Fundamental of Capital Budgeting. Case Application
Immediately after their graduation, Hawazen, Maha, Rolaand Layan decided to start their own business, HMRLCorporation. At the beginning, HMRL Corp. is expected to be a modest sweet factory that will develop a unique product called the HMRL Sweet basket which will be delivered to the home of their selected gourmet customers.
The initial investment is around SR 20 million which is comprised by the building SR 5 million, the kitchen and office equipment of SR 12 million and the 20 trucks (SR 150,000 each) to distribute the product 24x7 across the city.
The useful life of the building is estimated to be around 25 years, equipment 10 years, and vehicles 4 years.
The setup of the project will take one year. During the first year the marketing department projects sales of 100,000 units, increasing in the following years as indicated below:
Y2: +10%; Y3: +55%; Y4: 35% and by Y5 the sales will decrease by -5%.
The unitary sale price is considered at SR 150 along the horizon period.
The production cost and the administration cost are considered as 30% and 15% of the price, respectively.
To penetrate the market and considering that they will do business with premium customers, they assume their credit sales will be around 30% of their total. Meanwhile to respond quickly to demand they will have inventory of raw materials equivalent to 25% of their production cost.
In addition, they will keep credit with their main suppliers estimated at 15% of their production cost.
They should not forget to pay their taxes (40% of the income).
Finally, due the substantial drop of the projected sales in Year 5, our investors assumed that they will liquidate the company at the end of that year. The market value of the building is SR 7 million and the equipment is SR 4 million. However, the vehicles will not be sold as it will be fully depreciated.
1) Assuming that the appropriate discount rate is 20%, should they go ahead with this investment?
2) What happens if the sale volumes remain flat after the first year of the opening? Do you consider that the project has a high sensitivity to the sale volumes changes?
3) In order to be prudent and avoid the loss of all their savings, our investors developed a "Worst Case Scenario" to evaluate their project.
The main assumptions of the Worst Case Scenario are as follows:
Worst case Scenario Assumptions'
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Oiscotrit rate increase by
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7%
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Annual growth in sales is only
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ID%
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Initial Investment higher by SR
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5,000,000
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A/R & Inventory increased to
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35%
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Production & Adrrin cost up by
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3%
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Increment: 50% Building; 50% to Equipment
a. Please interpret the results.
In order to be prudent and avoid the loss of all their savings, our investors developed a "Worst Case Scenario" to evaluate their project. The main assumptions of the Worst Case Scenario are as follows: (all the other variables remain unchanged; assume the straight-line method for depreciation)
Worst case Scenario Assumptions
Amua growth ii sales is only 5%
Initial Inyearnent higher by 5R 10,000,000
Production & Adrnli cost up by 5% (The Kist 5 ye as after th at sales saltine are assumed as uncial plan} Invested an the factor/ huddlig
a. What is the Worst case scenario NPV and IRR, should they accept the project? Please interpret the results.