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Capital Budgeting techniques

5 questions on NPV, IRR, Cost of Capital, Financial planning

(See attached file for full problem description)

1. Banner Forklift, Inc. has identified the following two mutually exclusive projects:

(a) Apply NPV and IRR to decide which of these two projects you would accept. The required return on the project is 11%.

(b) Over what range of discount rate would you choose Project X? Project Y? At what discount rate would you be indifferent between these two projects?

2. Flubber Corporation (FC) most recently paid a dividend of $0.10 per share. It expects its dividends to grow at 30% per year for the next 5 years, after which it is expected to maintain a sustainable growth rate of 8% per year. Apply the discounted cash flow framework to value FC's stock, assuming that the discount rate is 15% during the high growth stage and 10% during the stable growth phase.

3. The City of Lowland is accepting bids to build playgrounds. You are working on a bid to construct three playgrounds per year over the next 2 years. This project requires the purchase of $48,000 of equipment which will be depreciated using straight-line depreciation to a zero book value over 2 years. The equipment can be sold at the end of the project for $30,000. You will also need $10,000 in net working capital over the life of the project. The fixed costs will be $15,000 a year and the variable costs will be $65,000 per playground. Your required rate of return is 12% for this project and your tax rate is 35%. What is the minimal amount that you should bid per playground?

4. The Dinghy Boat Company (DBC), a prominent sailboat builder is designing a new 30-foot sailboat. First, DBC would have to invest $10,000 at t=0 for the design and model tank testing of the new boat. DBC's managers believe that there is a 60% probability that this phase will be successful and the project will continue. If Stage 1 is not successful, the project will be abandoned with zero salvage value.

The next stage, if undertaken, would consist of making the molds and producing two prototype boats. This would cost $500,000 at t=1. If the boats test well, DBC would go into production. If they do not, the molds and prototypes could be sold for $100,000. The managers estimate that the probability is 80% that the boat will pass testing, and that Stage 3 will be undertaken.

Stage 3 consists of converting an unused production line to produce the new design. This would cost $1,000,000 at t=2. If the economy is strong at this point, the net value of sales would be $3,000,000, while if the economy is weak, the net value would be $1,500,000. Both net values occur at t=3, and each state of the economy has a probability of 0.5. DBC's cost of capital is 12%.

Assuming that this project is of average risk, construct a decision tree and determine the project's NPV.

5. Preface: One of the questions that came out from our discussion of dividend discount models is, "Can we apply the stock-valuation models covered thus far to firms that pay no dividends?" Yes and no. On the affirmative side, firms that do not currently pay dividends may begin paying them in the future. In that case, we simply modify the equations presented earlier to reflect that the firm pays its first dividend, not in one year, but several years in the future. However, from a practical standpoint, predicting when firms will begin paying dividends and what the dollar value of those far off dividends will be is extremely difficult.

One way to deal with the valuation challenges presented by a firm that pays no dividends is to value the firm as a whole (called "enterprise" value) rather than to value only the firm's shares. That is, we estimate the free cash flows (FCFs) that a firm will generate over time; then we can discount them at an appropriate rate (called the firm's cost of capital) to obtain an estimate of the total enterprise value. Note when analysts value FCFs, they use some of the same types of models that we have used to value dividend streams. We could assume that a firm's FCFs will experience zero, constant, or variable growth, and in each instance the procedures and equations would be the same as those introduced earlier for dividends, except we would now substitute FCF for dividends.

Problem: Tube Investments of India (TI) is a diversified manufacturing firm, with its headquarters in South India. The following information was reported for the year 2004:
? EBIT = Rs 1,422.4 million
? Depreciation = Rs 378.10 million
? Tax = Rs 276.30 million
? Capital expenditures = Rs. 1,025.90 million
? Working capital expenses = Rs 381.50 million
? Debt = Rs 1,296.60 million
? No. of shares outstanding = 36.95 million

The firm's cost of capital (discount rate) is 15.60%.

(a) Calculate the firm's FCF for 2004.

(b) At a perpetual FCF growth rate of 7%, estimate the enterprise value of TI at the end of 2004.

(c) Estimate TI's value per share.


Solution Preview

Several different procedures are available to analyze potential business investments. Some concepts are better than others when it comes to reliability but all provide enough information to get the general scope of the investment. The five procedures that provide useful information are the Net present Value (NPV), the Payback Rule, the Average Accounting Return (AAR), the Internal Rate of Return (IRR), and the Profitability Index (PI). These procedures will help rank the projects from the greatest investment to the worst.
First, the most important concept of evaluating these investments is the NPV. 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. The projects can be ranked from the most positive NPV to the lowest to determine profitability. This quantitative ranking method is the best to use due to its consideration of the time value of money and its more accurate breakdown of value.
COMMENTS: NPV is a discounted cash flow technique, which explicitly recognize the time value of money. It is defined as the difference between the present value of cash inflow and cash outflows.
Second, the payback rule is how long it takes to recover the initial investment. It is noted on the case study as to which year the investment is recouped and it is easy to rank the projects, however this is not the best procedure to use. This rule does not involve discounting which means that time value of money is disregarded, it fails to consider risk differences, and an accurate cutoff period cannot be picked.
Third, another possible approach is the AAR. This is defined as an investment's average net income divided by its average book value. The projects can be ranked according to the excess of AAR compared to the target AAR. Once again, this is a flawed approach because it is not comparable to the returns offered, it ignores time value, it does not have an objective cutoff period, and it does not use ...

Solution Summary

This explains various capital budgeting techniques through various case studies. The tools discussed are NPV, IRR, Free cash flow etc.