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Captial Budgeting Case

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 corpo-rations 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, analyze, and submit items (a) through (g) in a spreadsheet format and answer questions in (h) and (i) in Microsoft Word format.
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. Based on items (a) through (g), which company would you recommend acquiring?
i. In a 800-1,200-word memo, define, analyze, and interpret the answers to items (c) through (g). Present the rationale behind each item and why it supports your decision stated in item (h). 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 ana-lyze 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).

Solution Preview

H. Which company to acquire. Let us put all parameters in a table as below :

Parameter Corp A Corp B
NPV 20,979 40,251
IRR 13.1% 16.9%
Payback Period 3yrs 8 months 3 yrs 4 months

Since Corp B is better on all parameters, it should be acquired.

I. The projected income statements have been created using the year 1 as the base year and then increasing the revenues are per the percentage given. Similarly, for expenses, year 1 is the base year and then they increase year on year based on the percentage given. The depreciation expense is contact in all the years. Using these, income before tax has been arrived and appropriate tax rate applied to get the income
after tax for each of the 5 years.
The cash flow statement has been arrived at by adding the depreciation amount to the income after tax. Depreciation being non-cash item does not change the cash flows but helps in reducing the tax liability. It has first been taken as an expense in income before tax and then added again in income after tax.
The Net Present Value is the difference between the sum of the present values of the cash flows in the years 1to 5 and the initial investment. The given discounting ...

Solution Summary

The solution explains how to calculate the projected income statement and cash flows for two corporations and to use it to calculate the payback period, NPV and IRR

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