Capital Budgeting

Case #2

Problem # 1

Consider the following for an 8 year special revenue generating project. (this is the base case)

· Sales revenue $250,000 in the first year and will increase by 20% per year for the next 4 years. In year 6 the revenue will decrease by 15% a year through year 8. There is no expected cash flow after 8 years as this venture has a constrained timeline and no expected value after 8 years.

· Costs of goods sold will be 70% of sales.

· Advertising and administrative expenses will be fixed at $10,000 per year.

· Equipment will be purchased for $300,000 and will be depreciated using the 7 year MACRS asset class depreciation schedule. Salvage value is expected to be $25,000

· Working capital investment in year 0 is estimated to be $20,000 and is expected to be recovered in the final year of the project.

Cost of Capital is 8% and Tax Rate is 30%.

A: Base Case scenario

· Calculate the project’s NPV

· What is your recommendation?

B: Pessimistic View

· What is the impact on NPV based on pessimistic assumptions (consider both at the same time):

· If Sales Revenue in the first year was only $150,000 and only increase by 10% for the next 4 years and then decline by 20% a year through year 8?

· If Cost of Goods Sold were 75% of sales?

Problem #2

Company is replacing existing equipment with new equipment which can replicate what the existing machine does and also support a new product line.

Old equipment was purchased 3 years ago for 100,000 and was being depreciated using a MACRS 5 year asset class depreciation schedule. It was expected to have a 15,000 salvage value at the end of year 5 when it was planned to be sold. The company is considering replacing it now with a new machine. The old machine can be sold today for 35,000.

New machine will cost 180,000 and is expected to have an economic life of 8 years but is expected to use the MACRS 5 year asset class depreciation schedule for tax purposes. It is expected to have a salvage value of 12% of the original equipment costs at the end of 8 years. The remaining operational years beyond the depreciation tax schedule will not have any depreciation expense but will continue to have operational impact.

The new machine will require an increase in working capital of 10,000 in the first year of the project and will be fully recovered at the end of the project.

The new equipment is expected to increase revenue by 40,000 per year and reduce costs by 5,000 per year before tax impact and consideration of depreciation impact of the new machine.

Cost of Capital is 10% and Tax Rate is 40%.

A: Base Case scenario

· Calculate the project’s NPV

· What is your recommendation?

B: Alternate Analysis Scenarios

· What if revenue impact was only 50% of projections for the first 4 years what would be the impact on NPV?

· What if cost reduction assumptions were not realized and no operational costs saving were achieved? What would the impact on NPV be?

· What if both alternative scenarios happened concurrently.