Question

Capital Budgeting – Example 1

General Farm Supply is considering the feasibility of expanding their line of fertilizers. They evaluate such projects by determining the net present value and internal rate of return.

General recently completed a feasibility study that indicated they would be able to sell as much fertilizer as they can produce. The study was performed by Fertilizer Consultants, Inc. at a cost of $100,000.

General has also determined facility needs that will accompany the expansion. Warehouse expansion will cost $500,000 and will be depreciated using the 5-year MACRS depreciation schedule. (.20, .32, .192, .1152, .1152, .0576). Equipment installation costs will total $50,000. General currently owns land next to their existing facility that can be used for the expansion. The land was purchased 10 years ago for $5,000. Current market value for the land is $20,000.

In order to finance the expansion, General plans to issue $500,000 in bonds. The bonds will have a 10% coupon rate and will mature in 10 years. They will have to pay $50,000 per year in interest on the bonds.

General uses a corporate-wide hurdle rate of 10.1% when evaluating capital projects. Their marginal tax rate is 35%.

General has determined that the expansion will allow them to sell 1,000,000 pounds of fertilizer per year at an estimated price of $0.30 per pound. Fixed costs per year are forecast at $40,000. Variable costs of $0.10 per pound are forecast.

General forecasts the following one-time changes in working capital in year 0:

Inventory will increase $20,000

Accounts receivable will increase $10,000

Accounts payable will increase $8,000

Any increase in NWC should be recaptured at the end of year 7.

Due to anticipated technological changes in the fertilizer industry, General is forecasting zero cash flow from this project beyond year 7.

General forecasts that the equipment that was purchased for this project can be sold for $40,000 at the end of year 7.

Help General’s CFO evaluate the project by completing the following on the Excel spreadsheet provided:

Find annual cash flows for years 0 through 7

Find the net present value

Find the internal rate of return

Should General do the project? Why or why not?

Answer 1

General farm supply - Capital budgeting problem:

Given data:

Feasibility study cost - $1,00,000 - Can't be used in the project cash flow analysis as it is a sunk cost

Warehouse expansion cost - $5,00,000

Equipment installation cost - $50,000

Depreciation factor

Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
0.2	0.32	0.192	0.1152	0.1152	0.0576	0	0	0	0

Depreciation schedule = $5,00,000 * Depreciation factor

Land market value = $20,000 – Not considered in the analysis as there is no cash flow from this parameter in our analysis

Bonds issued = $5,00,000 – Not considered as this is a financing cashflow and not project cashflow and hence not considered in NPV analysis

Hurdle rate = 10.1%; Marginal tax rate = 35%

Net working capital = Current assets – Current liabilities = Inventory + Receivables – Payables

= $20,000 + $10,000 – $8,000 = $22,000 - Considered in Year 0 made available for operations starting from Year 1

Revenues = No. of pounds that can be sold * price per pound = 10,00,000 * $0.30 = $3,00,000

Fixed cost per year = $40,000 – considered in the analysis as they need to be incurred during the project operations year on year

Variable costs = No. of pounds that can be sold * Variable cost per pound = 10,00,000 * $0.10 = $1,00,000

Since the equipment is expected to be sold in year 7, the firm’s operations are expected to end from year 8. Hence, there won’t be any cash flows from Year 8. The project would give a cash inflow of $40,000 at the end of Year 7 due to sale of equipment

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Initial capital expenditure	-550000
Change in Net Working Capital	-22000
Revenue		300000	300000	300000	300000	300000	300000	300000	0	0	0
Fixed cost		-40000	-40000	-40000	-40000	-40000	-40000	-40000	0	0	0
Variable cost		-100000	-100000	-100000	-100000	-100000	-100000	-100000	0	0	0
EBITDA		160000	160000	160000	160000	160000	160000	160000	0	0	0
Depreciation		-100000	-160000	-96000	-57600	-57600	-28800	0	0	0	0
EBIT		60000	0	64000	102400	102400	131200	160000	0	0	0
Tax outflow		-21000	0	-22400	-35840	-35840	-45920	-56000	0	0	0
NOPAT i.e. EBIT*(1-T)		39000	0	41600	66560	66560	85280	104000	0	0	0
Net cash inflow	0	139000	160000	137600	124160	124160	114080	144000	0	0	0
NOPAT	0	39000	0	41600	66560	66560	85280	104000	0	0	0
Depreciation	0	100000	160000	96000	57600	57600	28800	0	0	0	0
Sale of equipment		0	0	0	0	0	0	40000	0	0	0
Net cash outflow	-572000	0	0	0	0	0	0	0	0	0	0
INWC	-22000
Capex	-550000
Net cashflow	-572000	139000	160000	137600	124160	124160	114080	144000	0	0	0
Hurdle rate	10.10%
NPV	₹ 79,973.06
IRR	15%

Since NPV is positive for the project (in other terms IRR > Hurdle rate), the general should do the project.