Description
Case 1 – [Company’s] Purchase Decision
This case is a simple capital budgeting exercise that should reinforce your understanding of the
following topics:
• Incremental unlevered net income
• Free cash flow
• Sensitivity analysis and scenario analysis
In this exercise you will choose the company that is making the purchase decision. The company
needs to be a publicly traded company. I would recommend that you choose a company in an
industry that you have experience with or a company that you find personally interesting. BOTH MATERIALS NEEDED FOR INSTRUCTIONS AND EXCEL TEMPLATE ARE ATTACHED. Thank you
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Case 1 – NPV Calculation
Company Name:
Assumptions (Amounts in $ Thousands Unless Otherwise Indicated)
Initial Capital Expenditure
Useful Life of Equipment
Annual Depreciation
Sales in Year 1
Sales Growth through Year 6
Sales Growth Year 6 Onward
Free Cash Flow Year 6 Onward
Cost of Goods Sold (% of sales)
Incremental SG&A Expense
Market Research Expense
Initial Net Working Capital
Accounts Receivable % of Next Year Sales
Inventory % of Next Year COGS
Accounts Payable % of Next Year COGS
Interest Expense
Tax Rate
Cost of Capital
Unlevered Income Statements
Sales
Year
0
Year
1
Year
2
Year
3
Year
4
Year
5
Year
6
Unlevered Net Income
Working Capital Calculations
Inventory
Accounts Receivable
Accounts Payable
NWC Level
Change in NWC
CF from Change in NWC
Unlevered Cash Flows
Unlevered Net Income
Add Back: Depreciation
CF from Change in NWC
CF from Capital Expenditure
Free Cash Flow
Terminal Value
Discount Factor
FCF Present Value
NPV
in which
PV(Terminal Value of FCFs in Year 6
and Beyond)
Copy your baseline projections to this sheet, so that
your sensitivity analysis won’t alter your baseline
result in the NPV sheet.
Sensitivity Analysis
Parameter
Initial AssumptionWorst CaseBest Case
NPV
NPV
NPV
NPV
Question: Suppose you are the financial manager, if you are asked to use limited resources to refine
the assumption on ONLY ONE of the above four parameters, which one should you choose and why?
(fill in the blanks highlighted in yellow)
Answer:
Question: Why are the four assumptions you choose appropriate for your company?
Answer:
Copy your baseline projections to this sheet, so that
your scenario analysis won’t alter your baseline result
in the NPV sheet.
o this sheet, so that
er your baseline result
Scenario Analysis
1st Assumption2nd Assumption
NPV
Scenario 1
Scenario 2 (Baseline)
Scenario 3
Scenario 4
Question: Which scenario generates the highest NPV? (fill in the blanks highlighted in yellow)
Answer:
Question: Why are the assumptions you choose appropriate for your company?
Answer:
Case 1 – [Company’s] Purchase Decision
This case is a simple capital budgeting exercise that should reinforce your understanding of the
following topics:
• Incremental unlevered net income
• Free cash flow
• Sensitivity analysis and scenario analysis
In this exercise you will choose the company that is making the purchase decision. The company
needs to be a publicly traded company. I would recommend that you choose a company in an
industry that you have experience with or a company that you find personally interesting.
Introduction
[Your company] has developed a new procedure that greatly improves durability and efficiency.
After spending $500,000 on the research and development, [company] is considering
implementing the procedure in a project that requires an initial investment of $9,000,000 in new
equipment.
•
The equipment must be purchased before the new procedure can begin. For tax purposes, the
equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero
salvage value. For simplicity, however, we will continue to assume that the asset can actually
be used out into the indefinite future (i.e., the actual useful life is effectively infinite).
•
[Company] anticipates that the sales will be $30,000,000 in the first year (Year 1). They
expect that sales will initially grow at an annual rate of 6% until the end of sixth year. After
that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity.
•
The cost of goods sold is estimated to be 72% of sales.
•
The accounting department also estimates that at introduction in Year 0, the new project’s
required initial net working capital will be $6,000,000. In future years accounts receivable
are expected to be 15% of the next year sales, inventory is expected to be 20% of the next
year’s cost of goods sold and accounts payable are expected to be 15% of the next year’s
cost of goods sold.
•
The selling, general and administrative expense is estimated to be $6,000,000 per year, but
$1 million of this amount is the overhead expense that will be incurred even if the project
is not accepted.
•
The research and development to support the product was completed last month at a cost
of $500,000 to be paid by the end of next year.
•
The annual interest expense tied to the project is $1,000,000.
1
•
[Company] has a cost of capital of 20% and faces a marginal tax rate of 21% and an average
tax rate is 30%.
Instructions
I posted an incomplete Excel template for your analysis. You need to figure out how to construct
the pro forma income statements and calculate the incremental unlevered net income. You should
include ONLY the factors that will affect your capital budgeting decision. Revise the template
if necessary.
Note that your analysis should be set up so the assumptions that impact the cash flow estimates
can be easily changed to identify the sensitivity of your calculations to these assumptions.
There are three sheets in the template. Use the worksheet “NPV” for questions 1 to 4, and the other
two sheets for questions 5 and 6.
Submit your Excel spreadsheet through blackboard. Clearly show your work so that I can trace
your numbers.
Questions
1.
Use Excel to construct six-year pro forma income statements and calculate the incremental
unlevered net income for the first six years.
2.
Calculate six-year projections for free cash flows. Remember to include cash flows from
the income statement and depreciation, changes in net working capital, and capital
expenditures or dispositions.
Hint: You need to calculate the level of net working capital (NWC) and change in NWC.
Pay attention to the timing of NWC.
3.
[Company] expects that free cash flow from Year 6 onwards will increase at a constant rate
of 2%/year into the indefinite future. Calculate PV(terminal value that captures the value
of future free cash flows in Year 6 and beyond). That is, calculate the terminal value first,
then find its value in Year 0 (today). If you need to calculate free cash flow for Year 7 or
later, use the free cash flow growth rate and the previous free cash flow. Do not construct
the entire unlevered net income in order to calculate the free cash flow.
Hint:
We went over this in Lecture Note 6, so let me briefly review the key points:
a. Assuming the cash flows grow at a constant rate g after Year N+1, then
Year N TV = (Year N+1 CF)/(r−g)
(from growing perpetuity formula).
where r is discount rate
2
b. We should discount this Terminal Value back to Year 0.
4.
Determine the NPV of the project. Remember to net out any initial cash outflows.
5.
Perform a sensitivity analysis on four parameters: Select four parameters from the list
below and explain why those parameters are important to analyze for your company. Make
sure your explanation makes sense for YOUR company. For example a retail company
may be very concerned with inventory. The Worst and Best case for each assumption is
already provided. Write your answer in Excel.
Parameter
Initial
Assumption
Worst Case
Best Case
Sales in Year 1 (in thousands)
Sales Growth through Year 6
Cost of Goods Sold (% of Sales)
Accounts Receivable % of Next Year Sales
Inventory % of Next Year COGS
Accounts Payable % of Next Year COGS
$30,000
6%
72%
15%
20%
15%
$27,000
0%
77%
20%
25%
10%
$33,000
10%
67%
10%
15%
20%
Initial NWC
Sales Growth After Year 6
Free Cash Flow growth After Year 6
Initial Capital Expenditure
$6,000
2%
2%
$9,000
$7,500
0%
0%
$11,000
$4,500
6%
4%
$7,000
For example, vary the parameter “Sales in Year 1” from the worst case $27,000,000 to the
best case $33,000,000, holding all the other parameters fixed (at the level of initial
assumptions). Then fill in the highlighted blank boxes for NPV in Excel.
Do the same thing for the other three parameters.
Suppose you are the financial manager, if you are asked to use limited resources to refine
the assumption on ONLY ONE of the four selected parameters, which one should you
choose and why? Write your answer in Excel.
6.
Perform a scenario analysis by simultaneously varying two parameters. Choose two
parameters that best fit your company and are likely to vary simultaneously and construct
3 scenarios in addition to the baseline For example, vary Sales Growth through year 6 and
the % of Cost of Goods Sold, holding all the other parameters fixed (at the level of initial
assumptions) and then fill in the highlighted blank boxes for NPV in Excel.
3
Explain why the two parameters you picked should simultaneously vary and why they are
important to analyze for your company. Write your answer in Excel.
Which scenario generates the highest NPV? Write your answer in Excel.
4
Purchase answer to see full
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