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Case Study I: Dinsmore Artists International (19 points)…
Case Study I: Dinsmore Artists International (19 points)
Dinsmore Artists International is in the business of managing singers and other artists in the entertainment industry. It is considering the purchase of an executive jet plane to transport its executives and the artists it represents to various meetings and performance sites. It expects that by owning its own executive jet, it can save $1,400,000 the first year of operation for expenses that it would otherwise incur for buying seats on commercial flights or for chartering flights. It expects that the year-to-year growth in the annual savings would be 10%.
The choice has narrowed down to two planes: the Aero Commander and the Super Eagle. Both provide the same savings and the same basic service (e.g., the same passenger and luggage capacity, flight speed, and maximum altitude of operation).
The Aero Commander jet sells for $4,500,000. Its normal operating expenses would be $290,000 the first year and would increase 8% per year thereafter. In addition, there would be a cost of $350,000 for a major engine overhaul at the end of the third year. Treat the overhaul cost as an operating expense. The cabin noise level in the Aero Commander is lower than in the Super Eagle, and its seats are somewhat more comfortable.
The Super Eagle jet sells for $3,950,000. Its normal operating expenses would be $325,000 the first year and would increase 8% per year thereafter. In addition, there would be major engine overhauls at the end of the second and fourth years, each of which would cost $300,000. Treat the overhaul costs as operating expenses.
Dinsmore uses a WACC or discount rate of 10% and a reinvestment rate of 9% to evaluate its investments in fixed assets. Tax rates are 38% for regular income and 25% for capital gains or losses.
The jet purchased would be paid for and put into service during the first quarter of Dinsmore’s financial year. It would be depreciated according to the appropriate MACRS schedule from (i.e., 7-year life with first-quarter convention).
Dinsmore expects to sell whichever plane it chooses at the end of the fifth year for 20% of its purchase price.
What is the NPV, IRR, and modified internal rate of return associated with each of the two jet planes? Based on these values, what action do you recommend Dinsmore to take?
2. What non-financial information should Dinsmore take into consideration before making its final decision? Why might the information be important in Dinsmore’s decision? How might this information change the decision in part 1?
Case Study II: How Expensive a Home Can You Afford to Buy (18 points)
Lenders generally allow clients to borrow as much as they believe borrowers can afford, based on their income, debts, and credit history. When deciding whether or not a potential buyer qualifies for a first mortgage on a home, lenders usually look at two ratios, called the front-end and the back-end ratios,. Each ratio generally produces a different home price that a buyer can afford. The maximum home price a buyer can afford is the lesser of the two affordable home prices produced by the two ratios.
? The front-end ratio is the monthly cost of ownership, which includes the monthly payments on the mortgage (principal plus interest), taxes, insurance, and any home-owners association dues, as a percentage of the buyer’s monthly income. Lenders used to limit front-end ratios up to 33 percent, but later they allowed up to 40 percent.
? The back-end ratio is the sum of the monthly cost of ownership (as in part a) plus other debt payments, such as loans for cars, furniture, and home appliances, as a percentage of the buyer’s monthly income. Lenders used to limit back-end ratios up to 36 percent, but later they allowed up to 42 percent (and sometimes higher).
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Marilyn and Paul Jones are potential first-time home owners. Their combined annual income is $115,000. They are making $510 monthly payments on a 3-year old car and $90 monthly payments for the furniture they have had in the apartment they have rented for the past two years. They have saved enough money to make a down payment of $90,000 on the purchase of a home.
The annual cost of home ownership and liability insurance would be 0.5% of the selling price of the home, and the annual taxes would be 1% of the selling price of the home. The lender will charge an annual interest rate of 6% on a conventional 30-year first mortgage.
a. Using the guide lines above, what is the maximum mortgage and home price Marilyn and Paul can afford? Include both a front-end and back-end analysis side-by-side on a single worksheet. Use maximum allowable values of 40% for the front-end ratio and 42% for the back-end ratio. Show all input data and all calculations or results. Use an IF statement to identify the maximum mortgage and home price Marilyn and Paul can afford.
b. Suppose Marilyn and Paul used $10,000 to pay off the entire balance of their car and furniture loans, thereby reducing their home down payment to $80,000. How would this change the maximum mortgage and home price they can afford?
Case Study III: Northwest Property Management (18 points)
Norwest Property Management (NPM) was founded in 1987 by Henri Rouark. Mr. Rouark had arrived from France several years earlier and had worked in an uncle’s hotel in San Francisco, where he obtained a firsthand background in property management. Wishing to be his own boss, he founded his own company, Norwest Property Management.
NPM provides management services to homeowners in popular resort areas. The company contracts with home owners to rent their properties to vacationers during times when the homeowners will not be using their homes. The company charges the homeowners a percentage of the rent as their fee, and the homeowner receives the difference between the rent paid and NPM’s fee.
In return for the fee, Mr. Rouark and his staff make all arrangements with the renters and collects rents from them. The company arranges for cleaning the property after renters leave. For an additional fee, at a homeowner’s option, NPM will also provide maintenance services.
Under Mr. Rouark’s direction, the company has signed contracts with many owners of second homes in the Lake Tahoe, Russian River, and Grass Valley areas of Northern California; in the areas around Klamath Falls and Bend, Oregon; and on the island of Oahu, Hawaii.
NPM has done an excellent job for both homeowners and renters, and the company has prospered as a result. NPM’s annual receipts (in millions of dollars) have grown as follows during the past 8 years:
Year 1997 1996 1995 1994 1993 1992 1991 1990
Receipts ($ million) 74.4 57.1 44.3 33.2 25.3 19.8 15.8 12.6
In March 1998, Mr. Rouark was approached by Ms. Isabel Monroe, representing Goliath Home Services (GHS), about buying NPM. GHS is a successful company that provides similar services in Southern California, Nevada, and Arizona and wants to expand further. The company is well financed and is somewhat larger than NPM. Rouark is receptive to the idea of selling his company, provided he can get a good price for it.
Both parties recognize that Rouark’s company is well based and positioned to continue to grow in the future. In fact, GHS’s interest is based not only on NPM’s financial track record since 1990 but also on NPM’s future potential. Therefore, in order to help provide a basis for negotiating a fair purchase price, Monroe has projected the NPM’s annual receipts to the end of the current year and the next two that is, to the ends of 1998, 1999, and 2000. In order to be objective and avoid personal bias, Monroe did this by using linear regression analysis.
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a. Evaluate the coefficients of a linear regression equation (i.e., the intercept and slope) for projecting the trend of NPM’s annual receipts for 1990 to 1997. Provide a complete specification for the linear regression model. The specification should include the equation of the model, with the values for the intercept and slope determined from the data, and a definition of the model’s dependent and independent variables. Also include the model’s standard error of estimate.
b. Evaluate the coefficient of correlation for the linear regression model.
c. Use the linear regression model determined in part (a) to forecast NPM’s annual receipts for 1998, 1999, and 2000.
