Question

Cash Flow Estimation and Capital Budgeting Criteria

The Ballpark Company is evaluating the market potential of brightly colored bowling balls. The results of an initial questionnaire that Ballpark has conducted in major markets six months ago and cost $50,000 were positive. A more comprehensive market test study that will cost an additional $250,000 was just completed and affirmed at least a 15% of the total bowling ball market. Ballpark has not yet paid for this study.

Now Ballpark is at the point where it is considering investing in the assets needed to produce the colored balls. The balls would be produced in a building owned by the firm. The building, which was bought by Ballpark 20 years ago for $60,000, is currently vacant but it can be sold for $160,000. The value of the building on Ballpark’s books is $32,000. Ballpark can depreciate this $32,000 over four years on a straight-line basis. In order to estimate the market value of the building at project’s end, the company assumes that the price change will follow the trend experienced in the last 20 years. The land on which the building sits was bought for $51,000 twenty years ago and it is valued at $136,000 today. The expected appreciation in the land value is 4% per year over the coming ten-year period. Ballpark assumes that it will be able to sell both the building and the land together at their expected values at the end of the project’s life.

The price of the new equipment needed is $912,000. It will require and additional $48,000 in shipping and installation costs. The useful life of the machine is 15 years but the company intends to use it for only the ten years that is the life of the project and then sell it at the termination of the project. It estimates its salvage value at $512,000. Production is estimated to be 37,500 units in the first year, rising by 17% per year for the following five years then falling by 7% per year for the remaining life of the project. The price of the balls in the first year will be $28. The bowling ball market is highly competitive and Ballpark believes that the price will increase by 3.5% per year. However, the plastic used to produce bowling balls is rapidly becoming more expensive. Variable production costs that will be $11 per unit in the first year will rise by 14% per year for the next four years then by 8% per year for the following five years. Total fixed costs excluding depreciation expense is assumed to stay constant at $480,000 per year for the life of the project. In addition, Ballpark is aware of the fact that some of the demand for its colored balls will be the result of shifting demand from its sales of the old black balls. It estimates that the new production will replace 3,200 units per year that bring in an after-tax EBIT of $13 per unit. The marginal tax rate applicable to this project is 25%.

Ballpark anticipates that it will maintain an investment in working capital equal to $48,000 initially (at time point zero) and rising by 4% per year in the first seven years then declining by 16% in each of years eight and nine before is completely retrieved in year ten.

Ballpark uses the straight line depreciation for all its depreciable assets.

1. On an Excel spreadsheet, estimate the following:
   1. Initial net investment (NINV) (show it clearly in one box)
   2. Total after-tax salvage value (ATSV) for all assets (clearly show details for each salvageable asset in another box)
   3. The annual depreciation schedule
   4. The annual incremental investment in NWC
   5. Annual free cash flows (FCF)

At this point in the project, assume that the required rate of return on Ballpark’s project of similar risk is 15%.

2. Use the capital budgeting decision criteria to decide which ones point to acceptance of the new project. Show in as much detail as possible on an Excel spreadsheet how you will evaluate the project including all estimates of cash flows and all the necessary calculations. Assume Ballpark uses a required payback of 6 years or less.

3. Ballpark is not always comfortable with the estimate of its cost of capital so it uses a sensitivity analysis to check how robust its project valuations to various estimates of cost of capital. The estimate should start with 0% and increase by increments of 5% points until it reaches 30%. For each estimate an NPV is calculated to analyze the sensitivity of NPV to various discount rate assumptions. Plot the NPV profile (NPV on y-axis and discount rates on x-axis). Watch where the NPV curve intersects with the x-axis. What do you call the intersection point?

Spreadsheet is due as an Excel file (email it and keep the file)

(Hint: use Excel’s “round” function to round the number of units to zero decimals, price per unit and variable cost per unit to two decimals).

Answer 1

The amount spent on the market research and the market test study which is $50,000 and $250,000 is a sunk cost. Which means that the company have already taken up the services and has paid or are required to be paid irrespective of the final decision.

For land and building, they were lying vacant and company had no intentions of selling them therefore they would also not be considered for this calculation.

1.

Initial Net Investment

Initial Net Investment
New Equipment
Purchase Price	912000
Installation Cost	48000
Total Cost	960000
Working Capital	48000
Total Initial Investment	1008000

Total Initial Net Investment = Total Cost of New Equipment and Working Capital

Total After-Tax Salvage Value & Annual Depreciation Schedule

Year	0	1	2	3	4	5	6	7	8	9	10
New Equipment
Purchase Price	912000
Installation Cost	48000
Total Cost	960000
Depreciation		64000	64000	64000	64000	64000	64000	64000	64000	64000	64000
Written Down Value											320000
Salvage Value											512000
Capital Gain/Taxable Value											192000
Tax @ 25%											48000
After Tax Salvage Value											464000

Depreciation Calculation = Total Cost/Useful Life = 960000/15 = 64000

Capital Gain = Salvage Value - Written Down Vale

After Tax Salvage Value = Salvage Value - Tax on Capital Gain

Net Working Capital

Year	0	1	2	3	4	5	6	7	8	9	10
Net Working Capital
Working Capital Required	48000	49920	51917	53994	56154	58400	60736	63165	53059	44570	0
Annual Incremental WC	-48000	-1920	-1997	-2077	-2160	-2246	-2336	-2429	10106	8489	44570

For the first 7 years, Working Capital would increase by 4% annual and then decrease by 16% annually

Operating Revenue and Profit

Year	1	2	3	4	5	6	7	8	9	10
Sales Unit	37500	43875	51334	60061	70271	82217	76462	71110	66132	61503
Selling Price	28.00	28.98	29.99	31.04	32.13	33.25	34.41	35.61	36.86	38.15
Variable Cost	11.00	12.54	14.3	16.3	18.58	20.07	21.68	23.41	25.28	27.3
Contribution per Unit	17.00	16.44	15.69	14.74	13.55	13.18	12.73	12.20	11.58	10.85
Total Contribution	637500	721305	805430	885299	952172	1083620	973361	867542	765809	667308
Fixed Cost	480000	480000	480000	480000	480000	480000	480000	480000	480000	480000
EBITDA	157500	241305	325430	405299	472172	603620	493361	387542	285809	187308
Depreciation	64000	64000	64000	64000	64000	64000	64000	64000	64000	64000
EBIT	93500	177305	261430	341299	408172	539620	429361	323542	221809	123308
Tax @ 25%	23375	44326	65358	85325	102043	134905	107340	80886	55452	30827
Earnings After Tax	134125	196979	260072	319974	370129	468715	386021	306656	230357	156481
Add: Depreciation	64000	64000	64000	64000	64000	64000	64000	64000	64000	64000
Free Cash Flow from Operations	198125	260979	324072	383974	434129	532715	450021	370656	294357	220481

Sales (units) would grow at 17% for first 6 years and then decrease by 7% for next 4 years

Selling Price per Units will increase by 3.5% per year

Variable Cost will increase by 14% for first 5 years and then by 8% for next 5 years

Contribution per Unit = Selling Price per Unit - Variable Cost per Unit

Total Contribution = Contribution per Unit * Sales Unit

EBITDA = Total Contribution - Fixed Cost

EBIT = EBITDA - Depreciation

Tax @ 25% on EBIT

Free Cash Flow

Year	0	1	2	3	4	5	6	7	8	9	10
Free Cash Flow
New Equipment	-960000
Working Capital	-48000	-1920	-1997	-2077	-2160	-2246	-2336	-2429	10106	8489	44570
Free Cash Flow from Operation		198125	260979	324072	383974	434129	532715	450021	370656	294357	220481
Cannibalization of Sales		-41600	-41600	-41600	-41600	-41600	-41600	-41600	-41600	-41600	-41600
After Tax Salvage Value											464000
Free Cash Flow	-1008000	154605	217382	280395	340214	390283	488779	405992	339162	261246	687451

Cannibalization of Sales = (3200*13) = Units Cannibalized * Sales Price