Prepare a capital budget analysis of the following data, your analysis should determine WACC, Net Operating Cash Flow, NPV, IRR, PI, and Payback analysis.
This analysis is for the manufacture of a transportation bus.
Should this project be approved or rejected with the following company parameters: IRR above 12% and a Payback less than ten years.
Exhibit 1: Financing Assumptions
The following assumptions are used to determine the cost of capital.
Historically, the company has maintained a debt ratio is 40%. This ratio was used, becauselowering the debt implies giving up the debt tax shield, and increasing it makes debt service aburden on the firm's cash flow. In addition, increasing the debt level may cause a reduced ratingof the company's bonds. The marginal tax rate is 40%. All the numbers are expressed in today'sdollars. The forecasted average inflation per year is 3.5%.
Cost of debt:
The company's bond rating is roughly at the high end of the A range. Surveying the debt marketyielded the following information about the cost of debt for different rating levels:
Bond rating AA A BBB
Interest cost range 5.5% ~6.5% 6.25%~7.5% 7.5%~9%
The company's current bonds have a yield to maturity of about 6.5%.
Cost of equity:
The current 10-year Treasury notes have a yield to maturity of 4.0% and the forecast for the S&P500 market return is 9.5%. The company's overall Beta is 1.15.
Exhibit 2: Investment Needs
To implement the project, the firm has to invest funds as shown in the following table:
Year 0 Year 1 Year 2
$1 billion* $100 million* $100 million*
*The Company estimated that it would cost a total of $1 billion to build the factory and purchase the necessary equipment to produce the buses. The other $200 million investment, divided equally in years 1 and 2, is for non-depreciable labor training costs. Such investment is treated as regular business expenses. Project life is twenty years.
Straight line depreciation will be used for the sake of simplicity.
To facilitate the operation of manufacturing the project, the company will have to allocate fundsto net working capital (NOWC) equivalent to 10% of annual sales, this will be a yearlyallocation beginning in Year 0. Please refer to Chapter 11 for NOWC yearly allocation. Theinvestment in NOWC will be recovered at the end of the project.
The equipment will be sold for salvage at about $15,000,000 at the end of the project.
Exhibit 3: Sales and Cost Forecast
The sales forecast is based on projected levels of demand. All the numbers are expressed intoday's dollars. The forecasted average inflation per year is 3.5%
Selling Price per bus $220,000
Units sold per year $11,000
Labor cost per bus $50,000
Components & Parts
Selling General &
NOTE: Average warranty cost per year per bus for the first five years is $1,000. The present value of this cost will be used as a cost figure for each bus. Afterwards, the bus operator will become responsible the repairs on the buses.
The buses can be produced for twenty years. Afterwards, the designs become obsolete.
Engine Detroit engines
Price per engine, including installation $20,000
Average annual warranty cost per year for five $1,500
years. Afterwards, the bus operator will become
responsible for the repairs on the buses.
The engine will be installed in every bus and will become a cost figure for each bus. The present value of this warranty, as with the bus warranty cost, will be used as a cost figurefor each bus.