Question

Case Project Create a company. Your represents the capital budgeting committee of a successful firm. You have been invited to the next Board of Directors meeting to present your analysis and recommendation on a new capital project. Your presentation should contain the following: 1. Brief description of the proposed capital project 2. Estimation of the incremental cash flows related to the project 3. Estimation of the weighted average cost of capital 4. Financial evaluation of capital budget project (using NPV or IRR) 5. Recommendation to the Board of Directors on whether or not to proceed with the proposed capital project. A written summary should accompany your presentation. The written summary should be no more than five (5) pages, including exhibits. Your presentation should be no more than 20 minutes in length. You may use whatever means necessary to convey your analysis and recommendation. You may choose to use a recognized publicly held firm or a fictitious entity. Please use the following information as a guide to your analysis: 1. Target capital ratio: % of debt and % of equity 2. Beta coefficient 3. Risk-free rate is equal to the current level of a point on the Treasury yield curve. 4. The market risk premium is equal to 5% 5. Corporate tax rate is 35% 6. All cash flows related to the project are positive (except the initial expenditure) 7. Useful product life 8. “Straight-line” depreciation method.

Answer 1

Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase of new equipment, expansion of production facilities, buying another company, acquiring new technologies, launching a research & development program, etc., etc., etc. Capital expenditures often involve large cash outlays with major implications on the future values of the company. Additionally, once we commit to making a capital expenditure it is sometimes difficult to backout. Therefore, we need to carefully analyze and evaluate proposed capital expenditures.

Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. We are trying to answer the following question: Will the future benefits of this project be large enough to justify the investment given the risk involved?

It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluating a project. We will include three stages within Capital Budgeting Analysis

1. Decision Analysis for Knowledge Building !

2 .Option Pricing to Establish Position !

3. Discounted Cash Flow (DCF) for making the Investment Decision

Stage - 1 Decision Analysis

Decision-making is increasingly more complex today because of uncertainty. Additionally, most capital projects will involve numerous variables and possible outcomes. For example, estimating cash flows associated with a project involves working capital requirements, project risk, tax considerations, expected rates of inflation, and disposal values. We have to understand existing markets to forecast project revenues, assess competitive impacts of the project, and determine the life cycle of the project. If our capital project involves production, we have to understand operating costs, additional overheads, capacity utilization, and startup costs. Consequently, we can not manage capital projects by simply looking at the numbers; i.e. discounted cash flows. We must look at the entire decision and assess all relevant variables and outcomes within an analytical hierarchy.

In financial management, we refer to this analytical hierarchy as the Multiple Attribute Decision Model (MADM). Multiple attributes are involved in capital projects and each attribute in the decision needs to be weighed differently. We will use an analytical hierarchy to structure the decision and derive the importance of attributes in relation to one another. We can think of MADM as a decision tree which breaks down a complex decision into component parts. This decision tree approach offers several advantages:

! We systematically consider both financial and non-financial criteria.

! Judgements and assumptions are included within the decision based on expected values.

! We focus more of our attention on those parts of the decision that are important.

! We include the opinions and ideas of others into the decision.

Group or team decision making is usually much better than one person analyzing the decision. Therefore, our first real step in capital budgeting is to obtain knowledge about the project and organize this knowledge into a decision tree. We can use software programs such as Expert Choice or Decision Pro to help us build a decision tree.

2. Discounting Cash Flows:

o we have completed the first two stages of capital budgeting analysis: (1) Build and organize knowledge within a decision tree and (2) Recognize and build options within our capital projects. We can now make an investment decision based on Discounted Cash Flows or DCF. Unlike accounting, financial management is concerned with the values of assets today; i.e. present values. Since capital projects provide benefits into the future and since we want to determine the present value of the project, we will discount the future cash flows of a project to the present. Discounting refers to taking a future amount and finding its value today. Future values differ from present values because of the time value of money. Financial management recognizes the time value of money because:

1. Inflation reduces values over time; i.e. $ 1,000 today will have less value five years from now due to rising prices (inflation).

2. Uncertainty in the future; i.e. we think we will receive $ 1,000 five years from now, but a lot can happen over the next five years.

3. Opportunity Costs of money; $ 1,000 today is worth more to us than $ 1,000 five years from now because we can invest $ 1,000 today and earn a return

Calculating the Discounted Cash Flows of Projects:

1. Depreciation: Capital assets are subject to depreciation and we need to account for depreciation twice in our calculations of cash flows. We deduct depreciation once to calculate the taxes we pay on project revenues and we add back depreciation to arrive at cash flows because depreciation is a non-cash item.

2. Working Capital: Major investments may require increases to working capital. For example, new production facilities often require more inventories and higher salaries payable. Therefore, we need to consider the net change in working capital associated with our project. Changes in net working capital will sometimes reverse themselves at the end of the project.

3. Overhead: Many capital projects can result in increases to allocated overheads, such as computer support services. However, the subjective nature of overhead allocations may not make any difference at all. Therefore, you need to assess the impact of your capital project on overhead and determine if these costs are relevant.

4. Financing Costs: If we plan on financing a capital project, this will involve additional cash flows to investors. The best way to account for financing costs is to include them within our discount rate. This eliminates the possibility of double-counting the financing costs by deducting them in our cash flows and discounting at our cost of capital which also includes our financing costs.

We also need to ignore costs that are sunk; i.e. costs that will not change if we invest in the project. For example, a new product line may require some preliminary marketing research. This research is done regardless of the project and thus, it is sunk. The concept of sunk costs and relevant costs applies to all types of financing decisions.

Example — Make or Buy Decision

You have the option to manufacture your own parts or purchase them from outside suppliers. If we purchase the parts, it will cost $ 50.00 per part. Our factory is operating at 70% of capacity and our total costs to manufacture parts is: Direct Materials $ 15.00 / part Direct Labor $ 19.00 / part Overhead - Variable $ 14.00 / part Overhead - Fixed $ 12.00 / part Total Costs $ 60.00 / part Since we are operating at 70% capacity, we do not expect an increase in fixed overhead; this is a sunk cost. We would manufacture the parts since it is $ 2.00 / part cheaper: Purchase $ 50.00 vs. Manufacture $ 48.00 ($ 15.00 + $ 19.00 + $ 14.00)

Calculating the Present Value of Cash Flows:

Our next step is to calculate present values of our two cash flow streams. We will use our cost of capital to discount the cash flows. We will assume that our cost of capital is 12%. We will use the present value tables in Exhibits 1 and 2 for finding the appropriate discount factor per the life of our cash streams and the 12% cost of capital

Example — Calculate Present Value of Cash Flows Annual Project Cash Flows $ 5,788 Discount Factor per Exhibit 2 x 3.605 (1) Present Value of Annual Flows $ 20,866 Terminal Cash Flow $ 3,250 Discount Factor per Exhibit 1 x .567 (2) Present Value of Terminal Flow 1,843 Total Present Value $ 22,709.