Basics Of Capital Budgeting

1 2 3=1-2 4 5=3-4 6 7=5-6 8 Add: 6 9 10 11 12 13

Revenue COGS Gross Profit SG&A EBITDA Depreciation and Amortization EBIT EBIT(1-t) Depreciation and Amortization Less: Δ Investment in Working Capital Less: Δ Investment in Fixed Assets Add: Working capital Salvaged Add: Fixed Assets Salvaged FREE CASH FLOWS TO FIRM

1 2 3=1-2 4 5=3-4 6 7=5-6

Revenue COGS Gross Profit SG&A EBITDA Dep&Amortz EBIT 8 Less: Interest 9=7-8 EBT 10 Less: Tax 11=9-10 Net Income

South India Paper Mills is examining a five year life project on which the Initial Investment in Plant will be Rs 45 crores and the Investment in W/C will be Rs 5 crs. This is a paper recycling project on which the revenues the first year is expected to be Rs 50 crores and the revenues are likely to increase by 20% . Pa. In the third year of the project , Plant will have to be purchased at Rs 2 crores. Investment in Plant will be depreciated to zero book value by the end of the project life. Working capital to Revenues will have to be maintained by reinvestment upfront at the beginning of the year. 95% of working capital will be salvaged. The Rate Tax is 35% and the EBITDA margin is estimated at 65% of revenues. The Project will be funded as follows Internal Equity 20% New Issue of Equity30% Preference Sh 10% Debt 40% The 5 year T Bond trades at 9.1% and the Market is expected to return 16% The beta of paper projects ( unleavered ) is .85 New Issue of Equity has a floatation cost of 5% Preference Shares will carry a preference dividend at the rate of 12%. Debt will be sourced from IFCI and interest rate will be 17%. Required 1. Cash Flows on the Project 2. Hurdle Rate on the Project 3. NPV and IRR W/C

5

6

7.2

8.6

10.4

0 Revenues EBITDA Less: Depreciation EBIT EBIT(1-t) Add: Dep Less: Δ Investment in W/C Less: Δ Investment in F/A Add: W/C Salvaged FCFF DCF 112 Less: IO 50 NPV 62

1 50 33 9 24 15 9 1

2 60 39 9 30 20 9 1

3 72 47 9 38 25 9 1 2

4 86 56 10 46 30 10 2

23 20

27 21

30 20

38 22

Internal Equity New Issue of Equity Preference Sh

20% 30% 10%

Levered Beta= 1.22 Rf 9.10% Rm 16% ke 17.51% New ke= 18.43% kp= 12%

5 104 67 10 57 37 10

9.88 57 29

Debt 40% kd= 11.05% WACC= 14.65% Therefore the firm must accept the project because the firm value will increase by 62 crores. The firm must reject this project because it will destroy shareholders wealth by decreasing the firm value by 32 crores.

V and IRR

A Factory has an installed capacity to manufacture 50000 racquets and currently it manufactures only 20000 Tennis racquets. The firm wants to divert 50% of the capacity to manufacture 25000 squash racquets. An Average Tennis racquet costs $ 40 to make and sells for $100. Tennis racquets is a growing market growing by 10% p.a but squash racquet is a stable growth market. The Tax rate is 40% and the Discount rate on the project is 11%, compute the opportunity cost of diverting the production Opportunity: Cost of foregone alternative. 60 Potential Lost Lost post tax Sales Sales profit PV 0 20,000 1 22,000 2 24,200 3 26,620 1620 $58,320 $42,643 4 29,282 4282 $154,152 $101,545 5 32,210 7210.2 $259,567 $154,040 6 35,431 ### $375,524 $200,770 7 38,974 ### $503,076 $242,311 8 42,872 ### $643,384 $279,181 9 47,159 ### $797,722 $311,849 10 50,000 25000 $900,000 $316,966 $1,649,306

$36

A firm is examining a five year life project with an initial investment of Rs 5 lacs

on which the Annual after tax cash flows is expected to be Rs 3 lac. Apart from the initial investment in plant the project will also use some other resources already owned by the firm a) Two workers covered by a union contract which means that they cant be fired for the next two years each on an annual salary of Rs 80000 will be transferred to this project. b) A packaging plant already owned by the firm which has excess capacity will be used for this project thus causing us to replace the packaging plant at the end of the third year rather than the pre planned eight year at a cost of Rs 2.5 lacs c) A van, book value of Rs 50000 already owned by the firm on which it is claiming annual depreciation of 10% will also be used for the project thus loosing Rs 10000 annual rental it would have otherwise have earnt. The Tax rate is 30% and the Discount rate on the Project is 9%. Required Compute a) Opportunity cost if any associated with using the workers, packaging plant and the van. b) NPV on the project. 1 Salary ### Packaging Plant 67579.3 Van PMT 7000 n 5 i 9% PV of Annuity ### Annual Cash Flow n i PV of Annuity NPV= ###

2

3 4 5 112000 112000 112000 ### ### ###

6

250000 ###

300000 5 9% ### ### minus

7

8

250000 ###

500000 minus

###

A grocery store wants to stock garden tools and seeds in the spare space they have in the store. The racks will cost Rs 2 lacs and the annual cash flow from sale of seeds and garden inmpements will be Rs 50000. The gardening enthusiasts who will visit the store will also buy other products thus increasing the Annual cash flow of other items by Rs 10000 p.a. The store is expected to last 5 years and the discount factor is 9%. Should we sell garden implements? PMT 50000 10000 n 5 5 i 9% 9% PV of Annuity ### ### NPV= ### plus 38896.51 less 200000 ### You are wanting to offer baby sitting services in a mall to allow parents to shop for longer. The service will cost Rs 4 lacs to set up and will cost annually Rs 100000 to run. The tax rate is 30%. This is a free service and the parents will not pay anything. However the Annual Operating Income of the mall is expected to increase by Rs 2 lac per annum and the mall is expected to last eight years. Should you offer this service? Δ EBIT of the mall Less: Δ Cost Δ EBIT of the establishment EBIT(1-t) Add: Depreciation CFAT n i PV of Annuity Less: IO NPV

200000 100000 100000 70000 50000 120000 8 9% ### 400000 ###