Case Study

ABC CORPORATION

(Basics of Capital Budgeting)

Prior sessions have provided an overview of financial management, risk analysis, bond valuation, stock valuation, and the cost of capital. The capital budgeting sessions are timely, because the firm will soon be undertaking its capital budgeting review process, and the board must approve all projects calling for expenditures greater than $10 million.

The first capital budgeting session will focus on the different criteria that the board could use to evaluate proposed capital expenditures. ABCs top managers have discussed the appropriateness of different criteria, including the choice between NPV and IRR, and that will be one focus of the session.

ABC has a capital budgeting model to analyze all of its proposed projects. The model first forecasts each projects cash flows, after which it calculates the payback, Net Present Value (NPV), Internal Rate of Return (IRR), and Modified Internal rate of Return (MIRR). The model is also set up so that the analyst can see the effect of alternative sets of assumptions, ranging from scenarios where everything goes well to those where things to badly. These scenarios are used to get an idea of the projects risk.

Only the directors have participated in the prior sessions, However, the president, asked you to invite the controller and the vice presidents for marketing, production, and human resources to the capital budgeting sessions. Those executives must provide critical inputs for capital budgeting decisions, and the president wants to make sure that all participants know how the data they provide will be used to analyze capital budgeting decisions. In addition, several executives have questioned the weights that have been given to the decision criteria in actual capital budgeting decisions. For example, both the controller and the VP for marketing think that the most weight should be given to the payback, and that any project with a payback of less than 3 years should be accepted. Similarly, the VP for production thinks that the Payback is the best method, but several directors seem more comfortable with the IRR. You personally would like to consider only the NPV had the President not interceded and asked you to calculate all 5 criteria.

Table 1 provides some simplified data on two projects, S and L. Both involve developing a new microprocessor, but with different ways of handling the operation. Under plan S, the project would be accelerated; hence it would have high sales in Year 1. However, under S the firms competitors would learn about the product relatively soon, and sales would decline as competitors began to produce similar microprocessors. Therefore, Ss cash flows decline over its 4-year life. Under Project L, things would be handled differently. Here, ABC would operate slowly, carefully, and secretly, and customers would be locked in through long-term contracts. Thus under L, sales and cash flows would rise over time. Even so, new products would eventually replace this microprocessor, so L would also have a 4-year life. Moreover, sometimes the different projects are independent, meaning that both can be accepted because their cash flows are not related to one another, but at other times projects are mutually exclusive, meaning that only one of several alternative projects can be accepted.

Another issues that arose recently concerns situations in which the company can structure a project so that it will have a relative short life or, by spending more money to buy longer-lasting equipment, a longer life. Two other proposed projects, SS and LL, whose cash flows are shown in Table 2, illustrate this situation. SS calls for the purchase of relatively inexpensive equipment that can be used for 2 years to produce a recently developed chip for the telecommunications industry. LL calls for the purchase of more expensive equipment that can be operated for 4 years. Such projects are, by definition, mutually exclusive, and again, decisions about them have led to heated discussions.

Yet another project involves rare earth metals, which ABC uses in some of its microprocessors. Rare earth metals are quite expensive, and often in short supply. The company has an opportunity to buy a rare earth mine that would produce for two years, after which the resources would be exhausted. At that point, the government would require company to spend a considerable sum to restore the land to its natural state. The projects projected cash flows are shown in Table 3. When you analyzed the project, you reported to management that it seemed to have two internal rates of return. You will have to report on this project to the President and the board, and a rate of return will have to be included in his report. At this point, you are not sure what return to report, so you have decided to raise the issue during this session.

As with the other sessions, they will use an Excel model both to quantify the analysis and to help the directors learn more about how Excel is used in financial analysis.

QUESTIONS

1. Calculate the Payback, Discounted Payback, NPV, IRR, and modified IRR (MIRR) for Projects S and L. If these projects are independent, do the criteria indicate that either, or both, should be accepted? Postpone a consideration of the situation if the projects are mutually exclusive until later, after the pros and cons of the various methods have been analyzed.

2. Surveys by various academics indicate that most companies, large and small, calculate the

payback and apparently give it some weight in their capital budgeting decisions. Small companies often rely exclusively on the payback. What are the pros and cons of this criterion, and do you think ABC should give it any weight in its capital budgeting decision process?

3. If some of ABCs directors feel strongly that the IRR should be given significant weight in the decision process, would you recommend that they focus on the regular IRR, the MIRR, or both? Why?

4. The expected cash flows for Projects SS and LL are shown in Table 2. Explain why a problem

exists, and then recommend which of these projects, if either, ABC should choose. Calculation Required

5. The projected cash flows for the rare earth project are shown in Table 3. You must indicate

a specific IRR for the project. What is the proper IRR? Should ABC accept this project? Explain your answer. Construct the NPV Profile

6. If S and L are mutually exclusive, which project would you recommend? Explain your

choice in a manner that should satisfy the President and the other directors. HINT: Calculate the crossover rate and create a NPV profile. Show the Graph!

Table 1. Cash Flows and other Inputs for Projects S and L Other inputs: WACC: 10.00% Tax Rate: 40% Project S Year (t) -$100,000 Required investment Sales revenues $170,450 $58,333 $20,000 $20,000 $25,000 $20,000 $20,000 operating costs less depm $50,000 $25,000 $25,000 $25,000 $25,000 Depreciation (straight line) operating income $8,333 -$25,000 -$25,000 $95,450 Taxes $38,180 $3,333 -$10,000 -$10,000 Net operating income $57,270 $5,000 -$15,000 -$15,000 Add back depreciation $25,000 $25,000 $25,000 $25,000 -$100,000 S82.270 30,000 S10,000 S10,000 Net (free) cash flow Project L Year Required investment -$100,000 $20,000 $36,667 $116,667 $209,583 Sales revenues Operating costs less deprn $20,000 $20,000 $50,000 $100,000 Depreciation (straight line) $25,000 $25,000 $25,000 $25,000 Operating income -$25,000 -$8,333 $41,667 $84,583 40% -$10,000 -$3,333 $16,667 $33,833 Taxes Net operating income -$15,000 -$5,000 $25,000 $50,750 $25,000 Add back depreciation $25,000 $25,000 $25,000 Net (free) cash flow 100,000 10,000 $20,000 50,000 75,750