Question 6 (Capital Budgeting)

You are a financial manager for BPI Inc. and are asked to evaluate a potential investment opportunity by the senior manager of the R&D division. Key information about the project is given in the table below. Additional information is as follows:

The project wont generate any revenues, costs of goods sold, or SG&A expenses after year 3.

It will take a team of 10 engineers 3 months to get the project started. Engineers at BPI are typically paid upfront for projects and the average monthly salary of an engineer working for BPI

is $8,500. The salary of the engineers is considered an R&D expense.

The project will require an upfront investment in additional machinery of $600,000 today. The

machinery will be depreciated over 4 years using straight line depreciation starting at the end of

year 1.

In year 4 the machinery will need to be disposed of, which will generate a disposal cost of $50,000

that can be expensed for tax purposes.

The marginal tax rate of BPI is 21% and BPI as a firm is expected to generate at least $10 million

of pre-tax income each year for the next six years, regardless of whether it takes the new project

or not.

The appropriate interest rate to discount free cash flows is 11%

A midyear adjustment is not necessary.

To get more information about the project you have a meeting with the senior manager of the R&D division. In that meeting you learn that the R&D division has already built a prototype for this project in order to determine its feasibility and that the prototype cost $200,000 to develop. Moreover, you are being told that BPI will not hire additional engineers but will use in-house engineers that are currently employed by BPI. The senior manager of R&D claims that using in-house engineers will help increase the profitability of the project since they are already on the companys payroll.

This is the solution below: Please explain how to get to these numbers:

Question 6 (Capital Budgeting) You are a financial manager for BPI Inc. and are asked to evaluate a potential investment opportunity by the senior manager of the R\&D division. Key information about the project is given in the table below. Additional information is as follows: - The project won't generate any revenues, costs of goods sold, or SG\&A expenses after year 3. - It will take a team of 10 engineers 3 months to get the project started. Engineers at BPI are typically paid upfront for projects and the average monthly salary of an engineer working for BPI is $8,500. The salary of the engineers is considered an R\&D expense. - The project will require an upfront investment in additional machinery of $600,000 today. The machinery will be depreciated over 4 years using straight line depreciation starting at the end of year 1. - In year 4 the machinery will need to be disposed of, which will generate a disposal cost of $50,000 that can be expensed for tax purposes. - The marginal tax rate of BPI is 21% and BPI as a firm is expected to generate at least $10 million of pre-tax income each year for the next six years, regardless of whether it takes the new project or not. - The appropriate interest rate to discount free cash flows is 11% - A midyear adjustment is not necessary. To get more information about the project you have a meeting with the senior manager of the R\&D division. In that meeting you learn that the R\&D division has already built a prototype for this project in order to determine its feasibility and that the prototype cost $200,000 to develop. Moreover, you are being told that BPI will not hire additional engineers but will use in-house engineers that are currently employed by BPI. The senior manager of R\&D claims that using in-house engineers will help "increase the profitability of the project since they are already on the company's payroll". Part A (15 Points) Complete the Table below to calculate the free cash flows of the project (no discounting necessary). Add any additional line items that you think are relevant to calculate free cash flows. Round your numbers to the nearest integer (in $1,000 ) to save some space. The main difficulties here was estimating the R\&D Expense (8,500103=255,000) and realizing that CAPEX is not a part of NOPAT. Question 6 (Capital Budgeting) You are a financial manager for BPI Inc. and are asked to evaluate a potential investment opportunity by the senior manager of the R\&D division. Key information about the project is given in the table below. Additional information is as follows: - The project won't generate any revenues, costs of goods sold, or SG\&A expenses after year 3. - It will take a team of 10 engineers 3 months to get the project started. Engineers at BPI are typically paid upfront for projects and the average monthly salary of an engineer working for BPI is $8,500. The salary of the engineers is considered an R\&D expense. - The project will require an upfront investment in additional machinery of $600,000 today. The machinery will be depreciated over 4 years using straight line depreciation starting at the end of year 1. - In year 4 the machinery will need to be disposed of, which will generate a disposal cost of $50,000 that can be expensed for tax purposes. - The marginal tax rate of BPI is 21% and BPI as a firm is expected to generate at least $10 million of pre-tax income each year for the next six years, regardless of whether it takes the new project or not. - The appropriate interest rate to discount free cash flows is 11% - A midyear adjustment is not necessary. To get more information about the project you have a meeting with the senior manager of the R\&D division. In that meeting you learn that the R\&D division has already built a prototype for this project in order to determine its feasibility and that the prototype cost $200,000 to develop. Moreover, you are being told that BPI will not hire additional engineers but will use in-house engineers that are currently employed by BPI. The senior manager of R\&D claims that using in-house engineers will help "increase the profitability of the project since they are already on the company's payroll". Part A (15 Points) Complete the Table below to calculate the free cash flows of the project (no discounting necessary). Add any additional line items that you think are relevant to calculate free cash flows. Round your numbers to the nearest integer (in $1,000 ) to save some space. The main difficulties here was estimating the R\&D Expense (8,500103=255,000) and realizing that CAPEX is not a part of NOPAT