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.

Introduction

This portfolio work project is about one of the basic functions of the finance manager: allocating capital to areas that will increase shareholder value. There are many uses of cash managers can select from, but it is essential that the selected projects are ones that add the most value to the company. This means forecasting the projected cash flows of the projects and employing capital budgeting metrics to determine which project, given the forecast cash flows, gives the firm the best chance to maximize shareholder value.

As a business professional, you are expected to:

Use capital budgeting tools to compute future project cash flows and compare them to upfront costs.

Evaluate capital projects and make appropriate decision recommendations.

Prepare reports and present the evaluation in a way that finance and non-finance stakeholders can understand.

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%.

Answer 1

		PROJECT A
	A	Initial Cost	$10,000,000
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Required return=8%=0.08
		N=Year of Cash Flow
		CALCULATION OF CASH FLOWS AND PV OF CASH FLOWS:
	N	Year	1	2	3	4	5	6	7	8
	B	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
	C=0.6*B		$12,000,000	$12,000,000	$12,000,000	$12,000,000	$12,000,000	$12,000,000	$12,000,000	$12,000,000
	D=0.05*C	Reduction in cost of sales	$600,000	$600,000	$600,000	$600,000	$600,000	$600,000	$600,000	$600,000
	E=(1-0.25)*D	After tax Savings	$450,000	$450,000	$450,000	$450,000	$450,000	$450,000	$450,000	$450,000
		Depreciation Tax Shield
	F	MACRS -7 year depreciation rate	14.29%	24.49%	17.49%	12.49%	8.93%	8.92%	8.93%	4.46%
	G=F*10000000	Annual   depreciation	$          1,429,000	$            2,449,000	$        1,749,000	$     1,249,000	$         893,000	$          892,000	$      893,000	$            446,000
	H=G*0.25	Depreciation Tax Shield	$              357,250	$                612,250	$           437,250	$         312,250	$         223,250	$          223,000	$      223,250	$            111,500
	I	Before tax cash flow from salvage								$500,000
	J=I*(1-0.25)	After tax cash flow fromsalvage								$375,000
	K=E+H+J	Total Cash Inflow	$807,250	$1,062,250	$887,250	$762,250	$673,250	$673,000	$673,250	$936,500	SUM
	L=K/(1.08^N)	Present value(PV) of Total cash inflow	$              747,454	$                910,708	$           704,328	$         560,277	$         458,203	$          424,104	$      392,835	$            505,962	$ 4,703,870
	M	Sum of PV of Cash inflows	$          4,703,870
	NPV=M-A	Net Present Value	$        (5,296,130)
		PROJECT B
		Initial Cost:
		Start up cost	$7,000,000
		After tax cost =$7millionj*(1-0.3)	$4,900,000
		Net Working Capital	$1,000,000
	A	Total InitialCapital	$5,900,000
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Required return=12%=0.12
		N=Year of Cash Flow
		CALCULATION OF CASH FLOWS AND PV OF CASH FLOWS:
		Sales in year 0	$20,000,000
		Sales in year 1	$22,000,000	(20000000*1.1)
		Increase in sales in year 1	$2,000,000
		Sales in year (N+1)=1.1*(Sales in Year (N))
		Cost of sales in Year 0	$12,000,000	(0.6*20000000)
		Cost of sales in year 1	$13,200,000	(1.1*12000000)
	N	Year	1	2	3	4	5
	B	Sales	$22,000,000	$24,200,000	$26,620,000	$29,282,000	$32,210,200
	C=B-$20million	Increase in Sales	$2,000,000	$4,200,000	$6,620,000	$9,282,000	$12,210,200
	D	Cost of sale	$13,200,000	$14,520,000	$15,972,000	$17,569,200	$19,326,120
	E=D-$12million	Increase in cost of sales	$1,200,000	$2,520,000	$3,972,000	$5,569,200	$7,326,120
	F=C-E	Increase in pretax cash inflow	$800,000	$1,680,000	$2,648,000	$3,712,800	$4,884,080
	G=F*(1-0.3)	Increase in after tax cash in flow	$560,000	$1,176,000	$1,853,600	$2,598,960	$3,418,856
	H	TerminalCash inflow					$1,000,000
	I=G+H	Total Cash Inflow	$560,000	$1,176,000	$1,853,600	$2,598,960	$4,418,856	Sum
	PV=I/(1.12^N)	Present Value (PV)of total cash inflow	$              500,000	$                937,500	$        1,319,356	$     1,651,686	$      2,507,378	$       6,915,919
	J	Sum of PV of totalcash inflow	$          6,915,919
	NPV=J-A	Net Present Value	$          1,015,919
		PROJECT   C
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Required return=10%=0.10
		N=Year of Cash Flow
		Sales in year 1=1.15*$20million	$        23,000,000
		Cost in year 1=1.15*$12 million	$        13,800,000
	N	Year	1	2	3	4	5	6
	A	Cash flow for marketing/advertising	($2,000,000)	($2,000,000)	($2,000,000)	($2,000,000)	($2,000,000)	($2,000,000)
	B	Sales	$        23,000,000	$          26,450,000	$     30,417,500	$   34,980,125	$   40,227,144	$    46,261,215
	C=B-$20million	Increase in Sales	$          3,000,000	$            6,450,000	$     10,417,500	$   14,980,125	$   20,227,144	$    26,261,215
	D	Cost of sale	$        13,800,000	$          15,870,000	$     18,250,500	$   20,988,075	$   24,136,286	$    27,756,729
	E=D-$12million	Increase in cost of sales	$          1,800,000	$            3,870,000	$        6,250,500	$     8,988,075	$   12,136,286	$    15,756,729
	F=C-E	Increase in pretax cash inflow	$          1,200,000	$            2,580,000	$        4,167,000	$     5,992,050	$      8,090,857	$    10,504,486
	G=F*(1-0.25)	Increase in after tax cash inflow	$              900,000	$            1,935,000	$        3,125,250	$     4,494,038	$      6,068,143	$       7,878,365
	H=A+G	Net Cash Flow	$        (1,100,000)	$                (65,000)	$        1,125,250	$     2,494,038	$      4,068,143	$       5,878,365	SUM
	PV=I/(1.10^N)	Present Value (PV) of Net Cash Flow:	$        (1,000,000)	$                (53,719)	$           845,417	$     1,703,461	$      2,525,997	$       3,318,184	$ 7,339,340
	NPV=J-A	Sum of PV of Cash Flow	$          7,339,340
			NPV
		PROJECT A	$        (5,296,130)
		PROJECT B	$          1,015,919
		PROJECT C	$          7,339,340
		Project C brings most value to the company