Question

8-37 A firm must decide which of three alternatives to adopt to expand its capacity. The firm wishes a min- imum annual profit of 20% of the initial cost of each separable increment of investment. Any money not invested in capacity expansion can be invested elsewhere for an annual yield of 20% of initial cost. Alt. A B Initial Cost $100,000 300,000 500,000 Annual Profit $30,000 66,000 80,000 Profit Rate 30% 22% 16% Which alternative should be selected? Use a challenger-defender rate of return analysis.

Answer 1

The Firm wishes a minimum annual profit of 20% of the initial cost of each increment of investment. Alternative C will not be considered because it is yielding 16% of profit on initial cost.

The first alternative is called Defender.

The next higher investment cost alternative is called the challenger.

Incremental cash flow in B = Challenger investment - Defender investment = $300,000-$100,000 = $200,000

Incremental Profit in B = $66,000-$30,000 = $36,000

Incremental Return in B = $36,000/$200,000 = 18%

Profit rate in Alternative A is 30%. Incremental investment in B rather than A generates return of 18%, which is not acceptable. Alternative B yielding 22% can be considered on B-A increment. But B-A increment is yielding 18%, hence unacceptable.

Thus the best alternative would be $100,000 in A and balance $200,000 elsewhere for an annual yield of 20% on initial cost. It will produce return of $70,000 higher than B which will produce $66,000.