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Capital Budgeting Mini-Case

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This is an application of capital budgeting that integrates the
projection of a basic cash flow and the computation and analysis of six
capital budgeting tools.
Your company is thinking about acquiring another corporation. You have
two choices; the cost of each choice is $250,000. You cannot spend more
than that, so acquiring both corporations is not an option. The
following are your critical data:
a. Corporation A:
1) Revenues = 100K in year one, increasing by 10% each year.
2) Expenses = 20K in year one, increasing by 15% each year.
3) Depreciation Expense = 5K each year.
4) Tax Rate = 25%
5) Discount Rate = 10%
b. Corporation B:
1) Revenues = 150K in year one, increasing by 8% each year.
2) Expenses = 60K in year one, increasing by 10% each year.
3) Depreciation Expense = 10K each year.
4) Tax Rate = 25%
5) Discount Rate = 11%
You must compute and analyze items (a) through (h) using a Microsoft
Excel spreadsheet. Make sure that all calculations can be seen in the
background of the applicable spreadsheet cells. In other words, leave an
audit trail so that others can see how you arrived at your calculations
and analysis. Items (i), (j), and (k) should be submitted in Microsoft
Word.
c. A 5-year projected income statement
d. A 5-year projected cash flow
e. Net Present Value
f. Internal Rate of Return
g. Payback Period
h. Profitability Index
i. Discounted Payback Period
j. Modified Internal Rate of Return
k. Based on items (a) through (h), which company would you
recommend acquiring?
l. In a 1,050-1,500-word memo, define, analyze, and interpret the
answers to items (c) through (h). Present the rationale behind each item
and why it supports your decision stated in item (i). Also, attempt to
describe the relationship between NPV and IRR. (Hint: The key factor
here is the discount rate used.) In this memo, explain how you would
analyze projects differently if they had unequal projected years (i.e.,
if Corporation A had a 5-year projection and Corporation B had a 7-year
projection).

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Solution Preview

Hi,
See the help in attached Excel Sheet. I have solved the problems and given enough hints for you to work with your memo. Hope this will help. In case of any clarifications get back to me.
Thanks

a. Corporation A:
1) Revenues = 150 K in year one, increasing by 8% each year.
2) Expenses = 60 K in year one, increasing by 10% each year.
3) Depreciation Expense = 10 K each year.
4) Tax Rate = 25%
5) Discount Rate = 11%
6) Initial Purchase price 250 K

A 5-year projected income statement

Year 0 1 2 3 4 5
Revenue 150.00 162.00 174.96 188.96 204.07
Expenses 60.00 66.00 72.60 79.86 87.85
Depreciation 10.00 10.00 10.00 10.00 10.00
Profit Before tax 80.00 86.00 92.36 99.10 106.23
Tax 20.00 21.50 23.09 24.77 26.56
Profit After Tax 60.00 64.50 69.27 74.32 79.67

. A 5-year projected cash flow
Profit After ...

Solution Summary

This is an application of capital budgeting that integrates the projection of a basic cash flow and the computation and analysis of six capital budgeting tools. Could be used as a good practice for the exam preparation.

$2.19
See Also This Related BrainMass Solution

Cash Flow and Capital Budgeting Minicase

ACE Rental Cars, Incorporated (ACE) is analyzing whether to enter the discount used rental car market. This project would involve the purchase of 100 used, late-model, mid-sized automobiles at the price of $9,500 each. In order to reduce their insurance costs, ACE will have a LoJack Stolen Vehicle Recovery System installed in each automobile at a cost of $1,000 per vehicle. ACE will also utilize one of their abandoned lots to store the vehicles. If ACE does not undertake this project they could sublease this lot to an auto repair company for $80,000 per year. THe $20,000 annual maintenance cost on this lot will be paid by ACE whether the lot is subleased or used for this project. IN addition, if this project is undertaken, net working capital will increase by $50,000.
The automobiles will qualify as a 3-year class asset under the mondified accelerated cost recovery system (MACRS). Each car is expected to generate $4,800 a year in revenue and have operating costs of $1,000 per year, Starting 4 years form now, one-quarter of the fleet is expected to be replaced every year with a similar fleet of used cars. This is expected to result in a net cash flow (including acquistion costs) of $100,000 per year continuing infefinitely. This discount rental car business is expected to have aminimum impact on ACE's regular rental car business where the net cash flow is expected to fall by only $25,000 per year ACE expects to have a marginal tax rate of 32%.

Based on this information, answer the following questions.

1. What is the initial cash flow (fixed asset expenditure) for this discount used rental car project?

2. Is the cost of installing the LoJack System relevant to this analysis?

3. Are the maintenance costs relevant?

4. Should you consider the change in net working capital?

5. Estimate the depreciation costs incurred for each of the next 4 years.

6. Estimate the net cash flow for each of the next 4 years.

7. How are possible cannibalization costs considered in this analysis?

8. How does the opportunity to sublease the lot affect this analysis?

9. What do you estimate as the terminal value of this project at the end of
year 4 (use a 12% discount rate for this calculation)

10. Using the standard discount rate of 12% that ACE uses for capital
budgeting, what is the NPV of this project? If ACE adjusts the discount
rate to 14% to reflect higher project risk, what is the NPV?

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