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Calculate the metrics of capital budgeting

Assignment Help Financial Management
Reference no: EM13872179

Case Victoria Chemicals PLC (A) This case is a download from our Coursepack at Harvard Business Publishing.

You will learn the three steps in capital budgeting:

1 Identify relevant incremental cash flows

2 Calculate cost of capital (k-wacc) to use as the discount rate

3 Calculate the metrics of capital budgeting: Net Present Value, Profitability Index,

Internal Rate of Return, and Payback Period.

Then, you will apply the metrics and information in the case study to make a recommendation which project to approve, Merseyside or Rotterdam.

The essence of the capital budgeting process is to make sure, BEFORE an investment is made, that its prospective rate of return is high enough to justify the investment.

Reading Cohen Finance Workbook chapter 4 is a review of Time Value of Money, which you covered in a previous course.

Review it as necessary, but defer the review until you look at the TVM applications in chapter 5 beginning on p 79.

You need to know TVM to understand the capital budgeting metrics of NPV, PI, and IRR. Make sure you have that context in mind before reviewing the TVM chapter 4 (only if you need to).

Give the Victoria Chemical PLC (A) case a quick read to understand what is going on - about the decision metrics.

COMPUTE WEIGHTED AVERAGE COST OF CAPITAL

Q1:

Cohen Finance Workbook displays a K-wacc calculation for a company.

Suppose that the inputs to that k-wacc calculation have changed.

The company's financial risk has increased, so its coupon rate is now 9%.

Its marginal tax rate increased to 30%.

To reduce financial risk, its 'target' weight of debt is reduced to 30%.

The risk-free rate on treasury bonds is now 2%.

The risk premium stays the same at 8%.

The beta, reflecting higher financial risk, rises to 1.5.

Recalculate k-wacc, using the template at the top of this page.

Explain the significance of the change in k-wacc to the capital budgeting analysis and recommendation.

Q2:

There is no picture of a faucet - but - visualize a sink faucet turning on and off, controlling the flow of water.

Picture a receivables faucet, an inventory faucet, and a payables faucet.

The number of days can be lower (faucet turned low) or higher (faucet turned high).

This is how net working capital is controlled, by setting the number of days of each.

The investment in working capital is one of the entries in a forecast.

This question helps you learn how to forecast net working capital.

Q2a - Explain how the table below works, i.e., what are the inputs, what are the outputs, and how are the inputs transformed into the outputs.

Revenue   1000.0 1000.0 1000.0 1000.0 1000.0
Cost of goods sold   22.0 22.0 22.0 22.0 22.0
Receivables (enter days in Column B) 30 82.2 82.2 82.2 82.2 82.2
Inventory (enter days in Column B) 50 3.0 3.0 3.0 3.0 3.0
Payables (enter days in Column B) 25 1.5 1.5 1.5 1.5 1.5
Net working capital needs   83.7 83.7 83.7 83.7 83.7
Liquidation of working capital           0.0
Investment in working capital    83.7 0.0 0.0 0.0 0.0

Q2b - Explain how the investment in working capital changes (compared to the amount in Q2a) and why.

Change in Net Working Capital:

Revenue   1000.0 1100.0 1200.0 1300.0 1400.0
Cost of goods sold   22.0 24.2 26.4 28.6 30.8
Receivables (enter days in Column B) 30 82.2 90.4 98.6 106.8 115.1
Inventory (enter days in Column B) 50 3.0 3.3 3.6 3.9 4.2
Payables (enter days in Column B) 25 1.5 1.7 1.8 2.0 2.1
Net working capital needs   83.7 92.1 100.4 108.8 117.2
Liquidation of working capital




0.0
Investment in working capital    83.7 8.4 8.4 8.4 8.4

Q2c - B71 and B72 are changed from the number of days in Q2a and Q2b. Explain how the investment in working capital changes (compared to the amount in Q2b) and why.

Change in Net Working Capital:

Change in Net Working Capital:            
Revenue   1000.0 1100.0 1200.0 1300.0 1400.0
Cost of goods sold   22.0 24.2 26.4 28.6 30.8
Receivables (enter days in Column B) 60 164.4 180.8 197.3 213.7 230.1
Inventory (enter days in Column B) 100 6.0 6.6 7.2 7.8 8.4
Payables (enter days in Column B) 25 1.5 1.7 1.8 2.0 2.1
Net working capital needs   168.9 185.8 202.7 219.6 236.5
Liquidation of working capital           0.0
Investment in working capital    168.9 16.9 16.9 16.9 16.9

Q3:

Recall the Internal Rate of Return (IRR) calculations that were discussed in MBAD 6233 Financial Markets.

The panel above is extracted from p 85 in Cohen Finance Workbook.

Examine the formulas that calculate NPV, PI, and IRR.

Estimate PP by inspection using row 9 cumulative free cash flow-the year when cumulative free cash flow becomes a positive number.

Q3a

Using the data below for the three projects, and the formulas you discerned in B12, B13, and B14,

calculate NPV, PI, and IRR for the three projects, using two different k-wacc discount rates, 8% and 11%.

The data for Projects A,B,C are arrayed vertically; they are the same as row 8 in the horizontal panel above.

Q3b

Interpret the meaning of the calculations you made in Q3a.

Hint: Do you recommend accepting or rejecting the projects?

Hint: What is the impact on the decision metrics when k-wacc changes from 8% to 11%?

Hint: Do all three decision metrics lead to the same recommendation?

Reference no: EM13872179

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