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Week 8 Problems.xlsx

Problems

Problem Assignments: Week 8
Assigned
Problems
1	Ann Page Co. … fixed costs $30,000 per year. Variable costs per unit are $17. Sales price per unit is $30.
a)	What is the contribution margin of the product?
Answer:	$13.00	Contribution margin is unit sales price less unit variable cost.
b)	Calculate the breakeven point in unit sales and dollars.
Answer:	Breakeven in units is		2,308
	Breakeven in dollars =		$69,240.00
c)	What is the operating profit (loss) at:
	i) 1,500 units per year?
Answer:	-$10,500
	ii) 3,600 units per year?
Answer:	$16,800
d)	Plot a breakeven chart using the foregoing figures.
2	Mrs. Jones owns 100 shares of stock in Daimler-Benz valued at 16.5 Euros per share. What is the value in $U.S. of her stock if:
a)	0.90	€ = $1
Answer:	Value of 100 shares at €16.5 per share			1,650.00	Euros
	Value of	1,650.00	Euros at	0.90	€ = $1 is	$1,833.33
b)	0.70	€ = $1
Answer:	Value of	1,650.00	Euros at	0.70	€ = $1 is	$2,357.14
c)	1.20	€ = $1
Answer:	Value of	1,650.00	Euros at	1.20	€ = $1 is	$1,375.00
3	John is planning on purchasing his German dream car for					65,000	Euros
	How much does he need in $U.S. if there are				0.98	Euros to the $U.S.?
Answer:	Value of	65,000	Euros at	0.98	€ = $1 is	$66,326.53

Next Week

	The Week 8 assignment completed our course section on global finance.
	In Week 9, we turn to the effectiveness of product cost determination and pricing.
	For perspective, lets review where we have been, where we are, and where we are going.
	From the Syllabus, here are Weeks 1-10
	Subject Area	Topic
	Week 1: Economic Analysis	The economic environment of business
	Week 2: Financial Accounting	Evaluating corporate performance
	Week 3: Financial Statement Analysis
	Week 4: Financial Valuation	Valuation of stocks and bonds
	Week 5: Analysis of Financial Situations	More advanced financial valuation methods
	Week 6: Ethics and Financial Reporting	How reliable are audited financial statements?
	Week 7: Introduction to International Finance	Global finance
	Week 8: Global Financial Investment
	Week 9: Cost Measurement Systems	The effectiveness of product cost determination and pricing
	Week 10: The Balanced Scorecard	Effective strategy implementation and performance evaluation

Kellogg Capital Budgeting Case.doc

KELLOGG: A MINI CAPITAL BUDGETING CASE

Rathin S. Rathinasamy

Professor of Finance

THE CONTEXT

Kellogg Company , together with its subsidiaries, is engaged in the manufacture and marketing of ready-to-eat cereal and convenience foods, such as cookies, crackers, toaster pastries, cereal bars, fruit snacks, frozen waffles and veggie foods. These products are manufactured by Kellogg in 19 countries and marketed in more than 180 countries. Its cereal products are generally marketed under the Kellogg’s name, and are sold principally to the grocery trade through direct sales forces for resale to consumers. It also markets cookies, crackers, and other convenience foods under Kellogg's, Keebler, Cheez-It, Murray, Austin, and Famous Amos brands to supermarkets in the US through direct store-door delivery system and other distribution methods.

Image source:

www.kelloggcompany.com

Kellogg is doing quite well with annual sales of more than US$12 billion, gross profit margin of 43.7%, and a net profit margin of 9.1% last year. Its recent Return on Equity (ROE) is an impressive 48.7%, while Return on Assets (ROA) and Return on Capital funds are 9.7% and 14.8% respectively.

Kellogg stock is a very popular and highly sought-after investment in the US and the rest of the world and is held by several institutions as part of their portfolio holdings. The company is listed on the New York Stock Exchange (NYSE) under the symbol ‘K’. Kellogg is part of the Standard & Poor’s 500 Index and the Standard & Poor’s 1500 Composite Index.

Its Indian subsidiary is now among the fastest growing markets although it had a rocky start in the Indian market. In 1994, Kellogg entered the Indian market with a plan to create new breakfast habits. At that time, the Indian market held great significance for Kellogg because its US sales were stagnating and only regular price increases had helped boost the revenues in the 1990s. Besides cornflakes, its product offerings were wheat flakes and basmati rice flakes. However, it initially met with failure as Indians were used to eating hot breakfast such as paratas or thosais and pouring hot milk on crispy cornflakes made the flakes soggy.

The subsequent launch of Chocos and Frosties in India was the turning point and Kellogg decided to localize its products with the introduction of the Mazza series in local flavors such as coconut, mango and rose.

“It would be foolhardy for me to say Kellogg has replaced cooked breakfast,” said Anupam Dutta, managing director of Kellogg India. “I don't think we can ever hope for that. But we've become a part of the consideration set for breakfast in many Indian homes, and that's a tipping point.”

Anupam Dutta

Managing Director, Kellogg India

Image source:

www.expresshealthcaremgmt.com

Currently, its key competitors in the Indian market include General Mills Inc., Kraft Foods and PepsiCo, Inc. but the rapidly growing breakfast cereal market is seeing an influx of rivals such as Frito Lay’s Quaker, HUL’s Amaze and Nestlé’s Cerevita.

In India, Kellogg’s’ portfolio in India includes Kellogg’s All Bran Wheat Flakes and Kellogg’s Just Right Muesli. With the increasing globalization, and the emphasis on convenience and ready-to eat foods, Kellogg sees an opportunity to manufacture a new rice-based cereal called ‘Kelli-Rice-Mix’. The new plant will be based in Bangalore, India, and will cost Rs. 400 million. The salvage value of the plant at the end of its five-year economic life is estimated to be Rs. 50 million, net of any tax effects. This plant will also call for extra inventory holding of Rs. 200 million, and extra accounts payables of Rs. 100 million. In addition, it is estimated that the new product would reduce the sale of Kellogg’s existing Frosties cereal in India by Rs. 30 million per year, with the effect of “cannibalizing” it.

Projected sales from this new plant are Rs. 300 million per year. The fixed costs are estimated to be Rs.100 million per year, and the variable costs are estimated to be Rs. 50 million per year. Depreciation on the new plant after accounting for the salvage value will be Rs. 70 million per year. The Indian government will impose a 35% tax on the earnings whereas the US

Image source:

www.businessworld.in

Government will not impose any taxes. 100% of the cash flows will be remitted to the parent company. The exchange rate is expected to be stable at Rs. 43.50 per US$.

Commenting on the Indian market, Jayanta Roy of consulting company Frost & Sullivan said, “Every company that wants a share has to invest heavily, localise extensively and be very patient.”

Table 1: Kellogg’s Summary Financial Data (2005 – 2007) Consolidated results (US$, in millions) 2007 2006 2005 Net Sales $11,776 $10,907 $10,177 Net Sales Growth: 8.0% 7.2% 5.9% Operating Profit $1,868 $1,766 $1,750 Operating Profit Growth 5.8% 0.9% 4.1% Diluted Net Earnings Per Share (EPS) $2.76 $2.51 $2.36 EPS Growth 10% 6% 10% Table 2: Kellogg’s Income Statements (2003 – 2007)

Financial data in US$
Values in millions (Except for per share items)
	2007	2006	2005	2004	2003
Period End Date	12/29/2007	12/31/2006	12/31/2005	1/1/2005	12/27/2003
Period Length	12 Months	12 Months	12 Months	12 Months	12 Months

Revenue	11,776.00	10,906.70	10,177.20	9,613.90	8,811.50
Total Revenue	11,776.00	10,906.70	10,177.20	9,613.90	8,811.50

Cost of Revenue, Total	6,597.00	6,081.50	5,611.60	5,298.70	4,898.90
Gross Profit	5,179.00	4,825.20	4,565.60	4,315.20	3,912.60

Selling/General/Adminis-trative Expenses, Total	3,311.00	3,059.40	2,815.30	2,634.10	2,368.50
Research & Development	0	0	0	0	0
Depreciation/Amortization	0	0	0	0	0
Interest Expense (Income), Net Operating	0	0	0	0	0
Unusual Expense (Income)	0	0	0	0	0
Other Operating Expenses, Total	0	0	0	0	0
Operating Income	1,868.00	1,765.80	1,750.30	1,681.10	1,544.10

Interest Income (Expense), Net Non-Operating	-319	-308.4	-300.3	-308.6	-371.4
Gain (Loss) on Sale of Assets	0	0	0	0	0
Other, Net	-2	13.2	-24.9	-6.6	-3.2
Income Before Tax	1,547.00	1,470.60	1,425.10	1,365.90	1,169.50

Income Tax – Total	444	466.5	444.7	475.3	382.4
Income After Tax	1,103.00	1,004.10	980.4	890.6	787.1

Minority Interest	0	0	0	0	0
Equity in Affiliates	0	0	0	0	0
US GAAP Adjustment	0	0	0	0	0
Net Income Before Extraordinary Items	1,103.00	1,004.10	980.4	890.6	787.1

Total Extraordinary Items	0	0	0	0	0
Net Income	1,103.00	1,004.10	980.4	890.6	787.1


Total Adjustments to Net Income	0	0	0	0	0
Preferred Dividends	0	0	0	0	0
General Partners' Distributions	0	0	0	0	0

Basic Weighted Average Shares	396	397	412	412	407.9
Basic EPS Excluding Extraordinary Items	2.79	2.53	2.38	2.16	1.93
Basic EPS Including Extraordinary Items	2.79	2.53	2.38	2.16	1.93

Diluted Weighted Average Shares	400	400.4	415.6	416.4	410.5
Diluted EPS Excluding Extraordinary Items	2.76	2.51	2.36	2.14	1.92
Diluted EPS Including Extraordinary Items	2.76	2.51	2.36	2.14	1.92

Dividends per Share – Common Stock Primary Issue	1.2	1.14	1.06	1.01	1.01
Gross Dividends – Common Stock	475	449.9	435.2	417.6	412.4
Interest Expense, Supplemental	319	307.4	300.3	308.6	371.4
Depreciation, Supplemental	364	351.2	390.3	399	359.8

Normalized EBITDA	2,240.00	2,118.50	2,142.10	2,091.10	1,916.90
Normalized EBIT	1,868.00	1,765.80	1,750.30	1,681.10	1,544.10
Normalized Income Before Tax	1,547.00	1,470.60	1,425.10	1,365.90	1,169.50
Normalized Income After Taxes	1,103.00	1,004.10	980.4	890.6	787.1
Normalized Income Available to Common	1,103.00	1,004.10	980.4	890.6	787.1

Basic Normalized EPS	2.79	2.53	2.38	2.16	1.93
Diluted Normalized EPS	2.76	2.51	2.36	2.14	1.92
Amortization of Intangibles	8	1.5	1.5	11	13

Table 3: Kellogg’s Consolidated Balance Sheet (in millions) (2003–2007)
	2007	2006	2005	2004	2003
Period End Date	12/29/2007	12/31/2006	12/31/2005	1/1/2005	12/27/2003


Assets
Cash and Short Term Investments	524	410.6	219.1	417.4	141.2
Cash & Equivalents	524	410.6	219.1	417.4	141.2
Total Receivables, Net	1,026.00	944.8	879.1	776.4	754.8
Accounts Receivable – Trade, Net	903	833.5	775.8	776.4	754.8
Accounts Receivable – Trade, Gross	908	839.4	782.7	0	0
Provision for Doubtful Accounts	-5	-5.9	-6.9	0	0
Receivables - Other	123	111.3	103.3	0	0
Total Inventory	924	823.9	717	681	649.8
Prepaid Expenses	140	131.8	0	0	0
Other Current Assets, Total	103	115.9	381.3	247	242.1
Total Current Assets	2,717.00	2,427.00	2,196.50	2,121.80	1,787.90

Property/Plant/Equipment, Total – Net	2,990.00	2,815.60	2,648.40	2,715.10	2,780.20
Goodwill, Net	3,515.00	3,448.30	3,455.30	3,445.50	3,098.40
Intangibles, Net	1,450.00	1,419.70	1,438.20	1,442.20	2,034.40
Long Term Investments	0	0	0	0	0
Note Receivable – Long Term	0	0	0	0	0
Other Long Term Assets, Total	725	603.4	836.1	837.3	441.8
Other Assets, Total	0	0	0	0	0
Total Assets	11,397.00	10,714.00	10,574.50	10,561.90	10,142.70

Liabilities and Shareholders' Equity
Accounts Payable	1,081.00	910.4	883.3	726.3	703.8
Payable/Accrued	0	0	0	0	0
Accrued Expenses	694	649.1	597.4	322	323.1
Notes Payable/Short Term Debt	1,489.00	1,268.00	1,111.10	750.6	320.8
Current Portion of Long Term Debt/Capital Leases	466	723.3	83.6	278.6	578.1
Other Current Liabilities, Total	314	469.4	487.4	768.5	840.2
Total Current Liabilities	4,044.00	4,020.20	3,162.80	2,846.00	2,766.00

Total Long Term Debt	3,270.00	3,053.00	3,702.60	3,892.60	4,265.40
Long Term Debt	3,270.00	3,053.00	3,702.60	3,892.60	4,265.40
Deferred Income Tax	647	619.3	945.7	959.1	1,062.80
Minority Interest	0	0	0	0	0
Other Liabilities, Total	910	952.5	479.7	607	605.3
Total Liabilities	8,871.00	8,645.00	8,290.80	8,304.70	8,699.50

Redeemable Preferred Stock	0	0	0	0	0
Preferred Stock - Non Redeemable, Net	0	0	0	0	0
Common Stock	105	104.6	104.6	103.8	103.8
Additional Paid-In Capital	388	292.3	58.9	0	24.5
Retained Earnings (Accumulated Deficit)	4,217.00	3,630.40	3,266.10	2,701.30	2,247.70
Treasury Stock - Common	-1,357.00	-912.1	-569.8	-108	-203.6
Other Equity, Total	-827	-1,046.20	-576.1	-439.9	-729.2
Total Equity	2,526.00	2,069.00	2,283.70	2,257.20	1,443.20

Total Liabilities & Shareholders’ Equity	11,397.00	10,714.00	10,574.50	10,561.90	10,142.70


Total Common Shares Outstanding	390.05	397.7	405.33	413.02	409.7
Total Preferred Shares Outstanding	0	0	0	0	0

THE TASK

Kellogg’s board of directors is meeting tomorrow to decide whether or not to go ahead with the proposed plant construction In Bangalore, India. The board requires a comprehensive report on the economic viability of the proposed project. If it decides to go ahead with the project, a decision has to be made as to how to finance the project. The board is currently considering two options – the issue of new common stock at a cost of 15% or the issue of 15-year bonds at a net before-tax cost of 10%.

Steve Johnson, CFO of Kellogg who has been with the company for a long time, feels that both the project investment and financing should be carried out in tandem. As such, he feels that the required rate of return on the new capital investment would depend on how it is financed. In other words, if Kellogg chooses to go with the equity, the ROR here should be 15%; and if debt is used, then the relevant debt cost should be used.

On the other hand, his young deputy, Brangelina Aniston who has an MBA from Stanford Graduate School of Business, feels strongly that investment and financing decisions should be kept separate, and that the project’s required rate of return should be based on the risk of the project. As an analyst, your task is to evaluate Kellogg’s proposed new investment and assess if the project should be accepted.

GUIDE TO THE TASK

Having just completed 612 Finance, you are confident you are up to the task of evaluating the proposed new plan investment in its entirety. Reflecting on what you have learnt in the course, you decide that, at the very least, you need to calculate the following:

· Estimate Net Investment Cost at time 0.

· Estimate Incremental After-tax Cash Flows in Years 1 through 5.

· Using data from the latest income statement and balance sheet, compute the relevant cost of debt.

· Using data from the latest income statement and balance sheet, compute the relevant cost of equity. (For this part, assume all funds for the project are raised internally.)

· Estimate the Required Rate of Return for the project using

- the Security Market line Equation of the Capital Asset Pricing

Model and

- Weighted Average Cost of Capital

· Compute the Net Present Value (NPV), Internal Rate of Return (IRR) and the Modified IRR (MIRR) of the project.

· Re-calculate the NPV’s, IRR’s and the MIRR’s for the two exchange rate scenarios given below:

Scenario A

t = time 1 2 3 4 5

Rs. 45/US$ Rs. 47.50/US$ Rs. 50/US$ Rs. 52.5/US$ Rs. 55/US$

Scenario B

t = time 1 2 3 4 5

Rs. 45/US$ Rs. 42.50/US$ Rs. 40/US$ Rs. 38/US$ Rs. 36/US$

· Using the historical Indian rupee exchange rates, provide a (subjective) forecast of the Indian rupee versus US dollar during the investment horizon of 0–5 years. (A website on exchange rates can be found here .) Give your opinion as to whether exchange rate expectations provide ‘auspicious’ support for Kellogg’s proposed investment at the present time.

· Reconcile the divergent views of Johnson and Aniston, and incorporate the right approach in your analysis wherever appropriate.

· Convert the cash flows to US dollars and provide your answers also in US dollars.

Note: The long-run average return on the S&P 500 Index is 12.4%. T-bills and T-bill rates can be found here . Information on beta of Kellogg can be obtained at Yahoo Finance or MSN Money pages. Include charts and tables, where appropriate. Clearly state your assumptions and provide detailed calculations, where necessary.

� This Mini Case was developed as Open-book Open-Web (OBOW) Final Exam for the MBA 612 Finance Course of Universitas21 Global (U21G) in the Summer of 2008. The author expresses his thanks to U21G for the permission granted to him to use this case in the UMUC AMBA 605 Course Sections.

Airline Borrowing Case.doc

Airline Borrowing Case: May 1985

It is May 1985 and UAL, Inc., parent of United Airlines, needs to borrow $500 million to finance the purchase of Hertz. You are Assistant Treasurer and must make a recommendation about the choice between borrowing in the USA in U. S. Dollars or in Japan in Yen (¥). As background, UAL, Inc. owns United Airlines and Westin Hotels. It is buying Hertz from RCA. United Airlines will generate about 80% of the UAL revenue and the remainder will be evenly split between Hertz and Westin. United Airlines, Hertz, and Westin Hotels are worldwide service companies that generate revenue in many countries and currencies, mainly in the U.S., Canada, Latin America, and Europe. The Treasurer considers this to be a “No Brainer” or easy choice.

If the loan is in U. S. Dollars in the USA, company policy requires the use of a specific investment banker. This firm describes the terms of the USA loan as follows: An interest rate of 11% per year paid semi-annually in December and June for 10 years. The principal of $500 million would be repaid at the end of the 10-years. There would be a one-time underwriting fee of 0.5% to be paid when the loan funds are received.

A leading Japanese bank is offering a loan with the interest and principal denominated in Yen. The interest rate will be 5% and there are no upfront fees. Both loans require interest payments in December and in June. The entire principal is due in June 1995.

In May 1985, the exchange rate fluctuated between 250 and 252 yen to the dollar. For convenience, use 250 ¥ to the $ as the exchange rate in May 1985. Each student must (a) recommend one alternative and (b) discuss why your alternative is wise.

You can find historical currency rates at http://www.oanda.com/convert/fxhistory . This link is provided to allow the reader to check the exchange rates included in the case.

Kellogg Analysis Key.xls

Calculations

Calculations
1. Cost of debt					2007	2006	2005	2004	2003
	Long term debt	- Current portion of LT debt		usd mill	466	723	84	279	578
		- LT portion of LT debt		usd mill	3,270	3,053	3,703	3,893	4,265
	Total Long term debt			usd mill	3,736	3,776	3,786	4,171	4,844
	Annual interest cost			usd mill	319	307	300	309	371
	Cost of debt before tax			%	8.54%	8.14%	7.93%	7.40%	7.67%
	Cost of debt after tax (1-35%)			%	5.55%	5.29%	5.16%	4.81%	4.98%
2. CAPM - Cost of Equity
	Re = Rf + βasset x (Rm-Rf)
	Rf	Assume 10 -Year US T-Bonds yield i.e. 4% as risk-free interest rate i.e. Rf								http://www.bondsonline.com/Todays_Market/Composite_Bond_Yields_table.php
	Rm	Assume the long-run average return on the S&P 500 Index is 12.4% as expected return on market portfolio i.e.Rm
	Beta	Equity Beta is 0.37
										http://finane.yahoo.com
	1. Beta from Yahoo Finance		0.37							www.bondsonline.com
	2. 10-year T-Bond Yield from		4.00%
	Bonds Online
	3. Market Return		12.40%
	4. Cost of Equity		7.11%
	1. Beta from Yahoo Finance		0.37
	2. 10-year T-Bond Yield from		4.00%
	Bonds Online
	3. Market Return		12.40%
	4. Cost of Equity		7.11%
3. WACC
	In Millions
	Component		Weight	Cost	WACC
	L. T. Debt	3,270	56.42%	5.55%	3.13%
	Total Equity	2,526	43.58%	7.11%	3.10%
	Total	5,796	100.00%		6.23%

http://www.bondsonline.com/Todays_Market/Composite_Bond_Yields_table.php

http://finane.yahoo.com

www.bondsonline.com

Analysis

Analysis
Rupees
Investment Cost	-400
Inventories	-200
Acct. Payables	100
Net Investmt. Cost	-500
Cashflows
Rupees
Revenues		300	300	300	300	300
Cannibalization		-30	-30	-30	-30	-30
Fixed Costs		-100	-100	-100	-100	-100
Var Costs		-50	-50	-50	-50	-50
Depreciation		-70	-70	-70	-70	-70
			120	120	120	120
EBT		50	50	50	50	50
Taxes @35%		17.5	17.5	17.5	17.5	17.5
Net Income		32.5	32.5	32.5	32.5	32.5
AT Cash Flow		102.5	102.5	102.5	102.5	102.5
Salvage Value						50
Release of Working Capital						100
						102.5
DISCOUNTED CASH FLOW METHODS
NPV@WACC OF 6.23%
								$ million
Cash Inflows	-500.00	102.50	102.50	102.50	102.50	252.50	NPV@WACC OF 6.23%	39.96	IRR	8.74%	MIRR	7.88%
Exchange Rate	43.5	43.5	43.5	43.5	43.5	43.5
US. $million	-11.49	2.36	2.36	2.36	2.36	5.80		0.92	IRR	8.74%	MIRR	7.88%
WACC	6.23%
Weak Rupee	43.5	45	47.5	50	52.5	55
US. $	-11.49	2.28	2.16	2.05	1.95	4.59		(0.80)	IRR	3.88%	MIRR	4.71%
Strong Rupee	43.50	45.00	42.50	40.00	38.00	36.00
US. $	-11.49	2.28	2.41	2.56	2.70	7.01		2.23	IRR	11.94%	MIRR	10.06%
NPV@COST OF EQUITY OF 7.11%
Cash Inflows	-500.00	102.50	102.50	102.50	102.50	252.50	NPV@EQUITY Cost of 7.11%	25.44	IRR	8.74%	MIRR	7.88%
Exchange Rate	43.50	43.50	43.50	43.50	43.50	43.50
								$
US. $	-11.49	2.36	2.36	2.36	2.36	5.80		0.58	IRR	8.74%	MIRR	8.18%
Internal Equity Cost - CAPM	7.11%
Weak Rupee	43.50	45.00	47.50	50.00	52.50	55.00
US. $	-11.49	2.28	2.16	2.05	1.95	4.59		($1.08)	IRR	3.88%	MIRR	5.02%
Strong Rupee	43.50	45.00	42.50	40.00	38.00	36.00
US. $	-11.49	2.28	2.41	2.56	2.70	7.01		$1.84	IRR	11.94%	MIRR	10.35%

NPV@WACC OF 6.23%

NPV@COST OF EQUITY OF 7.11%

NPV@EQUITY Cost of 7.11%

NPV@WACC OF 6.23%

Summary

KELLOGG CASE KEY
Executive Summary
At the Board’s request, we made a viability study for the proposed investment – a new plant located in Bangalore for manufacturing the new product of ‘Kelli-Rice-Mix’ (“Investment”).
The key drivers of the purposed Investment have been identified are:
It will support the long-term strategies of Kellogg in India;
It will further strengthen Kellogg’s leading position amongst foreign competitors by launching new product;
It will enhance Kellogg’s profitability and increase shareholder’s value;
It will show Kellogg’s commitment to local market.
We have applied the net present value, IRR and Modified IRR (“MIRR”) methods in evaluating the Investment. The future cash flows associated to the Investment have been discounted at the both costs of capital identified by using Capital Asset Pricing Model (“CAPM”) and Weighted Average Cost of Capital (“WACC”) methods. Different scenarios have been worked out with the considerations of future currency exchange fluctuations.
WACC was calculated at 6.23% and CAPM Equity cost at 7.11%.
We assume the cost of capital for the Investment is same as for the company. In reality, the project’s risk could be higher than the company’s itself, as the plant will be located in India, an emerging market, where risk maybe higher.
The key financial figures can be summarized as below:
Base case – Exchange rate remained stable at Rs. 43.50 / USD
	WACC	CAPM
	6.23%	7.11%
NPV $million	$0.92	$0.58
IRR	8.74%	8.74%
MIRR	7.88%	8.18%
Scenario A – assume Rupee will depreciate in the next 5 years
	WACC	CAPM
	6.23%	7.11%
NPV $million	-$0.80	-$1.08
IRR	3.88%	3.88%
MIRR	5.02%	5.02%
Scenario B – assume Rupee will appreciate in the next 5 years
	WACC	CAPM
	6.23%	7.11%
NPV $million	$2.23	$1.84
IRR	11.94%	11.94%
MIRR	10.06%	10.35%
Thus, the Investment will be profitable with a positive NPV and higher IRR than cost of capital in the base case and strong Rupee scenarios. However, in weal Rupee scenario, the project has a negative NPV and therefore, will not be acceptable.
Key Assumptions
The financial appraisal of the Investment was derived from the following key assumptions:
1. Investment time-horizon - 5 years
2. Initial Investment - Initial investment cost was assumed at Rs.400 mill and Rs.50 residual value at the end of Year 5.
3. Working capital requirement was assumed at Rs.100 mill (extra inventory Rs.200 mill minus extra accounts payables of Rs. 100 mill), and it was assumed as cash inflow at the end of Year 5 accounting for the release of working capital.
4. Sales reduced of existing product due to the new plant – Rs.30 mill per year.
5. Projected annual sales – Rs.300 mill
6. Projected annual fixed cost – Rs.100 mill
7. Projected annual variable cost – Rs. 50 mill
8. Depreciation cost – Rs. 70 mill per year. Assume capital allowance for tax purpose same as depreciation cost.
9. Tax rate – 35% through out the 5 years.
10. 100% cash flow will be remitted to the parent company.
11. Exchange rate Rs 43.5 / USD was assumed in the base case through out the 5 years. The cash flow was converted from Rupee to USD before being discounted.
12. Exchange rate – Scenario A & B:
13. Cost of Debt – assume 5.55% (2007) as the cost of debt after tax (see the below table)
14. CAPM - Cost of Equity
	Re = Rf + β x (Rm-Rf)
	Rf	Assume 10 -Year US T-Bonds yield i.e. 4% as risk-free interest rate i.e. Rf
	Rm	Assume the long-run average return on the S&P 500 Index is 12.4% as expected return on market portfolio i.e.Rm
	Beta	Equity Beta is 0.37
	1. Beta from Yahoo Finance					0.37
	2. 10-year T-Bond Yield from					4.00%
	Bonds Online
	3. Market Return					12.40%
	4. Cost of Equity					7.11%
	1. Beta from Yahoo Finance					0.37
15. WACC						6.23%
US Treasury Bonds (July 18, 08)
Maturity	Yield	Yester-day	Last Week	Last Month	Yield Change
3 Month	1.31	1.3	1.46	1.83	-0.08
6 Month	1.78	1.77	1.92	2.18	-0.05
2 Year	2.51	2.47	2.56	2.83	-0.03
5 Year	3.28	3.25	3.25	3.53	-0.04
10 Year	4	3.97	3.93	4.11	-0.03
30 Year	4.6	4.59	4.51	4.69	-0.03
(Table source: http://www.bondsonline.com/Todays_Market/Composite_Bond_Yields_table.php &
http://finance.yahoo.com)
· Rm - Assume the long-run average return on the S&P 500 Index is 12.4% as expected return on market portfolio
· Equity Beta – assume 0.37
Beta						0.37
Dividend & Yield						1.24 (2.38%)
Earnings/Share						2.77
Forward P/E						17.3
Market Cap.						19.55 Bil
P/E						18.8
Return on Equity						48.66
Total Shares Out.						378.82 Mil
(Table source: http://moneycentral.msn.com/detail/stock_quote?Symbol=k)
Financial Highlights
Sales						12.07 Bil
Income						1.10 Bil
Net Profit Margin						9.09%
Return on Equity						48.66%
(Table sources: http://moneycentral.msn.com/investor/invsub/results/hilite.asp?Symbol=K &
http://finance.yahoo.com
Discounted Cash flow
The attached excel file has addressed the following questions:
· Estimate Net Investment Cost at time 0
· Calculated cash flows in Years 1- 5 of the project
· Estimate incremental after-tax Cash flows in Year 1 through 5
· Calculation of cost of debt
· Calculation of cost of equity – CAPM method and WACC method
· Calculation of NPV, IRR and MIRR
- base case (fixed exchange rate) at CAPM and WACC
- scenario A (depreciated exchange rate) at CAPM and WACC
- scenario B (appreciated exchange rate) at CAPM and WACC
MIRR method is normally used to handle the multiple IRR problem by combining cash flows until only on change in sing remains.
Exchange Rate Forecast and its Impact on the Investment
Historical data indicated Rupee has been appreciating against USD in the past 8 years. According to the forecast by Economist, the trend of the appreciation will continue for the next 5 years.
Rupee vs. USD - Historical data (2000 – 2008)
INR	Average
	bid	ask
2000	46.30928	46.4123
2001	48.10998	48.25872
2002	47.85516	48.0217
2003	45.30488	45.45658
2004	44.51369	44.63854
2005	44.58344	44.73505
2006	44.14819	44.22516
2007	40.35312	40.36298
2008	43.12797	43.13797
(Table source: http://www.oanda.com/convert/fxaverage_result)
Rupee versus USD - Forecast (2007 – 2012)
Key indicators				2007	2008	2009	2010	2011	2012
Real GDP growth (%)				9	7.7	7.1	7.5	7.6	8.1
Consumer price inflation (average; %)				6.4	7.1	6.2	5.3	5	5.2
Budget balance (% of GDP)				-2.8	-3.4	-3.3	-3.2	-3	-2.7
Current-account balance (% of GDP)				-1	-3	-2.7	-2.6	-2.9	-2.9
Lending rate (average; %)				13.1	14	13.9	12	11	10
Exchange rate Rs:US$ (average)				41.3	40.5	39	38	37	36
Exchange rate Rs:¥100 (average)				35.1	38.9	39.2	40.3	40.3	39.2
(Table source: http://www.economist.com/countries/India/profile.cfm?folder=Profile%2DEconomic%20Data)
It seems the investment will be more attractive in the case of Rupee appreciation than in its deprecation against USD. NPV and IRR are both positive in scenario B of Rupee appreciation; also, both IRR and MIRR are greater than the WACC. NPV’s are negative in scenario A of Rupee depreciation, and both the IRR and MIRR are below the WACC. Thus, the project is acceptable in the base and strong Rupee scenarios; it will be unacceptable in the case of weak Rupee scenario.
Ideally, one would like to have a weak Rupee (foreign currency) at the time=0 of original investment, and stronger Rupee when the funds are repatriated inn years 1 through 5 of the project leading to higher $ flows. Nevertheless, the fluctuations of foreign exchange rates make an international company exposed to foreign currency risk, which must be managed and minimized.
Investment decision vs. Financing decision
In response to the CFO of Kellogg’s concern, we believe how to finance a project should have no impact on investment decision. Thus,
the separation theorem rules: investment and financing decisions should always be kept separate; one should decide on investments first,
followed by financing decision.
Cost of capital used for evaluating project has already comprised the elements of cost of equity and/or cost of debt, financing costs would
be double counted if they were factored into cash flow again, and would distort capital investment evaluation.
In an efficient market, it is not easy for finance managers to improve a project’s evaluation by factoring how to finance.
References:
http://www.bondsonline.com/Todays_Market/Composite_Bond_Yields_table.php
http://moneycentral.msn.com/detail/stock_quote?Symbol=k
http://moneycentral.msn.com/investor/invsub/results/hilite.asp?Symbol=K
http://www.economist.com/countries/India/profile.cfm?folder=Profile%2DEconomic%20Data)
http://www.oanda.com/convert/fxaverage_result