Questions:

1.
Develop operating cash flow forecasts for the relevant lives of each type of
tanning equipment using 100% (Best Case), 80% (Most Likely Case), and 50%
(Worst Case) occupancy estimates for each tanning option. Assume straight line
depreciation and a tax rate of 30%.
Refer to Excel Sheet
2.
Calculate and comment upon the accounting, cash, and financial break-even
sales for the dome unit and the tanning bed unit respectively.
Refer to the Excel sheets for calculations. Both projects are profitable, but the
tanning beds pay for themselves in a shorter amount of time. The tanning beds also
have a higher IRR than the dome does. So at first glance we would probably opt for
the beds over the dome. But waittheres more later on.
3.
Calculate the net present value, payback period, and the traditional IRR for
each tanning option under the various scenarios. What do the decision rules
indicate?
See the Excel sheets for the calculations. The IRR is high so both projects are
profitable and acceptable.
4.
Can Patsy evaluate this business decision project by assuming just a one-time
purchase? Why or why not? What other evaluation methods should Patsy use?
As, this project involves a capital expenditure and that means the use of capital
budgeting techniques, it should not go for this.
Typically, investment decisions are known as capital expenditure decisions. The
investment decisions include expansion, acquisition, modernization and
replacement of long-term assets. Capital budgeting has following characteristics:
1. The exchange of current funds for future benefits;
2. The funds are invested in long-term assets;
3. The future benefits will occur to the firm over a series of years.
Now the criteria used to select a Capital Budgeting project are:
1. Maximizes shareholders wealth;
2. Must consider ALL cash flows in order to determine the actual profitability of
the project;
3. Should provide an objective and unambiguous way of separating good
projects from bad;
4. It should help rank projects according to their actual profitability;

5. It should recognize the fact that bigger cash flows are preferable to smaller
ones (and early cash flows are preferable to later ones);
6. Help choose among exclusive projects which project maximizes the
shareholders wealth;
7. It should be a criterion, which applies to any investment project that is
independent of others.
Traditionally the most important concept of evaluating investments is the NPV. NPV
is the difference between an investments market value and its cost. After all, only
a good investments make money (so we need a positive NPV). Projects can be
ranked from the highest NPV to the lowest in order to determine profitability. This
quantitative ranking is used because it factors in the time value of money (and its
more accurate breakdown of value). The IRR is the next best alternative to the NPV.
The IRR is the discount rate that makes an investments NPV zero. An investment
should be accepted if it is higher than the required return and rejected if it is lower.
A word of caution: the IRR can be a problem if cash flows are unconventional, or
when there are multiple projects to compare. The IRR can be misleading and not
provide the actual best investment. With mutually exclusive investment decisions,
it is best to choose the one with the largest NPV not necessarily the one with the
largest IRR.
The payback rule is how long it takes to recover the initial investment. The
Profitability Index is calculated by dividing the present value of an investments
future cash flow divided by its initial cost. The Profitability Index is directly related to
the NPV because if the NPV is positive, then the payback will be over 1.00.
The decision rules are pretty simple to go by. Accept the project if the following
circumstances:

If the NPV is positive

If the IRR is more than the cost of capital

If the discounted payback is less than our targeted discount payback period

If payback period is less than our targeted payback period

If Profitability Index is more than 1.00

5.
If you decide to use the replacement chain method, how do the calculation
and decision change?
Calculating NPV for projects with different life spans can lead to incorrect
decisions that is unless adjustments are made. Two ways to overcome this are
the Replacement Chain Method and the Equivalent Annual Annuity Method.

The Replacement Chain Method requires a common life span be found for the
projects under consideration. This is similar to finding the common denominator
when using fractions.
Two projects, one with a 3 year life span and one with a 5 year life span would be
common at 15 years. If we assume that each project can be repeated, we repeat
the cost-benefit flows for each. For the 3 year project the stream is repeated 5
times; for the 5 year project the stream is repeated 3 times. So if the NPV of the
3 year project is 2,500 and the five year is 2,750 the we look at the new,
extended NPVs. The 3 year, 2,500 NPV becomes 2,500 * 5 = 12,500. The 5 year,
2,750 NPV becomes 2,750 * 3 = 8,250.
See, the result is two projects each with fifteen year useful lives and we can see
them on an even playing field. The most common mistake when calculating the
Replacement Chain Method is not repeating the initial cash outflow. Oh, and this
method can be a pain if multiple projects of different life spans must be
compared. If that is the case then use the Equivalent Annual Annuity method.
In this scenario, the common life span is 40 years because one project is good
for 5 years and the other is good for 8 years. Nowhere along the numerical
spectrum do these two intersect until 40, so 40 years it is.
Now we assume each project can be repeated and so we repeat the stream of
cost-benefit flows that each generates. For Project Dome Unit we repeat it 5
times; for the Tanning Beds we repeat it 8 times.
Using the worst case scenario (that would be 50% capacity) we see the
following:
Dome Unit is 43,738 * 5 = $218,690
Tanning Beds are 22,834 * 8 = $182,672
6.
What are some externalities, side effects, and other relevant issues that could
affect the decision?
These potential fixed costs and will affect the calculations: additional
advertisement costs, space, or overhead costs. Add to these any change is
business, such as customers preferring a different tanning method, more oil per
session, longer sessions, etc. can force adjustments to be made.
7.

Based upon your analysis which of the two units is Too Hot To Handle? Why?
The dome unit.
Why? Thats not so easy since there are many ways to analyze investments. But
most experts will agree that the NPV is the Big Kahuna. Remember, it is the
difference between an investments market value and its cost and only a good
investment makes money. This quantitative ranking method is the best to use

due to its consideration of the time value of money and it is a more accurate
breakdown of value.
We also used the IRR; remember it is the next closest alternative to the NPV
calculations. The IRR is the discount rate that makes the investments NPV zero.
An investment should be accepted if it is higher than the required return. The
IRR can be a problem if cash flows are not conventional or when in this case with
eight projects to compare, the IRR can be misleading and not provide the actual
best investment. With mutually exclusive investment decisions, it is best to
choose the one with the largest NPV not necessarily the one with the largest IRR.
We also talked about the payback rule (how long it takes to recover the initial
investment). This rule does not involve discounting and so the time value of
money is disregarded and it does not factor in risk differences.
Using the methods described, the dome project is the best project to venture into
and will provide the largest financial growth.