td1 investment decision and capital budgeting

8/8/2019 TD1 Investment Decision and Capital Budgeting

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ICN ECOLE DE MANAGEMENT

Master ICN 2

2010-2011

Financial Management

Tutorial n1

Course ID on MyFinanceLab

XL0I-S1TD-801Z-00F2

Investment decision and capital budgeting

S. Mbarek

V. Moskalu

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Financial management is

Financing decisions

Investing decisions (=capital budgeting) by equity or debt, allows to analyze

alternative investments and to know which one to accept/to reject.Three steps: Evaluate your project NPV, Choose your decision criterion,

Risk management like solvency risk, liquidity risk, foreign exchange, investment rate.

Some basic principles in financial management = To think in monetary cash flows + To think

in time value of money (compounding and discounting the expected cash flows)

Case 5 Etang de la Comtesse

Etang de la comtesse company, located in the Vosges, is specialized in fish farming. It plans

to expand its product range and plans to implement a packaging line. Technical departmentconsider that investment expenditure would be 7,000,000 euros. This new machine could be

installed in a building belonging to the company. This machine will be depreciated over 4

years and after this period, its residual value may be considered null.

Commercial department set at 30 the unit price of the new product. This price will increaseby 3% per year. Production engineer estimated production costs at 5 per year and the

workers are paid 10 per hour. These wages should increase by 2% per year. The company

is currently subject to the income tax (at 33%), it also uses a discount rate of 9%.

Estimations :

2011 2012 2013 2014

Quantities sold 50 000 100 000 125 000 100 000

Number of hours of production 15 000 25 000 30 000 28 000

Advise the company by offering an assessment of the NPV and the discounted payback period.

Discuss the assumptions and results.

Project: Assumptions

- Investment 7 000 000 euros

- 4 years

- 30 euros/unit + 3%/year

- Production costs 5euros/product/year

- Salaries 10 euros/hour + 2%/year

- Income tax 33%

- Discount rate 9%

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2011 2012 2013 2014

price 30 30,9 31,827 32,78181

Quantities (in

thsd)

50 100 125 100

CA 1500 3090 3978,375 3278,181

Wage/hour 10 10,2 10,404 10,61206N of hours (in

thsd)

15 25 30 28

Total wages 150 255 312,12 297,13824

Production costs 250 500 625 500

Investment 7000

Depreciation ( 7000/4) = 1750

Taxe rate 0,33

WACC 0,09

2010 2011 2012 2013 2014

sales 1500 3090 3978,375 3278,181

Production

costs

250 500 625 500

Wages 150 255 312,12 297,13824

EBITDA 110 2335 3041,255 2481,04276

Depreciation 1750 1750 1750 1750

EBIT -650 585 1291,255 731,04276

Tax -214,5 193,05 426,11415 241,2441108Net income -435,5 391,95 865,14085 489,798692

Depreciation 1750 1750 1750 1750

Cash flows 1314,5 2141,95 2615,14085 2239,7986492

Discounted

CF

1205,9633 1802,8364 2019,3685 1586,7298

Discounted

rate

1,09 1,19 1,3 1,41

NPV (Discounted CF investment) = - 385,10

The NPV is negative so we have to reject the project. Instead the firm will lose money.

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Case No. 4 Company Olima

A company producing plastic parts for automobiles plans to expand ( = capacity investment)

by exporting a part of its production to Russia. Commercial department believes that the

market penetration would be quick as indicated by the important development of the

company's business.

Year 2011 2012 2013 2014 2015

Sales withoutexport

10,000 11,000 13,000 15,000 17,000

Sales withexport

11,000 12,000 15,500 18,000 20,000

Units: Thousands of Euros

This additional activity would not alter the operating conditions of the company. These canbe summarized as follows: EBIT 14% of sales, Income Tax rate 33% and a NWC. 35% of

turnover

This decision requires an increase in the production capacity of the company. The new

equipment requires an investment of 100,000 euros depreciated over five years usingthe straight line method. Eventually, the residual value may be considered as null.

The company currently uses a discount rate of 9%.

Advise this company.


- Investment 100 K

- EBITDA 14% of sales

- NWC 35% of sales

- Tax rate 33%

- Depreciation 20 K

2011 2012 2013 2014 2015

Sales amount 10 000 11 000 13 000 15 000 17000

EBITDA 1400 1540 1820 2100 2380

NWC 3500 3850 4550 5250 5950Sales with exp 11000 12000 15500 18000 20000

EBITDA 2 1540 1680 2170 2520 2800

NWC 2 3850 4200 5425 6300 7000

Incremental

earnings

140 140 350 420 420

Incremental

NWC

350 350 875 1050 1050

Cash Flows calculation

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2010 2011 2012 2013 2014 2015

Incremental

EBITDA

140 140 350 420 420

Depreciation 20 20 20 20 20

EBIT 150 255 312,12 297,13824 297,13824

Tax 110 2335 3041,255 2481,04276 2481,04276Net income 1750 1750 1750 1750 1750

Depreciation -650 585 1291,255 731,04276 731,04276

-214,5 193,05 426,11415 241,2441108 241,2441108

Cash flows -435,5 391,95 865,14085 489,798692 489,798692

NWC 1750 1750 1750 1750 1750

Incremental

NWC

1314,5 2141,95 2615,14085 2239,7986492 2239,7986492

1205,9633 1802,8364 2019,3685 1586,7298 1586,7298

Cash flows

Discountingfactor 1,09 1,19 1,3 1,41 1,54

Discounting

CF

NPV (Discounted CF investment) =

The NPV is negative so we have to reject the project. Instead the firm will lose money.

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Case No. 1 Company Locmarie

At the end of year N, Locmaries director is considering launching a new product whose life

is estimated at 5 years. This project requires an initial investment of 210 K in machines

(depreciated over 7 years using a straight-line basis ). A company that specializes in market

studies worked for two months on the project, the cost of this study ( 3K) is paid during theyear N-1. The company releases earnings currently. The sales forecast for year N+1 wouldbe 400 K and should increase 9% per year thereafter.

The construction of buildings (cost of 360K depreciated over 10 years) should be on a landbelonging to the company that is now estimated at 39K. Its value should increase by 6%

annually.

Variable costs represent 40% of the selling price. An advertising campaign should be

launched in N+1 to promote sales. Its cost would reach 33 K .

The need for working capital represents 20% of sales the following year. The tax rate is 33

1/3 %. The cost of capital for the project is 16%. The resale value of the building and

machinery after 5 years is estimated at 234 K .

Calculate the NPV of the project and the IRR. Should he make the investment?


- Capital expenditures (= dpenses)

Machines Investment 210K (depreciated over 7 years => 30K)

Buildings construction 360K (depreciated over 10 years => 36K)

Land belonging to the company 39K increasing by 6%/Year

(residual value in 5 years => 52,1908K)

=609K

- Study 3K (paid N-1) Not to integrate! Already paid even if you reject the project or

not

- Sales N+1 400K and then a 9% increase/year

- Variable costs 40% of selling price

- Advertising campaign 33K (launched N+1)

- Working capital need 20% of sales- Taxe rate 1/3%

- Cost of capital 16% discounting factor 1,6

- Sales value of buldings and machines after 5 years 234K

! Not the same as Book value (valeur comptable) = (360-36x5) (210 -30x5)= 240K

N N+1 N+2 N+3 N+4 N +5

investment 609

sales 400 436 475,24 518,0116 564,6326

Var costs 160 174,4 190,0960 207,2046 225,8531

Fixed costs 33EBITDA 207 261,6 285,1440 310,8070 338,7796

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(sales-costs)

Depreciation

(30 + 36)

66 66 66 66 66

EBIT

(EBITDA-

depreciation)

141 195,6 219,1440 255,8070 272,7796

Tax 46,95

30

65,1348 72,9750 81,5207 90,8356

Net income 94,04

70

130,4652 146,1690 163,2862 181,9440

Cash flows

(net income

+

depreciation)

180,0

470

196,4652 212,1690 229,2862 247,8440

NWC

(=BfR)

(20% sales

next year)

80 87,2 95,0480 103,6023 112,9265 0

Incremental

NWC

(NWC N+1

NWC N)

7,2 7,8480 8,5543 9,3242 (112,9265

)

(80)

recovered

NWC

Cash Flows

(CF

incremental

NWC)

152,8

470

188,6172 203,6147 219,9620 360,8705 206,1908

234

residual

value of

buildings

&

machines

52,1908

residual

value of

land

Discounted

CF ( CF/1,6)

131,7

647

140,1723 130,4473 121,4831 171,8151 84,6294

NPV

(discounted

CF

-investment )

261,

3126

Calculating

Internal Rate

of Return = 0

20

or

21%

The NPV is positive.

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The IRR is about 20 or 21%. The IRR is bigger than the cost of capital (=16%) so we can

accept the project.

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The case studies n1, 4 and 5 must be prepared for the tutorial of Tuesday 21st,

September 2010

It is strongly recommended to do the training exercises to get familiar with capital

budgeting calculations

Exercise 1

A company can choose between two exclusive projects. They are characterized by the

following flows:

Year Project A Project B

0 -100 -100

1 50 70

2 70 753 40 10

Calculate the NPV for a cost of capital of 10% and 20%. Conclude.

Exercise No. 2

The Financial department of a company is considering the replacement of an industrial

project. This project can be characterized by the following flows:

T=0 T from 1 to 7 T=8

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Cash flows - 1000 +200 +500

Given that the weighted average cost of capital of this company is 12%, calculate the NPV of

this project. What is its significance?

What effect would a reduction in the depreciation period of the machine on the NPV?

Exercise 3

A company has to choose between two projects, valued on a 2-year life long basis, taking into

account the two following assumptions:

A1: Activity remains stable or slightly increases (probability: 0.60)

A2: The activity tends to decline (probability: 0.4)

First project: Total Initial investment : I = 6000 k

Second project: Initial investment is limited with possible extension after one year: an initialinvestment of 3,000 k at date 0 and 4,000 k at date 1 if the hypothesis A1est verified;

The decision tree is given to you below.

The cost of capital is 10%

Should we make the extension T = 1 for project 2?

Compute the expected NPV for the Project 1.

Tree Project 1:

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Project tree 2 :

ECF : Expected Cash FlowsP : Probability

Invest : -

6000

ECF 500

500

ECF 3500

500

ECF 3000

ECF 2500P=40%

P=60%

P=40%

P=60%

P=60%

ECF = 2000

000

P=40%

ECF =

1 000

t=0t=2 to

6

t=1

11

-3000

P = 60%

ECF = 1500

1111111150

0

extention

n

No extension

P= 0,6

P=0,4

F

T

E

=

P

0,

6

=

0,

6

P=0,6

P=0,4

ECF = 4,500

000

FTE = 500

ECF= 2000

ECF=1750

ECF=100

ECF=500

ECF=2000

P= 40%

P=0,4

P=0,6

P=0,6

p=0,6

P=0,4

T=1 t=2 to t=6


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Case No. 2 Company Baberlec

Given the success of one of its products, Barbelec is considering a new location. Continued

sales growth depends, however, on economic conditions. The first year there is 65% chance

that the demand is high, in which case there will be 75% chance that it remains high the

following years. However, if the initial demand is low, it remains low thereafter in 60% of

cases.

The firm is studying two possibilities:

The first solution involves the construction of a plant with large capacity which would require

an investment of 750K. The production capacity would be sufficient to meet demand 10years ahead.

The second solution lies in the choice of a small capacity plant costing only 250 K . It

would, however, not meet demand if economic conditions are very good. Management

believes, however, that if demand is strong, they have the opportunity to build an extension at

the end of the first year. This extension will cost 180 K .

We consider the investment over two periods, the second period is associated with cash flows

generated by the investment between the 2nd and the 10th year in present values. The discount

rate is 7%.

The flows are as follows:

Cash flow for year 1

>

Demand High low

Big factory 800 -150

Small factory 230 20

Cash flows for years 2-10

Demand High/high High/low Low/high Low/low

Gig factory 1 700 150 1 100 -1 000

Small (without

extension)

740 400 680 30

Small (with

extension)

1 400 210

Draw the tree corresponding to the decision taken by the company.

Case No. 3 Reider

Reider is considering an major investment project requiring an initial outflow of 150 Keuros.

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This investment will take effect over the next ten years. However, commercial department

considers that the effects of this investment are linked to economic conditions and in

particular the settlement of a customer in the industrial area of the company. Currently, the

relocation decision is not taken yet and it would be effective only in one year.

Commercial department had considered that in the case of an implementation of the client, the

net cash flows could be estimated at 19,000 euros. However, if implantation does not occur,

the net cash flows would be only 12,000 euros.

The CFO is wondering: Should I invest? If yes, when?

He asks you to prepare a rationale for this decision.

Rq. Discount rate: 8%.

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td1 investment decision and capital budgeting

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