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Question:

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:

1. Net Present Value (NPV)
2. 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%

 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

 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%

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 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)

 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)

References

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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My Assignment Help. Capital Budgeting And Business Valuation [Internet]. My Assignment Help. 2021 [cited 16 June 2024]. Available from: https://myassignmenthelp.com/free-samples/fin505-foundations-of-financial/financial-accounting-theory.html.

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