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Diploma In Accounting Program BUSI 370: Business Finance Section 202 Assignment #3 Capital Budgeting Case Study Chapter 13 Capital Budgeting, Risk Considerations, and Other Special Issues Due date: March 14, 2016 11:59 pm Turnitin Chapter 13 is an introduction to the capital budgeting process and its relationship to corporate strategy Capital budgeting refers to the process through which a firm makes large and strategic capital expenditure decisions by: (1) identifying investment alternatives, (2) evaluating these alternatives, (3) implementing the chosen investment decisions, and (4) monitoring and evaluating the performance of the implemented decisions. Objectives Understand the quantitative decision criteria, (discounted cash flow analysis or DCF) used to evaluate investment alternatives Perform discounted cash flow analysis using a financial calculator and a spreadsheet (Excel) to solve for net present value (NPV) and internal rate of return (IRR) Compare and evaluate the relationship between NPV and IRR in the context of mutually exclusive projects Calculate and apply the payback and discounted payback period criteria to the evaluation of projects Calculate and apply the profitability index (PI) criteria to the evaluation of projects Construct an investment opportunity schedule to assist in capital budgeting decision making Required: Complete the following questions using a financial calculator and a spreadsheet, (do not use a spreadsheet solely for your calculations. You will be required to solve similar problems on the final exam using only a financial calculator). The emphasis is on showing all your work (the equations, calculator steps, Excel formulas and answers) for each question. Your submitted work must be typed. Please note that Turnitin only accepts documents in MS Word, WordPerfect, RTF, PDF, PostScript, HTML, and plain text (.txt) formats. See the TurnItIn Student Quickstart Guide for step-by-step instructions (including special instructions for submitting scanned PDFs). My suggestion is you save any Excel output in Word or PDF format and submit into Turnitin. Important: Once your work has been graded, you must log into Turnitin in order to view your results. BUSI 370 Business Finance -1- Graham McIntosh 2016 Diploma In Accounting Program BUSI 370: Business Finance Section 202 Grading: 3% of the overall grade Assignments will be grading using a rubric as per below: Assignment #3 Grading Rubric out 100 points = 3% of Overall Course Grade Assignment 3 Rubric Criteria Outstanding Excellent Very Good+ Very Good Good + Good Fair Pass Attempted Not Attempted Question Value 100% 90% 85% 80% 75% 70% 60% 50% 30% 0% 1 30% 2 40% 3 10% 4 10% 5 10% I have summarized the questions elements on the following pages to help guide you through the questions. You can use this template to organize your calculations and answers. BUSI 370 Business Finance -2- Graham McIntosh 2016 Diploma In Accounting Program BUSI 370: Business Finance Section 202 Pr Copper Corp. is copper mining company. The company operates in many different countries (Canada (B.C.), Chile, Nigeria, and Australia). Two experienced geologists, Mary Karlsson and Pierre Kim, founded the company 10 years ago. Having worked on many different mining sites all over the globe, these two scientists are well known and respected in the mining community. Their rigorous management and impeccable track record have also earned them an excellent reputation among the financial community. Copper has been mined and used for at least 10,000 years. Evidence of the use of copper 8,000 years BCE has been found in Iraq. Copper has become one of the most demanded base metals. Thanks to its high conductivity, copper is a key input for the production of electronic components used, in the telecommunications, computer, and automobile industries. For example, the average car now contains approximately 25 kg of copper (50 kg for a hybrid car). The demand for copper is sustained by a growing demand for electronic components. However the demand and price for copper can also be quite volatile in the short term. China is the main consumer of copper (39% of the 2010 world production). Therefore, any slowdown or expected slowdown of the Chinese economic growth rate has strong consequences for the price of copper (See current and historical quotations provided by the London Mercantile Exchange (LME), the world largest market for copper: www.lme.com). The main risks associated with the operation of copper mines and production includes: . commodity price risk (copper price volatility on international markets); . currency risk, also called foreign exchange risk (most mines are located outside of Canada, and contracts and prices are set in US dollars); . political risk: many mines are located in politically unstable countries, sometimes close to active war zones; . economic risk; and . geological risk. The Pr Copper Corp. mines are open pit mines. Normally, copper mining involves the following production steps: . Ore extraction (mining); . Crushing in order to produce a concentrate of the copper ore; . Benefication (milling, flotation): separation of the copper from the gangue (impurities and wastes) . Mineral processing (smelting): further extraction or refining of the copper. Smelting operations can be co-located (on site) or off site. Co-located smelting sites are more efficient in terms of transportation costs but produce larger amounts of waste locally. This increases the mine remediation cost at the end of the mine's life. Off sites smelting operations allow the centralization of smelting operations for different nearby mines. Sometimes, such smelting operations are even pursued in a neighbor country, resulting in BUSI 370 Business Finance -3- Graham McIntosh 2016 Diploma In Accounting Program BUSI 370: Business Finance Section 202 higher transportation costs and export taxes. This is the case for Pr Copper Corp.'s operations in Nigeria. These different possible designs will have different costs and will impact projects' expected cash flows accordingly. Source: sbmmine.com Depending on the overall economic situation as well as the nature of the company's operations, a localization risk premium is applied to the discount rate to be used in capital budgeting calculations (Risk Adjusted Discount Rate). Pr Copper Corp. is considering a set of projects (A, B, C, D, E, F and G). All projects, except project D, are located in Nigeria. The Nigerian site is composed of 3 different pits (known as Pit 1, Pit 2 and Pit 3). To reflect the riskiness of the different projects, a risk adjusted discount rate of 17.5% will be applied to projects A, B, C, D, E, and F, while project G's discount rate is 7.8 %. BUSI 370 Business Finance -4- Graham McIntosh 2016 Diploma In Accounting Program BUSI 370: Business Finance Section 202 Question 1: Table 1 contains the forecasted cash flows for the projects Pr Copper Corp. is considering (30 Marks) Table 1 Year 0 1 2 3 4 5 6 7 8 9 10 Annual forecasted project cash flows for Pr Copper Corp. (,000$) Project A Project B Project C Project D Project E Project F Project G -$10,000.00 -$8,500.00 -$7,500.00 -$10,500.00 -$11,500.00 -$12,500.00 $1,890.00 $4,500.00 $4,000.00 $4,000.00 $3,100.00 $3,600.00 $2,800.00 -$1,680.00 $4,320.00 $4,170.00 $3,040.00 $3,920.00 $3,500.00 $3,800.00 $2,065.00 $4,100.00 -$2,500.00 $2,000.00 $4,000.00 $3,400.00 $4,000.00 -$2,070.00 -$1,500.00 $3,000.00 $3,000.00 $3,700.00 $3,300.00 $4,500.00 $0.00 $3,150.00 $3,000.00 $0.00 $3,600.00 $3,240.00 $6,080.00 $0.00 $3,000.00 $2,100.00 $0.00 $3,400.00 $3,000.00 $6,100.00 $0.00 $0.00 $0.00 $0.00 $3,100.00 $2,700.00 $5,300.00 $0.00 $0.00 $0.00 $0.00 $500.00 $2,300.00 $3,700.00 $0.00 $0.00 $0.00 $0.00 -$3,000.00 $2,100.00 -$5,000.00 $0.00 $0.00 $0.00 $0.00 -$5,000.00 $2,000.00 -$7,000.00 $0.00 Decision criteria for projects A, B, C, D, E and F Cost of Capital = 17.5%; Payback = 3.5 years; Discounted Payback = 4.00 years Projects A, B and C refers to the possible addition of new hauling trucks (240 tons trucks) for one of the company's open pit mines: Pit 1 in Nigeria. The overall costs and benefits (net cash flows) for three different models of hauling trucks are compared. The price range for the various models of new 240 ton hauling trucks: $3,300,000 - $3,500,000 each. Projects D and E refers to different options for a new copper smelting facility. Project D involves building and operating a co-located smelting facility near Pit 1; while Project E involves the building and operating of an off-site smelting facility. Project F refers to the developing and operating of a new open pit mine, Pit 2 in Nigeria. Decision criteria for project G Cost of Capital = 7.8%; Payback = 3.5 years; Discounted Payback = 4.00 years Project G consists of two major international conferences organized by Pr Copper Corp. on the topic of \"Mining companies' social and environmental responsibility\". This project aims at improving Pr Copper Corp.'s image among existing and potential shareholders and other stakeholders. In recent years, the company has invested heavily to reduce its ecological footprint and led many social initiatives to improve the safety and quality of the life of their employees and of the population surrounding the mining sites. Still, Pr Copper's CEO, Adam Smith, feels that these efforts have not yet been fully acknowledged by investors and stakeholders. Question 1.a. Which of Pr Copper Corp.'s projects are mutually exclusive? Which of Pr Copper Corp.'s projects are independent? Explain why. BUSI 370 Business Finance -5- Graham McIntosh 2016 Diploma In Accounting Program BUSI 370: Business Finance Section 202 Question 1.b. Fill in Table 2 below. Calculate the discounted values of each cash flow (this is required in order to calculate the Discounted Payback period for each Project) Table 2 Year 0 1 2 3 4 5 6 7 8 9 10 NPV Annual Forecasted DISCOUNTED cash flows (,000 $) Project A Project B Project C Project D Project E Calculations: Project A: Project B: Project C: Project D: Project E: Project F Project G Project F: BUSI 370 Business Finance -6- Project G: Graham McIntosh 2016 Diploma In Accounting Program BUSI 370: Business Finance Section 202 Question 2: 2.a Complete Table 3 below. (40 Marks) Table 3 Project A NPV IRR Payback Discounted Payback Profitability Index Calculations: Project B Project C Project D Project E Project F Project G 2.b. If the firm is not capital constrained, and if the projects described in Table 1 (Question 1) are independent, which projects should the firm undertake? (10 Marks) BUSI 370 Business Finance -7- Graham McIntosh 2016 Diploma In Accounting Program BUSI 370: Business Finance Section 202 Question 3. Consider Projects A and C Determine which project is preferred assuming an 17.5% cost of capital using the: 3.a Chain replication approach (show your work) 5 Marks Ax _____ Cx 0 1 2 3 4 5 6 7 8 9 10 11 12 NPV 3. b. Equivalent Annual NPV approach. Show your work. (5 Marks) BUSI 370 Business Finance -8- Graham McIntosh 2016 Diploma In Accounting Program BUSI 370: Business Finance Section 202 Question 4 (10 Marks) Construct an investment opportunity schedule for Projects A to G. If there is $19,000,000 available for investment, which project or combination of projects should be undertaken (assuming all projects are independent). Justify your recommendations to the CFO. Show your calculations Project Initial Cost ($) Useful Life NPV ($) NPV IRR PI IRR PI A B C D E F G Rank 1st 2nd 3rd 4th 5th 6th Reject Recommendations: BUSI 370 Business Finance -9- Graham McIntosh 2016 Diploma In Accounting Program BUSI 370: Business Finance Section 202 Question 5 (10 marks) John is willing to invest $ 3,481,000 in Stock A and $1,519,000 in Stock B (both are listed on the TSX). Considering John's perspective on the Canadian economy, complete the following table. Calculations required. Show your work in the space provided below the table. State of the Economy Expansion Normal Recession Probability of Occurance 15% 60% 25% Stock A Expected Return -6% 12% 18% Stock B Expected Return 35% 20% -10% Expected Return Expected Portfolio Return Variance Standard Deviation Covariance A and B Correlation Coefficient Portfolio Weight in A Portfolio Weight in B Portfolio Variance Portfolio Standard Deviation Calculations: BUSI 370 Business Finance - 10 - Graham McIntosh 2016