HBS Valued Project Case Study

(1)

Growth Enterprise , Inc. (GEI)

Project Type of cash flow Year 0 Year 1 Year 2 Year 3

A. Investment -$10,000 0 0 0

Revenue 0 $21,000 0 0

Operating expense 0 $11,000 0 0

Lifespan 1

Depreciation $10,000

Free Cash Flow $10,000

B. Investment -$10,000 0 0 0

Revenue 0 $15,000 $17,000 0

Operating expense 0 $5,833 $7,833 0

Lifespan 2

Depreciation $5,000 $5,000

Free Cash Flow $7,500 $7,500

C. Investment -$10,000 0 0 0

Revenue 0 $10,000 $11,000 $30,000

Operating expense 0 $5,555 $4,889 $15,555

Lifespan 3

Depreciation $3,333 $3,333 $3,333

Free Cash Flow $4,000 $5,000 $10,000

D. Investment -$10,000 0 0 0

Revenue 0 $30,000 $10,000 $5,000

Operating expense 0 $15,555 $5,555 $2,222

Lifespan 3

Depreciation $3,333 $3,333 $3,333

Free Cash Flow $10,000 $4,000 $3,000

1-a). Calculate Payback of each project and rank the four projects in order of preference based on payback approach (1 point).

Project Initial Outlay Year 1 Year 2 Year 3 Payback Period

A $10,000 $0 $0 1 Outstandin -10000 $0 $0 $0 B $7,500 $7,500 $0 0.33 1.33 Outstandin -10000 -$2,500 $5,000 $5,000 C $4,000 $5,000 $10,000 0.10 2.1 Outstandin -10000 -$6,000 -$1,000 $9,001 D $10,000 $4,000 $3,000 1 Outstandin -10000 $0 $4,001 $7,001

Payback period is 1 year for project A, 1.33 years for project B, 2.1 years for project C and 1 year for project D

1-b). Calculate IRR of each project and rank the four projects in order of preference based on IRR (2 points).

A B C D

Initial Outl -$10,000 -$10,000 -$10,000 -$10,000

Year 1 $10,000 $7,500 $4,000 $10,000

(2)

Year 3 $0 $0 $10,000 $3,000

IRR 0.00% 31.88% 33.53% 42.75%

1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the projects in order of preference (2 points)

A B C D Year 0 -$10,000 -$10,000 -$10,000 -$10,000 Year 1 $10,000 $7,500 $4,000 $10,000 Year 2 $0 $7,500 $5,000 $4,000 Year 3 $0 $0 $10,000 $3,000 NPV -$909.09 $3,016.88 $5,282.24 $4,651.32

1-d). If the projects are independent of each other, which should be accepted? If they are mutually exclusive, which one is best? Explain why. (1 point)

If the projects are independent of each other, projects B, C, and D should be accepted because they have a positive IRR and NPV that is greater than the cost of capital.

If the projects are mutually exclusive and only one can be accepted, Project D should be accepted because it has the highest IRR, shortest payback time, and second-highest NPV, just behind project C.

(3)

1-a). Calculate Payback of each project and rank the four projects in order of preference based on payback approach (1 point). Payback Period years years years years

Payback period is 1 year for project A, 1.33 years for project B, 2.1 years for project C and 1 year for project D

(4)

1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the projects in order of preference (2 points)

1-d). If the projects are independent of each other, which should be accepted? If they are mutually exclusive, which one is best? Explain why. (1 point)

If the projects are independent of each other, projects B, C, and D should be accepted because they have a If the projects are mutually exclusive and only one can be accepted, Project D should be accepted because it has the highest IRR, shortest payback time, and second-highest NPV, just behind project C.

(5)

Electronics Unlimited (EU)

Sales Year 1 $10,000,000 Year 2 $13,000,000 Year 3 $13,000,000 Year 4 $8,667,000 Year 5 $4,333,000

Cost of Sales 60% of sales

SGA Expenses 23.50% of sales

Tax Rate 40%

New Specialized Equipment $500,000

Net Working Capital 27% of sales

Introductory expenses

Year 1 $200,000

Life of equipment 5 years

2-a) Estimate the new product's cash flows (3 points)

Year 0 1 2 Sales $10,000,000 $13,000,000 Cost of Sales $6,000,000 $7,800,000 SGA Expense $2,350,000 $3,055,000 Depreciation $100,000 $100,000 Introductory Expense $200,000

Income before tax $1,350,000 $2,045,000

Tax $540,000 $818,000

Net Income $810,000 $1,227,000

Operating Cash Flow $910,000 $1,327,000

Working Capital $2,700,000 $3,510,000 $3,510,000

Change in Working Capital -$2,700,000 -$810,000 $0

Equipment -$500,000

Total cash flows -$3,200,000 $100,000 $1,327,000

2-b) Assuming a 20% cost of capital, what is the product’s net present value? What is its internal rate of return? Should EU introduce the new product? Explain why? (2 points).

Cost -$3,200,000

Free Cash Flow

Year 1 $100,000 Year 2 $1,327,000 Year 3 $2,496,910 Year 4 $2,068,213 Year 5 $1,638,877 Cost of Capital 20%

Net Present Value $905,862.19

IRR 29.55%

EU should introduce the new product because the NPV is positive and the IRR is greater than the cost of capital. The positive NPV means that the project generates a surplus after all costs, including financing costs. The IRR of 29.55% is higher than the 20% cost of capital implying that the rate of return on the project is more than the desired rate.

(6)

3 4 5 $13,000,000 $8,667,000 $4,333,000 $7,800,000 $5,200,200 $2,599,800 $3,055,000 $2,036,745 $1,018,255 $100,000 $100,000 $100,000 $2,045,000 $1,330,055 $614,945 $818,000 $532,022 $245,978 $1,227,000 $798,033 $368,967

$1,327,000 $898,033 $468,967 Net income + depreciation

$2,340,090 $1,169,910 $0

$1,169,910 $1,170,180 $1,169,910 Working capital recovered $2,496,910 $2,068,213 $1,638,877

2-b) Assuming a 20% cost of capital, what is the product’s net present value? What is its internal rate of return? Should EU introduce the new product? Explain why? (2 points).

EU should introduce the new product because the NPV is positive and the IRR is greater than the cost of capital. The positive NPV means that the project generates a surplus after all costs, including financing costs. The IRR of 29.55% is higher than the 20% cost of capital implying that the rate of return on the project is more than the desired rate.

(7)

Value-Added Industries, Inc. (VAI)

3-a) What is the net present value of this project (1 point)?

Present Value of Cash Flow $210,000 Initial Investment -$110,000

NPV $100,000

3-b) How many shares of common stock must be issued, and at what price to raise the required capital? (1 point)

Number of shares outstanding 10,000

Market value of shares $100

Existing value of shares $1,000,000

NPV $100,000

Total Value $1,100,000

Value per share $110

Amount to be raised $110,000 Number of shares to be issued 1000

To raise the required capital, VAI should issue 1000 shares of common stock at $110 each.

3-c) What is the effect, if any, of this new project on the value of the stock of existing shareholders? (1 point)

(8)

3-b) How many shares of common stock must be issued, and at what price to raise the required capital? (1 point)

(9)

FIN 500 Assignment 4, due 08/21/11, 9:00 pm California time Total points 14

This assignment provides you an opportunity to practice estimating cash flow for capital budgeting projects (chapter 12), using the common approaches in capital budgeting (chapter 13) such as payback, internal rate of return and net present value in choosing project , using Excel functions such as irr() and npv() to calculate IRR and NPV. To complete this assignment, students need to get familiar with course content in chapter 12 and chapter 13.

Problems in this assignment are chosen from Harvard Business School’s Case on Valuing Capital Project and are revised by the instructor. This assignment should be done as an

individual work. Your completed Assignment 4 should be saved and submitted as an

Excel workbook file, i.e., .xls file. The filename should begin assign4, then your last name and first letter of your first name. For example, if Allen Smith completes this assignment, he should name this assignment as assign4SmithA, save and submit it as an Excel

workbook file (.xls file). 10% of this assignment points will be deducted if it’s not

named or formatted as required.

There are three problems in this assignment, each problem has several questions.

1. Growth Enterprise , Inc. (GEI) has $40 million that it can invest in any or all of the four capital investment projects (A, B, C, D), which have cash flows as shown in the

following table.

Table 1. Comparison of Project Cash Flows ($ thousand dollars) Project Type of

cash flow

Year 0 Year 1 Year 2 Year 3

A. Investment -$10,000 0 0 0 Revenue 0 $21,000 0 0 Operating expense 0 $11,000 0 0 B. Investment -$10,000 0 0 0 Revenue 0 $15,000 $17,000 0 Operating expense 0 $5,833 $7,833 0 C. Investment -$10,000 0 0 0 Revenue 0 $10,000 $11,000 $30,000 Operating expense 0 $5,555 $4,889 $15,555 D. Investment -$10,000 0 0 0 Revenue 0 $30,000 $10,000 $5,000 Operating expense 0 $15,555 $5,555 $2,222

 All revenues and operating expenses can be considered cash items.

Each of these projects is considered to be of equivalent risk. The investment will be depreciated to zero on a straight- line basis for tax purpose. For simplicity, the depreciation per year for a

(10)

following table.

cash flow Year 0 Year 1 Year 2 Year 3

1-a). Calculate Payback of each project and rank the four projects in order of preference

based on payback approach (1 point).

1-b). Calculate IRR of each project and rank the four projects in order of preference

based on IRR (2 points).

1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the

projects in order of preference (2 points)

1-d). If the projects are independent of each other, which should be accepted? If they are

mutually exclusive, which one is best? Explain why. (1 point)

Hint: You need to estimate the free cash flows (FCF) to the firm first, FCF = EBIT(1 –tax rate) + depreciation – Gross fixed asset expenditure – change in net operating working

(11)

FIN 500 Assignment 4, due 08/21/11, 9:00 pm California time Total points 14

This assignment provides you an opportunity to practice estimating cash flow for capital budgeting projects (chapter 12), using the common approaches in capital budgeting (chapter 13) such as payback, internal rate of return and net present value in choosing project , using Excel functions such as irr() and npv() to calculate IRR and NPV. To complete this assignment, students need to get familiar with course content in chapter 12 and chapter 13.

Problems in this assignment are chosen from Harvard Business School’s Case on Valuing Capital Project and are revised by the instructor. This assignment should be done as an

individual work. Your completed Assignment 4 should be saved and submitted as an

Excel workbook file, i.e., .xls file. The filename should begin assign4, then your last name and first letter of your first name. For example, if Allen Smith completes this assignment, he should name this assignment as assign4SmithA, save and submit it as an Excel

workbook file (.xls file). 10% of this assignment points will be deducted if it’s not

named or formatted as required.

There are three problems in this assignment, each problem has several questions.

following table.

cash flow

Year 0 Year 1 Year 2 Year 3

(12)

following table.

cash flow Year 0 Year 1 Year 2 Year 3

1-a). Calculate Payback of each project and rank the four projects in order of preference

based on payback approach (1 point).

1-b). Calculate IRR of each project and rank the four projects in order of preference

based on IRR (2 points).

1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the

projects in order of preference (2 points)

1-d). If the projects are independent of each other, which should be accepted? If they are

mutually exclusive, which one is best? Explain why. (1 point)

Hint: You need to estimate the free cash flows (FCF) to the firm first, FCF = EBIT(1 –tax rate) + depreciation – Gross fixed asset expenditure – change in net operating working

(13)

2. Electronics Unlimited (EU)was considering the introduction of a new product that had 5 years of life and was expected to generate sales in Year 1 through 5 as the following:

Year 1 Year 2 Year 3 Year 4

$10,000, 000 $13,000,000 $13,000,000 $8,667,000

No material levels of revenues or expenses associated with the new product were expected after five years of sales. Based on past experience, cost of sales for the new product was expected to be 60% of total annual sales revenue during each year of its life cycle. Selling, general and administrative expenses were expected to be 23.5% of total annual sales. Taxes on profits generated by the new product would be paid at a 40% rate.

To launch the new product, EU would have to incur immediate cash outlays of two types. First, it would have to invest $500,000 in specialized new production

equipment. This capital investment would be fully depreciated on a straight- line basis over the five-year anticipated life of the new product. There would be no salvage value left for the equipment at the end of its depreciable life. No further fixed capital expenditures were required after the initial purchase of equipment.

Second, additional investment in net working capital to support sales would have been made. EU generally required 27 cents of net working capital to support each dollar of sales. That is, change in net working capital is 27% of change in sales. As a practical matter, the buildup of working capital would have to be made at the

beginning of the sales year in question (or, equivalently, by the end of the previous year). For example, Sales in year 2 were expected to be $13,000 thousand, $3,000

Finally, EU expected to incur tax-deductible introductory expenses of $200,000 in the first year of the new product’s sales. Such cost would not be recurring over the product’s life cycle. Approximately $800,000 had already been spent developing and testing marketing the new product.

2-a) estimate the new product’s cash flows. (3 points)

2-b) Assuming a 20% cost of capital, what is the product’s net present value? What is

its internal rate of return? Should EU introduce the new product? Explain why? (

points).

(14)

Finally, EU expected to incur tax-deductible introductory expenses of $200,000 in the first year of the new product’s sales. Such cost would not be recurring over the product’s life cycle. Approximately $800,000 had already been spent developing and testing marketing the new product.

2-a) estimate the new product’s cash flows. (3 points)

2-b) Assuming a 20% cost of capital, what is the product’s net present value? What is

its internal rate of return? Should EU introduce the new product? Explain why? (

points).

(15)

3. You are the CEO of Value-Added Industries, Inc. (VAI). Your firm has 10,000 shares of common stock outstanding, and the current price of the stock is $100 per share. The firm does not have any debt. You discover an opportunity in a new project that produces positive net cash flows with a present value of $210,000. Your total initial costs for investing and developing this project are only $110,000. You will raise the necessary capital for this investment by issuing new equity. All potential buyers of your common stock will be fully aware of the project’s value and cost, and are willing to pay “fair value” for the new share of VAI common stock.

3-a) What is the net present value of this project (1 point)?

3-b) How many shares of common stock must be issued, and at what price to raise the

required capital? (1 point). Hint: the stock price should reflect the value created by the investment opportunity.