Capital Budgeting Scenarios
Shannan Coleman
FIN/486
September 23, 2012
Sal Sadiq
Capital Budgeting Scenarios
Capital Budgeting: Proposal A – New Factory Proposal A is to build a new factory to decide if this would be a feasible move for the company they need to perform a net present value analysis. To do this they will only need to look at the incremental cash flows, which are as follows: 1. Initial investment of $10 million that will be the cost to build the new factory. 2. Sales of $3 million a year that will result in an increase of $150,000 in gross margin giving the company a 5% gross margin. 3. Value of salvage at the end of the life of the project of $14 million.
NPV Computation
The following table displays
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The present value was figured out by using the following formula
PV Factor = 1/(1+r)^t r = cost of capital t = year
By multiplying the cash flow column with the present value column the present value of each of the cash flows was found.
Assuming the weighted average cost of capital is 6% on the other hand, the net present value would be negative $1,078,460, which is shown below, and this amount is higher than what the NPV was with a cost of capital of 10%. Year | Cash Flow | PV Factor | Present Value | 0 | (10,000,000) | 1.0000 | (10,000,000) | 1 | 150,000 | 0.9434 | 141,509 | 2 | 150,000 | 0.8900 | 133,499 | 3 | 150,000 | 0.8396 | 125,943 | 4 | 150,000 | 0.7921 | 118,814 | 5 | 150,000 | 0.7473 | 112,089 | 6 | 150,000 | 0.7050 | 105,744 | 7 | 150,000 | 0.6651 | 99,759 | 8 | 150,000 | 0.6274 | 94,112 | 9 | 150,000 | 0.5919 | 88,785 | 10 | 14,150,000 | 0.5584 | 7,901,286 | | NPV | | (1,078,460) |
On the other hand, using a cost of capital of 12% the NPV is still negative showing a negative amount of $4,644,841. These figures show that the 12% cost of capital is lower than the 6% cost of capital and higher than the 10% cost of capital. Year | Cash Flow | PV Factor |
Thus, final free cash flows for the project come out to be $-3.750 million, $0.889 million, $2,563 million, $5,719 million and $2,388 million for years 2011, 2012, 2013, 2014 and 2015 years respectively.
After evaluating the Super Project for General Foods, the two main things that management needed to address were the relevant incremental and non-incremental cash flows discussed below and incorporate the NPV and the net cash flows (yearly) to make a decision on whether to accept or reject the project. The start-up costs were determined by splitting up the costs of $160,000 in 1967 and $40,000 in 1968. To calculate the yearly cash flows, I used year 1 through 10, and the gross profit was calculated by subtracting out relative cash flows and the before tax depreciation. The NPV of $169,530 is positive for the 10% discount rate, which is less than the IRR of 11.4%.
What is the net present value of this follow-up investment and the combined base and expansion investments?
2. Use the projections provided in the case to compute the incremental cash flows for the PCB project. Provide a reasonable estimate for cash flows after 2009 as well.
Step Three: Draw out a timeline, and then take the present value of all cash flows
Since computed IRR for the Boeing is equal to 15.67%, the required rate of return has to be higher in order to have positive NPv. There are 3 possibilities that involves NPV. The first, NPV is higher than 0 and WACC is less than IRR, which means Boeing would gain more profits. This project scenario should pursue by the Boeing. Next is NPV is equal to 0, which means that there would be no gains and no losses from this project. Lastly, NPV is less than 0, which tells that Boeing would lose if they pursue this scenario. According to the table above, I compared Boeing with Lockheed Martin’s levered beta. My calculations are: . For the risk free rate, I have 4.56%. It is 30-year Treasury bond yield on June 2003. When Treasury bonds are in long term,
Net Present Value (NPV) calculates the sum of discounted future cash flows and subtracting that amount with the initial investment of the project. If the NPV of a project results in a positive number, the project should be undertaken. It is the most widely used method of capital budgeting. While discount rate used in NPV is typically the organization’s WACC, higher risk projects would not be factored in into the calculation. In this case, higher discount rate should be used. An example of this is when the project to be undertaken happens to be an international project where the country risk is high. Therefore, NPV is usually used to determine if a project will add value to the company. Another disadvantage of NPV method is that it is fairly complex compared to the other methods discussed earlier.
The required interest rate which would return an NPV of zero is 9.22%. This is less than the cost of capital of 10%.
In the case of Worldwide Paper Company we performed calculations to decide whether they should accept a new project or not. We calculated their net income and their cash flows for this project (See Table 1.6 and 1.5). We computed WPC’s weighted average cost of capital as 9.87%. We then used the cash flows to calculate the company’s NPV. We first calculated the NPV by using the 15% discount rate; by using that number we calculated a negative NPV of $2,162,760. We determined that the discount rate of 15% was out dated and insufficient. To calculate a more accurate NPV for the project, we decided to use the rate of 9.87% that we computed. Using this number we got the NPV of $577,069. With the NPV of $577,069 our conclusion is to accept this
Both of these factors cause a decrease in FCF, than in the terminal value, and ultimately in the total discounted present value. Final valuation through the “pessimistic” approach amounts to NPV (FCF) $34.60 million + PV (TV) $37.9 million equaling total PV $72.48 million.
The present value of the net incremental cash flows, totaling $5,740K, is added to the present value of the Capital Cost Allowance (CCA) tax shield, provided by the Plant and Equipment of $599K, to arrive at the project’s NPV of $6,339K. (Please refer to Exhibit 4 and 5 for assumptions and detailed NPV calculations.) This high positive NPV means that the project will add a significant amount of value to FMI. In addition, using the incremental cash flows (excluding CCA) generated by the NPV calculation, we calculated the project’s IRR to be 28%. This means that the project will generate a higher rate of return than the company’s cost of capital of 10.05%. This is also a positive indication that the company should undertake the project.
Under the second case scenario, which the firm is in a tax-free environment, the NPV equals to -$834,638.76
1. The net present value is the projects present value of inflows minus its cost. It shows us how much the project contributes to the shareholders wealth. The NPV of each franchise are:
The change in incremental cash flow can be examined through looking at the factors causing change
The Net Present Value is one of the techniques that are used by firms when evaluating which investment proposals to take on board and which ones to reject. The net present value is calculated by discounting all flows to the present and subtracting the present value of all inflows.