Growth Enterprise , Inc. (GEI) Project A.
B.
C.
D.
Type of cash flow Investment Revenue Operating expense Lifespan Depreciation Free Cash Flow Investment Revenue Operating expense Lifespan Depreciation Free Cash Flow Investment Revenue Operating expense Lifespan Depreciation Free Cash Flow Investment Revenue Operating expense Lifespan Depreciation Free Cash Flow
Year 0 Year 1 -$10,000 0 0 1
-$10,000 0 0 2
-$10,000 0 0 3
-$10,000 0 0 3
Year 2
Year 3
0 $21,000 $11,000
0 0 0
0 0 0
$10,000 $10,000 0 $15,000 $5,833
0 $17,000 $7,833
0 0 0
$5,000 $7,500 0 $10,000 $5,555
$5,000 $7,500 0 $11,000 $4,889
0 $30,000 $15,555
$3,333 $4,000 0 $30,000 $15,555
$3,333 $5,000 0 $10,000 $5,555
$3,333 $10,000 0 $5,000 $2,222
$3,333 $10,000
$3,333 $4,000
$3,333 $3,000
1-a). Calculate Payback of each project and rank the four projects in order of preference based on payback approach ( Project Initial Outlay A Outstandin B Outstandin C Outstandin D Outstandin
-10000 -10000 -10000 -10000
Year 1 Year 2 $10,000 $0 $7,500 -$2,500 $4,000 -$6,000 $10,000 $0
Payback Period 1
Year 3 $0 $0 $7,500 $5,000 $5,000 -$1,000 $4,000 $4,001
$0 $0 $0 $5,000 $10,000 $9,001 $3,000 $7,001
0.33
1.33
0.10
2.1 1
Payback period is 1 year for project A, 1.33 years for project B, 2.1 years for project C and 1 year for project D
1-b). Calculate IRR of each project and rank the four projects in order of preference based on IRR (2 points). A Initial Outl Year 1 Year 2
B -$10,000 $10,000 $0
C -$10,000 $7,500 $7,500
D -$10,000 $4,000 $5,000
-$10,000 $10,000 $4,000
Year 3 IRR
$0 0.00%
$0 31.88%
$10,000 33.53%
$3,000 42.75%
1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the projects in order of preference A Year 0 Year 1 Year 2 Year 3 NPV
B -$10,000 $10,000 $0 $0 -$909.09
C -$10,000 $7,500 $7,500 $0 $3,016.88
D -$10,000 $4,000 $5,000 $10,000 $5,282.24
-$10,000 $10,000 $4,000 $3,000 $4,651.32
1-d). If the projects are independent of each other, which should be accepted? If they are mutually exclusive, which on If the projects are independent of each other, projects B, C, and D should be accepted because they have a positive IRR and NPV that is greater than the cost of capital. If the projects are mutually exclusive and only one can be accepted, Project D should be accepted because it has the highest IRR, shortest payback time, and second-highest NPV, just behind project C.
ased on payback approach (1 point). Payback Period years years years years
1 year for project D
on IRR (2 points).
ojects in order of preference (2 points)
mutually exclusive, which one is best? Explain why. (1 point)
ause they have a
ccepted because it C.
Electronics Unlimited (EU) Sales Year 1 Year 2 Year 3 Year 4 Year 5 Cost of Sales SGA Expenses Tax Rate New Specialized Equipment Net Working Capital Introductory expenses Year 1 Life of equipment
$10,000,000 $13,000,000 $13,000,000 $8,667,000 $4,333,000 60% of sales 23.50% of sales 40% $500,000 27% of sales $200,000 5 years
2-a) Estimate the new product's cash flows (3 points) Year Sales Cost of Sales SGA Expense Depreciation Introductory Expense Income before tax Tax Net Income Operating Cash Flow Working Capital Change in Working Capital Equipment Total cash flows
0
$2,700,000 -$2,700,000 -$500,000 -$3,200,000
1 $10,000,000 $6,000,000 $2,350,000 $100,000 $200,000 $1,350,000 $540,000 $810,000 $910,000 $3,510,000 -$810,000
2 $13,000,000 $7,800,000 $3,055,000 $100,000
$100,000
$1,327,000
$2,045,000 $818,000 $1,227,000 $1,327,000 $3,510,000 $0
2-b) Assuming a 20% cost of capital, what is the product’s net present value? What is its internal rate of return? Shoul Cost Free Cash Flow Year 1 Year 2 Year 3 Year 4 Year 5 Cost of Capital Net Present Value IRR
-$3,200,000 $100,000 $1,327,000 $2,496,910 $2,068,213 $1,638,877 20% $905,862.19 29.55%
EU should introduce the new product because the NPV is positive and the IRR is greater than the cost of capital. The NPV means that the project generates a surplus after all costs, including financing costs. The IRR of 29.55% is higher 20% cost of capital implying that the rate of return on the project is more than the desired rate.
3 $13,000,000 $7,800,000 $3,055,000 $100,000
4 $8,667,000 $5,200,200 $2,036,745 $100,000
5 $4,333,000 $2,599,800 $1,018,255 $100,000
$2,045,000 $818,000 $1,227,000 $1,327,000 $2,340,090 $1,169,910
$1,330,055 $532,022 $798,033 $898,033 $1,169,910 $1,170,180
$614,945 $245,978 $368,967 $468,967 Net income + depreciation $0 $1,169,910 Working capital recovered
$2,496,910
$2,068,213
$1,638,877
s its internal rate of return? Should EU introduce the new product? Explain why? (2 points).
ater than the cost of capital. The positive osts. The IRR of 29.55% is higher than the sired rate.
Value-Added Industries, Inc. (VAI) 3-a) What is the net present value of this project (1 point)? Present Value of Cash Flow Initial Investment NPV
$210,000 -$110,000 $100,000
3-b) How many shares of common stock must be issued, and at what price to raise the required capital? (1 point) Number of shares outstanding Market value of shares Existing value of shares NPV Total Value Value per share Amount to be raised Number of shares to be issued
10,000 $100 $1,000,000 $100,000 $1,100,000 $110 $110,000 1000
To raise the required capital, VAI should issue 1000 shares of common stock at $110 each.
3-c) What is the effect, if any, of this new project on the value of the stock of existing shareholders? (1 point) The new project has increased the value of existing stock from $100 to $110 per share.
required capital? (1 point)
hareholders? (1 point)
FIN 500 Assignment 4, due 08/21/11, 9:00 pm California time Total points 14 This assignment provides you an opportunity to practice estimating cash flow for capital budgeting projects (chapter 12), using the common approaches in capital budgeting (chapter 13) such as payback, internal rate of return and net present value in choosing project , using Excel functions such as irr() and npv() to calculate IRR and NPV. To complete this assignment, students need to get familiar with course content in chapter 12 and chapter 13. Problems in this assignment are chosen from Harvard Business School’s Case on Valuing Capital Project and are revised by the instructor. This assignment should be done as an individual work. Your completed Assignment 4 should be saved and submitted as an Excel workbook file, i.e., .xls file. The filename should begin assign4, then your last name and first letter of your first name. For example, if Allen Smith completes this assignment, he should name this assignment as assign4SmithA, save and submit it as an Excel workbook file (.xls file). 10% of this assignment points will be deducted if it’s not named or formatted as required. There are three problems in this assignment, each problem has several questions.
1. Growth Enterprise , Inc. (GEI) has $40 million that it can invest in any or all of the capital investment projects (A, B, C, D), which have cash flows as shown in the following table. Table 1. Comparison of Project Cash Flows ($ thousand dollars) Project Type of Year 0 Year 1 Year 2 Year 3 cash flow A. Investment -$10,000 0 0 0 Revenue 0 $21,000 0 0 Operating 0 $11,000 0 0 expense B.
Investment Revenue Operating expense
-$10,000 0 0
0 $15,000 $5,833
0 $17,000 $7,833
0 0 0
C.
Investment Revenue
-$10,000 0
0 $10,000
0 $11,000
0 $30,000
Operating expense
0
$11,000
0
0
B.
Investment Revenue Operating expense
-$10,000 0 0
0 $15,000 $5,833
0 $17,000 $7,833
0 0 0
C.
Investment Revenue Operating expense
-$10,000 0 0
0 $10,000 $5,555
0 $11,000 $4,889
0 $30,000 $15,555
D.
Investment Revenue Operating expense
-$10,000 0 0
0 $30,000 $15,555
0 $10,000 $5,555
0 $5,000 $2,222
All revenues and operating expenses can be considered cash items.
Each of these projects is considered to be of equivalent risk. The investment will be depre to zero on a straight- line basis for tax purpose. For simplicity, the depreciation per year
1-a). Calculate Payback of each project and rank the four projects in order of preference based on payback approach (1 point). 1-b). Calculate IRR of each project and rank the four projects in order of preference based on IRR (2 points). 1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the projects in order of preference (2 points) 1-d). If the projects are independent of each other, which should be accepted? If they are mutually exclusive, which one is best? Explain why. (1 point) Hint: You need to estimate the free cash flows (FCF) to the firm first, FCF = EBIT(1 –tax rate) + depreciation – Gross fixed asset expenditure – change in net operating working
lifornia time Total points 14
estimating cash flow for capital oaches in capital budgeting net present value in choosing calculate IRR and NPV. To with course content in chapter 12
usiness School’s Case on Valuing signment should be done as an be saved and submitted as an begin assign4, then your last name Smith completes this assignment, and submit it as an Excel s will be deducted if it’s not
oblem has several questions.
on that it can invest in any or all of the four ich have cash flows as shown in the
housand dollars) 1 Year 2
Year 3
000 000
0 0 0
0 0 0
000 33
0 $17,000 $7,833
0 0 0
000
0 $11,000
0 $30,000
000
0
0
000 33
0 $17,000 $7,833
0 0 0
000 55
0 $11,000 $4,889
0 $30,000 $15,555
000 555
0 $10,000 $5,555
0 $5,000 $2,222
ed cash items.
lent risk. The investment will be depreciated simplicity, the depreciation per year for a
four projects in order of preference projects in order of preference
PV of the four projects and rank the
hich should be accepted? If they are (1 point)
to the firm first, FCF = EBIT(1 –tax – change in net operating working
2. Electronics Unlimited (EU)was considering the introduction of a new product that had 5 years of life and was expected to generate sales in Year 1 through 5 as the following: Year 1 Year 2 Year 3 Year 4 $10,000, 000 $13,000,000 $13,000,000 $8,667,000 No material levels of revenues or expenses associated with the new product were expected after five years of sales. Based on past experience, cost of sales for the new product was expected to be 60% of total annual sales revenue during each year of its life cycle. Selling, general and administrative expenses were expected to be 23.5% of total annual sales. Taxes on profits generated by the new product would be paid at a 40% rate. To launch the new product, EU would have to incur immediate cash outlays of two types. First, it would have to invest $500,000 in specialized new production equipment. This capital investment would be fully depreciated on a straight- line basis over the five-year anticipated life of the new product. There would be no salvage value left for the equipment at the end of its depreciable life. No further fixed capital expenditures were required after the initial purchase of equipment. Second, additional investment in net working capital to support sales would have been made. EU generally required 27 cents of net working capital to support each dollar of sales. That is, change in net working capital is 27% of change in sales. As a practical matter, the buildup of working capital would have to be made at the beginning of the sales year in question (or, equivalently, by the end of the previous year). For example, Sales in year 2 were expected to be $13,000 thousand, $3,000
Finally, EU expected to incur tax-deductible introductory expenses of $200,000 in the first year of the new product’s sales. Such cost would not be recurring over the product’s life cycle. Approximately $800,000 had already been spent developing and testing marketing the new product. 2-a) estimate the new product’s cash flows. (3 points) 2-b) Assuming a 20% cost of capital, what is the product’s net present value? What is its internal rate of return? Should EU introduce the new product? Explain why? ( points). Note: Except for the change in net working capital, which must be made before the
testing marketing the new product. 2-a) estimate the new product’s cash flows. (3 points) 2-b) Assuming a 20% cost of capital, what is the product’s net present value? What is its internal rate of return? Should EU introduce the new product? Explain why? ( points). Note: Except for the change in net working capital, which must be made before the
3. You are the CEO of Value-Added Industries, Inc. (VAI). Your firm has 10,000 shares of common stock outstanding, and the current price of the stock is $100 per share. The firm does not have any debt. You discover an opportunity in a new project that produces positive net cash flows with a present value of $210,000. Your total initial costs for investing and developing this project are only $110,000. You will raise the necessary capital for this investment by issuing new equity. All potential buyers of your common stock will be fully aware of the project’s value and cost, and are willing to pay “fair value” for the new share of VAI common stock. 3-a) What is the net present value of this project (1 point)? 3-b) How many shares of common stock must be issued, and at what price to raise the required capital? (1 point). Hint: the stock price should reflect the value created by the investment opportunity. 3-c) What is the effect, if any, of this new project on the value of the stock of existing
