Case 1 - Canyon Buffs Chemical Equipment 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 Introduction Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment. The equipment must be purchased before the chemical production 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). Canyon Buff 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 product'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 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 market research 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. Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30% and an average tax rate is 20%. 2 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. Canyon Buff 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). 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 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 by varying the four parameters as follows: 3 Parameter Initial Assumption Worst Case Best Case Sales in Year 1 $30,000 $27,000 $33,000 NPV Sales Growth through Year 6 6% 0% 10% NPV Cost of Goods Sold (% of Sales) 72% 77% 67% NPV Cost of Capital 20% 23% 17% NPV For example, vary the parameter Sales in Year 1 from the worst case $27,000 to the best case $33,000, 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 above four parameters, which one should you choose and why? Write your answer in Excel. 6. Perform a scenario analysis by simultaneously varying the two parameters below: Sales Growth through Year 6 % Cost of Goods Sold NPV Scenario 1 (Baseline) 5% 71% Scenario 2 6% 72% Scenario 3 8% 73% Scenario 4 9% 74% Which scenario generates the highest NPV? Write your answer in Excel