Capital Budgeting Group Presentation Project Instructions: This project requires

Question

Capital Budgeting Group Presentation Project

Instructions: This project requires you to apply the concepts and methods learned in the course. This is a group project.

Assignment: You are interested in proposing a new venture (Project I) to the management of your company. Pertinent financial information is given below.

Balance Sheet Data

Cash

3,000,000

Accounts Payable and Accruals

14,000,000

Accounts Receivable

24,000,000

Notes Payable

41,000,000

Inventories

45,000,000

Long-Term Debt

50,000,000

Preferred Stock

20,000,000

Net Fixed Assets

128,000,000

Common Equity

75,000,000

Total Assets

200,000,000

Total Liabilities &

Owners’ Equity

200,000,000

Last year’s sales were $210,000,000.

The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 9 percent semi-annual coupon, and are currently selling for $870.73.

You also have 100,000 shares of perpetual preferred stock outstanding, which pays a dividend of $7.80 per share. The current market price is $94.00.

The company has 10 million shares of common stock outstanding with a current price of $15.00 per share. The stock exhibits a constant growth rate of 8 percent. The last dividend (D0) was $.90.

Your firm does not use notes payable for long-term financing.

The firm’s target capital structure is 25% debt, 5% preferred stock, and 70% common equity. The firm does not plan to issue new common stock.

Your firm’s federal + state marginal tax rate is 38%.

The firm has the following investment opportunities currently available in addition to the venture that you are proposing:

Project

Cost

IRR

A

17,000,000

21%

B

21,000,000

19%

C

16,000,000

15%

D

28,000,000

11%

E

25,000,000

8%

All projects, including Project I, are assumed to be of average risk. Your venture would consist of a new product introduction (You should label your venture as Project I, for “introduction”). You estimate that your product will have a six-year life span, and the equipment used to manufacture the project falls into the MACRS 5-year class. The resulting MACRS depreciation percentages for years 1 through 6, respectively, are 20%, 32%, 19%, 12%, 11%, and 6%. Your venture would require a capital investment of $17,000,000 in equipment, plus $1,000,000 in installation costs. The venture would also result in an increase in accounts receivable and inventories of $1,000,000 (value at the end of year 6). At the end of the six-year life span of the venture, you estimate that the equipment could be sold at a $5,000,000 salvage value. Your venture would incur fixed costs of $1,000,000 per year, while the variable costs of the venture would equal 30 percent of revenues. You are projecting that revenues generated by the project would equal $6,000,000 in year 1, $14,000,000 in year 2, $15,000,000 in year 3, $16,000,000 in year 4, $11,000,000 in year 5, and $8,000,000 in year 6.

The following list of steps provides a structure that you should use in analyzing your new venture. Note: Carry all final calculations to two decimal places.

1. Find the costs of the individual capital components (15 points):

a. long-term debt

b. preferred stock

c. retained earnings (use DCF approach)

2. Determine the weighted average cost of capital. (5 points)

3. Compute the Year 0 investment for Project I. (5 points)

4. Compute the annual operating cash flows for years 1-6 of the project. (20 points)

5. Compute the non-operating (terminal) cash flow at the end of year 6. (10 points)

6. Draw a timeline that summarizes all of the cash flows for your venture. (5 points)

7. Compute the IRR, payback, discounted payback, and NPV for Project I. (20 points)

8. Prepare a report for the firm’s CEO indicating which projects should be accepted and why. (45 points)

9. Conclude the project with your reflections on what you have learned from this course and how it has affected your view of your own job and career. (45 points)

10. A 15-20 minute presentation will report out on items 1-9. (65 pts.)

Please Note: Complete the capital budgeting group project according to the instructions contained in the syllabus, and upload all documentation and calculations into this assignment folder. There will be only one submission per group, and submitter will be chosen by the group. Please let the instructor know who will be submitting the group project to Moodle.

Cash

3,000,000

Accounts Payable and Accruals

14,000,000

Accounts Receivable

24,000,000

Notes Payable

41,000,000

Inventories

45,000,000

Long-Term Debt

50,000,000

Preferred Stock

20,000,000

Net Fixed Assets

128,000,000

Common Equity

75,000,000

Total Assets

200,000,000

Total Liabilities &

Owners’ Equity

200,000,000

Explanation / Answer

When you are trying to analyze cash flows in any capital budgeting problem you have to break them down into smaller parts otherwise you won't have a good place to start. There are 3 big groups to put your cash flows in that will organize this problem... 1. initial outlay 2. project life 3. terminal year.
Lets start with the initial outlay... These cash flows happen at year zero (or today) if we decide to do the project. They include things like initial investment, net working capital changes, and any other relevant cash flows that happen at time 0 of the project.
1. Initial Outlay
Initial Investment: -17,000,000 + -1,000,000 = -18,000,000
NWC change: -1,000,000
Total: -19,000,000
This next section is project life cash flows. These get a bit more tricky especially since we need to make sure that we don't use some of the irrelevant information given in the problem. Annual operating cash flows are going to include things like... revenue from the project, depreciation tax benefits, taxes we pay on project revenues, fixed/variable costs, etc. Since our revenues, depreciation, variable costs are changing every year we will need to calculate these cash flows year by year for years 1-6.

2. Project Life Cash Flows
Year 1
-Revenue: 6,000,000
-Depreciation benefit: 18,000,000 * MACRS rate 20% = 3,400,000
-Costs: -1,000,000 Fixed cost + -1,500,000 Variable costs (5M*.30) = -2,500,000
-taxes: 5,000,000 - 3,400,000 - 2,500,000 = -900,000 tax loss * .40 tax rate = +360,000 refund
Total year 1: 5,000,000 - 2,500,000 + 360,000 = 7,860,000
Year 2
-Revenue: 14,000,000
-Depreciation benefit: 18,000,000*MACRS rate 32% = 5,440,000
-Costs: -1,000,000 fixed cost + -3,000,000 variable cost (10M*.30) = -4,000,000
- taxes: 10,000,000 - 5,440,000 - 4,000,000 = 560,000 taxable income * .40 = -224,000
total year 2: 14,000,000 - 4,000,000 - 224,000 = 5,776,000
Year 3
Revenue: 15,000,000
Depreciation: 18,000,000*MACRS rate 19.2% = 5,440,000
Costs: -1,000,000 Fixed Cost + -4,200,000 Variable cost (14M*.30) = -5,200,000
- taxes: 14,000,000 - 5,440,000 - 5,200,000 = 3,360,000 taxable income * .40 = -1,344,000
total year 3: 14,000,000 - 5,200,00 - 1,344,000 = 7,456,000
Year 4
- Revenue: 16,000,000
- Depreciation: 18,000,000*MACRS rate 11.52% = 1,958,400
- Costs: -1,000,000 fixed cost + -4,800,000 variable cost = -5,800,000
- taxes: 16,000,000 -1,958,400 - 5,800,000 = 8,241,600 * .40 = -3,296,640
total year 4: 16,000,000 - 5,800,000 - 3,296,640 = 6,903,360
Year 5:
- Revenue: 11,000,000
- Depreciation: 18,000,000*MACRS rate 11.52% = 1,958,400
- Costs: -1,000,000 fixed cost + -3,600,000 variable cost = -4,600,000
- taxes: 12,000,000 - 1,958,400 - 4,600,000 = 5,441,600 * .40 = -2,176,640
total year 5: 12,000,000 - 4,600,000 - 2,176,640 = 5,223,360
Year 6:
- Revenue: 8,000,000
- Depreciation: 18,000,000*MACRS rate 5.76%= 979,200
- Costs: -1,000,000 fixed cost + -2,400,000 variable cost= -3,400,000
- taxes: 8,000,000 - 979,200 - 3,400,000 = 3,620,800 * .40 = -1,448,320
total year 6: 8,000,000 - 3,400,000 - 1,448,320 = 3,151,680
I want to note a few things here... I assumed that the 2M installation costs were capitalized. Generally most installation costs can be capitalized but this isn't always the case. Your problem should have said whether or not these would be capitalized, but what are you going to do... With depreciation you will also noticed that a 5 year MACRS asset still gets some depreciation in year 6. This is because of the half year convention for personal property cost recovery. Without getting into too much detail you get a 1/2 years worth of depreciation after the last "class year" of the asset (it's just the way the IRS does it).

3. Terminal Year cash flows
We only have 2 terminal year cash flows here... the salvage value and NWC.
Salvage Value 4,000,000 ... Book value 0, so we have a taxable gain of 4,000,000 * tax (.40) = 1,600,000
Get cash of 4,000,000 - 1,600,000 taxes = + 3,400,000 after tax salvage value
NWC will "come back" so we have an inflow of +4,000,000
year 6 terminal total: 4,000,000 + 3,400,000 = 7,400,000
Now have finally figured out all of the annual cash flows
year 0: -19,000,000
year 1: 7,860,000
year 2: 5,776,000
year 3: 7,456,000
year 4: 6,903,360
year 5: 5,223,360
year 6: 7,400,000+3,151,680 = 10,551,680
Alright this basically answers your question. Most of the bullets in your problem seem to hint that it may also want you to calculate the WACC. We could then use this rate to discount our cash flows and see if we have a positive or negative NPV.

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