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Growth Enterprise , Inc.

(GEI)
Project A. Type of cash flow Investment Revenue Operating expense Lifespan Depreciation Free Cash Flow Investment Revenue Operating expense Lifespan Depreciation Free Cash Flow Investment Revenue Operating expense Lifespan Depreciation Free Cash Flow Investment Revenue Operating expense Lifespan Depreciation Free Cash Flow Year 0 Year 1 -$10,000 0 0 1 Year 2 0 $21,000 $11,000 $10,000 $10,000 0 $15,000 $5,833 $5,000 $7,500 0 $10,000 $5,555 $3,333 $4,000 0 $30,000 $15,555 $3,333 $10,000 0 0 0 Year 3 0 0 0

B.

-$10,000 0 0 2

0 $17,000 $7,833 $5,000 $7,500 0 $11,000 $4,889 $3,333 $5,000 0 $10,000 $5,555 $3,333 $4,000

0 0 0

C.

-$10,000 0 0 3

0 $30,000 $15,555 $3,333 $10,000 0 $5,000 $2,222 $3,333 $3,000

D.

-$10,000 0 0 3

1-a). Calculate Payback of each project and rank the four projects in order of preference based on payback approach (1 Project Initial Outlay A Outstanding Balance B Outstanding Balance C Outstanding Balance D Outstanding Balance Year 1 Year 2 $10,000 $0 $7,500 -$2,500 $4,000 -$6,000 $10,000 $0 Year 3 $0 $0 $7,500 $5,000 $5,000 -$1,000 $4,000 $4,001 $0 $0 $0 $5,000 $10,000 $9,001 $3,000 $7,001 Payback Period 1 0.33 0.10 1.33 2.1 1

-10000 -10000 -10000 -10000

Payback period is 1 year for project A, 1.33 years for project B, 2.1 years for project C and 1 year for project D

1-b). Calculate IRR of each project and rank the four projects in order of preference based on IRR (2 points). A Initial Outlay Year 1 Year 2 Year 3 IRR -$10,000 $10,000 $0 $0 0.00% B -$10,000 $7,500 $7,500 $0 31.88% C -$10,000 $4,000 $5,000 $10,000 33.53% D -$10,000 $10,000 $4,000 $3,000 42.75%

1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the projects in order of preference A Year 0 Year 1 Year 2 Year 3 NPV -$10,000 $10,000 $0 $0 -$909.09 B -$10,000 $7,500 $7,500 $0 $3,016.88 C -$10,000 $4,000 $5,000 $10,000 $5,282.24 D -$10,000 $10,000 $4,000 $3,000 $4,651.32

1-d). If the projects are independent of each other, which should be accepted? If they are mutually exclusive, which on If the projects are independent of each other, projects B, C, and D should be accepted because they have a positive IRR and NPV that is greater than the cost of capital. If the projects are mutually exclusive and only one can be accepted, Project D should be accepted because it has the highest IRR, shortest payback time, and second-highest NPV, just behind project C.

ased on payback approach (1 point). Payback Period years years years years

1 year for project D

on IRR (2 points).

ojects in order of preference (2 points)

mutually exclusive, which one is best? Explain why. (1 point)

cause they have a

accepted because it C.

Electronics Unlimited (EU)


Sales Year 1 Year 2 Year 3 Year 4 Year 5 Cost of Sales SGA Expenses Tax Rate New Specialized Equipment Net Working Capital Introductory expenses Year 1 Life of equipment $10,000,000 $13,000,000 $13,000,000 $8,667,000 $4,333,000 60% of sales 23.50% of sales 40% $500,000 27% of sales $200,000 5 years

2-a) Estimate the new product's cash flows (3 points) Year Sales Cost of Sales SGA Expense Depreciation Introductory Expense Income before tax Tax Net Income Operating Cash Flow Working Capital Change in Working Capital Equipment Total cash flows 0 1 $10,000,000 $6,000,000 $2,350,000 $100,000 $200,000 $1,350,000 $540,000 $810,000 $910,000 $3,510,000 -$810,000 $100,000 2 $13,000,000 $7,800,000 $3,055,000 $100,000 $2,045,000 $818,000 $1,227,000 $1,327,000 $3,510,000 $0 $1,327,000

$2,700,000 -$2,700,000 -$500,000 -$3,200,000

2-b) Assuming a 20% cost of capital, what is the products net present value? What is its internal rate of return? Should Cost Free Cash Flow Year 1 Year 2 Year 3 Year 4 Year 5 Cost of Capital Net Present Value IRR -$3,200,000 $100,000 $1,327,000 $2,496,910 $2,068,213 $1,638,877 20% $905,862.19 29.55%

EU should introduce the new product because the NPV is positive and the IRR is greater than the cost of capital. The p NPV means that the project generates a surplus after all costs, including financing costs. The IRR of 29.55% is higher 20% cost of capital implying that the rate of return on the project is more than the desired rate.

3 $13,000,000 $7,800,000 $3,055,000 $100,000 $2,045,000 $818,000 $1,227,000 $1,327,000 $2,340,090 $1,169,910 $2,496,910

4 $8,667,000 $5,200,200 $2,036,745 $100,000 $1,330,055 $532,022 $798,033 $898,033 $1,169,910 $1,170,180 $2,068,213

5 $4,333,000 $2,599,800 $1,018,255 $100,000 $614,945 $245,978 $368,967 $468,967 Net income + depreciation $0 $1,169,910 Working capital recovered $1,638,877

s its internal rate of return? Should EU introduce the new product? Explain why? (2 points).

eater than the cost of capital. The positive osts. The IRR of 29.55% is higher than the esired rate.

Value-Added Industries, Inc. (VAI)


3-a) What is the net present value of this project (1 point)? Present Value of Cash Flow Initial Investment NPV $210,000 -$110,000 $100,000

3-b) How many shares of common stock must be issued, and at what price to raise the required capital? (1 point) Number of shares outstanding Market value of shares Existing value of shares NPV Total Value Value per share Amount to be raised Number of shares to be issued 10,000 $100 $1,000,000 $100,000 $1,100,000 $110 $110,000 1000

To raise the required capital, VAI should issue 1000 shares of common stock at $110 each.

3-c) What is the effect, if any, of this new project on the value of the stock of existing shareholders? (1 point) The new project has increased the value of existing stock from $100 to $110 per share.

required capital? (1 point)

hareholders? (1 point)

FIN 500 Assignment 4, due 08/21/11, 9:00 pm California time Total points 14 This assignment provides you an opportunity to practice estimating cash flow for capital budgeting projects (chapter 12), using the common approaches in capital budgeting (chapter 13) such as payback, internal rate of return and net present value in choosing project , using Excel functions such as irr() and npv() to calculate IRR and NPV. To complete this assignment, students need to get familiar with course content in chapter 12 and chapter 13. Problems in this assignment are chosen from Harvard Business Schools Case on Valuing Capital Project and are revised by the instructor. This assignment should be done as an individual work. Your completed Assignment 4 should be saved and submitted as an Excel workbook file, i.e., .xls file. The filename should begin assign4, then your last name and first letter of your first name. For example, if Allen Smith completes this assignment, he should name this assignment as assign4SmithA, save and submit it as an Excel workbook file (.xls file). 10% of this assignment points will be deducted if its not named or formatted as required. There are three problems in this assignment, each problem has several questions.

Please provide detailed solutions and necessary explanations. Just providing a number as answer to a problem will not earn you any point. I need to see your solution process.

1. Growth Enterprise , Inc. (GEI) has $40 million that it can invest in any or all of the four capital investment projects (A, B, C, D), which have cash flows as shown in the following table. Table 1. Comparison of Project Cash Flows ($ thousand dollars) Project Type of Year 0 Year 1 Year 2 Year 3 cash flow A. Investment -$10,000 0 0 0 Revenue 0 $21,000 0 0 Operating 0 $11,000 0 0 expense B. Investment Revenue Operating expense Investment Revenue Operating expense Investment Revenue Operating expense -$10,000 0 0 0 $15,000 $5,833 0 $17,000 $7,833 0 0 0

C.

-$10,000 0 0

0 $10,000 $5,555

0 $11,000 $4,889

0 $30,000 $15,555

D.

-$10,000 0 0

0 $30,000 $15,555

0 $10,000 $5,555

0 $5,000 $2,222

Operating expense C. Investment Revenue Operating expense Investment Revenue Operating expense

$5,833

$7,833

-$10,000 0 0

0 $10,000 $5,555

0 $11,000 $4,889

0 $30,000 $15,555

D.

-$10,000 0 0

0 $30,000 $15,555

0 $10,000 $5,555

0 $5,000 $2,222

All revenues and operating expenses can be considered cash items.

Each of these projects is considered to be of equivalent risk. The investment will be depreciated to zero on a straight-line basis for tax purpose. For simplicity, the depreciation per year for a project is equal to the project investment value divided by the life of the project. Project A has 1-year life, Project B has two-year life, and both Project C and D have 3-yar life. GEIs marginal corporate tax rate on taxable income is 40%. None of the projects will have any salvage value at the end of their respective lives.

1-a). Calculate Payback of each project and rank the four projects in order of preference based on payback approach (1 point). 1-b). Calculate IRR of each project and rank the four projects in order of preference based on IRR (2 points). 1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the projects in order of preference (2 points) 1-d). If the projects are independent of each other, which should be accepted? If they are mutually exclusive, which one is best? Explain why. (1 point) Hint: You need to estimate the free cash flows (FCF) to the firm first, FCF = EBIT(1 tax rate) + depreciation Gross fixed asset expenditure change in net operating working capital. Specifically speaking, in this problem, FCF = (revenue operating expensedepreciation)*(1 marginal tax rate) + depreciation

l points 14

ow for capital udgeting n choosing NPV. To in chapter 12

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questions.

viding a ee your

est in any or all of the four ws as shown in the

Year 3 0 0 0

0 0 0

0 $30,000 $15,555

0 $5,000 $2,222

0 $30,000 $15,555

0 $5,000 $2,222

estment will be depreciated epreciation per year for a e of the project. Project A have 3-yar life. GEIs ojects will have any

der of preference

f preference

ects and rank the

epted? If they are

CF = EBIT(1 tax rating working ing expense-

2. Electronics Unlimited (EU)was considering the introduction of a new product that had 5 years of life and was expected to generate sales in Year 1 through 5 as the following: Year 1 Year 2 Year 3 Year 4 Year 5 $10,000, 000 $13,000,000 $13,000,000 $8,667,000 $4,333,000 No material levels of revenues or expenses associated with the new product were expected after five years of sales. Based on past experience, cost of sales for the new product was expected to be 60% of total annual sales revenue during each year of its life cycle. Selling, general and administrative expenses were expected to be 23.5% of total annual sales. Taxes on profits generated by the new product would be paid at a 40% rate. To launch the new product, EU would have to incur immediate cash outlays of two types. First, it would have to invest $500,000 in specialized new production equipment. This capital investment would be fully depreciated on a straight-line basis over the five-year anticipated life of the new product. There would be no salvage value left for the equipment at the end of its depreciable life. No further fixed capital expenditures were required after the initial purchase of equipment. Second, additional investment in net working capital to support sales would have been made. EU generally required 27 cents of net working capital to support each dollar of sales. That is, change in net working capital is 27% of change in sales. As a practical matter, the buildup of working capital would have to be made at the beginning of the sales year in question (or, equivalently, by the end of the previous year). For example, Sales in year 2 were expected to be $13,000 thousand, $3,000 thousand increase from Year 1s sales, so a buildup of working capital of 27% of $3,000 should be made at the end of Year 1. i.e., the change in net working capital for year 1 is $3,000*27%=$810 thousand. At the end of the new products life cycle, all remaining net working capital would be liquidated and the cash recovered.

Finally, EU expected to incur tax-deductible introductory expenses of $200,000 in the first year of the new products sales. Such cost would not be recurring over the products life cycle. Approximately $800,000 had already been spent developing and testing marketing the new product. 2-a) estimate the new products cash flows. (3 points) 2-b) Assuming a 20% cost of capital, what is the products net present value? What is its internal rate of return? Should EU introduce the new product? Explain why? (2 points). Note: Except for the change in net working capital, which must be made before the start of each sales year, you should assume that all cash flows occur at the end of the year in question. To find the NPV, you need to estimate the free cash flow in each year and discount them at cost of capital of 20%.

points). Note: Except for the change in net working capital, which must be made before the start of each sales year, you should assume that all cash flows occur at the end of the year in question. To find the NPV, you need to estimate the free cash flow in each year and discount them at cost of capital of 20%.

product that h 5 as the

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3. You are the CEO of Value-Added Industries, Inc. (VAI). Your firm has 10,000 shares of common stock outstanding, and the current price of the stock is $100 per share. The firm does not have any debt. You discover an opportunity in a new project that produces positive net cash flows with a present value of $210,000. Your total initial costs for investing and developing this project are only $110,000. You will raise the necessary capital for this investment by issuing new equity. All potential buyers of your common stock will be fully aware of the projects value and cost, and are willing to pay fair value for the new share of VAI common stock. 3-a) What is the net present value of this project (1 point)? 3-b) How many shares of common stock must be issued, and at what price to raise the required capital? (1 point). Hint: the stock price should reflect the value created by the investment opportunity. 3-c) What is the effect, if any, of this new project on the value of the stock of existing shareholders? (1 point)

10,000 is $100 per a new 10,000. y $110,000. equity. All cts value ommon

to raise the eated by

of existing

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