Payeur Business Finance

Case Study Time Value of Money & Capital BudgetingNAME______________________________

Learning Targets

Discuss the capital budgeting process.

Discuss the use of net present value.

Calculate the net present value.

Calculate the internal rate of return.

Explain the relationship between the internal rate of return and net present value.

For the point of this case study, you are to assume the role of a financial analyst at O. REO, a cookie company. The CEO, Mr. Reo, has asked you to evaluate an expansion project that is under consideration.

O. REO

O. REO has been very successful developing cookies for retail purchase and bringing them to market. The company has historically focused on packaged cookies for home consumption. The retail snack food industry is competitive and the CEO has recently become interested in expanding into other types of snack foods and has identified a project that looks promising.

Engineers have identified expansion equipment that is for sale for $2,000,000 along with acquisition costs (R&D, Labor, Maintenance, etc) are valued at $95,000 (total project cost of $2,095,000). After breakeven calculations of the new snack food, it is forecasted that this equipment will bring $175,000 in sales per year for 10 years. The equipment has a $1,000,000 salvage value 10 years from now (assume a sale 10 years from now).

The current investments at O. REO are yielding an 7.5% return. You have been asked to use this rate of return as your WACC in your analysis of this project. At the asking price, does an NPV analysis of this project indicate that it would be a good deal? What is the IRR of this project? The CEO is considering making an offer of $1,595,000 (inclusive of the $95,000 acquisition costs). At what price range will the project generate an IRR sufficient to meet O. REOs return expectations?

Prepare an Excel spreadsheet comparing the two cash flow streams. Identify and show the present values of the benefits and the present values of the costs. You will present and explain your calculations comparing the $2,095,000 offer and the $1,595,000 asking, and your plan to the CEO. The CEO has also asked that you include the answers to the following questions in your analysis:

1. Without changing any of the cash flows, understanding this investment may be negotiated, what is the maximum amount O. REO should offer for this to remain beneficial? (compare this third amount in your Excel sheet)

2. Do NPV and IRR analysis always agree on whether a proposed investment creates value for the firm? What evidence do you have?

3. Are there other capital budgeting techniques that we might use to evaluate this project? What are the Pros and Cons of each?Calculate at least three others as examples.

4. What other considerations should Mr. Reo be concerned with in regards to TVM and Capital Budgeting?

5. What other recommendations do you have for Mr. Reoregarding the long-term success of O. REO Cookies?