Question

Choice 2: Capital Budgeting Decision Since LSUS corporation is producing at full capacity, Amanda has decided to have Han examine the feasibility of a new manufacturing plant. This expansion would represent a major capital outlay for the company. A preliminary analysis of the project has been conducted at a cost of $1.6 million. This analysis determined that the new plant will require an immediate outlay of $54 million and an additional outlay of $31 million in one year. The company has received a special tax dispensation that will allow the building and equipment to be depreciated on a 20-year MACRS schedule. For Property Placed in Service after December 31, 1986 10-Year 3-Year 7-Year 15-Year 20-Year Recovery Year 5-Year (200% DB) (200% DB) (200 % DB) (200 % DB ) (150% DB) (1509% DB) 5.00 10.00 18.00 3333 1 20.00 14.29 3.750 7.219 44.45 32.00 24.49 9.50 1481 3 19.20 1749 6.677 14.40 8.55 11.52 7.70 6.177 4 741 11.52 12.49 11.52 8.93 6.93 5.713 9.22 5.76 7.37 6.23 5.285 8.92 655 5.90 8.93 4.888 4.46 6.55 S.90 4522 8 6.56 S.91 4.462 655 5.90 10 4.461 3.28 5.91 4.462 11 5.90 12 4461 5.91 13 4.462 14 5.90 4.461 5.91 4.462 15 16 2.95 4.461 17 4.462 18 4.461 4.462 19 4.461 20 21 2.231 Swinchover to straight-line depreciation Because of the time necessary to build the new plant, no sales will be possible for the next year. Two years from now, the company will have partial-year sales of $17 million. Sales in the following four years will be $28 million, $37 million, $40 million, and $43 million. Because the new plant will be more efficient than LSUS corporation's current manufacturing facilities, variable costs are expected to be 65 percent of sales, and fixed costs will be $2.4 million per year. The new plant will also require net working capital amounting to 8 percent of sales for the next year Han realizes that sales from the new plant will continue into the indefinite future. Because of this, he believes the cash flows after Year 5 will continue to grow at 2.5 percent indefinitely. The company's tax rate is 40 percent and the required retun is 12 percent

4) After the empirical results, Han would like to provide the recommendation to Amanda and Board of Directors, what is Han’s recommendation? Amanda also wants Han to provide a sensitivity analysis and change any one of elements documented before and see what happens? For example, increase or decrease growth rate and at what level the firm can break even when NPV=0.

Answer 1

		$1.6 million spent on preliminary analysis is sunk cost .
		This cost is not relevant for the capital budgeting decision
		Present value of Cash flow=(Cash flow)/((1+i)^N)
		i=discount rate=Required Return=12%=0.12
		N=year of Cash Flow
		DEPRECIATION EXPENSES
		Total Investment in assets =54+31 =	$85	million
		Year(From Today)	3	4	5	6	7
	A	Book Value of depreciable Assets in beginning of year($ million)	$85	$81.81	$75.91	$70.84	$66.46
	B	MACRS Depreciation Rate	3.750%	7.219%	6.677%	6.177%	5.713%
	C=A*B	Annual Depreciation($ Million)	$3.19	$5.91	$5.07	$4.38	$3.80
	D=A-C	Book Value of depreciable Assets at End of year($ million)	$81.81	$75.91	$70.84	$66.46	$62.67
		CASH FLOW ANALYSIS (Cash Flows in $ Million)
	N	Year (From Today)	0	1	2	3	4	5	6	7	8
	a	Investment cash flow	($54)	($31)
	b	Sales Revenue				$17.00	$28.00	$37.00	$40.00	$43.00
	c=b*65%	Total Variable Costs				-$11.05	-$18.20	-$24.05	-$26.00	-$27.95
	d	Fixed Cost				($2.40)	($2.40)	($2.40)	($2.40)	($2.40)
	e	Depreciation expenses				($3.19)	($5.91)	($5.07)	($4.38)	($3.80)
	f=b+c+d+e	Profit before tax				$0.36	$1.49	$5.48	$7.22	$8.85
	g=f*40%	Tax expense				-$0.15	-$0.60	-$2.19	-$2.89	-$3.54
	h=f+g	After tax profit(Rupees million)				$0.22	$0.90	$3.29	$4.33	$5.31
	i	Add: Depreciation (non cash expense)				$3.19	$5.91	$5.07	$4.38	$3.80
	j=h+i	Operating Cash Flow				$3.41	$6.80	$8.36	$8.71	$9.11
	k	Working Capital Need(8% of next years sale)			$1.36	$2.24	$2.96	$3.20	$3.44	$3.44	(Assumed to be constant)
	l	Cash flow due to change in working capital			-$1.36	-$0.88	-$0.72	-$0.24	-$0.24	$0.00
	CF=a+j+l	Net Cash Flow( in Million USD)	-$54.0000	-$31.0000	-$1.3600	$2.5250	$6.0824	$8.1173	$8.4703	$9.1088
	m	Net Cash Flow in Year 8=Net Cash Flow in year7*1.025									$9.34
	n=m/(0.12-0.025)	Horizon Cash Flow in Year 7 =9.34/(0.12-0.025)								$98.2792
	TCF=CF+n	Total Cash Flow	-$54.0000	-$31.0000	-$1.3600	$2.5250	$6.0824	$8.1173	$8.4703	$107.3880	SUM
	PV=TCF/(1.12^N)	Present Value of Cash Flow(Million $)	-$54.0000	-$27.6786	-$1.0842	$1.7972	$3.8655	$4.6060	$4.2913	$48.5769	-$19.6259
		RECOMMENDATION:
		PROJECT NOT ACCEPTABLE , SINCE NPV is NEGATIVE
			- $54.0000 $54.0000 $31.0000 -$1.3600 $27.6786 $1.0842 $2.5250 $1.7972 $6.0824 $3.8655 $8.1173 $4.6060 $8.4703 $4.2913 $107.3880 SUM $48.5769 -$19. TCF=CF+n Total Cash Flow PV=TCF/(1.124N) Present Value of Cash Flow(Million $) RECOMMENDATION: PROJECT NOT ACCEPTABLE, SINCE NPV is NEGATIVE $19.6259 $44.46 $64.0824 $141.67 To make NPV =0, Present Value of Cash Flow of Horizon Value to be increased by Current Present Value of Horizon Cash Flow =98.2792/(1.1247) Required PV of Horizon Value =44.46+19.6259= Required Horizon Value =64.0824*(1.1247)= 9.1088/(0.12-g)=141.67 0.12-g=9.1088/141.67= Required growthRate for NPV=0, g=0.12-0.064297845= Required growth rate for NPV=0 0.064297845 0.0557 5.57%