Managerial Project. II Akanksha Shahi.

Road Runner Delivery Company is a small firm that transports business packages between
New York and Chicago. It operates a fleet of small vans and moves packages to and from a
central depot within each city and uses a common carrier to deliver the packages between
the depots in the two cities. Road Runner Delivery recently acquired approximately $4 mil-
lion in cash capital from its owners and its president, Ray Hay, is trying to identify the
most profitable way to invest these funds.

The company’s operations manager believes that the money should be used to expand the
fleet of city vans at a cost of $900,000. He argues that more vans would enable the company
to expand its services into new markets, thereby increasing the revenue base. More specifi-
cally, he expects cash inflows to increase by $325,000 per year. The additional vans are ex-
pected to have an average useful life of four years and a combined salvage value of
$100,000. Operating the vans will require additional working capital of $50,000, which will
be recovered at the end of the fourth year.
In contrast, the firm’s chief accountant believes that the funds should be used to purchase
large trucks to deliver the packages between the depots in the two cities. The conversion
process would produce continuing improvements in operating savings and reduce cash out-
lays as follows:

Year 1 Year 2 Year 3 Year 4

$175000 $375000 $450000 $500000

The large trucks are expected to cost $1,000,000 and have a four year useful life and
$82,250 salvage value. In addition to the purchase price of the trucks, up-front training
costs are expected to amount to $20,000. Swift Delivery’s management has established a 10
percent desired rate of return

Please answer:
a.Determine the net present value of the two investment alternatives
b.Calculate the present value index for each alternative
c.Indicate which investment alternative you would recommend. Explain your choice

Net Present Value (NPV): It is the difference between the present value of cash inflows and ini-
tial cash outflow. It helps in making project investment decisions. If the NPV is positive then the
project should be accepted and if negative then it should be rejected. Projects with higher NPV
should be accepted in case of two mutually exclusive projects having positive net present value.
a) Determining the Net Present Value of the Two Investments Alternatives:

Alternative: 1 Expand the Fleet of Vans (Cash Inflows)

Particulars Amount * Table Value = Present Value

Annual cash inflows $325,000 * 3.169865 = $1030206.125
Salvage value $100,000 * 0.683013* = $68301.3
Working capital recovery $50,000 * 0.683013 = $34150.65
Total Cash Inflows $1,132,658.075
Cash outflows:
Cost of Vans -$900,000
Working capital increase -$50,000
Net present value 182658.075

* Salvage Value and working capital both at the end of year 4, therefore value of 10% at year 4
is to be considered in PV table.
* * Year 1, PVA table is considered.

Alternative: Purchase Large Truck (Cash Inflows)

Particulars Amount * Table Value = Present Value

Year 1 $175,000 * 0.909091** = $159090.925

Year 2 $375,000 * 0.826446 = $309917.25

Year 3 $450,000 * 0.751315 = $338091.75

Year 4 $500,000 * 0.683013 = $341506.5

Salvage Value $82,250 * 0.683013 = $56177.82

Total Cash Inflow $1204784.245

Cash Outflows:
Cost of Trucks -$1,000,000
Trianing Costs -$20,000

Net Present Value $184,784.24

b) Calculation of the Present Value of Index for Each Alternative:

Alternative: 1 ( Fleet of Vans)

PV Index = Present value of Cash inflow/ Present value of cash outflow

$1,132,658.075/950000= 1.19

Alternative: 2 ( Purchase Large Trucks)

PV Index = Present value of Cash inflow/ Present value of cash outflow

1204784.245/1020000=1.18

c) Because PV index is more for alternative 1 , therefore, it is better to expand fleet of vans
.

2. Thomas Company recently initiated a post audit program. To motivate employees to

take the program seriously, Gains established a bonus program. Managers receive a bonus
equal to 10 percent of the amount by which actual net present value exceeds the projected
net present value. Victoria Bolt, manager of the North Western Division, had an investment
proposal on her desk when the new system was implemented. The investment opportunity
required a $250,000 initial cash outflow and was expected to return cash inflows of $90,000
per year for the next five years. Thomas Company’s desired rate of return is 10 percent.
Ms. Bolt immediately reduced the estimated cash inflows to $70,000 per year and recom-
mended accepting the project.

Please answer:
A. Assume that the actual cash inflows turn out to be $91,000 per year. Determine the
amount of Ms. Bolt’s bonus if the original computation of net present value were based
on $90,000 versus $70,000

B. Is Ms. Bolt’s behavior in violation of any of the standards of ethical professional prac-
tice in Exhibit 10.19 of Chapter 10?

C. Speculate about the long-term effect the bonus plan is likely to have on the company

D. Recommend how to compensate managers in a way that discourages gamesmanship.

E) We will calculate the net present value of the project for the three cash inflows to work out
the answer:
 Present Value Table Factor (A) 3.790787 Table 2 Rate=x(10%) Years (n)=5

Inflow of Inflow of Inflow of

Particulars (B) $91,000 $90,000 $70,000
(Actual) (Projected) (Projected)

Present value of an ordinary annuity of $1 over

$3.79079 $3.79079 $3.79079
5 years

Present value of cash inflows C= A*B $344,962 $341,171 $265,355

Initial investment (D) -$250,000 -$250,000 -$250,000

Net present value (C-D) $94,962 $91,171 $15,355

($94,962- ($94,962-
Amount by which the actual net present value
$91,171) $15,355)
exceeds the budget value
$3,791 $79,607

Bonus = 10% of excess $379 $7,961

Bonus Calculation At $90,000

Actual NPV=$94,962
(-) projected NPV=$91,171
Variance= $3,791
Multiplied by 10% Bonus=$379

Bonus Calculation At $970,000

Actual NPV=$94,962
(-) projected NPV=$15,355
Variance= $79,607
Multiplied by 10% Bonus=$7,961

b. Mr Holts behavior is in violation of the Integrity Standard of Ethical conduct, which is stated
as following:

1. Mitigate actual or apparent conflicts of interest. Advise all parties of any potential conflict.

2.Refrain from engaging in any conduct that would prejudice carrying out duties ethically.

3. Abstain from engaging in or supporting any activity that might discredit the profession.
c. 1.Managers will continue to manipulate the cash inflows of capital projects to set them at the
lowest levels that will get the project approved, rather than at their actual levels.
2. The misrepresentation of cash flow will conflict with management’s ethical practices on the
grounds of integrity, which may reoccur in future in other processes swell.

d. The company can:

1. Set up an independent committee responsible for calculating the net present value of
projects, and still be the compensation on the difference between the actual and budgeted
levels.
2. Initiate a reward scheme or increment in salary or may as well draft a promotion policy to
compensate managers so to discourage gamesmanship.
3. Design a bonus scheme that has various components, and make accurate budgeting and
projecting of cash flows one of these.