2. Financial appraisal of investment projects The NextGen project is an example of how the financial appraisal of an investment project is conducted at Cengage Learning. The NextGen project passed through several stages of the capital investment process, which required the finance team to evaluate it and to what extent the project would drive incremental revenue or contribute toward revenue preservation. Instructions: Review the following stages of the financial appraisal process for this project and complete missing information as needed. Project Overview The Innovation team proposed a digital learning platform that will create a personalized learning experience for each student. The platform consists of a set of flexible tools that will allow students to customize the technology to suit their personal learning needs. The executive team believes that the value proposition offered by the NextGen project will be one of a kind in the digital learning space and give the company a first-mover advantage. The finance team conducted the financial appraisal of the project to evaluate it and to what extent the project would drive incremental revenue or contribute toward revenue preservation. Relevant Cash Flows The finance team scheduled a series of meetings to discuss the different aspects of the project analysis. Sanford Tassel, Senior Vice President, Finance and Operations, Dikran Yapoujlan, Vice President, Finance and other members of the finance-decision support team held a series of discussions. Some excerpts from their discussions follow: From: Yapoujian, Dikran To: Tassel, Sanford Cc: Buzzard, Chris; Muhleman, Purlen Subject: Relevant cash flows Attached: Data.xls Hey Sanford, I've been working with the team to evaluate the NextGen product in the capital approval pipeline. I've crafted the valuation model Attachment: Data.xls (A dollar values in millions) A B 1 Capitalized expenses Non-cash(depreciable) expenses Operating costs as a percentage of revenues $20.5 (spread over 3 years) $3.400 2 3 Year 1: 141% Year 2: 33% excerpts from their discussions follow: nature, restricting us to work with a relevant time horizon of six years and to ignore any cash flows after the sixth year. We would need to immediately approve a capital allocation of $1.70 million to jump-start the project. In addition, we would need to capitalize another $20.5 million almost equally for the next three years. These expenses will be incurred on an after-tax basis. The first year of the project is unlikely to bring any additional revenues, but from second year, we should see revenues increase by $1.800 million. Our preliminary estimates also show revenues growing to $9.700 million in year 2, $19.300 million in year 3, $22.800 million in year 4, and $24.600 million in year 5. I am also attaching some information the team used for the cash flow valuation. See you later to go over the numbers. Cheers, Dukran Attachment: Data.xls (Al dollar values in millions) 1 $20.5 (spread over 3 years) 2 Capitalized expenses Non-cash(depreciable) expenses Operating costs as a percentage of revenues $3.400 3 Year 1: 141% Year 2: 33% Year 3: 22% Year 4: 22% Year 5: 24% 4. Taxes 40% The analysts on the team created pro forma estimates of the expected cash flows that the project is likely to generate and also discussed some assumptions: Revenue estimates are based on the expectation of a higher price point resulting from a more robust product. Operating expenses include internal labor, maintenance, overhead expense, and cost avoidance from being able ramp down spending on existing platforms. The capitalized expenses include the costs of platform development, content creation, Internal and external labor, computers, facility Investment, and so on. These expenses are amortizable and depreciable the first three of the six years of the project's expected life. They are recognized separately from the normal depreciation and amortization expenses. . These capital expenses will be deducted from the project's annual cash flow from operations to derive at the project's total expected life. They are recognized separately from the normal depreciation and amortization expenses. . These capital expenses will be deducted from the project's annual cash flow from operations to derive at cash flows. project's total expected Complete the following cash flow analysis based on the information provided. (Note: Express all values in millions of dollars and round all values to three decimal places. Use a minus (-) sign to indicate any negative amount. Year o Year 1 Year 2 Year 3 Year 4 Year 5 Revenues 0 Less: Operating expenses Less: Depreciation & Amortization Operating Income Less: Tax Plus: Non-cash expenses Operating Cash Flow Less: Capitalized expenses 7.300 6.600 6.600 - Total Cash Flow Financing Costs The finance team got together to discuss the financing costs of the project. The following is an excerpt of their discussion. Read the dialogue and fill in the missing word or words. DIKRAN: Should we use the company's WACC or use the beta of a comparable project when applying a cost of capital to this project? SANFORD: We calculate our WACC on an annual basis based on the company's capital structure for the fiscal year. All of our investments are treated as cash investments so that we can fairly compare all initiatives based on their value proposition. This is a one-of-a-kind project in the ed tech space, and we believe that it will drive incremental revenues and contribute to the preservation of revenue for Cengage's existing products. The project also seems to align with the reinvestment objectives of our private equity owners. DIKRAN: Sounds good. We also calculate our applicable tax rates annually, and considering the digital landscape of this project, we necessarily need to use different tax rates based on the different states in which we operate. I guess it is fair to apply a standard tax rate in the valuation of the project cash flows. SANFORD: Let's use our standard WACC of 12%. I'll see you soon to discuss the valuation of the project. Financing Costs The finance team got together to discuss the financing costs of the project. The following is an excerpt of their discussion. Read the dialogue and fill in the missing word or words. DIKRAN: Should we use the company's WACC or use the beta of a comparable project when applying a cost of capital this project? SANFORD: We calculate our WACC on an annual basis based on the company's capital structure for the fiscal year. All of our investments are treated as cash investments so that we can fairly compare all initiatives based on their value proposition. This is a one-of-a-kind project in the ed tech space, and we believe that it will drive incremental revenues and contribute to the preservation of revenue for Cengage's existing products. The project also seems to align with the reinvestment objectives of our private equity owners. DIKRAN: Sounds good. We also calculate our applicable tax rates annually, and considering the digital landscape of this project, we necessarily need to use different tax rates based on the different states in which we operate. I guess it is fair to apply a standard tax rate in the valuation of the project cash flows. SANFORD: Let's use our standard WACC of 12%. I'll see you soon to discuss the valuation of the project. Project Evaluation The analysts in the team run the numbers and hand over the evaluation to Sanford. Complete the data in the report. (Note: Round your input values to three decimal places and your output values to two decimal places. Use a minus (-) sign to indicate any negative amount.) Year o Year 1 Year 2 Year 3 Year 4 Year 5 PV of cash flows NPV of the project IRR of the project Payback period % 3.30 years The Accept/Reject Recommendation The project proposal with supporting data was presented to the CFO and the board. After discussion and scrutiny of the assumptions in the report, the board is most likely to the project because of which of the following reasons? Check all that apply. Management believes that the project will help in increasing market share and protect existing penetration. The management team believes that this project will lead the transition toward becoming a digital-first company. Management is not confident about the digital Innovation team's track record. The project has a shelf-life shorter than the payback period of the investment. 4. Modified internal rate of return (MIRR) The IRR evaluation method assumes that cash flows from the project are reinvested at the same rate equal to the IRR. However, in reality the reinvested cash flows may not necessarily generate a return equal to the IRR. Thus, the modified IRR approach makes a more reasonable assumption other than the project's IRR. Consider the following situation: Fuzzy Button Clothing Company is analyzing a project that requires an initial Investment of $600,000. The project's expected cash flows are: Year Year 1 Year 2 Cash Flow $375,000 -125,000 475,000 450,000 Year 3 Year 4 Fuzzy Button Clothing Company's WACC IS 8%, and the project has the same risk as the firm's average project. Calculate this project's modified Internal rate of return (MIRR): O 17.42% 20.33% O 21.30% 0 19.36% If Fuzzy Button Clothing Company's managers select projects based on the MIRR criterion, they should this Independent project. Which of the following statements best describes the difference between the IRR method and the MIRR method? The IRR method uses the present value of the initial Investment to calculate the IRR. The MIRR method uses the terminal value of the Initial Investment to calculate the MIRR. The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital. O The IRR method uses only cash inflows to calculate the IRR. The MIRR method uses both cash inflows and cash outflows to calculate the MIRR. An electric utility is considering a new power plant in northern Arizona. Power from the plant would be sold in the Phoenix area, where it is badly needed. Because the firm has received a permit, the plant would be legal; but it would cause some air pollution. The company could spend an additional $40 million at Year O to mitigate the environmental problem, but it would not be required to do so. The plant without mitigation would require an initial outlay of $270.46 million, and the expected cash inflows would be $90 million per year for 5 years. If the firm does invest in mitigation, the annual Inflows would be $93.10 million. Unemployment in the area where the plant would be built is high, and the plant would provide about 350 good jobs. The risk adjusted WACC is 17%. a. Calculate the NPV and IRR with mitigation. Enter your answer for NPV in millions. For example, an answer of $10,550,000 should be entered as 10.55. Negative values, if any, should be indicated by a minus sign. Do not round Intermediate calculations. Round your answers to two decimal places. NPV: $ million IRR: % Calculate the NPV and IRR without mitigation. Enter your answer for NPV in millons. For example, an answer of $10,550,000 should be entered as 10.55. Negative values, if any, should be indicated by a minus sign. Do not round , Intermediate calculations. Round your answers to two decimal places. NPV: $ million IRR: % % b. How should the environmental effects be dealt with when evaluating this project? I. The environmental effects should be ignored since the plant is legal without mitigation II. The environmental effects should be treated as a sunk cost and therefore ignored. III. If the utility mitigates for the environmental effects, the project is not acceptable. However, before the company chooses to do the project without mitigation, it needs to make sure that any costs of "ill will for not " mitigating for the environmental effects have been considered in the original analysis. IV. The environmental effects should be treated as a remote possibility and should only be considered at the time in which they actually occur. V. The environmental effects if not mitigated would result in additional cash flows. Therefore, since the plant is legal without mitigation, there are no benefits to performing a "no mitigation" analysis. -Select C. Should this project be undertaken? I. The project should be undertaken only under the "mitigation assumption. II. The project should be undertaken since the IRR is positive under both the "mitigation" and "no mitigation" assumptions. III. The project should be undertaken since the NPV is positive under both the "mitigation" and "no mitigation" assumptions. IV. Even when no mitigation is considered the project has a negative NPV, so it should not be undertaken. V. The project should be undertaken only if they do not mitigate for the environmental effects. However, they have to make sure that they've done the analysis properly to avoid any ill will' and additional costs" that might result from undertaking the project without concern for the environmental Impacts. -Select- 2. Financial appraisal of investment projects The NextGen project is an example of how the financial appraisal of an investment project is conducted at Cengage Learning. The NextGen project passed through several stages of the capital investment process, which required the finance team to evaluate it and to what extent the project would drive incremental revenue or contribute toward revenue preservation. Instructions: Review the following stages of the financial appraisal process for this project and complete missing information as needed. Project Overview The Innovation team proposed a digital learning platform that will create a personalized learning experience for each student. The platform consists of a set of flexible tools that will allow students to customize the technology to suit their personal learning needs. The executive team believes that the value proposition offered by the NextGen project will be one of a kind in the digital learning space and give the company a first-mover advantage. The finance team conducted the financial appraisal of the project to evaluate it and to what extent the project would drive incremental revenue or contribute toward revenue preservation. Relevant Cash Flows The finance team scheduled a series of meetings to discuss the different aspects of the project analysis. Sanford Tassel, Senior Vice President, Finance and Operations, Dikran Yapoujlan, Vice President, Finance and other members of the finance-decision support team held a series of discussions. Some excerpts from their discussions follow: From: Yapoujian, Dikran To: Tassel, Sanford Cc: Buzzard, Chris; Muhleman, Purlen Subject: Relevant cash flows Attached: Data.xls Hey Sanford, I've been working with the team to evaluate the NextGen product in the capital approval pipeline. I've crafted the valuation model Attachment: Data.xls (A dollar values in millions) A B 1 Capitalized expenses Non-cash(depreciable) expenses Operating costs as a percentage of revenues $20.5 (spread over 3 years) $3.400 2 3 Year 1: 141% Year 2: 33% excerpts from their discussions follow: nature, restricting us to work with a relevant time horizon of six years and to ignore any cash flows after the sixth year. We would need to immediately approve a capital allocation of $1.70 million to jump-start the project. In addition, we would need to capitalize another $20.5 million almost equally for the next three years. These expenses will be incurred on an after-tax basis. The first year of the project is unlikely to bring any additional revenues, but from second year, we should see revenues increase by $1.800 million. Our preliminary estimates also show revenues growing to $9.700 million in year 2, $19.300 million in year 3, $22.800 million in year 4, and $24.600 million in year 5. I am also attaching some information the team used for the cash flow valuation. See you later to go over the numbers. Cheers, Dukran Attachment: Data.xls (Al dollar values in millions) 1 $20.5 (spread over 3 years) 2 Capitalized expenses Non-cash(depreciable) expenses Operating costs as a percentage of revenues $3.400 3 Year 1: 141% Year 2: 33% Year 3: 22% Year 4: 22% Year 5: 24% 4. Taxes 40% The analysts on the team created pro forma estimates of the expected cash flows that the project is likely to generate and also discussed some assumptions: Revenue estimates are based on the expectation of a higher price point resulting from a more robust product. Operating expenses include internal labor, maintenance, overhead expense, and cost avoidance from being able ramp down spending on existing platforms. The capitalized expenses include the costs of platform development, content creation, Internal and external labor, computers, facility Investment, and so on. These expenses are amortizable and depreciable the first three of the six years of the project's expected life. They are recognized separately from the normal depreciation and amortization expenses. . These capital expenses will be deducted from the project's annual cash flow from operations to derive at the project's total expected life. They are recognized separately from the normal depreciation and amortization expenses. . These capital expenses will be deducted from the project's annual cash flow from operations to derive at cash flows. project's total expected Complete the following cash flow analysis based on the information provided. (Note: Express all values in millions of dollars and round all values to three decimal places. Use a minus (-) sign to indicate any negative amount. Year o Year 1 Year 2 Year 3 Year 4 Year 5 Revenues 0 Less: Operating expenses Less: Depreciation & Amortization Operating Income Less: Tax Plus: Non-cash expenses Operating Cash Flow Less: Capitalized expenses 7.300 6.600 6.600 - Total Cash Flow Financing Costs The finance team got together to discuss the financing costs of the project. The following is an excerpt of their discussion. Read the dialogue and fill in the missing word or words. DIKRAN: Should we use the company's WACC or use the beta of a comparable project when applying a cost of capital to this project? SANFORD: We calculate our WACC on an annual basis based on the company's capital structure for the fiscal year. All of our investments are treated as cash investments so that we can fairly compare all initiatives based on their value proposition. This is a one-of-a-kind project in the ed tech space, and we believe that it will drive incremental revenues and contribute to the preservation of revenue for Cengage's existing products. The project also seems to align with the reinvestment objectives of our private equity owners. DIKRAN: Sounds good. We also calculate our applicable tax rates annually, and considering the digital landscape of this project, we necessarily need to use different tax rates based on the different states in which we operate. I guess it is fair to apply a standard tax rate in the valuation of the project cash flows. SANFORD: Let's use our standard WACC of 12%. I'll see you soon to discuss the valuation of the project. Financing Costs The finance team got together to discuss the financing costs of the project. The following is an excerpt of their discussion. Read the dialogue and fill in the missing word or words. DIKRAN: Should we use the company's WACC or use the beta of a comparable project when applying a cost of capital this project? SANFORD: We calculate our WACC on an annual basis based on the company's capital structure for the fiscal year. All of our investments are treated as cash investments so that we can fairly compare all initiatives based on their value proposition. This is a one-of-a-kind project in the ed tech space, and we believe that it will drive incremental revenues and contribute to the preservation of revenue for Cengage's existing products. The project also seems to align with the reinvestment objectives of our private equity owners. DIKRAN: Sounds good. We also calculate our applicable tax rates annually, and considering the digital landscape of this project, we necessarily need to use different tax rates based on the different states in which we operate. I guess it is fair to apply a standard tax rate in the valuation of the project cash flows. SANFORD: Let's use our standard WACC of 12%. I'll see you soon to discuss the valuation of the project. Project Evaluation The analysts in the team run the numbers and hand over the evaluation to Sanford. Complete the data in the report. (Note: Round your input values to three decimal places and your output values to two decimal places. Use a minus (-) sign to indicate any negative amount.) Year o Year 1 Year 2 Year 3 Year 4 Year 5 PV of cash flows NPV of the project IRR of the project Payback period % 3.30 years The Accept/Reject Recommendation The project proposal with supporting data was presented to the CFO and the board. After discussion and scrutiny of the assumptions in the report, the board is most likely to the project because of which of the following reasons? Check all that apply. Management believes that the project will help in increasing market share and protect existing penetration. The management team believes that this project will lead the transition toward becoming a digital-first company. Management is not confident about the digital Innovation team's track record. The project has a shelf-life shorter than the payback period of the investment. 4. Modified internal rate of return (MIRR) The IRR evaluation method assumes that cash flows from the project are reinvested at the same rate equal to the IRR. However, in reality the reinvested cash flows may not necessarily generate a return equal to the IRR. Thus, the modified IRR approach makes a more reasonable assumption other than the project's IRR. Consider the following situation: Fuzzy Button Clothing Company is analyzing a project that requires an initial Investment of $600,000. The project's expected cash flows are: Year Year 1 Year 2 Cash Flow $375,000 -125,000 475,000 450,000 Year 3 Year 4 Fuzzy Button Clothing Company's WACC IS 8%, and the project has the same risk as the firm's average project. Calculate this project's modified Internal rate of return (MIRR): O 17.42% 20.33% O 21.30% 0 19.36% If Fuzzy Button Clothing Company's managers select projects based on the MIRR criterion, they should this Independent project. Which of the following statements best describes the difference between the IRR method and the MIRR method? The IRR method uses the present value of the initial Investment to calculate the IRR. The MIRR method uses the terminal value of the Initial Investment to calculate the MIRR. The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital. O The IRR method uses only cash inflows to calculate the IRR. The MIRR method uses both cash inflows and cash outflows to calculate the MIRR. An electric utility is considering a new power plant in northern Arizona. Power from the plant would be sold in the Phoenix area, where it is badly needed. Because the firm has received a permit, the plant would be legal; but it would cause some air pollution. The company could spend an additional $40 million at Year O to mitigate the environmental problem, but it would not be required to do so. The plant without mitigation would require an initial outlay of $270.46 million, and the expected cash inflows would be $90 million per year for 5 years. If the firm does invest in mitigation, the annual Inflows would be $93.10 million. Unemployment in the area where the plant would be built is high, and the plant would provide about 350 good jobs. The risk adjusted WACC is 17%. a. Calculate the NPV and IRR with mitigation. Enter your answer for NPV in millions. For example, an answer of $10,550,000 should be entered as 10.55. Negative values, if any, should be indicated by a minus sign. Do not round Intermediate calculations. Round your answers to two decimal places. NPV: $ million IRR: % Calculate the NPV and IRR without mitigation. Enter your answer for NPV in millons. For example, an answer of $10,550,000 should be entered as 10.55. Negative values, if any, should be indicated by a minus sign. Do not round , Intermediate calculations. Round your answers to two decimal places. NPV: $ million IRR: % % b. How should the environmental effects be dealt with when evaluating this project? I. The environmental effects should be ignored since the plant is legal without mitigation II. The environmental effects should be treated as a sunk cost and therefore ignored. III. If the utility mitigates for the environmental effects, the project is not acceptable. However, before the company chooses to do the project without mitigation, it needs to make sure that any costs of "ill will for not " mitigating for the environmental effects have been considered in the original analysis. IV. The environmental effects should be treated as a remote possibility and should only be considered at the time in which they actually occur. V. The environmental effects if not mitigated would result in additional cash flows. Therefore, since the plant is legal without mitigation, there are no benefits to performing a "no mitigation" analysis. -Select C. Should this project be undertaken? I. The project should be undertaken only under the "mitigation assumption. II. The project should be undertaken since the IRR is positive under both the "mitigation" and "no mitigation" assumptions. III. The project should be undertaken since the NPV is positive under both the "mitigation" and "no mitigation" assumptions. IV. Even when no mitigation is considered the project has a negative NPV, so it should not be undertaken. V. The project should be undertaken only if they do not mitigate for the environmental effects. However, they have to make sure that they've done the analysis properly to avoid any ill will' and additional costs" that might result from undertaking the project without concern for the environmental Impacts. -Select