Session 8: Corporate Finance
Reading 29: Capital Budgeting
LOS c: Evaluate and select the optimal capital project in situations of 1) mutually exclusive projects with unequal lives, using either the least common multiple of lives approach or the equivalent annual annuity approach, and 2) capital rationing.
Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.
The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:
- The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.
- The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.
- Verban’s tax rate is 34 percent.
- Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.
- At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million. The building will be depreciated over 6 years. The equipment will be depreciated over 5 years. Depreciation expense will be $8.33 million in Year 1 and $11.68 in Years 2 through 6.
- Fixed operating costs are expected to be $65 million a year once the factory starts production.
- Variable operating costs should be 40 percent of sales.
- New inventories are likely to boost working capital by $7.5 million in the first year of production.
- Verban’s cost of capital for the factory project is 14.3 percent.
Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:
- Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”
- Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”
- Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”
- Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”
Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.
Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:
| Initial outlay |
Year 1 |
Year 2 |
Year 3 |
| -$30 million |
$15 million |
$17 million |
$28 million |
Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately reflect inflation, and would like to modify her models to reflect expected inflation over the next five years. She is uncertain, however, how this would affect WACC, IRR, and NPV.
If Haggerty decides to properly allocate the maintenance, land-purchase, and equipment-installation expenses Jenkins claimed were connected with the new factory project, which of the following numbers on the capital-budgeting model will be least likely to change?
Working capital will not be affected. The maintenance contract is a sunk cost and should not be included in the calculation. However, the use of the land is an opportunity cost, and should be included in the analysis. Land is not usually depreciable, so it will not affect depreciation. However, the installation expense for the specialized machinery will be added to the cost basis of the machinery, which will affect depreciation in every year after Year 1. While the land was not purchased at the same time cash is paid to the builder, the cost of the land can only be accounted for as part of the initial outlay. While the effect of the higher cost basis for the equipment has a very small effect on the project’s NPV, the addition of $30 million in land costs to the initial outlay drops the NPV from positive to negative, changing the accept/reject recommendation. (Study Session 8, LOS 29.c)
In the last year of the new factory project, cash flows will be closest to:
To calculate cash flows for Year 6, we must determine both the operating cash flow and the terminal value. Based on $205 million in sales, $65 million in fixed costs, variable costs equal to 40 percent of sales, and a 34 percent tax rate, the operating cash flow = ($205 ? $65 ? $82) × (1 ? 34%) = $38.28 million. Depreciation = ($85 million for building ? $35 million salvage value) / 6 + $20 million for equipment ? $3.25 million salvage value) / 5 = $11.68. Operating cash flow = cash from factory operations + (depreciation × t) = $42.25 million.
The terminal value represents the salvage value of the building and equipment, adjusted for taxes, plus the return of the $7.5 million in working capital added in Year 2. Terminal value = ($35 million for the building + $3.25 million for the equipment) + $7.5 million for working capital = $45.75 million. Since the market value and book value of the building and equipment are the same, there is no taxable gain or loss, and no need for a tax adjustment in the terminal-value calculation.
Year 6 Cash flows = $88.00 million. (Study Session 8, LOS 29.a)
Which of the following statements about the effect of inflation on the capital-budgeting process is most accurate?
Statement 1: Inflation is reflected in the WACC, but future cash flows should still be adjusted when calculating the NPV.
Statement 2: Inflation will cause the WACC to decrease.
Statement 3: Incorporating inflation in the cash flows tends to exert downward pressure on the NPV.
Statement 4: Because the IRR does not depend on the WACC, inflation has no effect on it.
Inflation causes the WACC to increase, so Statement 2 is false. Because the WACC reflects inflation, future cash flows must be adjusted to avoid a downward bias, so Statement 1 is true. Both the NPV and the IRR will tend to decline if cash flows are not adjusted — Statements 3 and 4 are false. (Study Session 8, LOS 29.b)
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发表于 2011-3-10 12:05
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