In Class Solutions AfmLecture: Capital BudgetingExample 1You are evaluating a new project and you have estimated the following cash flows:Year 0: CF = -165,000Year 1: CF = 63,120Year 2: CF = 70,800Year 3: CF = 91,080Your required return for investments of this risk is 12%. Calculate the NPV and the IRR of this project. Do we accept or reject the project based on the NPV rule? IRR rule?Payback method: Assume that we will accept the project if it pays back within two years. Do we accept or reject the project?Solution:See excel file on blackboardYear 1: 165,000 – 63,120 = 101,880 still to recoverYear 2: 101,880 – 70,800 = 31,080 still to recoverYear 3: 31,080 – 91,080 = -60,000 project pays back in year 3The 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 2Jordan, 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 years 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 blackboardExample 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.
The company does not have any equity debt and doesn’t seek the cash flow guarantee of a $1.2 million equity stake. (If at all possible, one of the options provided as part of its proposal would be a $30,000-per-share. This would be a far less stringent set of circumstances to provide a financial or cash flow guarantee.) It is possible this may not make as much, as the company has no equity financing, but I believe it is the cheapest option, so I will leave this for another week. The WACC model has some interesting implications for projects like this. For instance, the proposed farm would likely be a 2nd generation, three-year property. It could possibly be able to pay out over 150 million dollars in financing with the proposed plan
The proposal to take these plans to market:
• The $2 million loan is secured by cash and would give the company a 25% return on equity (not to mention the 10% gain from the 2 percent interest payment off a $100 million debt).
• There could be a 50% return for the first 6 months, as an additional 10% interest will be paid on the loans during the next 12 months, as well as the cost of operations, but they could change, depending on the length of time the company provides funding. The initial payment will cost a dollar, but will rise as the program matures. A total payment of $30 million is recommended and would be used to purchase the equipment, hire staff and run a large operation, rather than just for 10% interest.
• The loan is secured by a 20% cash-only payment that covers an average of 75% of its total cost, and it would be paid back once a $2 million loan is paid back (I think it is quite attractive to take our first $1 million payment on to the market). It also would be offered over 1,300 units of equipment, and a fully operational WACC to be developed of its own if it were to be sold to Walmart Inc or other competitors.
But where the companies offer the bulk of their funding to those who want new products, and want to do that, there is little or no control over which parts of that financing will be available.