Evaluating a capital budgeting proposal

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Reference no: EM13904005

1.    Rob Bruder, the CFO of Bruder Powertrain Products (BPP) has requested your assistance in evaluating a capital budgeting proposal. The proposal involves the production of a new line of gearboxes for use in heavy freight applications. Research and development costs to develop this new line of gearboxes were $410,000 last year (2012). Production of the new product would require investment in new machinery. The machinery to be purchased would cost $4,600,000, and would have a useful life of 5 years. BPP has conferred with its tax accountant (Mr. T. Rump) and has been informed that they must depreciate the machinery under the MACRs 5-year class. The machinery is expected to be sold for its market value of only $420,000 at the end of the 5-year period. 

Management expects to sell 5,300 gearboxes in years 1 and 2, and 6,500 gearboxes in each of the remaining three years. The sales price per gearbox is projected to be $850 in year one, and management believes that the sales price will increase by 2% per year over the life of the project. Variable production costs are projected to be $600 per gearbox in year one and management expects these costs to increase by 2.5% per year over the life of the project. Fixed production costs are expected to be $100,000 in the first year and are expected to increase at a rate of 1% per year. 

If the new line of gearboxes is produced, TPP will need to make additional investments in Net Working Capital (NWC) to support the increased operations. In particular, the increase in NWC (at time t) is expected to be 12% of incremental sales between time t and time t+1. Thus, the NWC investments at t=0 would be 12% of the projected sales for t=1. Additional NWC investments would be required to support any further increases in sales and the cumulative investments in NWC made as a result of this project would be recovered at the project's end. 

The discount rate (WACC – Weighted Average Cost of Capital) used to evaluate this project would be 10.25%, and the relevant tax rate is 35%. 

Develop the incremental cash flow projections for this proposal. Make sure to clearly identify (1) incremental operating cash flows, (2) NWC cash flows, (3) net capital spending, and then, (4) sum these three figures to get free cash flow. Next, use the projected free cash flows to calculate the project's NPV, IRR, MIRR, payback, and discounted payback. 

2.    A small factory is considering replacing its existing coining press with a newer, more efficient one. The existing press was purchased five years ago at a cost of $145,000, and it is being depreciated according to a 7-year MACRs depreciation schedule. The CFO estimates that the existing press has 5 years of useful life remaining. The purchase price for the new press is $278,000. The installation of the new press would cost an additional $32,000, and this cost would be added to the depreciable base. The new press (if purchased) would be depreciated using the 7-year MACRs depreciation schedule. Interest expenses associated with the purchase of the new press are estimated to be roughly $6,200 per year for the next 5 years.

The appeal of the new press is that it is estimated to produce a pre-tax operating cost savings of $95,000 per year for the next 5 years. Also, if the new press is purchased, the old press can be sold for $20,000 today. The CFO believes that the new press would be sold for $30,000 at the end of its 5-year useful life. Assume that NWC would not be affected.

The company has an average tax rate of 28% and a marginal tax rate of 35%. The cost of capital (i.e., discount rate) for this project is 11.5%.

Develop the incremental cash flows for this replacement decision and use them to calculate NPV and IRR. Next, make a conclusion about whether or not the existing coining press should be replaced at this time. Make sure that it is easy to determine how you arrived at your incremental cash flows! 

3.    Your firm is considering a project with a discount rate of 10.5%. If you start the project today, your firm will incur an initial cost of $475 and will receive cash inflows of $360 per year for 4 years. If you instead wait one year to start the project, the initial cost will rise to $530 and the cash flows will increase to $420 a year for the following 4 years. What is the value of the option to wait? (5 points) 

4.    A firm is considering a project with a 5-year life and an initial cost of $110,000. The discount rate for the project is 13%. The firm expects to sell 2,200 units a year for the first 3 years. The cash flow per unit is $20. Beyond year 3, there is a 50% chance that sales will fall to 1,200 units a year for both years 4 and 5, and a 50% chance that sales will rise to 2,500 units a year, for both years 4 and 5. The firm will have the option to abandon the project after 3 years (i.e., at t=3) by selling it for $58,000 (after-taxes). You will know which state will be realized in years 4 and 5 (should the project be continued) by the time you have to make the potential abandonment decision at t=3. What is the net present value of this project given the sales forecasts and the abandonment option?  

5.    Dalton Golf is considering manufacturing a new ‘super-sized’ golf club to compete with the highly successful debut of the Gargantuan Smasher, produced by Hardacker Industries. The initial investment for this project would include $3,900,000 in new machinery and an additional $110,000 in setup costs (the amount to be depreciated is the sum of the machinery and setup costs). The project life would be 5 years, however, in accordance with the IRS, the depreciation method would be 7-year MACRs. The relevant cost of capital has been estimated to be 12% and the applicable tax rate is 35%. For simplicity, assume that a $326,000 investment in NWC is required immediately (to be recovered at the project’s end) and the assets involved would have a salvage value of $70,000 (before tax) at the end of 5 years. The following year one projections reflect the best efforts of the marketing and engineering teams.

 

 

 

Slightly

Middle

Slightly

 

 

Pessimistic

Pessimistic

Scenario

Optimistic

Optimistic

Sales (in units)

72,000

77,000

82,000

87,000

92,000

Price per unit

$90

$100

$110

$120

$130

Variable costs (per unit)

$80

$78

$76

$74

$72

Fixed Production costs

$1,600,000

$1,500,000

$1,400,000

$1,300,000

$1,200,000

Probability of outcome

15%

20%

30%

20%

15%

For simplicity, assume that the state which is realized at t=1 will be in effect for the project's duration.

For simplicity, assume that the state which is realized at t=1 will be in effect for the project's duration.

a)    Conduct a scenario analysis for the 5 cases specified. What is the NPV in each scenario? What is the expected (i.e. probability-weighted) NPV? (10 points) 

b)    Conduct a sensitivity analysis on sales (# units), price per unit, variable costs, and fixed production costs. Specifically, calculate the dollar change in NPV, given a 10% change in the input variable from its base-case (most-likely) value (e.g., specify that a 10% change in sales results in an $X change in NPV, etc..) 

MACRS Depreciation Percentages -- Half-Year Convention

PROPERTY CLASS

RECOVERY  _________________________________________

YEAR               3-YEAR   5-YEAR   7-YEAR   10-YEAR

____________________________________________________

 

1

33.33%

20.00%

14.29%

10.00%

2

44.45

32.00

24.49

18.00

3

14.81

19.20

17.49

14.40

4

7.41

11.52

12.49

11.52

5

 

11.52

8.93

9.22

6

 

5.76

8.92

7.37

7

 

 

8.93

6.55

8

 

 

4.46

6.55

9

 

 

 

6.56

10

 

 

 

6.55

11

 

 

 

3.28

____________________________________________________

 

Totals

100.00%

100.00%

100.00%   100.00%

Extra credit opportunity 

In Module 6, I provide some lecture notes as a link off of the module overview page. In those notes, I show the relation between NPV and discounting periodic economic profits (Note that EVA, Economic Value Added, is just a trademarked variant of an economic profit analysis). In order to earn 5 additional bonus points, you must correctly identify the period-by-period economic profit (EVA) that reconciles with the correct NPV solution for question 1 of this assignment. Unsuccessful attempts will receive no extra credit. Good Luck!

 

 

Reference no: EM13904005

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