Question 1: Use the Payback period to assess the acceptability and relative ranking of each lathe?
Question 2: Assuming equal risk, use the following capital budgeting techniques to assess the acceptability and relative ranking of each lathe:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
Question 3: Use your findings in Question 1 & 2 to indicate on both (1) a theoretical basis and (2) a practical basis, which lathe would be preferred? Explain any difference in recommendations.
Question 1: Calculate the cost of capital (WACC)?
Question 2: Calculate the FCFF?
Question 3: Calculate the Terminal Value of the company using the Gordon model?
Question 4: Compute the Firm Value (VE) discounting FCFF and the Terminal Value at the WACC?
Question 5: Assuming the net debt value amounts to M$2,500 and it exists 200 million shares, what should be the share price?
Answer to Case A: Capital Budgeting
Particulars |
Years |
Lathe A |
Lathe B |
|
|
Cash Flows |
|
Initial Investment |
0 |
$ (660,000) |
$ (360,000) |
Cash Inflow |
1 |
$ 128,000 |
$ 88,000 |
Cash Inflow |
2 |
$ 182,000 |
$ 120,000 |
Cash Inflow |
3 |
$ 166,000 |
$ 96,000 |
Cash Inflow |
4 |
$ 168,000 |
$ 86,000 |
Cash Inflow |
5 |
$ 450,000 |
$ 207,000 |
Cost of Capital: 13%
Answer 1: Payback Period
Lathe A |
|||
|
Years |
Cash Flows |
Cumulative CF |
Initial Investment |
0 |
$ (660,000) |
$ (660,000) |
Cash Inflow |
1 |
$ 128,000 |
$ (532,000) |
Cash Inflow |
2 |
$ 182,000 |
$ (350,000) |
Cash Inflow |
3 |
$ 166,000 |
$ (184,000) |
Cash Inflow |
4 |
$ 168,000 |
$ (16,000) |
Cash Inflow |
5 |
$ 450,000 |
$ 434,000 |
|
|
|
|
Payback Period of Lathe A |
4.04 |
||
|
|
|
4 years 15 days |
(Firer, 2012)
Lathe B |
|||
|
Years |
Cash Flows |
Cumulative CF |
Initial Investment |
0 |
$ (360,000) |
$ (360,000) |
Cash Inflow |
1 |
$ 88,000 |
$ (272,000) |
Cash Inflow |
2 |
$ 120,000 |
$ (152,000) |
Cash Inflow |
3 |
$ 96,000 |
$ (56,000) |
Cash Inflow |
4 |
$ 86,000 |
$ 30,000 |
Cash Inflow |
5 |
$ 207,000 |
$ 237,000 |
|
|
|
|
Payback Period of Lathe A |
3.65 |
||
|
|
|
4 years 237 days |
Answer 2:
Lathe A Net Present Value |
||||
|
Years |
Cash Flows |
PVF @ 13% |
PV @ 13 % |
Initial Investment |
0 |
$ (660,000) |
1.000 |
$ (660,000) |
Cash Inflow |
1 |
$ 128,000 |
0.885 |
$ 113,274 |
Cash Inflow |
2 |
$ 182,000 |
0.783 |
$ 142,533 |
Cash Inflow |
3 |
$ 166,000 |
0.693 |
$ 115,046 |
Cash Inflow |
4 |
$ 168,000 |
0.613 |
$ 103,038 |
Cash Inflow |
5 |
$ 450,000 |
0.543 |
$ 244,242 |
|
|
|
NPV Lathe A |
$ 58,132.88 |
(Deegan, 2013)
Lathe B Net Present Value |
||||
|
Years |
Cash Flows |
PVF @ 13% |
PV @ 13 % |
Initial Investment |
0 |
$ (360,000) |
1.000 |
$ (360,000) |
Cash Inflow |
1 |
$ 88,000 |
0.885 |
$ 77,876 |
Cash Inflow |
2 |
$ 120,000 |
0.783 |
$ 93,978 |
Cash Inflow |
3 |
$ 96,000 |
0.693 |
$ 66,533 |
Cash Inflow |
4 |
$ 86,000 |
0.613 |
$ 52,745 |
Cash Inflow |
5 |
$ 207,000 |
0.543 |
$ 112,351 |
|
|
|
NPV Lathe B |
$ 43,483.24 |
Lathe A Internal Rate of Return |
||||||
|
Years |
Cash Flows |
PVF @ 15% |
PV @ 15 % |
PVF @ 20% |
PV @ 20% |
Initial Investment |
0 |
$ (660,000) |
1.000 |
$ (660,000) |
1.000 |
$ (660,000) |
Cash Inflow |
1 |
$ 128,000 |
0.870 |
$ 111,304 |
0.833 |
$ 106,667 |
Cash Inflow |
2 |
$ 182,000 |
0.756 |
$ 137,618 |
0.694 |
$ 126,389 |
Cash Inflow |
3 |
$ 166,000 |
0.658 |
$ 109,148 |
0.579 |
$ 96,065 |
Cash Inflow |
4 |
$ 168,000 |
0.572 |
$ 96,055 |
0.482 |
$ 81,019 |
Cash Inflow |
5 |
$ 450,000 |
0.497 |
$ 223,730 |
0.402 |
$ 180,845 |
|
|
|
|
$ 17,854.27 |
|
$ (69,016) |
|
|
|
|
|
|
|
|
|
IRR Lathe A |
16.03% |
|
|
|
(Brigham and Houston, 2012)
Lathe B Internal Rate of Return |
||||||
|
Years |
Cash Flows |
PVF @ 15% |
PV @ 15 % |
PVF @ 20% |
PV @ 20% |
Initial Investment |
0 |
$ (360,000) |
1.000 |
$ (360,000) |
1.000 |
$ (360,000) |
Cash Inflow |
1 |
$ 88,000 |
0.870 |
$ 76,522 |
0.833 |
$ 73,333 |
Cash Inflow |
2 |
$ 120,000 |
0.756 |
$ 90,737 |
0.694 |
$ 83,333 |
Cash Inflow |
3 |
$ 96,000 |
0.658 |
$ 63,122 |
0.579 |
$ 55,556 |
Cash Inflow |
4 |
$ 86,000 |
0.572 |
$ 49,171 |
0.482 |
$ 41,474 |
Cash Inflow |
5 |
$ 207,000 |
0.497 |
$ 102,916 |
0.402 |
$ 83,189 |
|
|
|
|
$ 22,466.90 |
|
$ (23,115) |
|
|
|
|
|
|
|
|
|
IRR Lathe B |
17.46% |
|
|
|
Answer 3:
On the basis of theoretical decision it is recommended to the company to invest in such Lathe that yield higher return and give maximum cash flow to the company. Also various factors such as nature of investment, size, ease of operation and other relevant factors must be consider before making taking the theoretical decision. It is recommended to the company to choose Lathe A as it generates higher rate of return and also give maximum cash flows to the company.
On the basis of practical ground it is also suggested to select Lathe A as it has lower payback period, higher NPV and IRR greater than cost of capital (Baker and Nofsinger, 2010).
Answer to Case 2: Business Valuation
Answer 1: Cost of Capital WACC
Capital Type |
Weight of Capital |
Cost of Capital (After Tax) |
Weighted Cost of Capital |
Equity Capital |
66.67% |
10.00% |
6.67% |
Debt Capital |
33.33% |
4.80% |
1.60% |
|
|
WACC |
8.27% |
(Arnold, 2013)
Answer 2: Calculation of FCFF
Calculation of FCFF |
||||||
Particulars |
Years |
|||||
1 |
2 |
3 |
4 |
5 |
5 |
|
|
Amount in Million $ |
|
||||
Revenues |
$ 3,960 |
$ 4,080 |
$ 4,200 |
$ 4,326 |
$ 4,458 |
|
Less: Raw Materials |
$ (1,782) |
$ (1,794) |
$ (1,806) |
$ (1,860) |
$ (1,917) |
|
Less: Production Cost |
$ (870) |
$ (897) |
$ (924) |
$ (996) |
$ (1,026) |
|
Less: Other Cost |
$ (396) |
$ (408) |
$ (420) |
$ (432) |
$ (447) |
|
EBITDA |
$ 912 |
$ 981 |
$ 1,050 |
$ 1,038 |
$ 1,068 |
|
Less: Depreciation |
$ (330) |
$ (315) |
$ (300) |
$ (300) |
$ (300) |
|
EBIT |
$ 582 |
$ 666 |
$ 750 |
$ 738 |
$ 768 |
|
Less: Tax @ 20% |
$ 116 |
$ 133 |
$ 150 |
$ 148 |
$ 154 |
|
EAT |
$ 466 |
$ 533 |
$ 600 |
$ 590 |
$ 614 |
|
Add: Depreciation |
$ 330 |
$ 315 |
$ 300 |
$ 300 |
$ 300 |
|
EBDAT |
$ 796 |
$ 848 |
$ 900 |
$ 890 |
$ 914 |
|
|
|
|
|
|
|
|
Less: Investment |
$ (300) |
$ (300) |
$ (300) |
$ (300) |
$ (300) |
|
Less: Working Capital |
$ (50) |
$ (50) |
|
|
|
|
Add: Working Capital recovery |
|
|
|
|
$ 100 |
|
FFCF |
$ 446 |
$ 498 |
$ 600 |
$ 590 |
$ 714 |
|
(Ross, Jaffe and Kakani, 2008)
Answer 3: Calculation of Terminal Value
Calculation of Terminal Value (TV) |
||
|
|
|
FCF of last year |
$ 714.40 |
|
Perpetual Growth rate (g) |
2% |
|
Discount Rate (WACC) |
8.27% |
|
|
|
|
Formula of TV |
(FCFn x (1 + g)) / (WACC – g) |
|
Terminal Value |
11627.68 |
|
Answer 4: Enterprise Value (Firm Value)
Calculation of Firm Value |
||||||
Particulars |
Years |
|||||
1 |
2 |
3 |
4 |
5 |
5 |
|
|
Amount in Million $ |
TV |
||||
Revenues |
$ 3,960 |
$ 4,080 |
$ 4,200 |
$ 4,326 |
$ 4,458 |
|
Less: Raw Materials |
$ (1,782) |
$ (1,794) |
$ (1,806) |
$ (1,860) |
$ (1,917) |
|
Less: Production Cost |
$ (870) |
$ (897) |
$ (924) |
$ (996) |
$ (1,026) |
|
Less: Other Cost |
$ (396) |
$ (408) |
$ (420) |
$ (432) |
$ (447) |
|
EBITDA |
$ 912 |
$ 981 |
$ 1,050 |
$ 1,038 |
$ 1,068 |
|
Less: Depreciation |
$ (330) |
$ (315) |
$ (300) |
$ (300) |
$ (300) |
|
EBIT |
$ 582 |
$ 666 |
$ 750 |
$ 738 |
$ 768 |
|
Less: Tax @ 20% |
$ 116 |
$ 133 |
$ 150 |
$ 148 |
$ 154 |
|
EAT |
$ 466 |
$ 533 |
$ 600 |
$ 590 |
$ 614 |
|
Add: Depreciation |
$ 330 |
$ 315 |
$ 300 |
$ 300 |
$ 300 |
|
EBDAT |
$ 796 |
$ 848 |
$ 900 |
$ 890 |
$ 914 |
|
|
|
|
|
|
|
|
Less: Investment |
$ (300) |
$ (300) |
$ (300) |
$ (300) |
$ (300) |
|
Less: Working Capital |
$ (50) |
$ (50) |
|
|
|
|
Add: Working Capital recovery |
|
|
|
|
$ 100 |
|
FFCF |
$ 446 |
$ 498 |
$ 600 |
$ 590 |
$ 714 |
$ 11,628 |
|
|
|
|
|
|
|
PVF @ 8.27% (WACC) |
$ 1 |
$ 1 |
$ 1 |
$ 1 |
$ 1 |
$ 1 |
Present Value |
$ 412 |
$ 425 |
$ 473 |
$ 430 |
$ 480 |
$ 7,815 |
|
|
|
|
|
|
|
Firm Value |
$ 10,034 |
|
|
|
|
|
(Peterson and Fabozzi, 2002)
Answer 5: Calculation of Share Price
Calculation of Share Price |
||
Enterprise Value (Firm Value) |
$ 10,034.21 |
Million |
Less: Debt Value |
$ 2,500.00 |
Million |
Equity Value |
$ 7,534.21 |
Million |
Number of Equity Shares |
200 |
Million |
Share Price |
$ 37.67 |
|
(Krantz, 2016)
Arnold, G., 2013. Corporate financial management. Pearson Higher Ed.
Baker, H.K. and Nofsinger, J.R. 2010. Behavioral Finance: Investors, Corporations, and Markets. John Wiley & Sons.
Brigham, F., and Houston, J. 2012. Fundamentals of financial management. Cengage Learning.
Deegan, C., 2013. Financial accounting theory. McGraw-Hill Education Australia.
Firer, C. 2012. Fundamentals of Corporate Finance. Berkshire.McGraw-Hill.
Krantz, M. 2016. Fundamental Analysis for Dummies. John Wiley & Sons.
Peterson, P,P and Fabozzi,F,J,. 2002. Capital budgeting: theory and practice. John Wiley & sons.
Ross, A., Jaffe, J. and Kakani, R.K. 2008. Corporate Finance. Pearson.
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