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F13 BUS-F301 Solution to Minicase of Chapter 10 1/11

BUS-F301 Financial Management Fall 2013, Class No. 14301 (Online)/ 14973 (Face-to-Face) Answers to Minicase of Chapter 10 on Page 341-342 of your textbook. Please print the minicase from Courseload on Oncourse and study it well before reading the following. You can find the instructions on how to print the textbook pages posted under Syllabus on Oncourse.

This minicase is a VERY CLOSE example for Case Study 2. Please learn the way below on how to present your answers to the questions in Case Study 2. You have to use your own words for your explanations to your answers for Case Study 2.

This is an in-depth capital budgeting problem. The initial cash outlay at Year 0 (i.e. Today) is simply the cost of the new equipment, $38,500,000. The sales each year are a combination of the sales of the new smart phone, the lost sales each year (due to the reduction in sales units of old smart phone), and the lost revenue (due to the reduction in selling price of old smart phone). In this case, the lost sales are 15,000 units of the old smart phone each year for two years at a price of $310 each. The company will also be forced to reduce the price of the old smart phone on the units they will still sell for the next two years. So, the total change in sales is:

Net sales = New sales – Lost sales – Lost revenue = Unit sales of new smart phone × Price of new smart phone – Reduction in unit sales of old smart phone × Current price of old smart phone – Reduced unit sales of old smart phone × Price reduction in old smart phone Year 1 = 74,000 × $480 – 15,000 × $310 – (80,000 – 15,000) × ($310 – $275) = $35,520,000 – $4,650,000 – $2,275,000 = $28,595,000 Year 2 = 95,000 × $480 – 15,000 × $310 – (60,000 – 15,000) × ($310 – $275) = $45,600,000 – $4,650,000 – $1,575,000 = $39,375,000

Year 3 = 125,000 × $480 = $60,000,000

Year 4 = 105,000× $480 = $50,400,000 Year 5 = 80,000× $480 = $38,400,000

Variable costs = Variable costs of new smart phone – Reduction of variable costs of old smart phone due to lost sales = Unit sales of new smart phone × Variable cost per unit of new smart phone – Reduction in unit sales of old smart phone × Variable cost per unit of old smart phone

Year 1 = 74,000 × $185 – 15,000 × $125 = $13,690,000 – $1,875,000 = $11,815,000

F13 BUS-F301 Solution to Minicase of Chapter 10 2/11

Year 2 = 95,000 × $185 – 15,000 × $125 = $17,575,000 – $1,875,000 = $15,700,000

Year 3 = 125,000 × $185 = $23,125,000 Year 4 = 105,000× $185 = $19,425,000 Year 5 = 80,000× $185 = $14,800,000

Please note that as the production of old smart phone is expected to be terminated in two years, there will not be any lost sales, lost revenue or reduction of variable costs due to the launch of the new smart phone beyond Year 2.

Depreciation = Cost of equipment × MACRS percentage

MACRS Depreciation Allowance Property Class Year Three-Year Five-Year Seven-Year 1 33.33% 20.00% 14.29% 2 44.45 32.00 24.49 3 14.81 19.20 17.49 4 7.41 11.52 12.49 5 11.52 8.93 6 5.76 8.92 7 8.93 8 4.46

Since the equipment will be depreciated on a seven-year MACRS schedule, the annual depreciation will be estimated as below.

Year 1 = $38,500,000 × 14.29% = $5,501,650 Year 2 = $38,500,000 × 24.49% = $9,428,650 Year 3 = $38,500,000 × 17.49% = $6,733,650 Year 4 = $38,500,000 × 12.49% = $4,808,650 Year 5 = $38,500,000 × 8.93% = $3,438,050

Net Working Capital (NWC)

It is estimated that net working capital for the smart phones will be 20 percent of sales. In addition, NWC is expected to occur with the timing of the cash flows for the year. Moreover, there is no initial outlay for NWC. However, changes in NWC will initially occur in Year 1 with the sales of the first year.

Thus, net working capital as at the end of the years can be estimated as below.

NWC = 20% × Net sales of the year = .2 × Net sales of the year

F13 BUS-F301 Solution to Minicase of Chapter 10 3/11

Year 0 = $0 (because of no initial outlay)

Year 1 = .2 × $28,595,000 = $5,719,000 Year 2 = .2 × $39,375,000 = $7,875,000

Year 3 = .2 × $60,000,000 = $12,000,000

Year 4 =.2 × $50,400,000 =$10,080,000 Year 5 = $0 (no need to carry NWC anymore at the end of the project, in fact, it is the time to recover the NWC)

Please note that the beginning balance of a year is equal to the ending balance of the previous year.

Cash flow estimation

Sales Year 1 Year 2 Year 3 Year 4 Year 5

New sales $35,520,000 $45,600,000 $60,000,000 $50,400,000 $38,400,000 – Lost sales 4,650,000 4,650,000 – Lost revenue 2,275,000 1,575,000

=Net sales $28,595,000 $39,375,000 $60,000,000 $50,400,000 $38,400,000 VC New $13,690,000 $17,575,000 $23,125,000 $19,425,000 $14,800,000 –Lost sales 1,875,000 1,875,000

=VC $11,815,000 $15,700,000 $23,125,000 $19,425,000 $14,800,000 Sales $28,595,000 $39,375,000 $60,000,000 $50,400,000 $38,400,000 –VC 11,815,000 15,700,000 23,125,000 19,425,000 14,800,000 – Fixed costs 5,300,000 5,300,000 5,300,000 5,300,000 5,300,000 –Depreciation 5,501,650 9,428,650 6,733,650 4,808,650 3,438,050

=EBT $5,978,350 $8,946,350 $24,841,350 $20,866,350 $14,861,950 –Tax (35%) 2,092,423 3,131,223 8,694,473 7,303,223 5,201,683

=NI $3,885,928 $5,815,128 $16,146,878 $13,563,128 $9,660,268 + Depreciation 5,501,650 9,428,650 6,733,650 4,808,650 3,438,050

=OCF $9,387,578 $15,243,778 $22,880,528 $18,371,778 $13,098,318 NWC Beg NWC $0 $5,719,000 $7,875,000 $12,000,000 $10,080,000 –End NWC 5,719,000 7,875,000 12,000,000 10,080,000 0

=NWC CF ($5,719,000) ($2,156,000) ($4,125,000) $1,920,000 $10,080,000 Net CF $3,668,578 $13,087,778 $18,755,528 $20,291,778 $23,178,318

Please note that here Net CF (Net cash flow) = OCF (Operating cash flow) + NWC CF (Net working capital cash flow).

F13 BUS-F301 Solution to Minicase of Chapter 10 4/11

Book Value (BV) of equipment = Cost of equipment – Accumulated depreciation over the project’s five year life = $38,500,000 – ($5,501,650+$9,428,650+$6,733,650+$4,808,650+$3,438,050) = $38,500,000 – $29,910,650

= $8,589,350

Since, at the end of the project life, the book value of the equipment ($8,589,350) is higher than its estimated market value ($5,400,000), we need to calculate the tax credit that can be realized on the sale of the equipment.

Tax credit on sale of equipment = (BV – MV)(TC) where BV is the book value of the equipment at the end of the project life MV is the estimated market value of the equipment at the end of the project life TC is the corporate tax rate Tax credit on sale of equipment

= (BV – MV)(TC) = ($8,589,350– $5,400,000)(.35) = $1,116,273

CF on sale of equipment = Estimated market value of equipment + Tax credit on sale of equipment = $5,400,000 + $1,116,273 = $6,516,273 So, the cash flows of the project are: Time Cash flow 0 –$38,500,000 1 3,668,578 2 13,087,778 3 18,755,528 4 20,291,778 5 29,694,591 (=$23,178,318 +$6,516,273)

1. The payback period is: Year Cash flow Cum. cash flow 0 –$38,500,000 –$38,500,000 1 3,668,578 – 34,831,422 (=–38,500,000+ 3,668,578) 2 13,087,778 – 21,743,644 (=–34,831,422 + 13,087,778) 3 18,755,528 –2,988,116 (=–21,743,644 + 18,755,528) 4 20,291,778 17,303,662 (=–2,988,116 + 20,291,778) 5 29,694,591 46,998,253 (=17,303,662 + 29,694,591)

Note: For answer similar to this in Case Study 2, your are required to show how you calculate the cumulative cash flows as above. Otherwise, your working will be considered as incomplete.

Full recovery takes place in Year 4 when the cumulative cash flow turns from negative to positive.

F13 BUS-F301 Solution to Minicase of Chapter 10 5/11

Payback = Number of years before full recovery + Unrecovered cash flow at the start of the full recovery year/ Cash flow generated during the full recovery year

years15.3

147257.3

8$20,291,77 3Payback

116,988,2$





2. The profitability index is:

By formula:

5 5

4 4

3 3

2 2

1 1

)r1()r1()r1()r1()r1( PV

CFCFCFCFCF

 

 

10.127,804,56$

)12.1(

591,694,29$

)12.1(

778,291,20$

)12.1(

528,755,18$

)12.1(

778,087,13$

)12.1(

578,668,3$

%)121(

591,694,29$

%)121(

778,291,20$

%)121(

528,755,18$

%)121(

778,087,13$

%)121(

578,668,3$ PV

54321



 

 

 

 

48.1

475432.1

000,500,38$

10.127,804,56$ PI



 Cost

Note: For answer similar to this in Case Study 2, if you use the formula method for your calculations, you are required to show what numbers you put in the formula in the same way as the above. Otherwise, your working will be considered as incomplete.

F13 BUS-F301 Solution to Minicase of Chapter 10 6/11

By financial Calculator:

The PV in this question can also be calculated using a financial calculator. Enter CF0 $0 C01 $3,668,578 F01 1 C02 $13,087,778 F02 1 C03 $18,755,528 F03 1 C04 $20,291,778 F04 1 C05 $ 29,694,591 F05 1 I 12 CPT NPV = $56,804,127.10 Please note that we calculate PV instead of NPV this time. We have to set CF0 = 0. Suggested keystrokes with Texas Instruments BA II PLUS: Press CF 2nd [CLR WORK] to clear the work sheet. After that, apply the following keystrokes. 0 ENTER Down Arrow 3668578 ENTER Down Arrow Down Arrow 13087778

ENTER Down Arrow Down Arrow 18755528 ENTER Down Arrow Down Arrow 20291778 ENTER Down Arrow Down Arrow 29694591 ENTER NPV 12 ENTER Down Arrow CPT

 Output = 56,804,126.10

48.1

475432.1

000,500,38$

10.127,804,56$ PI



 Cost

Note: For answer similar to this in Case Study 2, if you use a financial calculator for your calculations, you are required to include the cash flows you entered and the keystrokes as in the above. Otherwise, your working will be considered as incomplete.

F13 BUS-F301 Solution to Minicase of Chapter 10 7/11

By Excel:

A B C 1 Year Cash Flow

2 0 - $38,500,000 CF0 shows the cost of the project is

$38,500,000

3 1 3,668,578 To calculate PV, we use the function

NPV(rate, value1, [value 2]..)

4 2 13,087,778 5 3 18,755,528 6 4 20,291,778 7 5 29,694,591 8

At required rate of return (discount

rate) = 12% 10

11 PV = $56,804,127.10 Formula in Cell B11 is =NPV(B9, B3:B7)

12 13 PI = PV/Cost = 1.475432 Formula in Cell B13 is =B11/-B2

Note: For answer similar to this in Case Study 2, if you use Excel for your calculations, you are required to present your answer in the way as shown above. That is, you need to include the column heading and the row number as well as the Excel formulas, in addition to the cash flows and required return return. Otherwise, your working will be considered as incomplete.

3. The project IRR is:

54321 )1(

591,694,29$

)1(

778,291,20$

)1(

528,755,18$

)1(

778,087,13$

)1(

578,668,3$ 000,500,38$0

IRRIRRIRRIRRIRR  

 

 

Solve for IRR = 25.44% by trial and error. The new smart phone project has an IRR of 25.44 percent.

It is very difficult to solve for IRR without using a financial calculator or Excel. You have to substitute different values of IRR on the right hand side and calculate until you get the value equals the value on the left hand side (i.e. 0). We call this “trial and error” method.

F13 BUS-F301 Solution to Minicase of Chapter 10 8/11

By financial calculator:

The IRR in this question can also be calculated using a financial calculator. Enter CF0 -$38,500,000 C01 $3,668,578 F01 1 C02 $13,087,778 F02 1 C03 $18,755,528 F03 1 C04 $20,291,778 F04 1 C05 $29,694,591 F05 1 CPT IRR = 25.44% Suggested keystrokes with Texas Instruments BA II PLUS: Press CF 2nd [CLR WORK] to clear the work sheet. After that, apply the following keystrokes. 38500000 +/- ENTER Down Arrow 3668578 ENTER Down Arrow Down Arrow

13087778 ENTER Down Arrow Down Arrow 18755528 ENTER Down Arrow Down Arrow 20291778 ENTER Down Arrow Down Arrow 29694591 ENTER IRR CPT

 Output = 25.440579 Therefore IRR of the project = 25.44%.

F13 BUS-F301 Solution to Minicase of Chapter 10 9/11

By Excel:

A B C 1 Year Cash Flow

2 0 -$38,500,000 CF0 shows the cost of the project is $38,500,000 3 1 3,668,578 To calculate IRR, we use the function IRR(value) 4 2 13,087,778 5 3 18,755,528 6 4 20,291,778 7 5 29,694,590 8 9 IRR = 25.440579% Formula in Cell B9 is =IRR(B2:B7)

Note: For answer similar to this in Case Study 2, if you use Excel for your calculations, you are required to present your answers in the way as shown above. That is, you need to include the column heading and the row number as well as the Excel formula, in addition to the cash flows. Otherwise, your working will be considered as incomplete.

4. The project NPV is:

By formula:

10.127,304,18$

)12.1(

591,694,29$

)12.1(

778,291,20$

)12.1(

528,755,18$

)12.1(

778,087,13$

)12.1(

578,668,3$ 000,500,38$

%)121(

591,694,29$

%)121(

778,291,20$

%)121(

528,755,18$

%)121(

778,087,13$

%)121(

578,668,3$ 000,500,38$NPV

54321



 

 

 

 

Note: For answer similar to this in Case Study 2, if you use the formula method for your calculations, you need to show what numbers you put in the formula in the same way as the above. Otherwise, your working will be considered as incomplete.

F13 BUS-F301 Solution to Minicase of Chapter 10 10/11

By financial calculator:

The NPV in this question can also be calculated using a financial calculator. Enter CF0 -$38,500,000 C01 $3,668,578 F01 1 C02 $13,087,778 F02 1 C03 $18,755,528 F03 1 C04 $20,291,778 F04 1 C05 $ 29,694,591 F05 1 I 12% CPT NPV = $18,304,127.10 Suggested keystrokes with Texas Instruments BA II PLUS: Press CF 2nd [CLR WORK] to clear the work sheet. After that apply the following keystrokes. 38500000 +/- ENTER Down Arrow 3668578 ENTER Down Arrow Down Arrow

13087778 ENTER Down Arrow Down Arrow 18755528 ENTER Down Arrow Down Arrow 20291778 ENTER Down Arrow Down Arrow 29694591 ENTER Down Arrow NPV 12 ENTER Down Arrow CPT

 Output = $18,304,127.10 Therefore NPV of the project = $$18,304,127.10 Please note that if you have already entered all the cash flows in the previous question, what you need to do here to get the NPV is just to press NPV 12 ENTER Down Arrow CPT

F13 BUS-F301 Solution to Minicase of Chapter 10 11/11

By Excel:

A B C 1 Year Cash Flow

2 0 -$38,500,000 CF0 shows the cost of the project is $38,500,000

3 1 3,668,578 To calculate NPV, we use the function

NPV(rate, value1, [value 2]..) 4 2 13,087,778 5 3 18,755,528 6 4 20,291,778 7 5 29,694,591 8

At required rate of return

(discount rate) = 12%

11 NPV = $$18,304,127.10 Formula in Cell B11 is =NPV(B9, B3:B7) + B2

Note: For answer similar to this in Case Study 2, if you use Excel for your calculations, you are required to present your answer in the way as shown above. That is, you need to include the column heading and the row number as well as the Excel formula, in addition to the cash flows and required return. Otherwise, your working will be considered as incomplete.

Additional Notes In the estimation of the cash flows for the new smart phone project, we should not include the prototype developing cost of $750,000 and the marketing study cost of $200,000 because they are sunk costs to the project. By definition, sunk costs are those costs that occurred prior to the consideration of the project in hand. They cannot be recovered whether the project is accepted or not. Thus, they are not incremental cash flows as a result of undertaking of the project and should be irrelevant to the consideration of the project. The fixed costs of the old smart phone production should not be included either. This is because Conch has decided to continue the production of the old smart phone for just two more years. This decision is independent of the new smart phone project. Besides, the existence or non- existence of the fixed costs in the production of the old smart phones is not incremental to the new smart phone project thus should be irrelevant to the consideration of the new smart phone project. The NPV rule suggests that the new smart phone project should be accepted since its NPV is positive (i.e. > 0). The IRR and PI rules have the same suggestion as the project’s IRR > its required rate of return and its PI is greater than 1. Since we are not given the cutoff payback period, we cannot tell whether the project should be accepted or not just based on the computed payback period. As the NPV and IRR are the primary investment rules and they both suggest the new smart phone project should be accepted, we can probably conclude that the project should be accepted.