meet. These business operators were typically owners of growing and expanding businesses, and who needed to travel regionally on short notice. Other transportation alternatives such as commuter trains were not available and car services were too expensive and too slow (too much traffic). If successful, this concept might be considered for expansion to other cities of similar size that had good growth track records for small businesses.
Figure 2 Financial Analysis of Small plane/small airport shuttle service
| Proposal 2 Small plane/small airport shuttle service | ||||||
| Initial Invstmt | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Net cost of new business | 810000 | |||||
| Incremental Revenue | 105000 | 202000 | 303000 | 445000 | 595000 | |
| Operating cost | 36000 | 39000 | 42000 | 44000 | 46000 | |
| Depreciation (units of production) | 121500 | 145800 | 153900 | 162000 | 170100 | |
| Net increase in income | (52500) | 17200 | 107100 | 239000 | 378900 | |
| Less: Tax at 33 % | (17325) | 5676 | 35343 | 78870 | 125037 | |
| Increase in aftertax income | (35175) | 11524 | 71757 | 160130 | 253863 | |
| Add back depreciation | 121500 | 145800 | 153900 | 162000 | 170100 | |
| Net cash flow for the period | (810000) | 86325 | 157324 | 225657 | 322130 | 423963 |
Proposal 3
The third proposal involved the purchase and use of motor scooters for a courier system in the inner city. It was expected to be very competitive with other similar services, and might grow into the type of operation that could be expanded to other cities of similar size, using a direct investment or franchise model. The initial investment was estimated to be $296,000. The revenues were expected to grow substantially during the first four years, and then to level off as a result of anticipated competition entering the market and driving down rates.
Figure 3 Financial Analysis of Courier Service
| Proposal 3: Intra-city courier service | ||||||
| Initial Invstmt | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Net cost of new business | 296000 | |||||
| Incremental Revenue | 42000 | 75900 | 111250 | 230500 | 159000 | |
| Operating cost | 10500 | 11000 | 11150 | 11250 | 11750 | |
| Depreciation (units of production) | 44400 | 65120 | 62160 | 62160 | 62160 | |
| Net increase in income | (12900) | (220) | 37940 | 157090 | 85090 | |
| Less: Tax at 33 % | (4257) | (73) | 12520 | 51840 | 28080 | |
| Increase in aftertax income | (8643) | (147) | 25420 | 105250 | 57010 | |
| Add back depreciation | 44400 | 65120 | 62160 | 62160 | 62160 | |
| Net cash flow for the period | (296000) | 35757 | 64973 | 87580 | 167410 | 119170 |
Proposal 4
The final proposal under consideration involved the utilization of small vehicles for deliveries in a metropolitan center. The plan was to purchase a number of them and use them to more easily maneuver in congested traffic in downtown areas, and the revenue during the first two years of operation was expected to be substantial. This really generated a lot of attention from Albert.
Figure 4 Financial Analysis of Delivery Service
| Proposal 4: Intra-city delivery service | ||||||
| Initial Invstmt | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Net cost of new business | 513000 | |||||
| Incremental Revenue | 379500 | 331050 | 88750 | 77400 | 52300 | |
| Operating cost | 45150 | 42750 | 27900 | 26700 | 25200 | |
| Depreciation (units of production) | 76950 | 112860 | 107730 | 107730 | 107730 | |
| Net increase in income | 257400 | 175440 | (46880) | (57030) | (80630) | |
| Less: Tax at 33 % | 84942 | 57895 | (15470) | (18820) | (26608) | |
| Increase in aftertax income | 172458 | 117545 | (31410) | (38210) | (54022) | |
| Add back depreciation | 76950 | 112860 | 107730 | 107730 | 107730 | |
| Net cash flow for the period | (513000) | 249408 | 230405 | 76320 | 69520 | 53708 |
The plan was to present the information about each proposal in summary, develop a thorough analysis using appropriate financial analytical techniques and methodologies, and to anticipate the questions and concerns that would arise during the discussions with the executive management group. The only constraints were related to the amount of funds they had available for investment – they did not want to borrow at this juncture – and that they could only support one project given the limited availability of seasoned managers to run the project they ultimately chose. It had been determined that the cost of capital was 10% at the time, and that this rate should be used in any analysis.
Monica knew that she should use at least three capital budgeting techniques:
- Payback (PB)
- Internal rate of return (IRR)
- Net present value (NPV)
She was generally familiar with the techniques (she really wished she had given more attention to the capital budgeting techniques and rationale covered in her finance courses in her graduate degree program, but was reasonably confident that she could explain them clearly). She was more concerned that none of these would appeal to Albert, who had always been focused on accumulated earnings (increase in aftertax income). She had tried to convince Albert that the net present value method was the best approach, but he did not understand it and called it “mumbo-jumbo” and “hocus-pocus” finance. She nevertheless prepared her analysis and felt assured that she could convince the executive management group which project would be in the firm’s best interest and create the most value, and that Albert would listen to others if her presentation was clear and concise, and if the others understood.
The calculations are presented in an attachment (spreadsheet) for your review and use.
Case Questions
- Albert Ross admittedly focused on the level of earnings, and particularly the increase in aftertax income of each project (proposal). Which proposal do you think Ray will be focused on, and provide reasons/an explanation for your answer.
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- The first method Monica is to present is the payback technique. See the computations in the attachment (spreadsheet), and note the how PB is approximated using the proportion of the year to the nearest decimal place (i.e., 3.4 years).
- Which proposal should they select, given the requirements for the payback method?
- What are the primary disadvantages of this method, and why might it be appealing to an untrained investor?
- The next method Monica presented is the net present value (NPV) technique. Review the NPV calculated in the spreadsheet for each proposal and rank the proposals. Which proposal should be selected, based on the ranking?
- The next method in her presentation is the internal rate of return (IRR). Rank the projects on the basis of their IRR’s in the attached spreadsheet.
- Which proposal should they select, based on the criteria of IRR?
- What are the primary disadvantages of using the IRR method?
- If there were an unlimited capital budget, which projects should Carpe Diem invest in, based on the IRR criteria?
- If any are to be excluded, why?
- Do the IRR and NPV methods reject the same proposals? Discuss briefly.
- Given the limitations and recommendations from academicians, which proposal should you choose, and why?
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