Please find the attached case study of Saurabh Enterprises who is trying to make a capital budgeting decisions. Please help the company with its decision making. Please work all the calculations in excel and submit the excel file. Use the outputs of the excel sheet to provide a short write-up for the key decisions required in the text.

CASE INFORMATION

SAURABH CORPORATION

Saurabh Enterprises Corporation (SEC) is planning to invest in a special manufacturing system to produce a new product. The invoice price of the system is NPR 295,000. It would require NPR 5,000 in shipping expenses and NPR 25,000 in installation costs. The system falls in straight-line depreciation method. SEC plans to use the system for four years and it is expected to have a salvage value of NPR 40,000 after four years of use.

VEC expects the new system to generate sales of 1,510 units per year. The company estimates that the new product will sell for NPR 252 per unit in the first year with a cost of NPR 153 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. VEC’s net operating working capital would have to increase by 15% of sales revenues to produce the new product. The firm’s marginal tax rate is 40%.

SEC’s WACC

Rama Thapa, a recent MBA graduate of KUSOM, is conducting the capital budgeting analysis for the project. The company hired her only a few weeks ago as the head of the newly formed Capital Budgeting Analysis Department. In order to evaluate the feasibility of the investment in the new system, Rama’s first task is to estimate SEC’s WACC. She plans to use the financial data in Exhibit 1 to estimate the WACC. When SEC started evaluating the project, the following conversation took place between Rama and Padma Jyoti. Padma Jyoti, the CEO of the company, is a IIT graduate with a major in financial economics and long years of administrative experience.

Rama: It may be difficult to estimate the cost of borrowing in the current recessionary environment.

Padma: We can determine the yield to maturity (YTM) on our outstanding bonds by using their current market prices. We can assume that we will be able to issue additional bonds with this YTM as the cost of borrowing. We should be able to place the new bonds without any flotation costs. Therefore, we can assume no flotation costs in our calculations. We can re-examine the feasibility of the project later before raising funds by using sensitivity analysis to assess the impact of possible changes in interest rates on the net present value of the project.

Rama: Do you think the company’s current market value capital structure is optimal? Can we use the current percentages of the capital components as weights in the calculation of the company’s WACC?

Padma: Yes, I believe that the company’s current market value capital structure of 30% debt, 10% preferred stock and 60% equity is optimal. We have about NPR 80,000 in retained earnings this year, which is also available in cash. We should be able to use this year’s retained earnings to finance part of the equity financing required for the project.

However, we will have to issue some new common shares for the remainder of the necessary equity financing. We can assume a flotation cost of about 10% for the new common shares.

Rama: 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. Which of these methods should we use in the calculation of our cost of retained earnings?

Padma: Although each of these methods has its merits, I believe that the most appropriate approach for our company would be to find an average cost with the three methods.

Padma gave only one week to Rama for her estimation of SEC’s WACC. With the instructions she received from Padma and with the help of the financial data in Exhibit 1, Rama began the task of estimating the company’s WACC immediately.

Padma knew that estimating the company’s cost of capital was the first critical step in the capital budgeting process. Without this analysis, it would not be possible to determine if the new system would be a profitable investment for SEC. That is why he had asked Rama to estimate the company’s WACC as the first task. Padma was very pleased when he received Rama’s calculation results and the WACC estimate. He thought that he had made a good decision in hiring Rama as the head of the company’s newly established Capital Budgeting Analysis Department.

Exhibit 1: Financial data Rama plans to use in estimating SEC’s WACC

SEC’s current market value optimal capital structure:

		Weight
Bonds	NPR 30,000,000	30%
Preferred Stock	NPR 10,000,000	10%
Common Equity	NPR 60,000,000	60%

Data to be used in the calculation of the cost of borrowing with bonds:

Par value = NPR 1,000, non-callable

Market value = NPR 1,085.59

Coupon interest = 9%, semiannual payment

Remaining maturity = 15 years

New bonds can be privately placed without any flotation costs

Data to be used in the calculation of the cost of preferred stock:

Par value = NPR 100

Annual dividend = 9% of par

Market value = NPR 102

Flotation cost = 5%

Data to be used in the calculation of the cost of common equity:

CAPM data:

SEC’s beta = 1.2

The yield on T-bonds = 5%

Market risk premium = 5%

DCF data:

Stock price = NPR 19.08

Last year’s dividend (D0) = NPR 1.00

Expected dividend growth rate = 5%

Bond-yield-plus-risk-premium: Risk premium = 3.5%

Amount of retained earnings available = NPR 80,000

Amount of new common stock to be issued = (NPR 300,000) (0.6) - NPR 80,000

= NPR 100,000

This exhibit shows the data needed to estimate the firm’s WACC. Specifically, it first presents SEC’s current market value optimal capital structure used to determine the weights in the WACC calculation. It then 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.

Analysis of the Profitability of the Project

Padma and Rama had the following conversation regarding how they should evaluate the potential profitability of the project.

Rama: With the sales and cost estimates I have obtained from the marketing and accounting departments in Exhibit 2, we should be able to estimate the project’s cash flows for the four-year horizon.

Padma: Excellent!

feasible?

How are we going to evaluate the project’s profitability to determine if it is

Rama: The Net Present Value (NPV) and Internal Rate of Return (IRR) methods are generally used in the evaluation of projects. However, these two methods have different assumptions regarding the reinvestment rate of the intermediary cash flows. The NPV method assumes that the intermediary cash flows can be reinvested at the firm’s cost of capital. However, the IRR method assumes that the reinvestment rate is the project’s IRR. Academicians argue that the reinvestment rate assumption of the NPV method is more realistic. Therefore, they recommend the NPV method. The financial goal of a firm is to maximize market value. The NPV of a project shows its contribution to the market value of the firm.

Padma:

Correct! However, the NPV is a dollar amount. It is difficult to explain the profitability of a project as a dollar amount to the stockholders of the company. It is easier to compare the project’s IRR with the firm’s WACC to convince the stockholders that we can earn a higher percentage return on the investment than what it would cost to finance it. I have heard that there is a new improved capital budgeting technique that measures the profitability of a project as a percentage similar to the IRR method and it assumes that the project’s intermediary cash flows can be reinvested at the firm’s cost of capital as in the NPV method. I believe the technique is called the Modified Internal Rate of Return (MIRR) method.

Rama: No problem. We should be able to calculate the project’s MIRR.

Padma: Great! I would also like to see the NPV, IRR, simple payback period, and discounted payback period results for the project.

Rama: Consider it done!

With the instructions she received from Padma, Rama immediately started to work on the cash flow calculations using the data in Exhibit 2 to analyze the profitability of the project with the NPV, IRR, MIRR, simple payback period, and discounted payback period methods.

Guiding Questions:

Calculate SEC’s WACC.

Calculate project’s cash flows. Why is it important to take into account the effect of inflation in forecasting the cash flows?

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.