1 Case 1 [Companys] 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 projects 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 years cost of goods sold and accounts payable are expected to be 15% of the next years 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. 2 [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)/(rg) (from growing perpetuity formula). where r is discount rate 3 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) $30,000 $27,000 $33,000 Sales Growth through Year 6 6% 0% 10% Cost of Goods Sold (% of Sales) 72% 77% 67% Accounts Receivable % of Next Year Sales 15% 20% 10% Inventory % of Next Year COGS 20% 25% 15% Accounts Payable % of Next Year COGS 15% 10% 20% Initial NWC $6,000 $7,500 $4,500 Sales Growth After Year 6 2% 0% 6% Free Cash Flow growth After Year 6 2% 0% 4% Initial Capital Expenditure $9,000 $11,000 $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. 4 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.