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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:

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)

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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