center13970

Corporate Finance and Valuation

Case Study

Capital Budgeting

39528757429500

2448560698500

Koliopoulou Maria-Anna

47809151397000010/01/2018

Msc in Finance

Table of Contents

TOC o “1-3” h z u Question 1: PAGEREF _Toc502869611 h 3Question 2: PAGEREF _Toc502869612 h 3Question 3: PAGEREF _Toc502869613 h 3Question 4: PAGEREF _Toc502869614 h 3Question 5: PAGEREF _Toc502869615 h 5Question 6: PAGEREF _Toc502869616 h 5Question 7: PAGEREF _Toc502869617 h 6Question 8: PAGEREF _Toc502869618 h 6Question 9: PAGEREF _Toc502869619 h 6a. PAGEREF _Toc502869620 h 6b. PAGEREF _Toc502869621 h 7c. PAGEREF _Toc502869622 h 7

Tables

TOC h z c “Table” Table 1.1: Net Investment Outlay PAGEREF _Toc502917434 h 3Table 1.2: Non-Operating Cash Flows PAGEREF _Toc502917435 h 3Table 1.3: Projects Cash Flows (Total and Net Operating) PAGEREF _Toc502917436 h 4Table 1.4:Weigthed Average Cost of Capital PAGEREF _Toc502917437 h 4Table 1.5: Projects NPV, Payback Period, IRR, MIRR PAGEREF _Toc502917438 h 5Table 1. 6: Present Values of Cash flows for the 3 years PAGEREF _Toc502917439 h 6Table 1.7:Present Values of Cash Flows for year 2 PAGEREF _Toc502917440 h 7Table 1.8: Present Values of Cash Flows for year 1 PAGEREF _Toc502917441 h 7

Diagrams

TOC h z c “Diagram ” Diagram 1. 1: Upaward trend of Cash Flows PAGEREF _Toc502917465 h 6

Question 1:Incremental or relevant cash flows are the changes in cash flows that will occur of the project is undertaken. More specifically, are the cash flows related solely to the new project (lite tomato juice).

Incremental cash flows= Cash flows with the project- Cash flow without the project

The cash flow analysis should not include the interest expense because the discount rate that is used in WACC takes into consideration the firms cost of capital, therefore would include double counting.

Question 2:The interest in leasing that the juice producer would charge in the production site is considered opportunity cost and should be included in the calculation of NPV as a cash outflow. The amount that should be deducted is:

25.000 x (1-tax rate) = 25.000 x (1-0.30) =17.500 per year

Question 3:The investment outlays consist of investment in equipment, installation and any working capital at the end of year 0. At table 1.1.

Plant Restoration -25.000

Marketing Consultant Fee – Refundable-30.000

Used Machinery Cost -560.000

Shipping Costs -22.000

Installation Charges -55.000

?current Assets-123.000

?current Liabilities60.000

?NWC -63.000

Net operating cash flow -755.000

Table SEQ Table * ARABIC 1.1: Net Investment OutlayThe terminal cash flows are calculated based on the non-operating cash flows (that are not related to the operations of the business).

Non Operating CF Year 4

Salvage Value 85.000

Tax on Salvage Value -25.500

Recovery on NWC 98.000

net terminal Cash Flow Year 4 157.500

Table 1. SEQ Table * ARABIC 2: Non-Operating Cash FlowsQuestion 4:In the below Table 1.3, it is calculated the net cash flows of the new product. It must be mentioned that the training costs are 0.

Net Cash Flow Process Year 0 Year 1 Year 2 Year 3 Year 4

Expected sales 350.000 420.000 504.000 604.800

Revenues 875.000 1.470.000 1.764.000 2.116.800

Fixed Costs -120.000 -120.000 -144.000 -144.000

Variable Costs -385.000 -462.000 -554.400 -665.280

Insurance Costs -34.100 -34.100 -34.100 -34.100

Externalities -114.480 -161.798 -171.506 -227.246

Opportunity cost -92.000 -92.000 -92.000 -92.000

EBITDA -539.100 -616.100 -732.500 -843.380

Depreciation -210.210 -286.650 -95.550 -44.590

EBIT -80.790 313.452 672.444 909.584

Taxes 0 -94.035 -201.733 -272.875

NOPAT -80.790 219.416 470.711 636.709

Depreciation 210.210 286.650 95.550 44.590

Net OPERATING CASH Flow 129.420 506.066 566.261 681.299

Investment Outlay -755.000 – – -35.000 –

Cash Flows from Project – 129.420 506.066 566.261 681.299

Non Operating Cash Flow – – – – 157.500

Total Cash Flow -755.000 129.420 506.066 531.261 838.799

Table 1. SEQ Table * ARABIC 3: Projects Cash Flows (Total and Net Operating)After the calculation of net operating cash flows, on the Table 1.5. are presented the methods of capital budgeting NPV, IRR, payback period and MIRR.

NPV is the sum of the present values of all the expected incremental cash flows if a project is undertaken. A positive NPV is expected to increase shareholders wealth.

The payback period is defined as the number of years it takes to recover the initial cost of an investment.

The internal rate of return (IRR), is the discount rate that makes the present value of the expected incremental after-tax cash inflows just equal to the initial cost of the project.

The modified internal rate of return (MIRR) is a better measure in comparison to IRR. It is the discount rate which causes the terminal value to equal the present value of costs. The terminal value is compounded at WACC (WACC is shown on Table 1.4 and is given by the formula 1.1.

(wd) kd1-t+(we)(ke)).

WACC wd : weight average of dedt50,0%

kd : pre-tax cost of debt 10,0%

we : weight average of equity 50,0%

ke : cost of equity14,0%

t : tax rate 30,0%

WACC 10,5%

Table 1. SEQ Table * ARABIC 4:Weigthed Average Cost of Capitalmethods of capital budgeting

NPV

Year 0 Year 1 Year 2 Year 3 Year 4

PV -755.000 117.122 414.460 393.750 562.612

NPV 732.944 Payback Period

Year 0 Year 1 Year 2 Year 3 Year 4

Cash Flows -755.000 129.420 506.066 531.261 838.799

Cumulative CF -755.000 -625.580 -119.514 411.747 1.250.546

Payback period ( in years) 2,22 IRR

Year 0 Year 1 Year 2 Year 3 Year 4

Cash Flows -755.000 129.420 506.066 531.261 838.799

IRR 40,5% MIRR

Year 0 Year 1 Year 2 Year 3 Year 4

Cash Flows -755.000 129.420 506.066 531.261 838.799

FV of cash inflows 174.618 617.919 587.043 838.799

TV 2.218.379

MIRR 30,9% Table 1. SEQ Table * ARABIC 5: Projects NPV, Payback Period, IRR, MIRRQuestion 5:Qualitative factors are factors that cannot be measured. The first measure that should take into account the management is to evaluate the riskiness of the project and the research in the marketing domain. Historical data if there were available could be a good estimator of the riskiness, while a thorough and extensive research on marketing in order the product to be properly advertised.

It is also important the company not to harm the environment and to reassure the safety of its employees. This can happen by using eco-friendly machineries and production site, regardless of the financial benefits. This will help on the way the people work because the employees will respect their company.

Finally, in the dilemma of producing a low-cost product or a more expensive product. It must be noticed that a cheaper product usually has a lower quality.

Question 6:As it is shown in the Table the new product has positive cash flows with an upward trend (Diagram 1.1), so it would be irrational to end the project. If the project takes an extension all the factors of net CF would remain the same and regarding the depreciation (salvage value 85.000$) even if it goes to 0 there is no evidence that would stop working or not producing the same amounts.

Diagram 1. SEQ Diagram_ * ARABIC 1: Upaward trend of Cash FlowsQuestion 7:In a scenario of replacement revenues, costs and the change in depreciation should be noticed. Firstly, if the sales are expected to be higher, then a new calculation of the fixed costs would be ideal. Also, in case of replacement of the equipment or machine (perhaps selling the old one), the net investment outlay would decrease by after tax proceeds from the sale of the old resource. Regarding the depreciation the analysis the analysis would consist of subtracting the old depreciation from every year’s depreciation of the new asset, deducting tax from the difference between the two and adding tax savings to the net operating cash flow.

Question 8:The project cash flows are nominal because inflation is part of cost of debt and cost of equity. The PV of cash flows are real because revenues and costs do not change on year 4 due to inflation. The NPV is not biased as it is calculated by the discount rate of WACC, so it is adjusted for inflation. If it was not adjusted for inflation, NPV ‘ s value would be biased downwards because the denominator would be reduced but the numerator due to the estimation in terms of dollars wouldn’t increase.

Question 9:a.YearNet Cash FlowPv of Cash Flows End-of-year abandonment value

0 (40.000) (40.000) 40.000

1 16.800 15.273 24.800

2 16.000 13.223 16.000

3 14.000 10.518 0

Table 1. SEQ Table * ARABIC 6: Present Values of Cash flows for the 3 years*

PVIF10%, 1= 0.9091

PVIF10%, 2= 0.8264

PVIF10%, 3= 0.7513

Based on the below equation 1.1

NPVyear 3=

– 40.000 +16.800 x PVIF10%, 1+16.000x PVIF10%,2+14.000xPVIF10%,3= – 986$

b.Year Net Cash Flow Pv of Cash Flows

0 (40.000) (40.000)

1 16.800 15.273

2 32.000 26.446

Table 1. SEQ Table * ARABIC 7:Present Values of Cash Flows for year 2Based on the below equation 1.1 NPVyear 2=1.7191$

For year 1:

Year Net Cash Flow Pv of Cash Flows

0 (40.000) (40.000)

1 41.600 22.546

Table 1. SEQ Table * ARABIC 8: Present Values of Cash Flows for year 1Based on the below equation 1.1 NPVyear 1= – 2.181$

c.A positive NPV is expected to increase shareholder wealth, while a negative to decrease. The optimal period to keep the truck is 2 years as it has a positive NPV and will be added 1.719$. On years 1 and 3 NPV;0, which indicates that the value would be decreased.