Question

Create an Excel spreadsheet in which you use capital budgeting tools to determine the quality of 3 proposed investment projects, as well as a 6-8 page report that analyzes your computations and recommends the project that will bring the most value to the company.

Scenario

You work as a finance manager for Drill Tech, Inc., a mid-sized manufacturing company located in Minnesota. Three capital project requests were identified as potential projects for the company to pursue in the upcoming fiscal year. In the meeting to discuss capital projects, the director of finance (and your boss), Jennifer Davidson, gives you a synopsis of the projects along with this question: Which one of these projects will provide the most shareholder value to the company?

She also tells you that other than what is noted in each project scenario, all other costs will remain constant, and you should remember to only evaluate the incremental changes to cash flows.

The proposed projects for you to review are as follows.

Project A: Major Equipment Purchase

-A new major equipment purchase, which will cost $10 million; however, it is projected to reduce cost of sales by 5% per year for 8 years.

-The equipment is projected to be sold for salvage value estimated to be $500,000 at the end of year 8.

Being a relatively safe investment, the required rate of return of the project is 8%.

-The equipment will be depreciated at a MACRS 7-year schedule.

-Annual sales for year 1 are projected at $20 million and should stay the same per year for 8 years.

-Before this project, cost of sales has been 60%.

The marginal corporate tax rate is presumed to be 25%.

Project B: Expansion into Europe

-Expansion into Western Europe has a forecast to increase sales/revenues and cost of sales by 10% per year for 5 years.

-Annual sales for the previous year were $20 million.

Start-up costs are projected to be $7 million and an upfront needed investment in net working capital of $1 million.

-The working capital amount will be recouped at the end of year 5.

-Because of the higher European tax rate, the marginal corporate tax rate is presumed to be 30%.

-Being a risky investment, the required rate of return of the project is 12%

Project C: Marketing/Advertising Campaign

-A major new marketing/advertising campaign, which will cost $2 million per year and last 6 years.

-It is forecast that the campaign will increase sales/revenues and costs of sales by 15% per year.

-Annual sales for the previous year were $20 million.

-The marginal corporate tax rate is presumed to be 25%.

-Being a moderate risk investment, the required rate of return of the project is 10%.

Requirements:   Jennifer reiterates that your report is critical for the company to select the project that will bring the most value to shareholders. Your calculations and report should address these items for her and other stakeholders:

-Apply computations of capital budgeting methods to determine the quality of the proposed investments.

Use budgeting tools to compute future project cash flows and compare them to upfront costs. Remember to only evaluate the incremental changes to cash flows.

-Demonstrate knowledge of a variety of capital budgeting tools including net present value (NPV), internal rate of return (IRR), payback period, and profitability index (PI). The analysis of the capital projects will need to be correctly computed and the resulting decisions rational.

-Evaluate the capital projects using data analysis and applicable metrics that align to the business goal of maximizing shareholder value.

-Evaluate capital projects and make appropriate decision recommendations. Accurately compare the indicated projects with correct computations of capital budgeting tools and then make rational decisions based on the findings.

-Select the best capital project, based on data analysis and evaluation, that will add the most value for the company.

Prepare an appropriate evaluation report for requestors, using sound research and data to defend your decision.

Answer 1

	Project A: Major Equipment Purchase
	Present Value (PV) of Cash Flow:
	(Cash Flow)/((1+i)^N)
	i=Discount Rate=Required Return=8%=0.08
	N=Year of Cash Flow
N	Year	0	1	2	3	4	5	6	7	8
A	Initial cost of equipment	($10,000,000)
B	MACRS 7 year Depreciation rate		14.29%	24.49%	17.49%	12.49%	8.93%	8.92%	8.93%	4.46%
C=B*$10million	Annual Depreciation		$1,429,000	$2,449,000	$1,749,000	$1,249,000	$893,000	$892,000	$893,000	$446,000
D=C*0.25	Depreciation Tax Shield		$357,250	$612,250	$437,250	$312,250	$223,250	$223,000	$223,250	$111,500
E	Annual Sales		$20,000,000	$20,000,000	$20,000,000	$20,000,000	$20,000,000	$20,000,000	$20,000,000	$20,000,000
F=0.6*E	Cost of sales before the project		$12,000,000	$12,000,000	$12,000,000	$12,000,000	$12,000,000	$12,000,000	$12,000,000	$12,000,000
G=0.05*F	Saving in cost of sales(Before tax)		$600,000	$600,000	$600,000	$600,000	$600,000	$600,000	$600,000	$600,000
H=G*(1-0.25)	After tax savings		$450,000	$450,000	$450,000	$450,000	$450,000	$450,000	$450,000	$450,000
J=H+D	Increase in operating cash flow		$807,250	$1,062,250	$887,250	$762,250	$673,250	$673,000	$673,250	$561,500
K=50000*(1-0.25)	After Tax Salvage Value									$375,000
L=A+J+K	NET CASH FLOW	($10,000,000)	$807,250	$1,062,250	$887,250	$762,250	$673,250	$673,000	$673,250	$936,500	SUM
PV=L/(1.08^N)	Present value (PV) of Net Cash Flow	($10,000,000)	$747,454	$910,708	$704,328	$560,277	$458,203	$424,104	$392,835	$505,962	($5,296,130)
NPV=Sum of PV	Net Present Value	($5,296,130)
None of the project is acceptable
Because all have negative NPV