1) The document provides financial data for VEC to evaluate a new production system project, including calculating WACC, cash flows, and profitability measures.
2) Key capital budgeting techniques - NPV, IRR, MIRR, payback period - are calculated to determine if the project is profitable.
3) Sensitivity and scenario analysis are conducted to evaluate the stand-alone risk of the project under different economic conditions. This helps assess the project's risk and uncertainty.
1) The document provides financial data for VEC to evaluate a new production system project, including calculating WACC, cash flows, and profitability measures.
2) Key capital budgeting techniques - NPV, IRR, MIRR, payback period - are calculated to determine if the project is profitable.
3) Sensitivity and scenario analysis are conducted to evaluate the stand-alone risk of the project under different economic conditions. This helps assess the project's risk and uncertainty.
1) The document provides financial data for VEC to evaluate a new production system project, including calculating WACC, cash flows, and profitability measures.
2) Key capital budgeting techniques - NPV, IRR, MIRR, payback period - are calculated to determine if the project is profitable.
3) Sensitivity and scenario analysis are conducted to evaluate the stand-alone risk of the project under different economic conditions. This helps assess the project's risk and uncertainty.
1) The document provides financial data for VEC to evaluate a new production system project, including calculating WACC, cash flows, and profitability measures.
2) Key capital budgeting techniques - NPV, IRR, MIRR, payback period - are calculated to determine if the project is profitable.
3) Sensitivity and scenario analysis are conducted to evaluate the stand-alone risk of the project under different economic conditions. This helps assess the project's risk and uncertainty.
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LEADSTAR UNIVERSTY COLLEGE
FINANCIAL MANAGMENT ASSIGNMENT
DEPARTMENT OF LEADERSHIP& MANAGEMENT PROGRAM
ESPECIALIZATION IN ORGANIZATIONAL LEADERSHIP
SECOND BACH
PREPARED BY:
ID NO:
September 1, 2015 Adama Ethiopia
0 The capital budgeting decision is one of the most important financial decisions in business firms. In this case, variety enterprises corporation (VEC) is considering whether to invest in a new production system. To determine if the project is profitable, VEC must first determine the weighted average cost of capital to finance? The project. The simple payback periods, discounted payback period, net present value (NPV, internal rate of return (IRR), and modified internal rate of return (MIRR) techniques are used to study the profitability of the project. MIRR is a relatively new capital budgeting technique, which assumes that the reinvestment rate of the projects intermediary cash flows is the firms cost capital. The stand-alone risk of the project is evaluated with the sensitivity analysis and scenario analysis techniques assuming that manufacturing the new product would not affect the current market risk analysis techniques explained in standard finance textbooks in a real- world setting. The case is best suited for MBA and Master of accounting students and is expected to take approximately three to four hours to complete. The case may also be appropriate for under graduate senior finance majors.
Questions
Question 1: Calculate VEC WACC using the data in exhibit 1.
Solution 1: Cost of Debt: (the FV/PV charts, a financial calculator or a spreadsheet can be used in the calculation): rd=8%
1. CAPM:rs-rRf+(RPM)=0.05+(0.05)(1.2)=11% 2. DCF: rs {Do(1+g)/Po}rs ={$1(1+0.05)/$19.08}+0.05=10.5% 3. Own Bond-Yield-Plus-Risk-premium: rs=rd+Bond RP=0.08+0.035=11.5% 4. Cost of retained earnings (averages rs)=(11%+10.5%+11.5%)/3=11% 5. Cost of new common stock = 11%/(1-0.1) = 12.2% 6. WACC = Wd rd (1-T) +Wps Rps+Wre rs+Wncs re = (0.3) (0.08) (1-0.4)+(0.1)(0.093)+(0.6) (80,000/180,000) (0.11)+(0.6)(100,000/180,000)(0.122)=9.37%
1 Question 2: calculate the project’s cash flows using the data in exhibit 2. Why is it important to take into account the effect of inflation in forecasting the cash flows? Briefly comment
CF due to NOWC (56,250.00) (1,687.50) (1,738.13) (1,790.27) 61456.90
Salvage Cash Flow 24,000.00
Net Cash Flow ($356,250.00) $127,912.50 $144,961.88 $111,690.73 $192,211.32
The discount rate generally includes an inflation premium. If the cash flows are not adjusted for
inflation. The project’s NPV would be understated.
Question3: Evaluate the profitability of the project with the NPV, MIRR, simple payback period,
and methods. Is the project acceptable? Briefly explain. Why is the MPV method superior the other
methods of capital budgeting? Briefly explain.
Solution3: students can use the FV/PV charts, a fiancial calculator or an excel spreadsheet in the
calculation of the NPV, IRR and MIRR
NPV = $101,598.73 Simple payback period = 2.75 years
3 IRR = 21.17% Discounted pay back period = 3.24 years.
MIRR = 16.45%
The NPV technique is superior to the other techniques of capital budgeting. The goal of financial management is to maximize the market value of the firm. The NPV of a project shows the contribution of the project to the market value of the firm. The NPV method’s reinvestment rate assumption is also more realistic compared with the IRR method. Question 4: conduct the stand-alone risk analysis of the project with the sensitivity analysis and scenario analysis techniques. Explain why sensitivity analysis and scenario analysis can be useful tools in the capital budgeting decision-making process when economic and financial conditions are likely to change the future. Solution 4: Assume that WACC is 1 percentage point higher (9.37%+1%=10.37%): (use the same cash flow as in question 2 and 3 above but higher discount rate to find the project’s NPC) NPV = $91,250.68 Assume that WACC is 1 percentage point lower (9.37%-1% =8.37%): (use the same cash flows as in question 2 and 3 above but a lower discount rate to find the project’s NPV). NPV =$112,337.47 Assume that the project’s sales revenues and costs (excluding depreciation) are 10% higher: calculate new cash close and find the NPV of the project using the base WACC calculated in Answer 1). Operation Cash Flows: Year 1 Year 2 Year 3 Year 4
Net Cash Flow ($350,625.00) $119,081.25 $135,865.69 $102,321.66 $176,230.18
NPV @ 9.37% = $73,214.23
Best cash scenario: Sales revenues and cost (excluding depreciation) are 10% highest, and WACC is 1 percentage point lower: (Student uses the cash flows calculated above with 10% higher revenues, 10% higher costs, and discounts these cash flows to the present by using 9.37%-1% = 8.37% discount rate (New WACC):
Worst-Case Scenario: Sales revenues and costs (excluding depreciation) are 10% lower, and WACC is 1 percentage point higher. (student uses the cash flows calculated above with 10% lower revenues, 10%
6 lower costs, and discounts these cash flows to the present by using 9.37%+1% =10.37% discount rate (new WACC):
Sensitivity analysis and scenario analysis can be useful tools in the capital budgeting decision- making process when economic and financial conditions are likely to change in the future.
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