Learning Outcomes:
LO 4 Assess investment opportunities by using Capital budgeting techniques
LO 5 Evaluate investments in working capital and long-term assets
Capital Budgeting - Case Study
As she headed toward her boss's office, Fatima , chief operating officer for the Alpha Emirates Corporation-a logistics company-wished she could remember more of her training in financial management that she had been exposed to in college. Fatima had just completed the following tasks:
- Analyzing the financial statements of its nearest competitor and their own performance. She was not quite pleased with their performance. The competitor was performing much better.
- Summarizing the financial aspects of four capital investment projects that were open to Alpha-Emirates Corp during the coming year, she was faced with the task of recommending which should be selected.
Fatima had to explain their financial performance in the previous year and convince her boss to agree on investing in a project for future growth.
What concerned her was the knowledge that her boss, Mariam Smart, a "street smart" chief executive, with no background in financial theory, would immediately favor the project that promised the highest gain in reported net income. Fatima knew that selecting projects purely on that basis would be incorrect; but she wasn't sure of her ability to convince Mariam, who tended to assume finance people thought up fancy methods just to show how smart they were.
As she prepared to enter Mariam's office, Fatima pulled her summary sheets from her briefcase and quickly reviewed the details of the four projects, all of which she considered to be slight risky and therefore used a discount rate of between 9% and 12% as the minimum acceptable rate of return. The company uses a straight-line method for calculating depreciation and the company's tax rate is 30%.
Proposal -A:
This proposal is to add a jet to the company's fleet. The plane was only six years old and was considered a good buy at $250,000. In return, the plane would bring over $600,000 in additional revenue during the next five years with only about $56,000 in operating costs. The cost of capital is 10%.
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YR-0
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YR-1
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YR-2
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YR-3
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YR-4
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YR-5
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Initial investment
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(250,000)
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|
|
|
|
|
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Additional Revenue
|
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43,000
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76,800
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112,300
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225,000
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168,750
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Additional operating costs
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11,250
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11,250
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11,250
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11,250
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11,250
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Depreciation
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50,000
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50,000
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50,000
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50,000
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50,000
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Proposal -B:
This proposal is to diversify into shipping and the purchase of a container ship. The new business was expected to generate over $1.4 million in sales over the next five years. The cost of capital is 10%
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YR-0
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YR-1
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YR-2
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YR-3
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YR-4
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YR-5
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Initial investment
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(700,000)
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|
|
|
|
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Additional Revenue
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87,500
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175,000
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262,500
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393,750
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525,000
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Additional operating costs
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26,250
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26,250
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26,250
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26,250
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26,250
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Depreciation
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140,000
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140,000
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140,000
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140,000
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140,000
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Proposal-C:
This proposal is to buy a helicopter. The machine was expensive and, counting additionaltraining and licensing requirements, would cost $40,000 a year to operate. However, the versatility that the helicopter was expected to provide would generate over $1.5 million in additional revenue, and it would give the company access to a wider market as well. The cost of capital is 10%.
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YR-0
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YR-1
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YR-2
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YR-3
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YR-4
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YR-5
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Initial investment
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(800,000)
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|
|
|
|
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Additional Revenue
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100,000
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200,000
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300,000
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450,000
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600,000
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Additional operating costs
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40,000
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40,000
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40,000
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40,000
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40,000
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Depreciation
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160,000
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160,000
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160,000
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160,000
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160,000
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Proposal - D:
This proposal is to begin operating a fleet of trucks. Ten could be bought for only $51,000 each, and the additional business would bring in almost $700,000 in new sales in the first two years alone. The cost of capital is 10%.
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YR-0
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YR-1
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YR-2
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YR-3
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YR-4
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YR-5
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Initial investment
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(510,000)
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|
|
|
|
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Additional Revenue
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382,500
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325,125
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89,250
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76,500
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51,000
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Additional operating costs
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31,000
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31,000
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31,000
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31,000
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31,000
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Depreciation
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102,000
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102,000
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102,000
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102,000
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102,000
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In her mind, Fatima quickly went over the evaluation methods she had used in the past: payback, internal rate of return, and net present value. Fatima herself favored the net present value method, but she had always had a tough time getting Mariam to understand it.
One additional constraint that Fatima had to deal with was Mariam's insistence that no outside financing be used this year. Mariam was worried that the company was growing too fast and had piled up enough debt for the time being. She was also against a stock issue for fear of diluting earnings and her control over the firm. As a result of Mariam's prohibition of outside financing, the size of the capital budget this year was limited to $800,000, and with limited staff in the finance department, only one of the four projects under consideration could be chosen. Fatima wasn't too happy about that, either, but she had decided to accept it for now, and concentrate on selecting the best of the four.
As she closed her briefcase and walked toward Mariam's door, Fatima reminded herself to have patience; Mariam might not trust financial analysis, but she would listen to sensible arguments. Fatima only hoped her financial analysis sounded sensible!
Part B:
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Gamma corporation
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AlphaCorporation
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Sales
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$
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985,000
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$
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560,000
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Less: Cost of sales
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650,000
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397,000
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Gross profit
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335,000
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163,000
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Less: Selling and Admin. Expenses
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124,000
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|
75,000
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EBIT
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211,000
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88,000
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Less: Interest
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35,000
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10,000
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EBT
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176,000
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78,000
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Less: Taxes
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58,000
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25,000
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EAT
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118,000
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53,000
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|
|
|
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Balance Sheets as at Dec 31, XXX
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ASSETS
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|
|
|
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Current Assets
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$
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$
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$
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$
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Cash
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50,000
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45,000
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A/Receivable
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170,000
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395,000
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Inventory
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155,000
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140,000
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|
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Total Current assets
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375,000
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580,000
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Fixed Assets
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765,000
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610,000
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Total assets
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1,140,000
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1,190,000
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LIABILITIES
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|
|
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Current Liabilities
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|
|
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A/Payable
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235,000
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300,000
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Other payables
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130,000
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125,000
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Total Current Liabilities
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365,000
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425,000
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Long term Debt
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220,000
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270,000
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Total Liabilities
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585,000
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695,000
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SHAREHOLDERS' EQUITY
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|
|
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Common Stock
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450,000
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440,000
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Retained Earnings
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105,000
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|
55,000
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Total Shareholders' Equity
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555,000
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495,000
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Total Liab. & Sh. Equity
|
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1,140,000
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1,190,000
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Requirements:
This is an individual project.
Part A:
You will use MS-Excel to do the calculations in this case.
(Use a different worksheet for each of these proposals - Ex: Sheet 1 - Proposal A; Sheet 2 - Proposal B)
1. Calculate the Cash flows for each of the proposals.
2. Calculate the following for each of the proposals in the case
a. Payback period
b. Net Present value (NPV)
c. Internal rate of return (IRR)
d. What would happen if operating cost were 10% higher than expected?
e. What would happen if operating costs were 10% lower than expected?
3. You will write a short report to Mariam Smart, Chief executive officer of Alpha Emirates Company.
a. Your report should include your complete financial analysis
b. Recommendation as to which proposal should be adopted and the reasons for your recommendation in order to address her concerns and convince her of your choice.
You will submit the following:
c. The Excel spreadsheet - complete with calculations
d. Report to the CEO, Mariam Smart
Part B:
(You can use MS-Excel to do the ratios)
Analyze the financial statements of both Alpha & Gamma Corporations on the four key areas:
1. Liquidity
2. Asset Utilization
3. Debt Utilization
4. Profitability
A detailed analysis is expected in each of these four areas with suggestions for improvement.