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Capital Investment Decision Case Analysis

Cape Chemical co. & Elizabeth Webb Cooper

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CAPITAL INVESTMENT DECISION CASE

ANALYSIS CAPE CHEMICAL CO. & ELIZABETH WEBB

COOPER

COURSE CODE: F-303

SUBMITTED TO:

TAHER JAMIL LECTURER

DEPARTMENT OF FINANCE

UNIVERSITY OF DHAKA

SUBMITTED BY:

GROUP: SECTION: A

DEPARTMENT OF FINANCE

UNIVERSITY OF DHAKA

Date of submission: 18 August, 2015

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2

Group Members:

Serial Name ID

1 Maruf Hossain 19-013

2 Manjurul Ahsan 19-099

3 Md. Abdul Quyum 19-121

4 Md. Ripon Molla 19-123

5 Raqib Hossain 19-157

BBA 19TH BATCH, SECTION: A

DEPARTMENT OF FINANCE

UNIVERSITY OF DHAKA

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Letter of Transmittal

August 18, 2015,

Taher Jamil

Lecturer

Department of Finance

University of Dhaka

Subject: A report on “Capital Investment Decision- cases and scenerio”

Honorable Sir,

This is a great pleasure for us to submit the report on “Economic Intergration in the

prespective of Bangladesh” as a partial requirement of the BBA program in University of

Dhaka.

Preparation of this report has been a great pleasure & an interesting experience. It enabled

us to know about various financial knowledge more broadly than before.

This report helped us tremendously to understand and to know the various term of finance

and the use of different financial tools followed by different financial organizations.

We have undertaken our sincere effort for successful completion of the BBA program. If we

have any unintentional errors and omissions that may have entered into this report will be

considered with sympathy.

Therefore, we beg your kind consideration in this regard, we will be very grateful if you

accept our report and oblige there by.

Sincerely,

On the behalf of members of group

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Acknowledgement

We would like to pay our gratitude to all of the related books, articles, journals, authors and

related Web Sites that helped us a lot for the completion of this report before, during, and

after the working period. At first we would like to acknowledge the Almighty, who helped us

every time and was with us and gave us moral support and strength every moment.

We are especially grateful to our honorable course instructor Taher Jamil for giving us

valuable suggestions and support to prepare this report. Without his advice and support, it

would not be possible for us to prepare this report.

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Executive Summary

From ancient to present world finance is playing the most important role to take any

business related decision. By applying financial methods we can take decision about

any project that we should go ahead or not. Following this convention, we make

solution of two cases. The first case is about CAPE CHEMICAL: CAPITAL

BUDGETING ISSUES, in this case we have solved some requirements. These are

Cape Chemical’s weighted average cost of capital (WACC), should they proceed with

internal cost of capital and the new equipment with bank loan, evaluation of the

strengths and weaknesses of the Cash Payback Period, Discounted Cash Payback

Period, NPV, IRR and MIRR. Here we have calculated the Cash Payback Period,

Discounted Cash Payback Period, NPV, IRR and MIRR for each alternative. In the

second case we are concerned with Investing in a Brewpub: A Capital Budgeting

Analysis, in this case we have solved the requirement given. Such as we have

estimated the annual cash flows in best case scenario and the worst case scenario, then

we calculated the NPV and IRR, in the both scenario. We have showed the impact if

there would any change in cost of capital. In the both case we have taken the help of

MS excel to solve the problems.

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Table of Contents Chapter 1 ................................................................................................................................... 8

Introduction ............................................................................................................................... 8

1.1 Introduction ......................................................................................................................... 9

1.2 Objective of the study:......................................................................................................... 9

1.3 Scope of the report: ............................................................................................................. 9

1.4 Methodology of the report: ................................................................................................ 10

1.5 Limitation of the study: ..................................................................................................... 10

Chapter 2 ................................................................................................................................. 11

Theoretical Background .......................................................................................................... 11

2.1 Capital Budgeting: ............................................................................................................. 12

2.2 Different methods used in capital budgeting: .................................................................... 12

Net Present Value: ............................................................................................................... 12

Internal Rate of Return: ....................................................................................................... 12

Real Options Valuation: ....................................................................................................... 13

Equivalent Annuity Method: ............................................................................................... 13

2.3 Necessity of capital budgeting: ......................................................................................... 14

Chapter 3 ................................................................................................................................. 15

Case 1 ...................................................................................................................................... 15

CASE SYNOPSIS .................................................................................................................... 16

BACKGROUND ..................................................................................................................... 16

CHEMICAL DISTRIBUTION .................................................................................................... 17

THE SITUATION .................................................................................................................... 17

PROJECT EVALUATION PROCESS ......................................................................................... 18

Weighted Average Cost of Capital (WACC) ......................................................................... 18

Used Equipment .................................................................................................................. 19

New Equipment ................................................................................................................... 19

REQUIREMENTS .................................................................................................................. 19

SOLUTION OF THE CASE: ......................................................................................................... 20

Requirement – 1 .................................................................................................................. 20

Requirement 2 ..................................................................................................................... 21

Requirement 3 ..................................................................................................................... 21

Requirement 4 ..................................................................................................................... 21

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Requirement – 5 .................................................................................................................. 24

REQUIREMENT 6 .................................................................................................................. 28

Requirement 7 ..................................................................................................................... 32

Requirement 8 ..................................................................................................................... 32

Chapter 4 ................................................................................................................................. 33

Case 4 Analysis ....................................................................................................................... 33

4. CASE SCENARIO: .................................................................................................................. 34

4.1: case scenario: ................................................................................................................... 34

Requirements: ......................................................................................................................... 37

3.2: Solution: ........................................................................................................................... 38

Requirement 1 ..................................................................................................................... 38

(Best Case Scenario): Annual cash flow calculation .............................................................. 38

Requirement – 2 .................................................................................................................. 39

Requirement – 3 .................................................................................................................. 40

Requirement – 4 .................................................................................................................. 41

Requirement - 5 ................................................................................................................... 42

Requirement - 6 ................................................................................................................... 42

Conclusion ............................................................................................................................... 44

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Chapter 1

Introduction

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1.1 Introduction

Capital budgeting, or investment appraisal, is the planning process used to determine

whether an organization's long term investments such as new machinery, replacement

machinery, new plants, new products, and research development projects are worth

the funding of cash through the firm's capitalization structure (debt, equity or retained

earnings). It is the process of allocating resources for major capital, or investment,

expenditures. One of the primary goals of capital budgeting investments is to increase

the value of the firm to the shareholders. The report discusses about different capital

budgeting techniques used in businesses and organizations.

1.2 Objective of the study: The main objectives of this report are:

To gather knowledge broadly about Capital Budgeting.

To gather knowledge about different capital budgeting tools.

To decide the best way to valuate any business.

1.3 Scope of the report:

The report has been prepared by collecting information from study materials and

internet. The sources were relevant to the main problem of the report. Much data and

sources made the report simple. The scopes of the report have very good influence to

make it the perfect one.

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1.4 Methodology of the report:

We took help from the study material to understand the conceptual matters.

We also followed guidance of our course teacher.

We also make analysis with the help of internet browsing.

Though the analysis in Microsoft word and Microsoft Excel we have tried to draw

some valid conclusions and findings.

1.5 Limitation of the study:

I. Time limitation.

II. Lack of information.

III. Lack of previous experience on study on using financial calculation tools.

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Chapter 2

Theoretical Background

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2.1 Capital Budgeting:

Capital budgeting is the process in which a business determines whether projects such as

building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a

prospective project's lifetime cash inflows and outflows are assessed in order to determine

whether the returns generated meet a sufficient target benchmark.

It is also known as "investment appraisal."

Many formal methods are used in capital budgeting, including the techniques such as

Accounting rate of return

Payback period

Net present value

Profitability index

Internal rate of return

Modified internal rate of return

Equivalent annual cost

Real options valuation

2.2 Different methods used in capital budgeting:

NET PRESENT VALUE:

Capital Budgeting projects are classified as either Independent Projects or Mutually

Exclusive Projects. An Independent Project is a project whose cash flows are not affected by

the accept/reject decision for other projects. Thus, all Independent Projects which meet the

Capital Budgeting criterion should be accepted.

Mutually Exclusive Projects are a set of projects from which at most one will be accepted.

For example, a set of projects which are to accomplish the same task. Thus, when choosing

between "Mutually Exclusive Projects" more than one project may satisfy the Capital

Budgeting criterion. However, only one, i.e., the best project can be accepted.

INTERNAL RATE OF RETURN:

The internal rate of return (IRR) is defined as the discount rate that gives a net present

value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually

exclusive) projects in an unconstrained environment, in the usual cases where a negative cash

flow occurs at the start of the project, followed by all positive cash flows. In most realistic

cases, all independent projects that have an IRR higher than the hurdle rate should be

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accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project

with the highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The

IRR exists and is unique if one or more years of net investment (negative cash flow) are

followed by years of net revenues. But if the signs of the cash flows change more than once,

there may be several IRRs. The IRR equation generally cannot be solved analytically but

only via iterations.

REAL OPTIONS VALUATION:

Real options analysis has become important since the 1970s as option pricing models have

gotten more sophisticated. The discounted cash flow methods essentially value projects as if

they were risky bonds, with the promised cash flows known. But managers will have many

choices of how to increase future cash inflows, or to decrease future cash outflows. In other

words, managers get to manage the projects - not simply accept or reject them. Real options

analysis try to value the choices - the option value - that the managers will have in the future

and adds these values to the NPV.

EQUIVALENT ANNUITY METHOD:

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it

by the present value of the annuity factor. It is often used when assessing only the costs of

specific projects that have the same cash inflows. In this form it is known as the equivalent

annual cost (EAC) method and is the cost per year of owning and operating an asset over its

entire lifespan.

It is often used when comparing investment projects of unequal lifespans. For example if

project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11

years it would be improper to simply compare the net present values (NPVs) of the two

projects, unless the projects could not be repeated.

The use of the EAC method implies that the project will be replaced by an identical project.

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2.3 Necessity of capital budgeting:

1. As large sum of money is involved which influences the profitability of the firm

making capital budgeting an important task.

2. Long term investment once made cannot be reversed without significance loss of

invested capital. The investment becomes sunk, and mistakes, rather than being

readily rectified, must often be borne until the firm can be withdrawn through

depreciation charges or liquidation. It influences the whole conduct of the business

for the years to come.

3. Investment decision are the base on which the profit will be earned and probably

measured through the return on the capital. A proper mix of capital investment is

quite important to ensure adequate rate of return on investment, calling for the need

of capital budgeting.

4. The implication of long term investment decisions are more extensive than those of

short run decisions because of time factor involved, capital budgeting decisions are

subject to the higher degree of risk and uncertainty than short run decision.

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Chapter 3

Case 1

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2.1: CASE SCENARIO:

CASE SYNOPSIS

The case tells the story of Ann Stewart, President and primary owner of Cape Chemical. By

most measures, the performance of Cape Chemical has been very good over the last three

years. Double-digit sales growth has been achieved, new product lines have been added and

profits have more than tripled. The growth has required the acquisition of equipment,

expansion of storage capacity and increasing the size of the work force. The unexpected

withdrawal of one of Cape Chemical's competitors from the region has provided the

opportunity to increase its blended packaged goods sales. However, Cape Chemical's

blending equipment is already operating at capacity. To take advantage of this opportunity,

additional equipment must be obtained, requiring a major capital investment. It is estimated

that Cape Chemical must increase its annual blending capacity by 800,000 gallons to meet

expected demand for the next three years Annual capacity of 1,400,000 gallons is necessary

to meet projected demand beyond the next three years. The firm has no systematic capital

expenditure evaluation process.

BACKGROUND

Cape Chemical is a relatively new regional distributor of liquid and dry chemicals,

headquartered in Cape Girardeau, Missouri. The company, founded by Ann Stewart, has

been serving southeast Missouri, southern Illinois, northeast Arkansas, western Kentucky and

northwest Tennessee for five years and has developed a reputation as a reliable supplier of

industrial chemicals. Stewart’s previous business experience provided her with a solid

understanding of the chemical industry and the distribution process. As a general manager

for a chemical manuf Stewart had profit and loss (P&L) responsibility, but until beginning

Cape Chemical, she had limited exposure to company accounting and finance decisions. The

company reported small losses during its early years of operation, but performance in recent

years has been very good. Sales have grown at double-digit rates, new product lines have

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been added and profits have more than tripled. The growth has required the acquisition of

additional land, equipment, expansion of storage capacity and more than tripling the size of

the work force. Stewart has proven to be an expert marketer, and Cape Chemical has

developed a reputation with its customers of providing quality products and superior service

at competitive prices. Despite its business success, Cape Chemical is still a “large” small

business with Stewart making all important decisions. She recognized the need to develop a

professional managerial staff, particularly in the area of finance. Recently, she hired Kate

Clarkson as the company’s first finance professional and placed her in charge of the

company’s accounting and finance activities. Cape Chemical’s board of directors is

composed of Stewart, her brother and the company’s attorney. The board’s existence

satisfies state regulatory requirements for corporations but provides no input to business

operations.

CHEMICAL DISTRIBUTION

A chemical distributor is a wholesaler. Operations may vary but a typical distributor

purchases chemicals in large quantities (bulk - barge, rail or truckloads) from a number of

manufacturers. They store bulk chemicals in "tank farms", a number of tanks surrounded by

dikes to prevent pollution in the event of a tank failure. Tanks can receive and ship materials

from all modes of transportation. Packaged chemicals are stored in a warehouse. Other

distributor activities include blending, repackaging, and shipping in smaller quantities (less

than truckload, tote tanks, 55-gallon drums, and other smaller package sizes) to meet the

needs of a variety of industrial users.

THE SITUATION

The unexpected withdrawal of one of Cape Chemical’s competitors from the region has

provided the opportunity to increase its blended packaged goods sales. That's the good news.

The bad news is Cape Chemical’s blending equipment is operating at capacity, thus to take

advantage of this opportunity, additional equipment must be obtained, requiring a major

capital investment. It is estimated that Cape Chemical must increase its annual blending

capacity by 800,000 gallons to meet expected demand for the next three years Annual

capacity must increase by 1,400,000 gallons to meet projected demand beyond the next three

years. Stewart is considering two alternatives proposed by the company’s engineer. The

first is the acquisition and installation of used equipment that will provide the capacity to

blend an additional 800,000 gallons annually. The used equipment will cost $105,000 to

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acquire and $15,000 to install. The equipment is projected to have an estimated life of three

years. The second option is the acquisition and installation of new equipment with the

capacity to blend 1,600,000 gallons annually. The new equipment would have a substantially

higher cost of $360,000 to acquire and $60,000 to install, but have a higher capacity and an

economic life of seven years. The newacturer, equipment is also more efficient thus the cost

of blending is less than the blending cost of the used equipment. Stewart asked Clarkson to

lead the evaluation process. Stewart thinks the used equipment could be obtained without a

new bank loan. The acquisition of the new equipment would require new bank borrowing.

The evaluation of each alternative will require an estimate of the financial benefits associated

with each. The marketing and sales staff estimated incremental sales of blended package

material will be 600,000 gallons the first year and increase by 15% each year thereafter.

During the last year, the average selling price for blended material has been near $4.05 per

gallon and material cost (not including a cost for blending the material) has been

approximately $3.53. The marketing staff anticipates no significant change in either future

selling prices or product costs; however they do estimate variable selling and administrative

expenses associated with the increased blended material sales to be $.20 per gallon.

PROJECT EVALUATION PROCESS

The company has no formal process for evaluating capital expenditure projects. In the past

Stewart had reviewed investment alternatives and made the decision based on her “informal”

evaluation. Clarkson plans to develop a formal capital budgeting process using the Cash

Payback Period, Discounted Cash Payback Period, Net Present Value (NPV), Internal Rate of

Return (IRR) and Modified Internal Rate of Return (MIRR) evaluation methods.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Using input from an investment banking firm, Clarkson estimates the company's cost of

equity to be 18%. Their bank has indicated a long-term bank loan can be arranged to finance

the new equipment at an annual interest rate of 12% (before tax cost of debt). The bank

would require the loan to be secured with the new equipment. The loan agreement would

also include a number of restrictive covenants, including a limitation of dividends while the

loans are outstanding. While long-term debt is not included in the firm's current capital

structure, Clarkson believes a 30% debt, 70% equity capital mix would be appropriate for

Cape Chemical. Last year, the company's federalplus-state income tax rate was 30%.

Clarkson does not expect the income tax rate to change in the foreseeable future.

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USED EQUIPMENT

The used equipment will cost $105,000 with another $15,000 required to install the

equipment. The equipment is projected to have an economic life of three years with a

salvage value of $9,000. The equipment will provide the capacity to blend an additional

800,000 gallons annually. The variable cost to blending cost is estimated to be $.20 per

gallon. The equipment will be depreciated under the Modified Accelerate Cost Recovery

System (MACRS) 3-year class. Under the current tax law, the depreciation allowances are

0.33, 0.45, 0.15, and 0.07 in years 1 through 4, respectively. The increased sales volume will

require an additional investment in working capital of 2% of sales (to be on hand at the

beginning of the year).

NEW EQUIPMENT

The acquisition of new equipment with the capacity to blend 1,600,000 gallons annually is

the second alternative. The new equipment would cost $360,000 to acquire with an

installation cost of $60,000 and have an economic life of seven years and a salvage value of

$60,000. The new equipment can be operated more efficiently than the used equipment. The

cost to blend a gallon of material is estimated to be $.17. The equipment will be depreciated

under the MACRS 7-year class. Under the current tax law, the depreciation allowances are

0.14, 0.25, 0.17, 0.13, 0.09, 0.09, 0.09 and 0.04 in years 1 through 8, respectively. The

increased sales volume will require an additional investment in working capital of 2% of

sales (to be on hand at the beginning of the year).

REQUIREMENTS

Assume the role of a consultant, and assist Clarkson to answer the following questions.

1) Calculate Cape Chemical’s weighted average cost of capital (WACC). Note: round to the

nearest whole number. Discuss the theory used by Clarkson to determine Cape Chemical’s

optimum target capital structure (30% debt and 70% equity).

2) Since the used equipment will be financed with internal capital and the new equipment

with a bank loan, should the same discount rate be used to evaluate each alternative?

Explain.

3) Explain why an accurate WACC is important to a firm's long-term success.

4) Evaluate the strengths and weaknesses of the Cash Payback Period, Discounted Cash

Payback Period, NPV, IRR and MIRR capital expenditure budgeting methods. Prepare a

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recommendation for Stewart regarding the capital budgeting method or methods to use in

evaluating the expansion alternatives. Support your answer.

5) Calculate the Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and

MIRR for each alternative. For these calculations, assume a WACC of 15%. Based strictly

on the results of these methods, should either option be selected? Why? Solution requires

preparation of a spreadsheet.

6) Stewart is concerned that the projected annual sales growth rate of 15% for incremental

blended material may be optimistic. Recalculate the Cash Payback Period, Discounted Cash

Payback Period, NPV, IRR and MIRR for each alternative assuming the annual sales growth

rates of 10% and 5%. Assume a WACC of 15%. Does the change in growth rate alter the

recommendation made in question 5? Solution requires preparation of spreadsheets.

Explain.

7) The projected cash flow benefits of both projects did not include the effects of inflation.

Future cash flows were determined using a constant selling price and operating costs (real

cash flows). The cash flows were then discounted using a WACC that included the impact of

inflation (nominal WACC). Discuss the problem with using real cash flows and a nominal

WACC when calculating a project’s Discounted Payback Period, NPV, IRR and MIRR.

8) What other issues should Stewart and Clarkson considered before a final decision

regarding the expansion alternatives is made?

SOLUTION OF THE CASE:

REQUIREMENT – 1 WACC Calculation:

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A firm's WACC is minimized when its capital structure (mix of debt and equity) is optimum. Simply

stated, a firm's value is maximized when its WACC is minimized; therefore, firm's try to determine

the capital structure which will minimize its WACC.

The use of debt lowers Cape Chemical's cost of capital because low-cost debt capital is substituted

for high-cost equity capital. Debt has a lower cost than equity because to the holder of debt there is

less risk. Debt has less risk because the certainty of payments associated with debt (interest and

principal) is greater than the payments associated with equity (dividends and stock appreciation). Debt

payments are legal obligations thus are paid before any payment to equity shareholders. Because there

is less risk associated with debt, the providers of debt are satisfied with a lower but more certain

return. The downside of debt is the fixed nature of the payments, thus the use of debt by a firm

increases its financial risk. The more debt a firm has, the greater the financial risk or financial

leverage. The introduction of debt into a firm's capital structure will at first cause the WACC to

decline, but eventually the use of large amounts of debt will cause the WACC to increase. What

businesses attempt to achieve is a capital structure which provides the lowest cost of capital because it

is there the value of the firm is maximized.

REQUIREMENT 2 Different discount rate should be used in these two alternative. The reason is that when a project is

financed by equity, the cost is more than f that project would be financed by debt. As the cost of debt

is less than that og equity, so the discount rate mustn’t be the same. That’s why different discounting

rate should be used in these two alternative.

REQUIREMENT 3 Importance of Accurate WACC:

WACC is generally used as the discounting rate to evaluate all the projects of a firm. So it is closely

related to all the decision making. In a word, accepting or rejecting a project is totally dependent on

WACC. If the WACC is not accurate of a firm, all the decisions will be inaccurate. Because an

inaccurate WACC means an inaccurate discounting rate. Suppose the correct WACC is 15% but it is

inaccurately calculated as 14%. When a project is evaluated using this wrongly calculated WACC, it

will give a higher NPV. Let the NPV at 15% is -1000 and the NPV is 2000 if the discount rate is 14%.

So the firm may accept a project which should not be accepted if the correct WACC is used. This

must have a negative effect on the long term goal (wealth maximization) of a firm. That’s why an

accurate WACC is important in the long run for a firm.

REQUIREMENT 4 Strength and Weakness of Different Capital Budgeting Techniques:

Discounted Cash Payback Period was developed to correct one of the weaknesses of the Cash

Payback Period (ignoring the time value of money). The Discounted Cash Payback Period is the

number of years required to recover the original investment, but in this case the present value of

future cash flows are determined (using the firm's WACC as the discount rate) before the payback

period is calculated.

The advantages of the Discounted Payback Period include:

1) focuses on future cash flows,

2) incorporates time value of money and

3) places a premium on liquidity (i.e. a quick return of the investment).

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Disadvantages:

1) ignores cash flows beyond the payback period, and

2) does not include an accept/reject feature.

Net Present Value (NPV) method is determined by 1) calculating the present value of the

future cash flows (using the WACC as the discount rate) and 2) deducting the project's cost

from the present value of the future cash flows. If the present value of the future cash flows

exceeds the project's cost, the project is said to have a positive NPV. Stated another way, if

the project's value (the present value of its future cash flows) exceeds its cost, the project is a

good investment and should be accepted.

Advantages of this method include:

1) focuses on future cash flows,

2) takes into account time value of money,

3) considers all cash flows associated with the project,

4) assumes cash flows associated with the project are reinvested at the firm's WACC (the

WACC reflects the current risk level of the firm) and

5) includes an accept/reject feature.

Disadvantages:

1) relatively difficult to explain and calculate, and

2) requires knowledge of a firm's WACC.

Internal Rate of Return (IRR) method is calculated by determining the discount rate that will cause

the present value of the future cash flows to equal the project's cost. The discount rate is the project's

internal rate of return (IRR). If the IRR exceeds the firm's WACC, the project should be accepted.

Advantages of this method include:

1) focuses on future cash flows,

2) takes into account time value of money,

3) considers all cash flows associated with the project, and

4) does not require knowledge of a firm's WACC.

Disadvantages: 1) relatively difficult to explain and calculate,

2) if the project's future cash flows include some years with cash outflows rather than cash inflows,

multiple IRRs may result and

3) assumes the project's cash flows are reinvested at the project's rate of return rather than the firm's

WACC. A more reasonable assumption is that cash flows are reinvested at the firm's WACC.

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Modified Internal Rate of Return (MIRR) method was developed to correct the reinvestment rate

assumption associated with the IRR. The IRR is calculated by determining the discount rate that will

cause the present value of the project's terminal value (the future values of the project's cash flows,

compounded at the firm's WACC), to equal the project's cost. Like the IRR, if the MIRR exceeds the

firm's WACC, the project should be accepted.

Advantages of this method include:

1) focuses on future cash flows,

2) takes into account time value of money,

3) considers all cash flows associated with the project, and

4) does not require knowledge of a firm's WACC.

Disadvantages:

1) relatively difficult to explain and calculate, and

2) if the project's future cash flows include some years with cash outflows rather than cash inflows,

multiple IRRs may result.

Recommendation should include the use of all evaluation methods because each provides valuable

information regarding a potential project. Priority should be given to the results of the NPV method

because it compares the projects value (the present value of future cash flows, determined by using

the firm's WACC as the discount rate) to the projects cost. If a project's value exceeds its cost, it is a

good investment. For a more complete discussion of the superiority of the NPV method over the other

techniques, see Eugene Brigham and Joel Houston's "Fundamentals of Financial Management".

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REQUIREMENT – 5

Used Equipment:

OCF Calculation:

PCF Calculation:

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Calculation of Pay Back Period:

Discounted Pay Back Period:

NPV and IRR:

Decision:

As the NPV is positive and the IRR is more than the cost of capital, so the project is acceptable.

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The New equipment:

OCF Calculation:

PCF Calculation:

NPV and IRR:

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Pay Back Period:

Discounted Pay Back Period:

Decision:

Like the used asset, the new equipment also has a positive NPV and the IRR is more than the cost of

capital. So this alternative is also acceptable like the used equipment.

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REQUIREMENT 6

NPV and IRR with 5% & 10% Growth of Sales:

Used Equipment:

10% sales Growth:

If the sales growth is 10%, the NPV is positive and the IRR is more than the cost of capital. So the

recommendation given in question 5 is unchanged. That means, the alternative is still acceptable.

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At 5% Sales Growth:

Decision:

The NPV is still positive if the sales growth decreased to 5%. The IRR is 20% which is more than the

cost of capital. So the alternative is acceptable and there is no change of the recommendation in

question 5.

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New Equipment:

At 10% Sales Growth:

OCF and PCF:

NPV and IRR:

Pay Back Period:

5% sales Growth

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OCF & PCF:

NPV & IRR:

Pay Back Period:

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REQUIREMENT 7

Adjustment of Inflation:

In general, using "real" future cash flows and a "nominal" WACC will result in an

understated NPV and IRR or both will have a downward bias. If inflation is neutral,

impacting revenues and costs equally, the NPV and IRR will be underestimated. Because

revenues are usually greater than costs, revenues will increase by a greater dollar amount than

costs. The exact impact of combining "real" cash flows and a "nominal" discount rate can

only be determined by removing the impact of inflation from the discount rate or adding the

impact of inflation to the future cash flows.

REQUIREMENT 8

As discussed in the answer to question six, the growth rate assumption is key to the analysis.

Before a decision is made, the growth rate assumption needs to be revisited. Stewart appears

to understand this and requested additional analysis based on an annual growth lower than the

15% provided by the marketing department. Incorporating an assumption regarding future

inflation rates would also improve the analysis. The point of this question is to illustrate to

the students that the financial analysis is only part of the decision-making process.

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Chapter 4

Case 4 Analysis

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4. CASE SCENARIO:

4.1: case scenario: Two recent college graduates own a restaurant and want to decide whether to invest in a

brewpub system, which would allow the pair to sell beer on tap to their customers. The

business owners must complete a thorough cash flow analysis of their planned investment

using the concepts of operating cash flows, working capital investment and capital

expenditures. They need to have a keen understanding of relevant versus non-relevant cash

flows. Further, they must use these cash flows in order to come up with the net present value

(NPV) and internal rate of return (IRR) of the investment under different realistic business

scenarios. The pair also must use sensitivity analysis to see how their investment decision

may or may not change as a result of varying costs of capital. In the end, the pair needs to

decide whether to invest in the brewpub in light of their full analysis.

The Case

Samantha Myers and Grant Patrick graduated from college seven years ago. Since then, they

opened a casual, American-fare 80-seat restaurant, Explore Café, close to their college

campus. Their clientele mainly consists of undergraduate and graduate students from the

college (thus a lot of their business falls outside of the summer months), and an enthusiastic

group of local residents who love to come to the restaurant on a regular basis year-round.

Currently the restaurant is BYOB, meaning, the restaurant does not sell alcohol but allows

customers to bring in their own bottles of wine and beer for a small “corkage” fee. After

much consultation and market research (costing them roughly $2,000 and considerable time

and effort), Samantha and Grant decided that the way to grow their small restaurant was to

include a brewpub system, thus allowing the restaurant to offer beer on tap to their customers

and do away with the BYOB label.

Samantha did some research on the cost of a new brewpub system. She estimates that they

will need about 1,000 square feet of space in the store to accommodate a 7 barrel (bbl)

system. Currently they do not have the space available but it just so happens that the retail

space next door to Explore Café is available for rent. The space costs $3,000 per month but

Samantha thinks they can negotiate the rent down to $2,500 per month because of their good

relationship with the landlord. However, the space is not equipped to handle the brewpub

machinery. After talking with several contractors (with permission of the landlord) Samantha

expects that initial construction costs could be as high as $250,000.

In a barrel of beer, there are 31 gallons of beer. There are 8 pints in a gallon. Samantha

estimates that each seat in the restaurant will require about 7 barrels of beer (best case

scenario) per year. She is basing this on the expected number of patrons and on the number of

beers each patron is expected to order, on average, throughout the day. She uses some

scenario analysis to also include an estimate of 5 barrels of beer per year per seat for a worst-

case scenario outlook. They plan to sell 10 types of beer but all will have the same ingredient

costs and sales price.

The cost of a high-quality brewpub system is $300,000. This includes the heater,

fermentation tanks, chiller, stainless steel beer faucets, hoses, valves, and carbonator gauges.

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Samantha looks into some options for ingredients and finds the best deal from an outside beer

retailer. The ingredients will cost $4,000 to make 10 barrels of beer. These costs are expected

to increase 5 percent per year based on projected agriculture prices. Based on discussions

with the brewpub machinery manufacturer, Samantha estimates that it will cost about

$15,000 per year (after the first year of operations) in maintenance expenses to keep the

machinery running properly.

Meanwhile, Grant looked into any additional costs (beyond ingredients and rent) that the

Explore Café would encounter when they open the brewpub aspect to their business. He

figures that he would need at least three additional servers per day at a cost to the restaurant

of $80 per day per server (the servers earn most of their income through tips, and servers

typically work about 320 days out of the year). They also plan to hire a person to run the

brewery machinery on a full-time basis at a starting salary of $40,000 per year. Generally,

Grant and Samantha like to increase server and employee salaries by about 3 percent per

year. Insurance costs would increase since the restaurant will now serve alcohol. Grant

figures the insurance cost will be an additional $3,000 per year with the assumption that this

will increase by 5 percent in five years (based on his discussions with the insurance agent)

and hold steady at that new rate for the remainder of the time. The equipment itself will

require additional utilities costs beyond what the restaurant operates at without the brewpub

option. Grant estimates that utilities costs (water and electricity) will amount to an additional

$24,000 per year over what the restaurant currently pays in utilities expenses.

License fees and renewals were not something Grant initially thought about when opening

the brewpub but after some research, he found that the Explore Café would be required to pay

a $65,000 initial license fee before they open the doors to the new brewpub. License renewal

for the first year of sales and every year thereafter is expected to be $700 per year. This is the

typical cost structure for licensing fees for this particular city.

Grant and Samantha also decided that they would put a big effort into an advertisement

campaign for the new brewpub. The pair does not do much advertising now other than flyers

at the college and around the neighborhood and an occasional ad in the city newspaper. With

the addition of the brewpub they plan to increase advertising expenses to around $80,000 per

year to cover costs of outsourcing their Internet presence (website, Facebook, Twitter, etc.)

and more substantial ads in local newspapers. They decide to pay a media company fee of

$20,000 before the brewpub opens to immediately redesign their website and to begin

advertising.

As for sale price, the pair decides to set the price at $5 per pint during the first year of

operation. They hope to increase this price by 3 percent each year thereafter. Samantha also

realizes that they will need to store up on some inventory and receivables before they ever

sell a single pint of beer. The increased inventory and receivable investment will be, she

assumes, $10,000 just to get them started. Samantha figures that they will unwind the

investment in inventory and receivables when the brewpub machinery’s economic life is

complete.

It seems that brewpub systems have a 10-year economic life. They assume that they can sell

the materials from the brewpub system once the useful life is complete. They estimate that

they can get about $20,000 back from the scrapped material. After talking with their

accountant, they decide to depreciate the brewpub system using the straight-line method

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(down to zero) over the usable life of the machine. Right now, Explore Café pays a tax rate of

30 percent and this is expected to continue for the duration of the brewpub machinery’s

useful life. Grant estimates the cost of capital for the restaurant to be 8 percent based on

current and long-term loan rates.

To do

1. Estimate the annual cash flows for the brewpub project. Use the “best case scenario.” To

do this, you will need to calculate the annual revenues and annual expenses for the 10year

project, any changes in net working capital, and any changes to capital expenditures.

Describe all assumptions and calculations you used to arrive at the final cash flows.

2. Calculate the NPV and IRR of the project given the information presented using the “best

case scenario.” Should Samantha and Grant go ahead with the brewpub investment? Why or

why not?

3. What would be the impact on NPV and IRR if the “worst case scenario” occurs? Would

this alter Grant and Samantha’s decision whether to invest in the brewpub? Describe how you

found this result (also show in the spreadsheet).

4. Suppose they are operating under the best case scenario and they decide that in year 5 they

would like to do major renovations to the restaurant (a capital expense). They figure this will

cost an additional $1,000,000 in year 5. Along with the renovations, they figure they could

increase the price of the beer to $7 per pint and keep it at that price for the duration of the

project. How do these changes impact NPV and IRR? Is it worth it for the pair to go forward

with the renovations? Describe how you found this result (also show in the spreadsheet).

5. Would there be a significant impact to Samantha and Grant’s brewpub decision if there

were a change in the cost of capital? Describe how you found this result (also show in the

spreadsheet).

6. Are there any other issues that you think might influence the pair’s investment decision?

What, if anything, have Samantha and Grant not considered in their capital budgeting

analysis?

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Requirements:

1. “Best case scenario.” Calculation of annual revenues and annual expenses for the 10year

project, any changes in net working capital, and any changes to capital expenditures.

Describe all assumptions and calculations you used to arrive at the final cash flows.

2. Calculate the NPV and IRR of the project given the information presented using the “best

case scenario.” Should Samantha and Grant go ahead with the brewpub investment? Why or

why not?

3. What would be the impact on NPV and IRR if the “worst case scenario” occurs? Would

this alter Grant and Samantha’s decision whether to invest in the brewpub? Describe how you

found this result (also show in the spreadsheet).

4. Suppose they are operating under the best case scenario and they decide that in year 5 they

would like to do major renovations to the restaurant (a capital expense). They figure this will

cost an additional $1,000,000 in year 5. Along with the renovations, they figure they could

increase the price of the beer to $7 per pint and keep it at that price for the duration of the

project. How do these changes impact NPV and IRR? Is it worth it for the pair to go forward

with the renovations? Describe how you found this result (also show in the spreadsheet).

5. Would there be a significant impact to Samantha and Grant’s brewpub decision if there

were a change in the cost of capital? Describe how you found this result (also show in the

spreadsheet).

6. Are there any other issues that you think might influence the pair’s investment decision?

What, if anything, have Samantha and Grant not considered in their capital budgeting

analysis?

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3.2: Solution:

REQUIREMENT 1

(Best Case Scenario): Annual cash flow calculation

Calculating OCF:

Calculating PCF:

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REQUIREMENT – 2

NPV and IRR (Best Case Scenario):

Decision:

The project of Samantha Myers and Grant Patrick to convert their cafe from BYOB to brewpub

system gives a positive NPV. So total cash outflow of this project is less than the present

value of total cash inflow from the project.

The required rate of return of this project is 8%. Internal Rate of Return (IRR) is 27% which

ish more than their required rate of return.

So the project is acceptable for Samantha Myers and Grant Patric.

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REQUIREMENT – 3

Worst Case OCF:

PCF Calculation:

NPV is 682694 and the IRR is 27% in the best case scenario. But NPV decreased to 755

and the IRR decreased to 8%in worst case. NPV and IRR decreased but these are still

favorable. NPV is not negative or zero under worst case scenario and the IRR is not less

than the cost of capital. This indicates that the project is much safe to invest. They can invest

in the project even in the worst possible situation.

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REQUIREMENT – 4

Best Case with Renovation:

PCF, NPV, IRR Calculation:

If the partners go for the renovation under the best case scenario, the NPV goes down $493,478.51

from 682694. So the NPV is decreased by 189216 if renovation will be taken. The IRR will be

decreased by 11% (27% in the best case scenario and 16% in the best case scenario with renovation).

So the renovation worsen both the NPV and IRR of the project. So the pair should continue their

business with best case scenario without any renovation.

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REQUIREMENT - 5

Impact of Change in Cost of Capital:

Discounting rate is used to discount the cash flow and to calculate the NPV. A change in cost of

capital may have significant effect in the decision of a project. If we consider the cost of capital as

8%, the project is acceptable in both the best case and the worst case scenarios. But if the cost of

capital is increased to 10% from 8%, then the best case scenario will still be acceptable. But the

project will not be acceptable in the worst case situation because the NPV will be negative (-55816)

and the IRR (8%) will be less than the cost of capital.

REQUIREMENT - 6

Some consideration in Capital Investment Decision:

Samantha and Grant used the popular techniques of capital budgeting. So their estimation

about the success in this project is not realistic. But their estimation will be more successful if

they would take help of sensitivity analysis. Sensitivity analysis measure the significance of a

single variable on the project’s cash flow. This analysis would help them to know which

variable is most important for NPV or Sales Revenue etc.

For tax benefit they can also consider the option of taking loan instead of all equity financing

in the project. If the project would be financed with debt. As a result there would be possible

that the worst case NPV will be more than that of without any debt. So the IRR would be

increased. The decision would be more materialistic.

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Chapter 5

Conclusion

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Conclusion

By solving the two cases we learned how to apply the capital budgeting techniques to make

real life financial decisions .Capital budgeting is the most important mechanism to make

financial decisions. We have used different capital budgeting methods to solve the cases and

made decision .Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and

MIRR, WACC, ARR are used to solve the cases and make investment decisions. In our

report we completed all the requirement .The capital budgeting techniques helps to determine

the best way to decide the most prudent decision in organization. The financial managers take

decisions using the different capital budgeting techniques. After all the managers have to find

out the proper ways to solve different decisional activities.