Question

Katie Burns was recently hired as a cost analyst by WellCare Medical Supplies, Inc. One of Katie’s first assignments was to perform a net present value analysis for a new warehouse. Katie performed the analysis and calculated a present value index of 0.75. The plant manager, Samuel McHenry, is very intent on purchasing the warehouse because he believes that more storage space is needed. Samuel asks Katie into his office and the following conversation takes place: Samuel: Katie, you’re new here, aren’t you? Katie: Yes, sir. Samuel: Well, Katie, I’m not at all pleased with the capital investment analysis that you performed on this new warehouse. I need the warehouse for my production. If I don’t get it, where am I going to place our output? Katie: Hopefully with the customer, sir. Samuel: Now don’t get smart with me. Katie: No, really, I wasn’t trying to be disrespectful. My analysis does not support constructing a new warehouse. The numbers don’t lie; the warehouse does not meet our investment return targets. In fact, it seems to me that purchasing a warehouse does not add much value to the business. We need to be producing product to satisfy customer orders, not to fill a warehouse. Samuel: Listen, you need to understand something. J The headquarters people will not allow me to build the warehouse if the numbers don’t add up. You know as well as I that many assumptions go into your net present value analysis. Why don’t you relax some of your assumptions so that the financial savings will offset the cost? Katie: I’m willing to discuss my assumptions with you. Maybe I overlooked something. Samuel: Here’s what I want you to do. I see in your analysis that you don’t project greater sales as a result of the warehouse. It seems to me, if we can store more goods, then we will have more to sell. Thus, logically, a larger warehouse translates into more sales. If you incorporate this into your analysis, I think you’ll see that the numbers will work out. Why don’t you work it through and come back with a new analysis. I’m really counting on you on this one. Let’s get off to a good start together and see if we can get this project accepted. Required: What is your advice to Katie? Is Samuel correct in his assumptions? Be specific in your discussion.

Answer 1

As Samule Said, If there is Increase in Sales due to Construction of Whare house , the project will have have High Present Value Index.

Normally we accept the projects which having PV Index of >1.. As this Project has PV Index of 0.75 which is less than 1

PV of Index = NPV of the Project + Initial Investment / Initial Investment

So, if Slaes are incresed due to New Warehouse , NPV of the Project will go high and it has High PV Index

But , the Assumptions seems to be wrong, since Large Warehouse don't lead to High Sales at the same time it will lead to high cost of Storage if Products are not sold

So, Samul Asumption is Wrong and Katies Decison is Acceptable

Final Conslusion is that Construction of Warehouse is Not Viable