978-1259277160 Case Case 18

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Aerocomp, Inc. Case 18

Methods of Investment Evaluation

Purpose: The emphasis is on comparing the payback method, the internal rate of return, and the net

present value approaches for a series of investments. As the student progresses through the calculations,

the various advantages and disadvantages of the different approaches become evident. The reinvestment

assumption of a high return project under the internal rate of return can be highlighted and evaluated.

Capital rationing is also introduced into the case and plays a part in the analysis. Finally, the issue of

reported earnings to stockholders versus sophisticated capital budgeting techniques is brought up and

makes for interesting classroom discussion. Are stockholders and upper-level managers more concerned

with next quarter’s earnings or long-term benefits?

Relation to Text: The case should follow Chapter 12. The internal rate of return calculations can be

tedious and may be simplified by the use of calculators, such as the Hewlett-Packard 12C Model,

described in Appendix E of the text, or other appropriate calculator models.

Complexity: The case is fairly straightforward. The computation of the internal rate of return can be time

consuming if done by hand.

Solutions

1. Total Reported Earnings increases for each projects:

Project A Project B Project C Project D

Year 1: $(13,250) $ 29,313 $(60,000) $ 192,206

We are told in the case that Kay Marsh is sensitive to Aerocomp’s level of earnings. Therefore,

Project B, with over $820,000 in reported earnings increases (twice as much as any of the other

Note that Projects A and C both produce earnings decreases for the first two years. We would

2. Payback Period, IRR, and NPV of each alternative:

Project A Project B Project C Project D

Payback Period: 4 years 5 Years 5 Years 2 Years

written consent of McGraw-Hill Education.

(Students may get slightly different values due to rounding.)

Note: A few students may question the fact that Project B’s cost has not been completely recovered in

the five-year period shown, as the cost of the other projects has been. Therefore, they will claim, we

3. a. According to the Payback Method, Project D should be selected. The initial investment of

b. The chief disadvantage of the Payback Method is obvious at once: the method ignores cash flows

occurring after the payback period. In this case such an omission is disastrous, since Project D’s

c. In general, the Payback Method should not be used. However, it is used from time to time

because it is easy to understand, and because it favors projects which pay off quickly. This can be

4. a. According to the IRR method, Project A should be chosen. It returns nearly two percent more

b. Remember, that to achieve the IRR during a project’s life, the project’s cash inflows must be

reinvested at the IRR rate. This may be difficult or impossible to accomplish when high IRR’s

are involved. (Suppose you were Aerocomp’s financial manager, and you were getting the cash

c. Another disadvantage of the IRR method is that it does not give any consideration to project size.

For example, the IRR method would select a project which returned $10 on a $1 investment over

(Note: It is important to avoid confusion on this point. The IRR and NPV methods will both

written consent of McGraw-Hill Education.

d. If the size of Aerocomp’s capital budget were not limited, the IRR method would accept projects

5. a. According to the NPV method, Project C, with an NPV of over $52,000, will be chosen. It will

b. If the size of Aerocomp’s capital budget were not limited, the NPV method would accept projects

c. The likely selection is Project C because of its high net present value. This is partly attributable

to the fact that only one project can be selected. Had there not been capital limitations, one might

Kay may be persuaded by explaining the benefits of taking a long-term vs. short-term

written consent of McGraw-Hill Education.