Case study: Carpe Diem Fund Management Ltd

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

  1. 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.

f

  1. 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).
  2. Which proposal should they select, given the requirements for the payback method?
  3. What are the primary disadvantages of this method, and why might it be appealing to an untrained investor?

 

  1. 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?

 

  1. 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.
  2. Which proposal should they select, based on the criteria of IRR?
  3. What are the primary disadvantages of using the IRR method?
  4. If there were an unlimited capital budget, which projects should Carpe Diem invest in, based on the IRR criteria?
  5. If any are to be excluded, why?

 

 

  1. Do the IRR and NPV methods reject the same proposals? Discuss briefly.

 

 

  1. Given the limitations and recommendations from academicians, which proposal should you choose, and why?

 

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