Capital Budgeting Problems. Done in EXCEL. Simulation involved. Please help

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CAPITAL BUDGETING

There are three capital budgeting practice problems in this document. Recall that capital budgeting is the process that is used to assess whether or not a capital investment is desirable or not. We will discuss a number of capital budgeting techniques to work our way through recommendations on these problems. There are a number of capital budgeting issues that we will only scratch the surface on with these examples, although we will discuss many of the other issues in class. For example, for all of these practice problems we are valuing all of the cash flows to the project rather than only the cash flows to debt or equity. I expect that you are relatively comfortable working through capital budgeting problems. The Capital Budgeting Problem 3 shows a general framework that I use for working on a capital budgeting problem. This may (or may not) be of use to you.

For each of the problems, I also have included a simulation component which we will get to in a few class periods (that is, don’t work on these parts of the problems until we go through an introduction of the Monte Carlo simulation software). As analysts, we want to take advantage of all of the information that we have when evaluating a project. Capital budgeting problems that you have analyzed in the past likely just presented expected values for the inputs. In reality, there is usually additional information on inputs that may affect our decisions. The simulation analysis will allow us to explore the effects of input parameters a bit more directly.

Capital Budgeting Problem 1

Wally’s Water Works (WWW) is considering a new piping system with an installed cost (initial investment) of

$950,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the piping system can be scrapped for a cost of $100,000 (This means that the firm has to pay $100,000 to get rid of the system, not a salvage of $100,000.). The cost to scrap the system is a tax deductible operating expense. The piping system will not generate new sales, but it will decrease current Cost of Goods Sold (COGS) by $550,000 per year (this means that sales will not change, but COGS will be $550,000 lower). The system requires an initial investment in net working capital of $57,500 that will be returned at the end of the project.

The tax rate for this firm is 35 percent. The required return for projects of the same level of risk as this water system is 11%.

Do you recommend that WWW proceed with this project? Clearly present and justify your recommendation.

SIMULATION: The COGS decrease of $550,000 provided is the AVERAGE COGS decrease you can expect. You have developed additional information from some of your other water projects that the COGS decrease is expected to be uniformly distributed between $400,000 and $700,000. Does this additional information alter your recommendation?

Do you recommend that WWW proceed with this project? Clearly present and justify your recommendation.

Capital Budgeting Problem 2

Caine-Cleaseau BioPharma (CCB), a small, publicly traded pharmaceutical firm in Seattle, WA, is considering whether to develop a drug named SmoothSkin. In order to develop and produce SmoothSkin, CCB will have to buy an existing manufacturing lab for $35 million. This lab will be depreciated to zero using straight-line depreciation over the seven- year life of the project. The lab is expected to have a salvage value at the end of the project of $2 million.

CCB expects sales for SmoothSkin to be $70 million per year for the first year of the project, and sales are expected to show a growth rate of 10% per year for the life of the project. CCB expects the costs of goods sold to be 60% of sales, marketing and administrative expenses to be 10% of sales, and fixed costs of $10 million per year. Finally, the project will require an increase in net working capital of $8 million at the beginning of the project which will be recouped at the end of the project as inventory is sold, receivables are collected, and payables are paid.

This project is more risky than the average CCB project, so the advisors suggest the discount rate be increased to 1%

above that used to evaluate an average CCB investment.

CCB equity has a beta (bE) of 1.5. There are 3,000,000 shares outstanding, the current market price is $32/share, and

CCB does not pay dividends on common equity.

CCB has 200,000 preferred shares outstanding that pay a $2 annual dividend, and have a current market price of $32.

CCB has one issue of debt outstanding with a book value of $50 million. The bonds are currently selling at 95% of their $1,000 face value, mature in 10 years, and have a 6% coupon paid semiannually.

The current market risk premium is 5% and the return to treasury bonds is 2%. CCB’s corporate tax rate is 30%.

Do you recommend that CCB proceed with the SmoothSkin project? Clearly present and justify your recommendation.

SIMULATION: More information has been developed on sales and costs. CCB forecasts the sales to have an expected value of $70 million in the first year of the product sales, but that forecast has a standard deviation of $20 million. Sales growth for each subsequent year is forecast to be 10%, but that sales growth has a standard deviation of 5.0%. In addition, COGS are forecast to be 60% of sales for that year, but that forecast has a standard deviation of 10%.

Do you recommend that CCB proceed with the SmoothSkin project? Clearly present and justify your recommendation. Compare your recommendation to that of the ‘static’ analysis.

Capital Budgeting Problem 3

Karsten Golf is a smaller sports equipment company that specializes in high-quality, lower-priced golf clubs. The total market value of the company (debt, preferred and equity combined) is $100 million. The market value of outstanding

debt for the firm is $40 million. The single bond issue of the firm will mature in 10 years, has a coupon rate of 6.2% (paid semiannually), has a current market price of $1098, and has a face value of $1000.

Karsten has 250,000 shares of preferred stock outstanding with a current market price of $100 (that is, the current market price is par value). The return required on the preferred stock (that is, the cost of capital for preferred, rP) is 6%.

The current market price of a share of Karsten equity is selling for $80. Earnings next year are expected to be $10 per share and the growth rate in earnings is expected to be about 4% per year forever. The firm has a dividend payout ratio of

40 percent.

Treasury bills (the risk-free asset) are currently providing a return of about 3.7% per year. The tax rate for Karsten is 35 percent.

Karsten Golf has decided to sell a new line of golf clubs. The clubs will sell for $600 per set and have a variable cost of

$240 per set. The company has spent $150,000 for a credible marketing study that determined the company will sell 50,000 of the new line of clubs per year for seven years. The marketing study also determined that the company will lose sales of 12,000 sets per year of its high-priced clubs. The high-priced clubs sell at $1000 and have variable costs of $550. The company will also increase sales of its cheap clubs by 10,000 sets per year. The cheap clubs sell for $300 and have variable costs of $100 per set. The fixed costs associated with the manufacturing of the new line of clubs will be $8,000,000 per year. The plant and equipment for the new line of clubs will cost $28,000,000 and will be depreciated on a straight-line basis. The expected salvage value of the equipment at that time is zero. The new clubs will also require an increase in net working capital of $800,000 that will be returned at the end of the project as inventory is sold, account receivables are closed out, and accounts payable are paid off.

Do you recommend that Karsten proceed with this project? Clearly present and justify your recommendation.

Year 1

Year 2

Year 7

Change in Sales

Change in Cost of Goods Sold

Change in Depreciation

Change in EBIT

Change in Taxes

Change in Net Income

Change in Depreciation

Change in Operating CF Flow

Change in Net Working Capital

Capital Expenditures (CAPEX)

Project Cash Flow

SIMULATION: There is a significant probability that there will be increasing softness in the price of golf equipment; the cost forecasts are expected not to change. The standard deviation in price for all of the different sets is forecast to be 15% of the club expected set price. In addition, the sales forecasts are expected to have a standard deviation of 10% of the forecast expected sales. The realizations for all of these variables will be determined in the first year and then carried throughout the life of the project. Do you recommend that Karsten proceed with the project? What additional insights can you provide?

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