Question

Case Project 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

1.) ABC Inc. is planning to buy machine A which will cost $ 10 million. The expected life of the machine is 5 years. The salvage value of the machine is nil. ABC Inc. is expecting cash-flow of $ 5 million for the first two years, $ 3 million for the next 2 years & $ 2 million in 5th year. Operating expense is $ 1 million for every year. The machine will be financed in Debt:Equity ration of 70:30,cost of debt is 6%. Beta coefficent is 0.8, risk free rate is 0.60%, market risk premium is equal to 5%. Assume corporate tax rate at 35%. Evaluate the project.

2.) Incremenatal cashflows over next 5 years

Cashflows:

Amt($ million)	Year
Particulars	0	1	2	3	4	5
Project cost	-10.00
PAT		0.76	0.72	0.09	0.05	-0.28
Depreciation		2.00	2.00	2.00	2.00	2.00
Net cashflow	-10.00	2.76	2.72	2.09	2.05	1.72

Workings:

Particulars		1	2	3	4	5
Revenue		5.00	5.00	3.00	3.00	2.00
Operating exps		1.00	1.00	1.00	1.00	1.00
EBITDA		4.00	4.00	2.00	2.00	1.00
Depreciation		2.00	2.00	2.00	2.00	2.00
Interest	3.60%	0.23	0.18	0.13	0.08	0.03
Tax		0.62	0.64	-0.04	-0.03	-0.36
PAT		0.76	0.72	0.09	0.05	-0.28
Debt schedule		1	2	3	4	5
Opening		7.00	5.60	4.20	2.80	1.40
repayment		1.40	1.40	1.40	1.40	1.40
Closing		5.60	4.20	2.80	1.40	0.00
Depreciation		1	2	3	4	5
Opening		10.00	8.00	6.00	4.00	2.00
Depreciation		2.00	2.00	2.00	2.00	2.00
Closing		8.00	6.00	4.00	2.00	0.00

3) Weightage Average cost of capital

Cost of Equity : Risk free rate + Beta( Market risk premium-risk free rate)

= 0.60% + 0.8(5%-0.60%) =4.12%

WACC : 0.7 * 3.6% + 0.3 * 4.12%

= 3.76%

4) Financial Evaluation of the project using NPV

Amt($ million)	Year
Particulars	0	1	2	3	4	5
Project cost	-10.00
PAT		0.76	0.72	0.09	0.05	-0.28
Depreciation		2.00	2.00	2.00	2.00	2.00
Net cashflow	-10.00	2.76	2.72	2.09	2.05	1.72
NPV @3.76%	0.25

As NPV is greater than 0 i.e. $0.25 million, the proposal should be accepted.