Question

Create a presentation that includes a capital budget analysis, an interpretation of the analysis, and your recommended strategy for the Deluxe Corporation.

Deluxe Corporation is a large chain of retail stores operating in the USA. It sells top-of the- range, expensive clothes to a wealthy clientele throughout the country. Currently, Deluxe only operates in the USA. Its current market capitalization is $760 million and the current market value of debt is $350 million.

At last month’s management meeting the marketing director explained that sales volume had increased slightly in the previous year, largely due to heavy discounting in most of its stores. The finance director expressed concern that such a strategy might damage the image of the company and reduce profits over the longer term.

An alternative strategy to increase sales volume has recently been proposed by the marketing department. This would involve introducing a new range of clothing specifically aimed at the middle-income market. The new range of clothing would be expected to be attractive to consumers in Canada and Europe.

Assume your represent the financial management of Deluxe and have been asked to evaluate the marketing department’s proposal to introduce a new range of clothing. An initial investigation into the potential markets has been undertaken by a firm of consultants at a cost of $100,000 but this amount has not yet been paid. It is intended to settle the amount due in three months’ time. With the help of a small multi-department team of staff you have estimated the following cash flows for the proposed project:

• The initial investment required would be $46 million: This comprises $30 million for fixed assets and $16 million for net current assets (working capital).

• For accounting purposes, fixed assets are depreciated on a straight line basis over three (3) years after allowing for a residual value of 10%.

• The value of net current assets at the end of the evaluation period can be assumed to be the same as at the start of the period.

• Earnings before taxes are forecast to be $14 million in 2018, $17million in 2019 and $22 million in 2020.

The following information is also relevant:

The proposed project is to be evaluated over a three-year time horizon. The firm uses Net Present Value and Internal Rate of Return methods to evaluate projects.

Deluxe usually evaluates its investments using an after-tax discount rate of 8%. The proposed project is considered to be riskier than average and so a risk-adjusted rate of 9% will be used for this project.

Corporate tax is 25%.

Ignore inflation.

Prepare a Sensitivity Risk Analysis with the following variables: Earnings Before Taxes, Project Discount Rate, and Tax Rate. Your margins of variance are plus/ minus 10%, 20%, 30%. Your Sensitivity work should include a graph analysis.

What would you recommend provide capital budget analysis, risk analysis, SWOT analysis, as part of your evaluation.

Answer 1

Solution:

Here, depreciation per annum will be $9,000,000 after considering the salvage value of 10% (of $30 million).

Depreciable Capital	$30,000,000
Residual Value (10%)	$3,000,000
Depreciation each year	$9,000,000

Based on available information, total after tax cash flows for three years have been calculated in excel sheet as shown below:                 

	Present	2016	2017	2018
Investment Outlays
Fixed Capital	($30,000,000)
Net Working Capital	($16,000,000)
Total	($46,000,000) ($30,000,000 + $16,000,000)
EBT		$14,000,000	$17,000,000	$22,000,000
Tax (25%)		$3,500,000	$4,250,000	$5,500,000
Net Earnings		$10,500,000 ($14,000,000 - $3,500,000)	$12,750,000 ($17,000,000 - $4,250,000)	$16,500,000 ($22,000,000 - $5,500,000)
Add back Depreciation		$9,000,000	$9,000,000	$9,000,000
After tax operating cash flows		$19,500,000 ($10,500,000 + $9,000,000)	$21,750,000 ($12,750,000 + $9,000,000)	$25,500,000 ($16,500,000 + $9,000,000)
After tax salvage value				$2,250,000
Return of net working capital				$16,000,000
Total				$18,250,000 ($2,250,000 + $16,000,000)
Total after tax cash flows	($46,000,000)	$19,500,000	$21,750,000	$43,750,000 ($25,500,000 + $18,250,000)
NPV @ 9%	$115,979,475.36
IRR	32%

Using this base case, NPV and IRR have been calculated by using the excel formula as NPV(0.09, C16:E16) – B16 for NPV and IRR(B16:E16) for IRR.

Here, B16:E16 are the cash flows values as we calculated in above table.

For sensitivity analysis, we change the value of EBT, discount rate and tax rate by plus/minus 10%, 20% and 30% one by one in above table, then it will change the value of NPV and IRR. It is done in excel sheet. Once you change these values, you will automatically get the changed NPV and IRR value (as formula is already inserted there). These are shown as follows:

Sensitivity Analysis
NPV value with 10%, 20%, 30% plus/minus change in EBT, Discount rate and Tax rate
	Plus 10%	Minus 10%	Plus 20%	Minus 20%	Plus 30%	Minus 30%
EBT	$119,290,022.85	$112,688,927.88	$122,600,570.33	$109,358,380.39	$125,911,117.82	$106,407,832.91
Discount Rate	$114,711,167.81	$117,285,354.71	$113,479,016.71	$118,630,289.98	$112,281,671.72	$120,015,838.08
Tax rate	$118,790,133.12	$121,241,543.04	$117,564,428.16	$122,467,248	$116,338,723.20	$123,692,952.96
IRR value with 10%, 20%, 30% plus/minus change in EBT and Tax rate
	Plus 10%	Minus 10%	Plus 20%	Minus 20%	Plus 30%	Minus 30%
EBT	35%	29%	38%	26%	41%	23%
Tax rate	31%	33%	30%	35%	29%	36%

Here, few points should be noted:

• As the value of EBT is increased, the value of NPV and IRR both increases and vice versa.
• As the value of discount rate increases, the value of NPV decreases and vice versa.
• As the value of tax rate increases, the value of NPV and IRR both decreases and vice versa.
• From the sensitivity table, it is clear that the value of NPV is more sensitive to EBT than the discount rate and tax rate. So, if there is mistake in project EBT, the investment decision based on NPV could be wrong as the real NPV won’t be the same as expected.