In the good of days—before cable TV, fax machines, and multimedia personal computers—the phrase,”…and now a word from our sponsor…”usually meant just that, Television commercials were continued to thirty-and sixty—second messages, grouped together to occupy only two or three minutes of viewing time. Occasionally, if you stayed up late enough sitting in front of the tube, you’d see thirty minute segments on riveting topics like “How to Turn $10 Into$10 Million by Investing in Real Estate That Nobody Wants.” Since few people—except for a few former savings and loan executives–managed to stay awake through these half-hour programs, the shows attracted little interest.
The era of the infomercial, those thirty-minute paid video advertisements devoted to selling a particular idea or product, didn’t really begin until after the 1992 presidential campaign. Following Ross Perot’s unsuccessful bid for public office, however, things started looking up for this new marketing venue. If Perot could use the half-hour segments on late night TV to capture l 9 percent of the popular vote, surely other advertisers could use the infomercial as a way to communicate their message to a sleepy, yet receptive, audience.
Indeed, in the wake of the election, many Fortune-500 corporations selling consumer products were eager to take the plunge and go head-to-head with Letterman on late-night TV. Unfortunately, obtaining exclusive airtime and marketing rights in multiple television markets on the same night was a distribution nightmare. Traditional advertising agencies that purchased large blocks of television time bought it during prime viewing hours. In contrast, 1ate-night time was sold by individual stations to local advertisers on a spot basis. Consequently, nationwide distribution of corporate infomercials could be almost impossible.
Fortunately, the free enterprise system specializes in impossible situations In late 1992, sensing a new business opportunity, Infomercial Entertainment, lnc.(IEI) was chartered to Corral local late—night television time, and serve as a contract distribution agent for corporate clients seeking to air thing, minute infomercials throughout the United States. While IEI originally set out to be a distribution agent for late-night TV time, the firm soon realized that many medium—sized corporate advertisers lacked the production and duplication equipment necessary to produce multiple copies of their infomercial messages.
Sensing a new opportunity to expand their business, IEI’s management team sought to provide video production and duplication services for their customers. Through the careful purchase of used video equipment from a bankrupt motion picture studio in l993, IEI could acquire the necessary electronics and video hardware for $200, 000, plus a $25,000 charge for installation and delivery of the equipment. This equipment would be depreciated according to the MACRS schedule for Six-year property shown in Table l.
IEI’s managers believed they could mass-produce infomercial videos and offer them to corporate clients for$10 each. In 1993 the firm forecast total volume of 5,000 infomercial videos, and estimated the materials cost of production at 50 percent of the net sales price, Labor and overhead expenses would amount to an additional 12 percent of the unit selling price. The firm expected sales to grow at a constant 5 percent annually over the next ten years, at which time the newly acquired video equipment would be worn-out, Finally, IEI would require an additional investment in working capital totaling $l0, 000 to support the initial sales increase promised by the Infomercial project,
While IEI was interested in expanding its production operations, the firm also realized that acquisition of the video equipment would give it the added opportunity and capacity to produce corporate training videos for commercial clients, IEI’s managers believed they could produce 875 different training films in 1993, and that clients would order, on average, five copies of each film. The firm believed that demand for its training videos would grow at 7 percent annually over the next 10 years, Each training video would carry a net price of $8 per copy, production and materials costs would total 43 percent of this selling price, and overhead expenses would average 10 percent of the unit selling price, IEI would require an additional $5,000 investment in working capital to support the Training Video project.
After a ten-year service life, IEI could sell its video equipment for a nominal $20, 000. The firm’s after-tax weigh led average cost of capital is10 percent, and the video production projects–including both infomercials and training films—are considered to be only slightly more risky than the firm’s current business ventures IEI’s marginal tax rate is 35 percent, and the firm’s financial statement forecast shows that production costs, and overhead expenses will maintain a constant relationship with sales over the next 10 years.
1. What are the annual net cash flows associated with(a)the Infomercial project,(b)the Training Video project, and(c)the Combined project(i.e., the combination of the Infomercial and Training Video projects)?
2. Use the undiscounted payback method to rank order the three capital budgeting alternatives facing IEI. Based on this ranking, should the firm pursue (a) the Infomercial project, (b) the Training Video project or(c) the combined project? Why? In your answer, assume that IEI’s longest acceptable payback period is 4 years.
*3. Examine the payback periods you obtained for (a) the Infomercial project, and (b) the Training Video project. Notice that when the analyst rounds the payback Period for these projects to the nearest year, it is impossible to rank-order them. Why is this case? Can you think of a method involving the undiscounted payback technique that might permit a mole precise determination of these Projects’ payback periods? If so, describe this method, and use it to rank-order the three investment alternatives facing IEI.
4. Review your answer to Question 3. In order to incorporate fractional-year time periods within the payback homework, you made an important assumption about the timing of cash flows associated with each of these three projects. What is this assumption, and why is it dangerous to make such an assumption in most capital budgeting circumstances? 5. Now use the net present value methodology to evaluate the three capital budgeting alternatives facing IEI. Based on this evaluation, should the firm pursue (a) the Infomercial project, (b) the Training Video project, or (c) the combined project? Why?
6., as a final evaluation of the three capital budgeting alternatives facing IEI, use the internal rate of return methodology to rank-order these projects. Based on this evaluation, should the firm pursue (a) the Infomercial project,(b)the Training Video project, or(c) the Combined project? Why?
*7. Given your Knowledge of the shortcomings of the IRR methodology, is it accurate to use this method to evaluate the project alternatives facing IEI? Be sure to provide the necessary evidence to supping your answer
8. Review your answers to Questions 2, 5, and 6. Compare the manner in which (1) the undiscounted payback method,(b) the net present value method, and (c) the IRR method rank-ordered the three investment alternatives facing IEI. Based on this comparison, does any particular method of capital project evaluation seem superior to the other two? Why or why not? In general terms, is it possible to suggest that any of the three methods is superior to the other two? Why or why not?
*9. The case reports that both the infomercial project and the Training Video project are considered slightly more risky than IEI’s current business ventures. Suppose that this was not the case, and that the Training Video project exhibits substantially greater uncertainty than either the Infomercial project or IEI’S other business ventures. Describe how you would incorporate this change within the framework of the capital budgeting analysis using(a)t11e net present value procedure, and (b)the IRR procedure,
*10. Given the information provided in Question 9 and your response to this question, use the NPV and IRR methods to reevaluate (a) the Infomercial project,(b)the Training Video project, and(c)the Combined project. How does the NPV of each project change when the risk 1evel of the Training Video project is substantially greater than the riskiness of the infomercial project? How does the IRR change in this circumstance? Based on your revised capital budgeting analysis, which project should IEI select? Why?
Note: “*” means more Challenge Questions and are only optional for your solution.