Question

Problem #4 - ANALYTICAL THINKING: Dillon Hall, Inc. (DHI) operates a warehousing business that operates in the southern USA. It warehouses temperature sensitive inventory for its customers. The inventory that it warehouses must be kept in climate controlled environments to prevent spoiling or damage. The HVAC unit at DHI’s Virginia facility is at the end of its duty cycle and must be replaced or its highly profitable Virginia warehouse must be shut down. Because of rigid climate controlled specifications, DHI must install one of two HVAC options that meet its climate control specifications. The installation of either HVAC unit will allow DHI to maintain contracts with existing customers. The installation of a new HVAC unit will not cause DHI’s revenues to increase or decrease, so DHI faces a capital budgeting decision that consists of choosing a unit that has the least lifetime cost to DHI.

OPTION ONE is a “capital intensive HVAC unit” that has a high up-front cost, but low yearly operating costs.

OPTION TWO is an “operating intensive HVAC unit” that has a lower up-front cost, but higher yearly operating costs.

DHI expects both HVAC units to have operating lives of 5 years.

DHI’s weighted average cost of capital (WACC) is 7%.

Relevant HVAC cash flows appear below:

Year                                                                    0                          1                             2                        3                       4                         5

AFTER-TAX CASH FLOWS:                        |------------------|------------------|------------------|------------------|------------------|

Capital intensive HVAC unit            ($600,000)      ($50,000)          ($50,000)         ($50,000)         ($50,000)         ($50,000)

Operating intensive HVAC unit      ($100,000)    ($175,000)        ($175,000)       ($175,000)      ($175,000)       ($175,000)

TASKS: Please -

Calculate and interpret the “net present value” (NPV) capital budgeting metric for each of the HVAC units. Document TVM calculations and keystrokes.

Write “management recommendation memo” that explains your logic about the HVAC unit you would recommend.

If DHI’s controller asked you to calculate the IRRs and MIRRs of the two projects, what message would you deliver about the use of IRRs and MIRRs in this case?

Suppose that DHI’s WACC rose to 15%. Provide TVM calculations and a new “management recommendation memo” that indicates your recommendation and the logic behind your recommendation.

Answer 1

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