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Project value analysis

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Scenario
The board liked the analysis you did on valuation and agreed to proceed with the expansion plan. Your CFO, investment bankers, and consultants have all been working on the cost and benefits of various expansion options. They have agreed on an option that will see simultaneous expansion into five domestic markets (Chicago, Dallas, Miami, NY, and Charlotte), Germany and Brazil. The CFO has developed cost and benefits of the scenario in a spreadsheet and has asked you to review it.

Look at the spreadsheet and use present value analysis to discount the cash flows. Include the calculations for net income, operating cash flows, free cash flows and the present value cash flows and NPV in your spreadsheet. Does the project have a positive or negative NPV? What are the implications for CPI and its shareholders if there is a positive NPV or a negative NPV. Is the dollar value of the NPV important in light of the expenditure? In making the final decision what kind of economic assumptions do you think the CEO had to make. Articulate the economic and political risk with the strategy and list options to overcome. How will this decision affect the share price and the value of the company? In light of all this information, would you support the above mentioned option for expansion? Why or why not.

Additional Objectives: Explain the significance and implications of various economic theories pertaining to profit, consumer choice, demand and supply, forecasting, and optimization. Apply risk methodologies to economic situations using a variety of approaches ranging from basic statistics to certain equivalency.

The CEO's spreadsheet

Year 2011 2012 2013 2014 2015 2016
Cost of Capital 6% 6% 7% 8% 8%

(US$ in millions)
Revenue $30.10 $34.20 $38.10 $40.40 $45.60
Selling, General, Admin ($16.10) ($17.20) ($18.90) ($19.50) ($21.40)
Depreciation ($4.10) ($4.40) ($4.80) ($4.90) ($5.30)
Interest Expense ($0.45) ($0.56) ($0.69) ($0.73) ($0.78)
Taxes ($1.10) ($1.30) ($1.70) ($1.90) ($2.00)

Increase in fixed assets ($1.30) ($2.40) ($0.90) $0.00 ($4.90)

Year 2017
Cost of Capital 7%

(US$ in millions)
Revenue $50.00
Selling, General, Admin ($24.30)
Depreciation ($5.70)
Interest Expense (0.81)
Taxes (42.10)

Increase in fixed assets ($2.10)

Initial Capital Expenditure ($18.00)

Students need to calculate the following
Net Income

Depreciation (provided) year 2012 ($4.10) year 2013 ($4.40)
year 2014($4.80) year 2015 ($4.90) year 2016 ($5.30) year 2017 ($5.70)

Operating Cash Flows (FV) year 2012 4.25; year 2013 6.34; year 2014 7.21; year 2015 8.47; year 2016 10.82; year 2017 11.39

Increase in fixed assets (provided) year 2012($1.30) year 2013($2.40) year 2014($0.90) year 2015 $0.00 year 2016 $(4.90)
year 2017 ($2.10)

Pvif factor year 2012 0.943; year 2013 0.89; year 2014 0.816; year 2015 0.735; year 2016 0.681; year 2017 0.666
Need PV Cash Flows

Value of future flows
Initial expenditure
NPV

Period 1 1% = 0.990; 2%= 0.980; 3%= 0.971; 4% = 0962; 5% = 0.952;
6% = 0.943; 7% = 0.935; 8% = 0.926; 9% = 0.917; 10% 0.909

Period 2 1% = 0.980; 2% = 0.961; 3% = 0.943; 4% = 0.925; 5% = 0.907;
6% = 0.890; 7%= 0.873; 8% = 0.857; 9%= 0.842; 10% = 0.826

Period 3 1% = 0.971; 2% = 0.942; 3% = 0.915; 4% = 0.889; 5% = 0.864;
6% = 0.840; 7% = 0.816; 8% = 0.794; 9% = 0.772;10%= 0.751

Period 4 1%= 0.961; 2%= 0.924; 3%= 0.888; 4%=0.855; 5%=0.823; 6%=0.792; 7%=0.763; 8%=0.735; 9%=0.708; 10% = 0.683

Period 5 1%=0.951; 2% = 0.906; 3%=0.863; 4%=0.822; 5%=0.784; 6%=0.747;
7%=0.713; 8%=0.681; 9%=0.650; 10%=0.621

Period 6 1%=0.942; 2%=0.888; 3%=0.837; 4%=0.790; 5%=0.746; 6%=0.705;
7%=0.666; 8%=0.630; 9%=0.596; 10% = 0.564

Period 7 1% =0.933; 2%=0.871; 3%=0.813; 4%=0.760; 5%=0.711; 6%=0.665;
7%=0.623; 8%=0.583; 9%=0.547; 10%=0.513

Period 8 1%=0.923; 2%=0.853; 3%=0.789; 4%=0.731; 5%=0.677; 6%=0.627;
7%=0.582; 8%=0.540; 9%=0.502; 10%=0.467

Period 9 1%=0.914; 2%=0.837; 3%=0.766; 4%=0.703; 5%=0.645; 6%= 0.592;
7%=0.544; 8%=0.500; 9%=0.460 10%=0.424

Period 10 1%=0.905; 2%=0.820; 3%=0.744; 4%=0.676; 5%=0.614; 6%=0.558;
7%=0.508; 8%=0.463; 9%=0.422; 10%= 0.386

Compute the correct Net Present Value. Articulate the economic and political risk. List options to overcome risk. Form appropriate questions on economic assumptions. Make the correct decision on whether or not to adopt the strategy. Provide the NPV, IRR, MIRR, and Payback Ratio. Please show work.

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Solution Summary

The projected value analysis is examined.

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See Also This Related BrainMass Solution

Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not.

The Innovative Sporting Goods Company (JSGC) was founded in 1975 in Cambridge, MA. Its founder, Andy Pratt, a mechanical engineer, had developed a sound technique of making baseball bats. Under his leadership, the company had gained national reputation. Recently, however, a new machine had been developed in the industry, which would allow manufacturers to coat the aluminum baseball bats with a special compound giving them a satin finish and making them more durable and powerful. The prototype had been presented to the respective regulatory authorities and had been approved. Upon Andy's request, Douglas Adams, the head of the design group, had tested the new product and researched the relevant cost arid production process issues that a machine replacement would entail.

Doug reported that besides the initial price tag of $350,000 for one of these machines, users would have to incur shipping, handling, and installation costs of $4500 and annual fixed operating costs of about $20,000 per machine. Currently, the company incurs fixed operating costs of $28,000 for it's coating and finishing process. Initial marketing survey results indicated that the company would be able to increase sales of its newly designed baseball bats by about 15% in the first year of introduction and thereafter at a rate of 5% per year compared with forecasted sales growth of 2% per year for the current type of baseball bats. During the most recent year, ISGC sold 220,000 baseball bats at an average price of $12.50 per unit. The newly designed bat was expected to sell for $13 per unit.

Material, labor, general, and administrative costs were expected to remain constant at $10 per unit. The increased sales and production requirements would entail an increase in accounts receivables of $54,000, an increase in accounts payables of 30,000, and an increase in inventory of $ 20,000. It was assumed that any increase in net working capital would be recovered at the end of the useful life of the machine, which was estimated to be 10 years. The existing machine was purchased 5 years ago for $225,000. The depreciation on the existing machine was being calculated using a 15-year straight-line schedule with the assumption of no residual salvage value. The machine had a current market value of $100,000, and an expected market value of $10,000 after 10 more years of use. The new machine was expected to last for ten years -- the same as the remaining life of the old machine.

The new machine would qualify as a 5-year class life asset under MACRS depreciation rates (see Table 1) and was expected to have a market value of approximately $20,000 at the end of its economic life. ISGC'S marginal tax rate was 34% and its weighted average cost of capital was estimated at 15%. Part of the cost of replacing the existing machine would be financed by a bank loan that would require an annual interest expense of 10% on the outstanding balance.

Andy knows that the new technology is the way to go. However, being cautious and conservative by nature, he does not want to implement changes that would be financially detrimental to his company. After all, he has worked too hard to let it all slip away by making lousy financial decisions. Andy has long believed in the age-old saying, " If the coat fits wear it."

Table: 1
Depreciation schedule
Modified Accelerated Cost Recovery System
Recovery Period Class

Year 3-Year 5-Year 7-Year 10-Year
1 33.00% 20.00% 14.30% 10.00%
2 45.00% 32.00% 24.50% 18.00%
3 15.00% 19.20% 17.50% 14.40%
4 7.00% 11.50% 12.50% 11.50%
5 0.00% 11.50% 8.90% 9.20%
6 0.00% 5.80% 8.90% 7.40%
7 0.00% 0.00% 8.90% 6.60%
8 0.00% 0.00% 4.50% 6.60%
9 0.00% 0.00% 0.00% 6.50%
10 0.00% 0.00% 0.00% 6.50%
11 0.00% 0.00% 0.00% 3.30%
Total 100.00% 100.00% 100.00% 100.00%

Questions:
1. Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not. Indicate how would you proceed (without making any calculations)?

2. Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the context of this case.

3. As is often the case, the marketing department has overestimated the annual sales growth. How can more conservative and realistic estimates be generated? How can these estimates be incorporated into the analysis so as to arrive at a good and well justified decision?

4. What are the relevant factors and items to be considered when estimating the initial outlay? Calculate the initial outlay for this replacement project.

5. How are the interim cash flows to be computed for the productive life of the new machinery? How is depreciation to be accounted for?

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