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Corporate Finance and Investment EMBA Case Study 2) Capital budgeting, and CAPM Deadline is: January, 06, 2021 Should be covered and submitted before deadline to Ms Naz in Room S17 The Shell Company plans to expand its capacity and growth through the acquisition of a new Drilling machine which is expected to add value in the company. Making a valuation on capital investment is a standard process. The general management needs to evaluate the two drilling machines as alternative purchases, to replace an old one. Being in the decision making phase, it is the financial manager's responsibility to follow a certain methodology and perform a number of calculations in order to evaluate each machine separately as an independent project. Then, each project is evaluated and compared with the other. In the end, the financial manager demonstrates the results and makes the recommendation. The financial management starts the evaluation with the determination of values for the evaluation of each machine. This is done through: (1) the development of incremental cash flows (2) initial investment cash flows for all machines, (3) the calculation of incremental operating cash flows, (4) the calculation of terminal cash flows and (5) the calculation of discount rate. The managers decide to apply capital budgeting techniques such as: (a) the payback period (PB). (b) the net present value (NPV) and (c) the internal rate of return (IRR). Moreover, the parameter of risk is incorporated in the calculations. It is important to take into consideration the uncertainty. Risk can affect seriously the process of evaluating the investment and then may alter final decisions. The required data for analysis has been gathered by financial manager, which is presented as bellow: Old Machine: The machine has a current installed cost of Yearo --S 400,000 and a remaining economic life of 6 years (if the company decides to keep it). Its current net price is $ 400,000. We assume that if the company would decide to purchase it, this would cost the amount of 400,000 S in year (O). Below are given the relevant annual depreciation amounts: Year 1 2 3 Annual Depreciation 100,000 130,000 50,000 55,000 50,000 15000 400,000 Total If the old machine will be kept, it is expected that the machine could be sold at the end of year 6 for $ 40,000, according to the initial estimation. The tax rate for the company is 35 % or (0.35). Machine A 2 This new machine costs $ 1000,000. It has an additional installation cost of $ 100,000. Thus, the installed cost is Yearo- $ 1100,000. This machine could be sold at the end of year 6 for Year. =S 150,000. The purchase of this machine is expected to increase the net working capital of the company by 50,000 at the year. (Time of purchase). The machine has an installed cost of Yearo= $ 1100,000 and an estimated economic life of 6 years. Below are given the annual depreciation amounts: Year 1 2 3 Annual Depreciation 200000 300000 250000 150000 150000 50000 1100000 4 5 6 Total The tax rate for the company is 35% (0.35). Machine B 3 This machine costs $ 550,000. It has an additional installation cost of $ 20,000. Thus, the installed cost is Year - 570,000. The machine has an installed cost of Year-5570,000 and an estimated economic life of 6 years. Below are given the annual depreciation amounts: Year 1 2 Annual Depreciation 120000 200000 100,000 60,000 60,000 30,000 570,000 4 5 Total The Machine B can be sold at the end of year 6 for net $ 70,000. The tax rate for the company is 35% or (0.35). Other data: 1) Operating cash flow: It is intended to present the operating inflows for each of the three machines as below: Year 1 2 3 Earnings Before Depreciation and Teses Machine A Machine B 170.000 250,000 217.000 275.000 225.000 380,000 300,000 317.000 245.000 200,000 300.000 OM Machine 110,000 95.000 90.000 4 90.000 85.000 50.000 2) Cost of Capital: When evaluating an investment, it is required to take into consideration (a) the time value of money to be invested (opportunity cost) and (b) the risk taken in the investment (risk premium). The Capital Asset Pricing Model (CAPM) is used as a formula to estimate the cost of capital 4 which is the key input in the capital budgeting process and the valuation of an investment, financial manager will follow CAPM to calculate the cost of capital which is actually the required rate of return. It is worth to mention that all percentages are given by the general manager and they are based on assumptions. a. Rp=4.5% b. Rm 10% c. B = 1.5 Initial investment for the replacement decision for Machine A = initial investment of Machine A - current market price of old machine = (machine cost + installation cost) of Machine A - current market price of old machine = (1000,000+100,000) - 400,000 = 700,000 Similarly, initial investment for the replacement decision for Machine B = (machine cost + installation cost) of Machine B - current market price of old machine = (550,000+20,000) - 400,000 = 170,000 Answer to the Question :- As the Question requires, Computation of Incremental Operating Cash Flows :- Incremental Cash Flows Old Machine to Machine A Particulars 1 2 3 4 5 16 Incremental Operation Inflows 1,90,000 1,55,000 1,85,000 2,90,000 2,32,000 Inceremental Dep 1,00,000 1,70,000 2,00,000 95,000 1,00,000 Earnings brore Tax 90,000 -15,0001 -15,000 1,95,000 1,32,000 Tax @ 35% 31,500 -5,250 -5,250 68,250 46,2001 Earnings after Tax 58,500 -9,750 -9,750 1,26,750 85,800 Add back Depreciation 1,00,000 1,70,000 2,00,000 95,000 1,00,000 Earnings after Tax 1,58,500 1,60,250 1,90,2501 2,21,750 1,85,800 1,50,000 35,000 1,15,000 40,250 74,750 35,000 1,09,750 Old Machine to Machine B Particulars 1 Incremental Operation Inflows Inceremental Dep Earnings brore Tax Tax @ 35% Earnings after Tax Add back Depreciation Earnings after Tax 2 60,000 20,000 40,000 14,000 26,000 20,000 46,000 3 1,22,000 70,000 52.0001 18,200 33,800 70,000 1,03,800 1,35,000 50,000 85,000 29,750 55,250 50,000 1,05,250 5 2,10,000 5,000 2,05,000 71,7501 1,33,250 5,000 1,38,250 6 1,60,000 10,000 1,50,000 52,5001 97,500 10,000 1,07,500 1,50,000 15,000 1,35,000 47,250 87,750 15,000 1,02,750 Answer As the question requires, computation of incremental operating cash flow Incremental operating cash flow Old machine to machine A particular 1 2 3 5 6 Incremental 190000 155000 185000 290000 232000 150000 operation inflow Incremental 100000 170000 200000 95000 100030 35000 dep Earnings 90000 - 15000 - 15000 195000 132000 115000 before tax Tax 35% 31500 5250 -5250 68250 46200 40250 Earning 58500 74750 -9750 -9750 126750 85800 after tax 170000 200000 95000 100000 100000 Add back 35000 depreciation 109750 221750 185800 Earning 158500 160250 190250 after tax Old machine to machine R 135.000 210000 10000 15000 SO 115.000 150000 205000 85000 Old machine to machine particular 1 2 incremental 60000 122000 operation inflow Incremental 20000 70000 dep Earnings 40000 52000 before tax Tax 35% 14000 18200 Earning 26000 32900 after tak Add back 20000 70000 depreciation Earning 46000 103800 after tax 29750 55250 71750 133250 52500 97500 47250 87750 15000 10000 5000 50000 102750 105250 107500 138250 The Cost of Capital as per CAPM is given by, COC = Risk free rate + Beta * (Market Return - Risk free rate) Rf + B* ( Rm - Rp ) 4.5% + 1.5 * ( 10% - 4.5%) 4.5% + 1.5* 5.5% = 4.5% + 8.25% = 12.75% *Terminal value for each case would be = Net Sale Value of New Machine - Net Sale Value of Old Machine Payback period occurs in the year before the cumulative cash flow becomes positive. Payback period = Year of Payback + (Cumulative Cash Flow in Year of Payback / Next Year Cash Flow) 1 Corporate Finance and Investment EMBA Case Study 2) Capital budgeting, and CAPM Deadline is: January, 06, 2021 Should be covered and submitted before deadline to Ms Naz in Room S17 The Shell Company plans to expand its capacity and growth through the acquisition of a new Drilling machine which is expected to add value in the company. Making a valuation on capital investment is a standard process. The general management needs to evaluate the two drilling machines as alternative purchases, to replace an old one. Being in the decision making phase, it is the financial manager's responsibility to follow a certain methodology and perform a number of calculations in order to evaluate each machine separately as an independent project. Then, each project is evaluated and compared with the other. In the end, the financial manager demonstrates the results and makes the recommendation. The financial management starts the evaluation with the determination of values for the evaluation of each machine. This is done through: (1) the development of incremental cash flows (2) initial investment cash flows for all machines, (3) the calculation of incremental operating cash flows, (4) the calculation of terminal cash flows and (5) the calculation of discount rate. The managers decide to apply capital budgeting techniques such as: (a) the payback period (PB). (b) the net present value (NPV) and (c) the internal rate of return (IRR). Moreover, the parameter of risk is incorporated in the calculations. It is important to take into consideration the uncertainty. Risk can affect seriously the process of evaluating the investment and then may alter final decisions. The required data for analysis has been gathered by financial manager, which is presented as bellow: Old Machine: The machine has a current installed cost of Yearo --S 400,000 and a remaining economic life of 6 years (if the company decides to keep it). Its current net price is $ 400,000. We assume that if the company would decide to purchase it, this would cost the amount of 400,000 S in year (O). Below are given the relevant annual depreciation amounts: Year 1 2 3 Annual Depreciation 100,000 130,000 50,000 55,000 50,000 15000 400,000 Total If the old machine will be kept, it is expected that the machine could be sold at the end of year 6 for $ 40,000, according to the initial estimation. The tax rate for the company is 35 % or (0.35). Machine A 2 This new machine costs $ 1000,000. It has an additional installation cost of $ 100,000. Thus, the installed cost is Yearo- $ 1100,000. This machine could be sold at the end of year 6 for Year. =S 150,000. The purchase of this machine is expected to increase the net working capital of the company by 50,000 at the year. (Time of purchase). The machine has an installed cost of Yearo= $ 1100,000 and an estimated economic life of 6 years. Below are given the annual depreciation amounts: Year 1 2 3 Annual Depreciation 200000 300000 250000 150000 150000 50000 1100000 4 5 6 Total The tax rate for the company is 35% (0.35). Machine B 3 This machine costs $ 550,000. It has an additional installation cost of $ 20,000. Thus, the installed cost is Year - 570,000. The machine has an installed cost of Year-5570,000 and an estimated economic life of 6 years. Below are given the annual depreciation amounts: Year 1 2 Annual Depreciation 120000 200000 100,000 60,000 60,000 30,000 570,000 4 5 Total The Machine B can be sold at the end of year 6 for net $ 70,000. The tax rate for the company is 35% or (0.35). Other data: 1) Operating cash flow: It is intended to present the operating inflows for each of the three machines as below: Year 1 2 3 Earnings Before Depreciation and Teses Machine A Machine B 170.000 250,000 217.000 275.000 225.000 380,000 300,000 317.000 245.000 200,000 300.000 OM Machine 110,000 95.000 90.000 4 90.000 85.000 50.000 2) Cost of Capital: When evaluating an investment, it is required to take into consideration (a) the time value of money to be invested (opportunity cost) and (b) the risk taken in the investment (risk premium). The Capital Asset Pricing Model (CAPM) is used as a formula to estimate the cost of capital 4 which is the key input in the capital budgeting process and the valuation of an investment, financial manager will follow CAPM to calculate the cost of capital which is actually the required rate of return. It is worth to mention that all percentages are given by the general manager and they are based on assumptions. a. Rp=4.5% b. Rm 10% c. B = 1.5 Initial investment for the replacement decision for Machine A = initial investment of Machine A - current market price of old machine = (machine cost + installation cost) of Machine A - current market price of old machine = (1000,000+100,000) - 400,000 = 700,000 Similarly, initial investment for the replacement decision for Machine B = (machine cost + installation cost) of Machine B - current market price of old machine = (550,000+20,000) - 400,000 = 170,000 Answer to the Question :- As the Question requires, Computation of Incremental Operating Cash Flows :- Incremental Cash Flows Old Machine to Machine A Particulars 1 2 3 4 5 16 Incremental Operation Inflows 1,90,000 1,55,000 1,85,000 2,90,000 2,32,000 Inceremental Dep 1,00,000 1,70,000 2,00,000 95,000 1,00,000 Earnings brore Tax 90,000 -15,0001 -15,000 1,95,000 1,32,000 Tax @ 35% 31,500 -5,250 -5,250 68,250 46,2001 Earnings after Tax 58,500 -9,750 -9,750 1,26,750 85,800 Add back Depreciation 1,00,000 1,70,000 2,00,000 95,000 1,00,000 Earnings after Tax 1,58,500 1,60,250 1,90,2501 2,21,750 1,85,800 1,50,000 35,000 1,15,000 40,250 74,750 35,000 1,09,750 Old Machine to Machine B Particulars 1 Incremental Operation Inflows Inceremental Dep Earnings brore Tax Tax @ 35% Earnings after Tax Add back Depreciation Earnings after Tax 2 60,000 20,000 40,000 14,000 26,000 20,000 46,000 3 1,22,000 70,000 52.0001 18,200 33,800 70,000 1,03,800 1,35,000 50,000 85,000 29,750 55,250 50,000 1,05,250 5 2,10,000 5,000 2,05,000 71,7501 1,33,250 5,000 1,38,250 6 1,60,000 10,000 1,50,000 52,5001 97,500 10,000 1,07,500 1,50,000 15,000 1,35,000 47,250 87,750 15,000 1,02,750 Answer As the question requires, computation of incremental operating cash flow Incremental operating cash flow Old machine to machine A particular 1 2 3 5 6 Incremental 190000 155000 185000 290000 232000 150000 operation inflow Incremental 100000 170000 200000 95000 100030 35000 dep Earnings 90000 - 15000 - 15000 195000 132000 115000 before tax Tax 35% 31500 5250 -5250 68250 46200 40250 Earning 58500 74750 -9750 -9750 126750 85800 after tax 170000 200000 95000 100000 100000 Add back 35000 depreciation 109750 221750 185800 Earning 158500 160250 190250 after tax Old machine to machine R 135.000 210000 10000 15000 SO 115.000 150000 205000 85000 Old machine to machine particular 1 2 incremental 60000 122000 operation inflow Incremental 20000 70000 dep Earnings 40000 52000 before tax Tax 35% 14000 18200 Earning 26000 32900 after tak Add back 20000 70000 depreciation Earning 46000 103800 after tax 29750 55250 71750 133250 52500 97500 47250 87750 15000 10000 5000 50000 102750 105250 107500 138250 The Cost of Capital as per CAPM is given by, COC = Risk free rate + Beta * (Market Return - Risk free rate) Rf + B* ( Rm - Rp ) 4.5% + 1.5 * ( 10% - 4.5%) 4.5% + 1.5* 5.5% = 4.5% + 8.25% = 12.75% *Terminal value for each case would be = Net Sale Value of New Machine - Net Sale Value of Old Machine Payback period occurs in the year before the cumulative cash flow becomes positive. Payback period = Year of Payback + (Cumulative Cash Flow in Year of Payback / Next Year Cash Flow) 1