Corporate Financial Management Workshop Answers WEEK 10 (Capital Budgeting and Basic Cash Management) 1. The Noslan Plumbing Company is considering expanding its operations by purchasing a truck specially outfitted for work involving the unblocking of drains. The truck can be purchased for $140,000, fully equipped, and would have a useful working life of 10 years: there would be no installation costs. This purchase price would be depreciated fully over the truck’s working life using prime cost (straightline) depreciation, and the truck would have an expected salvage value of $20,000 after 10 years. The company pays a tax rate of 30%. If the new truck were put into operation, an increase in net working capital of $8,000 would be required. Purchase and operation of the truck would increase the company’s annual profit before depreciation and taxes by $28,000 over the useful life of the truck (i.e. ignoring any interest expense). (a) For the project involving purchase and operation of the truck, calculate the initial investment, annual operating cash inflow and terminal net cash flow for capital budgeting purposes (i.e. the relevant incremental after-tax cash flows). (b) Supposing the appropriate cost of capital for the project involving purchase and operation of the truck is 9% per annum, calculate the net present value of the project. State whether the project is acceptable or not by the net present value criterion. (c) Assuming the project of purchasing and operating the truck is ‘ongoing’ in the sense that the truck would be replaced by a similar truck at the end of its working life, determine the annual net present value (ANPV) of the project, again assuming a 9% per annum cost of capital. Answer: a) Initial investment 140,000 8,000 $148,000 (An outflow) 140,000 14,000 10 Annual net profits before taxes 28,000 14,000 14,000 Annual net profits after taxes 0.7(14,000) 9,800 Annual operating cash inflow 9,800 14,000 23,800 Annual depreciation Terminal net cash inflow 20,000 0.3 (20,000) 8,000 22,000 b) 1 23,800[1 (1.09) 10 ] 22,000 NPV 148,000 $14,033.29 0.09 (1.09)10 Since the NPV is positive, the project is acceptable. c) ANPV 2. NPV r 14,033.29 (0.09) $2,186.67 1 (1 r ) n 1 (1.09) 10 GJF, Problem 10-6 (p. 456) “Murdoch Paints is in the process of evaluating two mutually exclusive additions to their processing capacity. The firm’s financial analysts have developed pessimistic, most likely and optimistic estimates of the annual net cash inflows associated with each project. These estimates are given in the following table. Initial Investment Outcome Pessimistic Most likely Optimistic (a) (b) (c) (d) Project A $8000 Project B $8000 Annual net cash inflows (CF) $200 $900 1000 1000 1800 1100 Determine the range of annual net cash inflows for each of the two projects. Assume that the firm’s cost of capital is 10% and that both projects have 20-year lives. Construct a table similar to that above for the NPVs for each project. Include the range of the NPVs for each project. Do parts (a) and (b) provide consistent views of the two projects? Explain. Which project would you recommend? Why? Answer: (a) Range B = $1,100 – $900 = $200 Range A = $1,800 – $200 = $1,600 (b) Net Present Value Outcome Pessimistic Most likely Optimistic Range Project A -$6,297.29 513.56 7,324.41 $13,621.70 Project B -$337.79 513.56 1,364.92 $1,702.71 For example for the pessimistic case for Project A: 2 200 [1 (1.1) 20 ] NPV 8,000 $6,297.29 0.1 (c) Since the initial investment of projects A and B are equal, the range of cash flows and the range of NPVs are consistent. (d) Project selection would depend upon the risk disposition of the management. (A is more risky than B but also has the possibility of a greater return.) 3. Your friend is seeking your advice because he believes you have studied finance so must be good at making financial decisions. He is considering investing in a small business that has the following features: the business costs $20,000. It will generate a net cash inflow of $1500 in one year’s time since inception of the project but the cash inflow will grow thereafter at 1.5% p.a. for an indefinite period of time. Your friend requires a return of 8% p.a. from the investment. Using the NPV method, recommend whether your frienda) should invest in the business because its NPV is +$3,076.92. b) Should invest in the business because its NPV is +$23,076.92. c) Should invest in the business because its NPV is +$18,750. d) should invest in the business because its NPV is +$100,000 Answer: a) This is a case of growing perpetuity (recall the constant dividend growth model that we consider in stock valuation). We can find the present value as under: Present Value of the business = pmt $1500 $23,076.92 ke g 0.08 0.015 Hence, NPV = $23,076.92 -$20,000 = $3076.92. The positive NPV implies that the project can be accepted. 4. GJF, Problem 10-15 (p. 459) “Country Wallpapers is considering investment in one of three mutually exclusive projects, E, F and G. The firm’s cost of capital is 15%, and the risk-free rate, RF , is 10%. The firm has gathered the following basic cash flow and risk index data for each project. Project E $15,000 Initial Inv. Year (t) Project F $11,000 Project G $19,000 Net cash inflows ( CFt ) 1 2 3 $6,000 6,000 6,000 $6,000 4,000 5,000 $4,000 6,000 8,000 3 4 Risk Index (a) (b) RI j 6,000 1.80 2,000 1.00 12,000 0.60 Find the NPV of each project using the firm’s cost of capital. Which project is preferred in this situation? The firm uses the following equation to determine the risk-adjusted discount rate, RADR j , for each project j. RADR j RF [ RI j (r RF ] Where RF = risk-free rate of return RI j = risk index for project j r = cost of capital Substitute each project’s risk index into this equation to determine its RADR. (c) (d) Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation? Compare and discuss your findings in parts (a) and (c). Which project would you recommend that the firm accept? Answer: (a) 6,000 [1 (1.15) 4 ] NPVE 15,000 $2,129.87 0.15 NPVF 6,000 4,000 5,000 2,000 11,000 $1,673.05 1.15 (1.15) 2 (1.15)3 (1.15) 4 NPVG 4,000 6,000 8,000 12,000 19,000 $1,136.29 1.15 (1.15) 2 (1.15)3 (1.15) 4 Project E, with the highest NPV, is preferred. (b) 4 RADRE RF [ RI E (r RF ] 0.10 [1.80 (0.15 0.10)] 0.19 RADRF 0.10 [1.00 (0.15 0.10)] 0.15 RADRG 0.10 [0.06 (0.15 0.10)] 0.13 (c) 6,000 [1 (1.19) 4 ] NPVE 15,000 $831.51 0.19 NPVF $1,673.05 (As in part (a)) NPVG Rank: 1 2 3 4,000 6,000 8,000 12,000 19,000 $2,142.93 1.13 (1.13) 2 (1.13)3 (1.13) 4 Project G F E (d) After adjusting the discount rate, even though all projects are still acceptable, the ranking changes. Project G has the highest NPV and should be chosen, because the discount rate used to find this NPV reflects the risk of the project. Discussion question (student should read and understand this question, will not be discussed in the tutorial): 1. Consider the following statement: “There are benefits to investors from portfolio diversification; therefore firms consisting of a highly diversified collection of assets are more attractive to investors than firms that are relatively non-diversified in terms of their assets”. Is this statement valid? Give a reason for your answer. If the statement were valid, what would be the implications for capital budgeting by firms? Answer: This statement is generally considered invalid. The simple reason for this is that investors can cost effectively diversify their own portfolios by investing in a number and variety of assets. Therefore they do not need firms to diversify for them and will not value firms more highly simply because their assets are more diversified. 5 If the statement were valid, this would have important implications for capital budgeting. In particular, the NPV of a project could not be evaluated in isolation from the firm’s other projects and existing assets. For example, a project would have a different value depending on whether it is undertaken by a single-project firm or a multi-asset firm. In fact if the statement were valid, the market value of a firm could not be calculated as the sum of the individual market values of its assets (a fundamental assumption of most corporate finance). 6