# Capital Budgeting Decision for Target Corp.

A Capital Budgeting Decision of Your Company

Assume that TARGET CORP. is contemplating an investment in an expansion project. A team of experts from different units of the company came up with the following projections regarding the required investment and schedule, costs and revenues emanating from the investment over the next several years: (all the numbers in the Table are in thousands of US dollars). Assume that all of the revenues and the expenses take place at the beginning of each period.

Year Investment in Machinery and equipment Purchase of material Direct and indirect labor Marketing expenses Revenues

0 20,000 0 0 400 0

1 0 1,600 4,800 800 8,000

2 0 2,400 5,700 690 14,000

3 0 2,400 5,700 690 14,000

4 0 2,400 5,700 690 14,000

5 0 2,400 5,700 690 14,000

6 0 2,400 5,700 690 14,000

Assume that the systematic risk coefficient of the proposed project is estimated to be equal to the operating systematic risk coefficient of your company.

Assume also that in computing taxable income, the company is allowed to depreciate the investment in machinery and equipment on a straight line basis over 4 years. The company is of the opinion that at the end of year "6" it may be able to sell the M&E for US$8,000 thousand. (Note: this estimation has no bearing on the company's ability to depreciate the entire investment). The company's tax rate is the combined federal and state corporate income tax of 34% is applicable. (If your own company has accumulated large losses that appear on its balance sheet (where?) then the tax considerations are irrelevant.)

Here are the deliverables for this Module's SLP:

a. Prepare and present a side table of the effects of depreciation, year by year, on the company's future cash flow, including the tax shields of depreciation and the "tax rebates" emanating from the deductibility of depreciation for tax purposes.

b. Then construct the year-by-year after tax cash flow emanating from the proposed project and compute the net present value of the project.

c. Assess the Net Present Value of the proposed project and write a short memo to management recommending acceptance/rejection of the proposal by your company. Explain what cost of capital was used for the computation of the net present value of the proposed project.

d. Note that the projections in the table are in terms of "today's prices". Such projections are called "real terms cash flow".

Answer the following question: In light of the rising concern about inflation in the coming years, do you think adjustments should be made to either the cash flow or to the cost of capital? Explain your answer.

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ADDITIONAL COMMENTS AND EXPLANATIONS

1. It is your SLP Company that is considering the investment proposal. Therefore the computation of the Net Present Value must be performed using your SLP company's weighted average cost of capital (WACC) that you should have computed in Module 4 SLP. WACC = 6.04%

2. You have to construct the year-by-year after-tax cash flow of the proposed project.

The after tax cash flow in each year is defined as

ATCF = [Revenues - operating expenses]x(1 - T)+ [Annual depreciation x T] minus the investment undertaken in that year.

Therefore in the first year you are allowed to show 5,000 depreciation for tax purposes, in year 2 you can show 5,000 and so on for years 3 and 4. Therefore you are asked to prepare a table where you compute the depreciation that you can show the IRS each year. Of course, in year 5 and in year 6 you can't show depreciation because you already depreciated the entire amount of the investment. By the end of the period the 'book value' of the machinery and equipment is zero.

The annual depreciation provides the company with a tax shield. Each year the company can be viewed as if it gets a rebate from the IRS to the amount of the depreciation that it is allowed to show, times the corporate tax rate of 0.34

Year zero (now) cash flow will be: -20,000 - 400x(1 - 0.34) = -20,264

(You take into consideration the fact that it is 'your SLP Company' that is considering the project so that in the first two or three years despite the fact that you have a negative cash flow you still get the tax rebate because your company can 'use' these losses to offset taxable income from other activities of the company. The 400 marketing expenses undertaken immediately and are an expense provide you with a tax saving of 400x0.34 or 136, so the negative after tax cash flow in year zero is -20,000, minus only 264 for a total of -8,234).

In year 1 the after tax cash flow will still be negative as follows:

[ 8000 (revenues) - (1600+4800+800)(expenses) ]x(1-0.34) +5000(depreciation)x0.34 =

= 528 + 1700 = 2,228

Year 2 cash flow may also be negative, and you should figure this out,

YOU SHOULD PROCEED AND construct the after-tax cash flow year by year.

The residual value: You are told that it is projected that at the end of the 6 years period the company believed that it will be able to sell the used machinery and equipment for 7000 thousand dollars. If it will indeed be able to sell the staff for that money, it will have to pay tax on the difference between this amount and the book value of the machinery and equipment. Since the book value will then be zero (because you have depreciated the entire investment by that time), the entire selling price is taxable at 34% so the company's cash inflow at the end of year 6 is arrived at as [Revenues minus operating expenses]x(1-T) , plus the 7,000 x (1-T).

Now after you construct the after-tax cash flow of the proposal:

Take the after-tax cash flow year by year, and then compute the net present value of the proposal using your SLP Company's WACC as the discount rate. Then write a short memo to the company's top management recommending whether to undertake the investment proposal or to reject it.

The company is Target Corp.

The WACC is 6.04%

#### Solution Preview

a. Prepare and present a side table of the effects of depreciation, year by year, on the company's future cash flow, including the tax shields of depreciation and the "tax rebates" emanating from the deductibility of depreciation for tax purposes.

Kindly see the attached excel file for the calculations and analysis

b. Then construct the year-by-year after tax cash flow emanating from the proposed project and compute the net present value of the project.

Kindly see the attached excel file for the calculations and analysis

c. Assess the Net Present Value of the proposed project and write a short memo to management recommending acceptance/rejection of the proposal by your company. Explain what cost of capital was used for the computation of the net present value of the proposed project.

Capital budgeting uses Net Present Value (NPV) as a rule for budgeting decisions because an investment made today is in anticipation of returns in the distant future.

NPV is defined as the difference between an investment's market value and its cost. It is only a good investment if it makes money for the company so a positive NPV will be needed. Following steps have to be followed:

? Cash flows of the investment project should be forecasted based on realistic assumptions.

? Appropriate discount rate should be identified to discount ...

#### Solution Summary

This discusses the steps to solve the capital budgeting decision for an organization with calculations and analysis included in an attached Excel and attached Word document.