Economic Concept:Time value of money
CASE 1: Amcott Loses $3.5 Million; Manager Fired
ANSWER: As the manager of the foreign language division, he probably
relied on his marketing department for sales forecasts and on his legal
department for advice on contract and copyright law. The information he
obtained about future sales was indeed accurate, but apparently his legal
department did not fully anticipate all the legal ramifications of distributing
Magicword. Sometimes, managers are given misinformation.
The real problem in this case, however, is that Ralph did not properly act on
the information that was given him. Ralph’s plan was to generate $7 million
per year in sales by sinking $20 million into Magicword. Assuming there were
no other costs associated with the project, the projected net present value to
Amcott of purchasing Magicword was which means that Ralph should have
expected Amcott to lose over $1.6 million by purchasing Magicword.
Ralph was not fired because of the mistakes of his legal department but for
his managerial ineptness. The lawsuit publicized to Amcott’s shareholders,
among others, that Ralph was not properly processing information given to
him: He did not recognize the time value of money.
Cost of project $20,000,000
Future Cashflows
Year 1 7,000,000
Year 2 7,000,000
Year 3 7,000,000
Interest Rate 7%
PV 18,370,212
NPV= PV - C0 =$18,370,212 - $20,000000 = -$1,629,788
CASE 2: Automated Products
ANSWER: By spending $300,000 today on a new machine, the firm will
reduce costs by $365,000 over five years. However, the present value of the
cost savings is only $284,679.22.
Consequently, the net present value of the new machine is computed below:
Future Cash Flows
Year 1 50,000
Year 2 60,000
Year 3 75,000
Year 4 90,000
Year 5 90,000
Interest
8%
Rate
PV 284,679.22
NPV= PV =$284,679 - $$300,000 = -
- C0 $15,321
Since the net present value of the machine is negative, the manager
should not purchase the machine. In other words, the manager could earn
more by investing the $300,000 at 8 percent than by spending the money on
the cost-saving technology.
Economic Concept: Incremental Decisions
CASE 3: Slick Drilling Inc.
ANSWER: Incremental revenue of $183,200 if you adopt the project. To earn
these additional revenue you must spend an additional $90,000 for drill
augers and $75,000 for additional temporary workers. The sum of these cost
is $165,000 represents the incremental cost of the new drilling project. Since
your incremental revenue of $183,200 is higher than the incremental cost of
$165,000, you should give your “thumbs up” to the new project that will add
$18,200 to your bottom line.
NEW DRILLING PROJECT
Current After New Incremental
Situation Drilling Project Revenue and Cost
Total Revenue 1,740,400 1,923,600 183,200
Variable Cost -
Drill augers 750,000 840,000 90,000
Temporary workers 500,000 575,000 75,000
Total Variable Cost 1,250,000 1,415,000 165,000
Direct Fixed Cost -
Depreciation-equipment 120,000 120,000 -
Total Direct Fixed Cost 120,000 120,000 -
Indirect Fixed Cost -
Supervisor's Salaries 240,000 240,000 -
Offi ce Supplies 30,000 30,000 -
Total Indirect Fixed Cost 270,000 270,000 -
Profit 100,400 118,600 18,200
TOPIC: CVP Analysis
CASE 4: Break Even Analysis
1. Contribution Margin 56 (revenue of 16 dollars per ticket less variable cost
of 10 dollars)
2. Contribution Margin ratio : 37.5 % (CM of 6 Dollars/Revenue of 16 Dollars)
3. 8,000 tickets
4. 128 dollars
5. 10, 000 tickets and 160 dollars
6.
