Mini-Case I Capital Budgeting Decision (15 points) It was a Friday night, and you were sitting alone in some Irish bar on Crescent Street. Montreal was still Montreal, yet your life wasnt as easy as it was when you were a student. The loud music couldnt cheer you up. All you could think of was your angry manager at work and you just wanted to get wasted. Suddenly, you heard a familiar voice. It was Xiao Ming, a friend you had when you went to school at JMSB. Although you havent seen each other for a few years after graduation, you caught up with each other pretty well and laughed about those days when you rocked the Guitar Hero in the basement of your moms house A few days later, you received a call from Xiao Ming. It turned out that his dad passed away and left him a fortune, and Xiao Ming is now the board director and the CEO of a Company called NO-CAN-NO-BB (NCNB), and he would like to offer you the position of CFO there. I remember you were really good at FINA 395 he winked. After some paper work, you were hired as the CFO, and your first job was to evaluate a new project that the firm is considering called YOU-CAN-YOU-UP (YCYU). Sitting in your spacious corner office, you couldnt get over the idea that people were talking behind your back that you only got the job because you knew the CEO. You called your assistant for the case files, and decided to work all night and show your colleagues that you are not who they thought you were in the morning meeting of the following day. NCNB is a Canadian provider of streaming movies and TV shows, just like Netflix. YCYU is the proposed project on the executives table. In this project, the company is planning to invest in a new talk show called The BB King that is exclusively offered on NCNB, just like watching House of Cards on Netflix. Your staff in the Capital budgeting department has already collected enough information, now your job as the CFO is to determine whether the company should invest in this new project. After a refill of coffee, you sorted the following information from the files in order to determine the appropriate discount rate the firm should employ for its new project: NCNB is now selling for $20 per share and it has 14 million outstanding common shares. The company has an equity of 0.94. A dividend of 50 cents was just paid to all of the common shareholders and analysts estimate that it will grow steadily at 5% per year. As for the preferred shares, there are 1.5 million shares outstanding, each of which is selling at $25 with a $2.5 dividend. The firm has an AA rating bond currently quoted at 110. Coupon rate is 9% with semiannual coupons. There are 75 thousand outstanding bonds and time to maturity is 15 years. Besides that, you observe the of three companies that focus on producing talk shows, such as the Conan Show, the Ellen show, and the Chris Rock show. These are 1.35, 1.07, and 1.24. The expected marker return is 6.4%, the current risk-free risk rate is 1.9%, and the corporate tax rate is 40%.

Creating the Pro Forma Statement of Comprehensive Income for the new project took you a lot longer than you expected; 5 hours flew by before you realized it. You turned around and looked through the window, it was almost dawn. Sitting in the chair for such a long time made your muscle so sour that you had to stand up and do some stretches. While making some more coffee, you witnessed the most beautiful sunrise in your life. With a bitter smile, you turned off the lights, and went back to work. There was not much time left before the morning meeting, you needed to focus on estimating the cash flows from the following accounting terms you just sorted out. The project is expected to last 4 years. The company is planning to spend $2 million on fixed assets such as the filming equipments. Xiao Ming has already spent $100,000 on consultancy to check the feasibility of the project. There is an idle studio that the company bought a few years ago. The operation manager suggested that the studio is perfect to film the BB King, and it is worthy of $400,000 if it is sold on market today. The projected sales for the 4 years are $1 million, $1.7 million, $1.6 million, and $2 million. The variable cost is 50% of the projected sales, and the fixed cost is $500,000 for every year. The company also estimates its increases in gross profit from other existing projects to be $5 million, $3 million, $4 million, and $6 million for year 1, 2, 3, and 4, respectively. Your team thinks 20%, 50%, 30%, 10% of these increases in gross profit, respectively, are due to the introduction of YCYU. The initial net working capital is going to be $150,000, NWC increases by 200,000 for year 1, decreases by 75,000 for year 2, increases by 120,000 for year 3, and increases by 50,000 for year 4. The company is expecting to recover 80% of its initial NWC at the end of the project. Suppose both the studio and the filming equipments belong to class 8, and subject to an annual CCA rate of 20%. , and the total capital spending is estimated to have a salvage value of $1.1 million at the end of the project. Question 1: What is the NPV of this project today? Calculate the WACC and an appropriate interest rate using pure play method, and take the simple average of the two as the appropriate discount rate for the project. Use the CAPM model for common shares and the dividend growth Model for the preferred shares when calculating the cost of equity. Use the EAR, not the YTM, when calculating the cost of debt. (You will find how to do these in my Topic 10 COMM 308 lecture note) Present your answers with the Tax Shield Approach on an Excel spread sheet, of which you can find an example on Page 13 of my Topic 2 FINA 395 lecture note. Although exhausted, you earned other peoples respect in the morning meeting. Xiao Ming was especially happy and decided to ask your opinion on the choice of his company vehicle. He narrowed down his choices to two cars, Tesla Model S and Mercedes-Benz CLS. Once the choice is made, assume the company keeps buying the same type of car as soon as its useful life is over. Also Xiao Ming thinks these two cars give him the same level of pleasure, thus it all depends on the annualized cost of the car.

The Tesla Model S costs $100,000 initially, the operating expenses total to $15,000 per year and has a 4year life, after which it will sell for $15,000. The Mercedes-Benz CLS on the other hand costs $85,000 initially, the operating expenses total to $17,500 per year and has a 3-year life after which it will sell for $10,000. The CCA rate is 40%, and you assume a required rate of return of 12% in this case. Question 2: What are the EAC of these two cars while taking Tax and CCA tax shield into consideration? Which car should you recommend to Xiao Ming based on your findings? I have an EAC example which shows you how to do this in my Topic 7 COMM 308 lecture notes. You need to show me how you calculate the numbers, the Excel spread sheet is not necessary for this question. Xiao Ming seemed to be pleased by your recommendation of the company car over the lunch break unexpectedly, your uptight assistant Hannah knocked on your door when you were enjoying your afternoon nap. She was a little nervous when she recommended you to refine your report on the capital budgeting of the new project with some sensitivity analysis. You were amazed by your courageous assistant who turned out to be loyal and helpful in the following years. Questions 3: As Hannah suggested, the NPV can be sensitive to the estimations of discount rate and the cash flows. You decided to recalculate the NPV with a worse case where the projected sales are 75% of what your staff estimated, and with a worst case where the projected sales are 50% of what your staff estimated before. (This should be a few clicks away if you managed to figure out how to do calculation with Excel spread sheet from the last two questions) In addition, plot a graph for NPV (Y-Axis) and the discount rate (X-Axis) using Excel to show the sensitivity of NPV to the change in discount rate. You only need to do this for the original case (Do not change the cash flows but change the discount rate in this case) Time really flew. The YCYU project turned out to be a huge success with Hannahs help. Standing by the same window, you found yourself smiling. The sun felt warm looking up, you said to yourself, I might have just found my place in this world, Dad. In most Hollywood movies, it should all ends up here, and you live your life happily ever after. Well we do not live in the movie, and life is much more dramatic. Shocking news came to you that Xiao Ming and his French actress girlfriend died in a car accident. Apparently, they were drifting the car you recommended. The board of director elected a new CEO and out of blue, you were fired. Luckily, you developed some contacts over the years in NCNB, and a guy from Ivey School of Business in University of Western Ontario called you. He sent you the following Mini-Case to test your potential to teach in one of the affiliated college in UWO. After reading this email, you poured yourself some coffee. Looking at the moon outside, you packed up your depressive mood and said to yourself Here we go again No pain, no gain; no guts, no glory.

It was a Friday night, and you were sitting alone in some Irish bar on Crescent Street. Montreal was still Montreal, yet your life wasnt as easy as it was when you were a student. The loud music couldnt cheer you up. All you could think of was your angry manager at work and you just wanted to get wasted. Suddenly, you heard a familiar voice. It was Xiao Ming, a friend you had when you went to school at JMSB. Although you havent seen each other for a few years after graduation, you caught up with each other pretty well and laughed about those days when you rocked the Guitar Hero in the basement of your moms house A few days later, you received a call from Xiao Ming. It turned out that his dad passed away and left him a fortune, and Xiao Ming is now the board director and the CEO of a Company called NO-CAN-NO-BB (NCNB), and he would like to offer you the position of CFO there. I remember you were really good at FINA 395 he winked. After some paper work, you were hired as the CFO, and your first job was to evaluate a new project that the firm is considering called YOU-CAN-YOU-UP (YCYU). Sitting in your spacious corner office, you couldnt get over the idea that people were talking behind your back that you only got the job because you knew the CEO. You called your assistant for the case files, and decided to work all night and show your colleagues that you are not who they thought you were in the morning meeting of the following day. NCNB is a Canadian provider of streaming movies and TV shows, just like Netflix. YCYU is the proposed project on the executives table. In this project, the company is planning to invest in a new talk show called The BB King that is exclusively offered on NCNB, just like watching House of Cards on Netflix. Your staff in the Capital budgeting department has already collected enough information, now your job as the CFO is to determine whether the company should invest in this new project. After a refill of coffee, you sorted the following information from the files in order to determine the appropriate discount rate the firm should employ for its new project: NCNB is now selling for $20 per share and it has 14 million outstanding common shares. The company has an equity of 0.94. A dividend of 50 cents was just paid to all of the common shareholders and analysts estimate that it will grow steadily at 5% per year. As for the preferred shares, there are 1.5 million shares outstanding, each of which is selling at $25 with a $2.5 dividend. The firm has an AA rating bond currently quoted at 110. Coupon rate is 9% with semiannual coupons. There are 75 thousand outstanding bonds and time to maturity is 15 years. Besides that, you observe the of three companies that focus on producing talk shows, such as the Conan Show, the Ellen show, and the Chris Rock show. These are 1.35, 1.07, and 1.24. The expected marker return is 6.4%, the current risk-free risk rate is 1.9%, and the corporate tax rate is 40%.

Creating the Pro Forma Statement of Comprehensive Income for the new project took you a lot longer than you expected; 5 hours flew by before you realized it. You turned around and looked through the window, it was almost dawn. Sitting in the chair for such a long time made your muscle so sour that you had to stand up and do some stretches. While making some more coffee, you witnessed the most beautiful sunrise in your life. With a bitter smile, you turned off the lights, and went back to work. There was not much time left before the morning meeting, you needed to focus on estimating the cash flows from the following accounting terms you just sorted out. The project is expected to last 4 years. The company is planning to spend $2 million on fixed assets such as the filming equipments. Xiao Ming has already spent $100,000 on consultancy to check the feasibility of the project. There is an idle studio that the company bought a few years ago. The operation manager suggested that the studio is perfect to film the BB King, and it is worthy of $400,000 if it is sold on market today. The projected sales for the 4 years are $1 million, $1.7 million, $1.6 million, and $2 million. The variable cost is 50% of the projected sales, and the fixed cost is $500,000 for every year. The company also estimates its increases in gross profit from other existing projects to be $5 million, $3 million, $4 million, and $6 million for year 1, 2, 3, and 4, respectively. Your team thinks 20%, 50%, 30%, 10% of these increases in gross profit, respectively, are due to the introduction of YCYU. T

Xiao Ming seemed to be pleased by your recommendation of the company car over the lunch break unexpectedly, your uptight assistant Hannah knocked on your door when you were enjoying your afternoon nap. She was a little nervous when she recommended you to refine your report on the capital budgeting of the new project with some sensitivity analysis. You were amazed by your courageous assistant who turned out to be loyal and helpful in the following years.

Questions 3: As Hannah suggested, the NPV can be sensitive to the estimations of discount rate and the cash flows. You decided to recalculate the NPV with a worse case where the projected sales are 75% of what your staff estimated, and with a worst case where the projected sales are 50% of what your staff estimated before. (This should be a few clicks away if you managed to figure out how to do calculation with Excel spread sheet from the last two questions) In addition, plot a graph for NPV (Y-Axis) and the discount rate (X-Axis) using Excel to show the sensitivity of NPV to the change in discount rate. You only need to do this for the original case (Do not change the cash flows but change the discount rate in this case)