Review Case 9.32 in your textbook. Using the questions provided as a guide, explain what you would do if you were Amy in this situation.
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9.32 (LO 3) Net present value, ethics (adapted from Roland L. Madison, “Should Finance Make the Numbers ’Come Out’,” Strategic Finance, 86, no. 10 (April 2005): 17–18.) Amy Kimbell, CPA, CMA, and a member of the Institute of Management Accountants, recently joined Magee Metals and Moldings as a senior financial analyst. One of her major responsibilities is to prepare data to support capital equipment purchases.
Magee is trying to expand its international operations. The company is currently spending $275,000 each year on international travel, an amount that is expected to increase by 20% each year for the next four years and then level off. Since none of Magee’s current fleet of corporate jets has the range to fly internationally, Magee’s CFO, Tony Smith, recently asked Amy to run some numbers on the purchase of a new corporate jet with an international range.
Amy determined that the jet upper managers want to buy has a purchase price of $15 million and a useful life of 15 years. Variable operating costs are an estimated $220,000 per year, based on a projected usage of 400 hours per year. Fixed operating costs are estimated at $375,000 per year, not including depreciation. When Magee employees aren’t using the company’s jets, they are rented to other parties at a rate of $3,500 per hour. Based on existing rental requests, Amy estimated that the new jet would be rented for 500 hours each year.
Using Magee’s 12% discount rate, Amy calculated the net present value of the new jet purchase to be at most ($6,000,000). She knew there was no way the capital budget committee would approve a purchase with such a large negative net present value. When she presented her analysis to Tony, he responded. “Go back and check your work. When I ran the preliminary numbers, I found a positive net present value. You must have made a mistake.” Tony suggested that she increase the useful life of the jet to 25 years, raise the salvage value by 25%, and increase the rental usage by 50%.
Amy did some additional research and determined through discussions with the jet’s manufacturer that her original salvage value and estimated life were aggressive, but realistic. In fact, if the jet were used for 25 years, it would require a multimillion-dollar overhaul in year 15 to remain flightworthy. Beginning in year 11, operating costs would increase by 30%. With this new information, Amy reworked her analysis and obtained an even larger negative net present value.
When Tony saw the revised numbers, he blew up. “I told you what to do with the numbers and you did something else. Now go back and do what I said. And have the correct analysis back to me by the end of the day.”
Amy returned to her office slowly, thinking about what Tony was telling her to do. She had been at Magee for only a month and really liked her job. In fact, she was looking forward to a long career at Magee.
Required
1.
a. Should Amy make the changes Tony has requested, noting in her analysis that the
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