# Capital Budgeting sample essay

1. Define the term “incremental cash flow”. Since the project will be financed in part by debt, should the cash flow analysis include the interest expense? Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company’s cash flow will increase with the acceptance of the project.

Cash flow analysis should not include the interest expense. We discount project cash flows with a cost of capital that is the rate of return required by all investors. Interest expenses are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.

2. Suppose another juice producer had expressed an interest in leasing the lite orange juice production site for $25,000 a year. If this true, how would this information be incorporated into the analysis? This information would cause a slight change in the decision-making process. More specific, we would not recommend realizing the project if the average net profit per year (including the cost of capital) will be less than or equal to $25,000 which in fact can also be achieved with no risk at all. In order to recommend realizing the project we should either be certain that our profit will be higher than our opportunity cost ($25,000), or have no better alternative to invest the company’s capital.

Of course the above are valid only if there is no cannibalization effect to our sales from the other’s producer’s activities. In the case that we accept the leasing proposal, assume an agreement for 4 years and receive the payment at the end of each period, we have a NPV of $75,933, which is lower than the NPV of our project which is $1,203,759. So, assuming equal life of the projects and no other side-effects, we would prefer to go on with the Lite project and not to lease the production.

The fact that we decide to go on with the Lite project implies that the company will not receive the $25,000 from the leasing. This is an

opportunity cost and it should be charged to the project as A.T. opportunity cost = $Leasing (1 – Tax) = $25,000*(1 – 0.4) = $15,000. Failing to calculate this opportunity cost would cause the new project NPV to be higher than the real one.

Time 0

1st Year

2nd Year

3rd Year

4th Year

25,000

25,000

25,000

25,000

22,322

19,930

17,795

15,887

NPV 75,933

Leasing project NPV calculation

PVIF(12%,1)(25,000) = 22,322

PVIF(12%,2)(25,000) = 19,930

PVIF(12%,3)(25,000) = 17,795

PVIF(12%,4)(25,000) = 15,887

Or

PVIFA(12%,4)(25,000) = 75,933

3. What is the “orange plus” investment outlay on this project? What is the expected non-operating cash flow when the project is terminated at year 4? The net investment outlay consists on the sum of the gross initial outlay, which will represent the depreciation basis, plus the Addition in Net Working Capital. In this project, the gross initial outlay is composed of the following factors: Purchase price of new equipment (Machinery), Transportation cost, Site Preparation cost and Installation cost. The net investment outlay is $918,000.

Year 0

Net Investment Outlay:

Machinery

800,000

Shipping

20,000

Installation

50,000

Plant Preparation cost

25,000

Change in NWC (Inventory)

23,000

Net Investment Outlay

$918,000

Net Terminal Cash Flow corresponds to Salvage value, Tax on salvage value and Recovery on NWC. The expected value is $97,000.

Year 4

Salvage value

110,000

Tax on salvage values

-44,000

Change in WC (Recovery)

31,000

Net terminal CF

97,000

4. Estimating the project’s operating cash inflows. What is the project’s NPV, payback period, IRR and modified IRR.

Year 0

Year 1

Year 2

Year 3

Year 4

Net operating CF

266,880

752,880

774,230

900,411

Decision Measures:

NPV

$1,203,759

Payback period

1.9

IRR

51.2%

MIRR

35.6%

Excel attached with all calculations.

Observations:

Sunk costs such as the spending in R&D, marketing research or last year facilities improvement have been not taken into account because these costs are required to analyze the project and cannot be recovered even if the project is accepted. The opportunity cost of renting the plant is included in the analysis as a after tax cost (cash outflow) because it will not be earned as a result of utilizing the asset for the project. The cannibalization on Classic orange juice is a type of externality that should be included in the analysis as after tax cost (cash outflow) because the new project takes sales away from the existing product. The new project requires an increase in inventories in year 0 and year 3. This will change the net working capital. It will represent an outflow for year 0 and 3, and an inflow when the project terminates because we will recover it.

5. The project is assumed to end in year 4. Do you think that this is realistic? Can you estimate the value of the project’s operating cash flows beyond year 4? State any assumptions you made. This project is reasonable and worth to take it. It will add more value to the company since its NPV is positive and has an attractive IRR and MIRR (higher than WACC). Moreover, the breakeven occurs in year two, in the middle of the project lifecycle, which is a good sign as well.

Calculations to estimate the following years 5 and 6 are done in the excel tab called ‘Estimation Years 5 and 6’. Taking into account that the predicted remaining economic life of the machinery was 4 years, we estimated an extension of two years more for this project, assuming that the machinery salvage value will decrease because of the extra usage and presuming that the other factors will practically remain the same.

The detailed assumptions are:

The project is extended two years more

Growth in sales will be still 20%

Unit price for Lite will continue 2.8$

Unit cost for Lite will be 1.5$

Machinery can be used for 2 years more without incurring any expense Salvage value will drop 80% because machinery has been used for two more years and we assume that its value has decreased Lite will cannibalize Classic following the same behavior (5% decrease in sales) Cost of capital will

remain 10%

Expenses like the insurance will stay the same

The opportunity cost of renting the plant will be identical

We don’t need an increase in our inventory

Given the above assumptions the new measures tell us that, although the salvage value will be reduced, it is worth to increase the life of this project. The NPV is higher because the net cash flows beyond year 4 have increased due to the absence of depreciation cost. Also, IRR and MIRR are superior, 63% and 37% respectively (versus 51% and 36%).

Detailed operating cash flows for the estimated years 5 and 6 are:

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Net operating CF

266,880

752,880

774,230

900,411

1,061,477

1,285,187

If all the assumptions were real, it would be highly recommended not to terminate this project at year 4 and operate two more years in order to benefit from the positives cash flows of year 5 and 6.

6. Now suppose the project had involved replacement rather expansion of existing facilities. Describe briefly how the analysis would have to be changed to deal with a replacement project. The analysis changes if the new project is a replacement instead of an expansion. We have to consider the incremental revenues (DR), costs (DC) and the relevant depreciation would be the incremental change between the old and the new equipment (DD). For every time, t, CFt = (DRt – DCt- DDt)(1-T) + DDt + Salvage value terms.

The investment cost estimate may have to be adjusted if the project involves replacing one asset with another, presumably newer and more cost efficient. If the old asset is going to be sold, the investment outlay must be reduced by the after-tax proceeds from the sale of the old asset. It will consist of the selling of the old asset (as a positive cash flow) and the taxes on the gain (if the net book value of the old asset is higher than the selling price) or loss on disposal.

7. Does it appear that the project cash flows are real or nominal? Is WACC of the firm real or nominal? Is the current NPV biased, and if so, in what direction? The project cash flows are real because we don’t take into consideration the inflation. However, WACC, in DCF analysis, includes an estimate of inflation. Therefore, the fact that cash flow estimates are not adjusted for inflation (i.e., are in today’s dollars) will bias the NPV downward. Hence, discounting real CF with a higher nominal WACC implies that our NPV estimate is too low. It is important to include inflation when estimating cash flows. Nominal CF should be discounted with nominal WACC, and real CF should be discounted with real WACC. It is more realistic to find the nominal CF (i.e. increase cash flow estimates with inflation) than it is to reduce the nominal WACC to a real WACC.

8. Another project involves the fleet of delivery trucks with an engineering life of 3 years (that is, each truck will be totally worn out after 3 years). However, if the trucks were taken out of service, or ‘abandoned’ prior to the end of 3 years, they would have positive salvage values. Here are the estimated net cash flows for each truck: (Note that the opportunity cost of capital is 10%) Year

Initial investment

And operating cash flow

End-of-year

Abandonment Value

0

-40000

40000

1

16800

24800

2

16000

16000

3

14000

0

a) What would the NPV be if the trucks were operating for full 3 years?

NPV would be negative. The company should not take this project. Time 0

1st Year

2nd Year

3rd Year

16,800

16,000

14,000

15,273

13,223

10,518

NPV3-years -986

PVIF(10%,1)(16,800) = 15,273

PVIF(10%,2)(16,000) = 13,223

PVIF(10%,3)(14,000) = 10,518

CF0 = -40,000

NPV3-years = 15,273 + 13,223 + 10,518 – 40,000 = -986 < 0.
b) What if they were abandoned at the end of year 2? At the end of year1? Abandoned at the end year 2:
Time 0
1st Year
2nd Year
3rd Year
16,800
16,000 + 16,000
0
15,273
26,446
0
NPV2-years 1,719
PVIF(10%,1)(16,800) = 15,273
PVIF(10%,2)(32,000) = 26,446
NPV2-years = 15,273 + 26,446 – 40,000 = 1,719
Abandoned at the end year 1:
Time 0
1st Year
2nd Year
3rd Year
16,800 + 24,800
0
0
37,818
0
0
NPV1-years -2,182
PVIF(10%,1)(41,600) = 37,818
NPV1-years = 37,818 – 40,000 = -2,182 < 0.
c) What is the optimal period for which the company should keep the trucks? Since the only chance to have positive cash flow is to keep the trucks for 2 years, this should be the economic life of this project.

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