Aerocomp, Inc Case Study Week 7

1. Total Reported Earnings increases for each projects:

Proj A Proj B Proj C Proj D

($13,250.00 ($60,000.00 $192,206.0
1 ) $29,313.00 ) 0
($16,000.00 $129,846.0
2 ($450.00) $87,938.00 ) 0
$146,563.0 ($43,350.00
3 $25,494.00 0 $61,640.00 )
$101,003.0 $234,500.0 $162,140.0 ($62,475.00
4 0 0 0 )
$322,438.0 $262,640.0 ($94,350.00
5 $63,315.00   0   0   )
$176,112.0 $820,752.0 $410,420.0 $121,877.0
Total 0 0 0 0

With what we know about Kay Marsh, Kay is sensitive to Aerocomp’s level of earnings. Project B with
$820,000 in reported earnings increase is twice as much as other projects, will most likely attract Kay.
Project D may be interesting to Kay at the first year providing $192,206 but the later losses will lead to its
rejection rather quickly.
Projects A and C produce earnings decrease for years one and two. We can infer that if Emily thinks that
either project would be selected, she will need a convincing explanation.

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

Proj A Proj B Proj C Proj D

Payback
(years) 4 5 5 2
IRR 14.08% 7.18% 11.95% 12.48%
($63,848.00
NPV (10%) $39,971.00 ) $52,192.00 $20,609.00

3. a. According to the Payback Method, Project D should be selected because the initial investment of
$510,000 is recovered in the 2nd year.

b. The chief disadvantage of the Payback Method is that the method ignores cash flows occurring
after the payback period. This would be a concern since Project D’s reported earnings and cash
flows fall after the payback period and never recover. Another disadvantage of the Payback
Method is that it does not consider the timing of cash flows during the payback period.
 c. The Payback Method should not be used, unless it is used occasionally because it is easy to
understand, and because it favors projects which pay off quickly. There is value for the Payback
Method in fast-paced industries where a quick return is important. The Payback Method should
not be a primary analytical tool.

4. a. According to the IRR method, Project A should be chosen. It returns nearly 2% more than the
closest competing project.

b. A project’s cash flows must be reinvested at the IRR rate in order to achieve IRR during the
projects life. If a high IRR is involved it may be very difficult and improbable to achieve. If
Project A’s cash flows were reinvested at 7% annually and not the IRR rate of 14.08%, the total
return for five years would be 11.84% less.

c. Another disadvantage of the IRR methods is that it doesn’t consider project size. The IRR
method would select a project that returned $10 on a $ 1 investment over any of the projects in
this case. When the projects are mutually exclusive or if capital rationing is in effect, the IRR
method may lead the firm to an incorrect selection.

d. Assuming the size of Aerocomp’s capital budget were not limited, the IRR method would accept
projects A, C, and D. Project B, with an IRR of 7.18%, nearly three percentage points less than
the cost of capital, would be rejected.

5. a. According to the NPV method, Project C, with an NPV of over $52,000, will be chosen. It will
add to the present value of the firm over $12,000. Using the IRR, Project A will be selected. In
the IRR case Project C would just be the third choice.

b. If the size of Aerocomp’s capital budget were not limited, the NPV method would accept projects
A, C, and D. Project B, with an NPV of -$63,848, would be rejected. Both the NPV and IRR
methods rejected project B because its return is less than the cost of capital.

c. Project C would be selected because of its high net present value.