In Class Solutions Afm

Lecture: Capital Budgeting

Example 1

You are evaluating a new project and you have estimated the following cash flows:

• Year 0:        CF = -165,000
• Year 1:        CF = 63,120
• Year 2:        CF = 70,800
• Year 3:        CF = 91,080

• Your required return for investments of this risk is 12%.

1. Calculate the NPV and the IRR of this project.  Do we accept or reject the project based on the NPV rule? IRR rule?
2. Payback method: Assume that we will accept the project if it pays back within two years. Do we accept or reject the project?

Solution:

1. See excel file on blackboard

Year 1: 165,000 – 63,120 = 101,880 still to recover

Year 2: 101,880 – 70,800 = 31,080 still to recover

Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3

The payback period is year 3 if you assume that the cash flows occur at the end of the year as we do with all of the other decision rules. If we assume that the cash flows occur evenly throughout the year, then the project pays back in 2.34 years. So the payback method with 2-year cutoff will result in a rejection of the project.

Example 2

Jordan, Inc. is considering a proposal to manufacture high-protein milkshakes. The project would use an existing warehouse, which is currently rented by another firm.  The next year's rental charge on the warehouse is $100,000, and will remain at that level each year.  You can assume that the warehouse would be rented out again starting in year 5.  

In addition to using the warehouse, the proposal envisages an investment in plant & equipment of $1.2 million. This could be depreciated for tax purposes straight-line to zero over 10 years.  However, Jordan, Inc. expects to terminate the project at the end of four years and to resell the plant and equipment in year 4 for $700,000.  

Finally, the project requires an initial investment of net working capital of $350,000.  Thereafter, net working capital is forecast to be 10% of sales in each of years 1 through 4.

 Sales of the high-protein milkshakes are expected to be $4 million in each of the four years of the project’s life.  Manufacturing costs are expected to be 85% of sales, and profits are subject to corporate tax of 35%.  The appropriate weighted average cost of capital for the life of this project is 12%.  What is the NPV today of Jordan, Inc.'s proposed idea?

Solution: Excel spreadsheet on blackboard.

Lecture: Valuation (DCF, WACC, Flows to Equity)

Example 1: Spreadsheet on blackboard

Example 2:

Goodyear is thinking of divesting one of the plants. The plant will generate FCF of $3.8m at the end of the first year and the cash flows will grow at 3% forever. The plant is financed with a D/V of 0.5 which is expected to remain constant. Goodyear has an equity cost of capital of 10% and a debt cost of capital of 6% and a marginal tax rate of 40%. If the plant has an average risk similar to the whole firm, value the plant using the WACC method.

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