Case Study Analysis - only numbers/ equations are needed.

CASE STUDY: CAPITAL BUDGETING Deadline May 7th 2016- Uploaded on the Blackboard Estimating the company's WACC, Analysis of Cash Flow of a Project, and Risk Analysis Introduction The capital budgeting decision is one of the most important financial decisions in business firms. General Enterprises Corporation (GEC) is considering whether to invest in a new production system. To determine if the project is profitable, GEC must first determine the weighted average cost of capital to finance the project. The simple payback period, discounted payback period, net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR) techniques are used to study the profitability of the project. The stand-alone risk of the project is evaluated with the sensitivity analysis and scenario analysis techniques assuming that manufacturing the new product would not affect the current market risk of the company. Requirements Follow the details and the instructions given throughout the case. You are asked to compute the weighted average cost of capital, determine the project's cash flows, evaluate the project using different techniques, and perform the sensitivity and scenario analysis. Please, type and show your work. Ethical conduct While, you can work together, if I determine that this assignment was not written solely by the student whose name appears on the project, the grade for this case study will be zero. Case study presentation General Enterprises Corporation (GEC) is planning to invest in a special manufacturing system to produce a new product. The invoice price of the system is $280,000. It would require $10,000 in shipping expenses and $10,000 in installation costs. The system falls in MACRS 3-year class with depreciation rates of 33% for the first year, 45% for the second year and 15% for the third year. GEC plans to use the system for four years and it is expected to have a salvage value of $40,000 after four years of use. GEC expects the new system to generate sales of 1,600 units per year. The company estimates that the new product will sell for $260 per unit in the first year with a cost of $160 per unit, excluding depreciation. Management projects that both the sale price and the cost per unit will increase by 3% per year due to inflation. GEC's net operating working capital would have to increase by $60,000. The firm's marginal tax rate is 40%. You are conducting the capital budgeting analysis for the project. Your first task is to estimate the company's WACC. 1 A. Estimate the company's WACC You can determine the yield to maturity (YTM) on the company outstanding bonds by using their current market prices. It can be assumed that the company will be able to issue additional bonds with this YTM as the cost of borrowing. The company should be able to place the new bonds without any flotation costs. The company's capital structure is: 30% debt, 10% preferred stock and 60%. The company has about $80,000 in retained earnings this year, which is also available in cash. The company should be able to use this year's retained earnings to finance part of the equity financing required for the project. However, the company will have to issue some new common shares for the remainder of the necessary equity financing. It can be assumed that flotation costs are about 10% for the new common shares. There are three basic methods of calculating a firm's cost of equity when retained earnings are used as equity capital: 1) the capital asset pricing method (CAPM); 2) the discounted cash flow (DCF) approach; and, 3) the bond-yield-plus-risk-premium method. Although there are three methods, the most appropriate approach for this company would be to find an average cost with the three methods. The data needed to estimate the firm's WACC. It provides the data required to calculate the cost of debt, the cost of preferred stock and the cost of common stock. The amount of new common stock to be issued is provided at the end of the exhibit. General's current market value optimal capital structure: Weight 30% 10% 60% Bonds $30,000,000 Preferred Stock 10,000,000 Common Equity 60,000,000 Data to be used in the calculation of the cost of preferred stock: Par value = $100 Data to be used in the calculation Annual dividend = 8% of par of the cost of borrowing with bonds: Par value = $1,000, Market value = $102non-callable Market value Flotation cost == $1,085.59 4% Coupon interest = 8%, semiannual payment Remaining maturity = 10 yearsof the cost of common equity: Data to be used in the calculation New bonds placed beta without any flotation costs CAPM data:can be privately GEC's = 1.2 The yield on T-bonds = 5% Market risk premium = 5.5% DCF data: Stock price = $19.08 Last year's dividend (D0) = $1.00 Expected dividend growth rate = 4% Bond-yield-plus-riskRisk premium = 3.5% 2 premium: Amount of retained earnings available = $80,000 Amount of new common stock to be issued = ($300,000) (0.6)- $80,000 = $100,000 Note WACC = wd rd (1 - T) + wps rps + wre rs + wncs re, weretained earnings w = retained earnings+common stock new issued w ncss= wecommon stock new issued retained earnings+common stock new issued B. Analysis of the Profitability of the Project With the sales and cost estimates given below, you should be able to estimate the project's cash flows for the four-year horizon. You should be able to compute the NPV, IRR, MIRR, simple payback period, and discounted payback period results for the project The Machinery's Invoice Price Shipping Charges Installation Cost Depreciable Basis Changes in NWC MACRS Depreciation Rates 280,000 10,000 10,000 300,000 60,000 Year 1 Year 2 3 33% 45% Year 3 Year 4 Salvage Value: Annual revenue and cost estimates (assume 3% inflation rate): Year 1 1,600 Units Unit Price Unit Cost Sales Costs 15% 7% $40,000 Year 2 1,600 Year 3 1,600 Year 4 1,600 $260 $160 1,600*260 1,600*160 This table shows the data needed to calculate the cash flows for this project. The new production system has a useful life of 4 years, a salvage value of $40,000 and falls in MACRS 3-year class. Annual revenue and cost estimates are presented in the middle of the table. The system is expected to generate sales of 1,600 units per year, with a unit price of $260 and unit cost of $160. General's net operating working capital requirement is $60,000. C. Risk Analysis After you submitted the cash flow calculations and the project profitability analysis results, you have to perform the risk analysis for the project. Since the new product will be similar to the company's existing products, you do not believe the new project will change the company's beta and its overall market risk. Therefore, it should be sufficient to evaluate the stand- alone risk of the project. What are the techniques that we can use to assess the stand-alone risk of a project? Sensitivity analysis is a widely used technique to determine how much a project's NPV will change in response to a given change in an input variable. Input variables such as sales or the cost of capital are often used while holding other things constant. Sales figures are difficult to forecast with a high degree of accuracy. It should be sufficient to evaluate the impact of an increase or a decrease of 15% in sales and costs from the base forecast. Compute the NPV for a 15% increase in sales and costs, and for a 15 % 4 decrease. The actual WACC figure is also likely to deviate from the expected base level. You would like to know how sensitive the project's NPV is to an increase or decrease of 1.5% in the WACC. Compute the NPV considering the base sale and costs figures for an increase and decrease of 1.5% in WACC. Another analysis technique for project risk used in practice is scenario analysis. In this technique, the best and worst-case NPV scenarios are compared with the project's expected NPV. As the best-case scenario, assume that the sales and costs forecast will be 15% higher and the WACC will be 1.5% lower than our original estimates. For the worstcase scenario, assume that the sales forecast will be 15% lower and the WACC will be 1.5% higher. Please calculate the standard deviation and the coefficient of variation of the project's NPV probability distribution with these scenarios. You can assume a probability of 50% for the base NPV forecast, a probability of 15% for the best-case scenario, and a probability of 35% for the worst-case scenario. Answer the following questions: 1. Calculate GEC's WACC using the data in Table 1. 2. Calculate the project's cash flows using the data in Table 2. Why is it important to take into account the effect of inflation in forecasting the cash flows? Briefly comment. 3. Evaluate the profitability of the project with the NPV, IRR, MIRR, simple payback period, and discounted payback period methods. Is the project acceptable? Briefly explain. Why is the NPV method superior to the other methods of capital budgeting? Briefly explain. 4. Conduct the stand-alone risk analysis of the project with the sensitivity analysis and scenario analysis techniques. Explain why sensitivity analysis and scenario analysis can be useful tools in the capital budgeting decision-making process when 5 economic and financial conditions are likely to change in the future. Please calculate the standard deviation and the coefficient of variation of the project's NPV probability distribution with these scenarios. Reference Meric, Ilhan, et al. "Variety Enterprises Corporation: Capital Budgeting Decision." Review of Business & Finance Case Studies 1.1 (2010): 15-25. Appendix Setting up the cash-flow. Although, you don't have to use this set up, you might find it useful for determining the cash flow. Year 1 1,600 $260.00 160.00 Units Unit Price Unit Cost Year 2 1,600 Sales Costs Depreciation: Year 1 Year 2 Year 3 Year 4 33% x300,000 =? 45% x = 15% x = 6 7% x = Year 3 1,600 Year 4 1,600 Operating cash flows: Year 1 Year 2 Year 3 Year 4 Sales Costs Depreciation EBIT Tax (40%) Net Income Add Depreciation Net Operating Cash Flow Salvage value: ($40,000.00)(1 - 0.4) = Project net cash flows: Year 0 Year 1 Year 2 Year 3 Year 4 Initial Investment Operating Cash Flows CF due to NOWC Salvage Cash Flow Net Cash Flows Grading scale Estimate the company's WACC Cost of Debt Cost of Preferred Stocks Cost of retained earnings (3 methods) Cost of issuing new equity WACC Total Analysis of the Profitability of the Project Determining the cash-flow NPV IRR MIRR Grading 3 3 12 3 4 25 10 3 2 3 7 Traditional PayBack Discounted payback Answering the question on inflation Is the project acceptable? Why is the NPV method superior to the other methods of capital budgeting? Total Risk Analysis Simulation Increase sales and costs 15% Decrease sales and costs 15% Increase WACC by 1.5% Decrease WACC by 1.5% Scenario Increase sales and costs 15% and increase WACC by 1.5 Decrease sales and costs 15% and WACC by 15 Compute Standard Deviation and coefficient of variation Explain why sensitivity analysis and scenario analysis can be useful tools Total Total Case Study 8 2 3 4 5 3 35 5 5 5 5 5 5 5 5 40 100