Chapter6:InvestmentDecisionRules

DataCase
OnOctober6,2004,SiriusSatelliteRadioannouncedthatithadreachedanagreementwithHowardSternto
broadcasthisradioshowexclusivelyontheirsystem.Asaresultofthisannouncement,theSiriusstockprice
increaseddramatically.YouarecurrentlyworkingasastockanalystforalargeinvestmentfirmandXMRadio,
alsoasatelliteradiofirm,isoneofthefirmsyoutrack.YourbosswantstobepreparedifXMfollowsSiriusin
tryingtosignamajorpersonality.Therefore,shewantsyoutoestimatethenetcashflowsthemarkethad
anticipatedfromthesigningofStern.SheadvisesthatyoutreatthevalueanticipatedbythemarketastheNPV
ofthesigning,thenworkbackwardfromtheNPVtodeterminetheannualcashflowsnecessarytogeneratethat
value.Thepotentialdealhadbeenrumoredforsometimepriortotheannouncement.Asaresult,thestockprice
forSiriusincreasedforseveraldaysbeforetheannouncement.Thus,yourbossadvisesthatthebestwayto
captureallofthevalueistotakethechangeinstockpricefromSeptember28,2004,throughOctober7,2004.
Younodyourheadinagreement,tryingtolooklikeyouunderstandhowtoproceed.Youarerelativelynewto
thejobandthetermNPVissomewhatfamiliartoyou.

Date
Oct 7, 2004
Oct 6, 2004
Oct 5, 2004
Oct 4, 2004
Oct 1, 2004
Sep 30, 2004
Sep 29, 2004
Sep 28, 2004

Open
3,98
4,26
3,34
3,24
3,23
3,14
2,88
2,74

High
4,16
4,29
3,35
3,31
3,35
3,22
3,02
2,77

Low
3,91
3,67
3,28
3,21
3,12
3,12
2,86
2,60

Close
4,00
3,87
3,35
3,24
3,14
3,20
3,02
2,65

Volume
206,666,500
343,630,900
72,087,700
64,923,100
69,406,300
94,501,100
105,622,600
39,418,900

1.

Todeterminethechangeinstockpriceoverthisperiod,gotoYahoo!Finance
(http://finance.yahoo.com)andenterthestocksymbolforSirius(SIRI).ThenclickHistoricalPrices
andentertheappropriatedates.Usetheadjustedclosingpricesforthetwodates.

2.

Todeterminethechangeinvalue,multiplythechangeinstockpricebythenumberofshares
outstanding.Thenumberofsharesoutstandingaroundthosedatescanbefoundbygoingto
http://finance.google.comandtypingSIRIintotheSearchwindow.Next,selecttheIncome
Statementlinkontheleftsideofthescreen,andthenselectAnnualDataintheupperrighthand
corner.TheDilutedWeightedAverageSharescanbefoundforthe12/31/2007incomestatementon
thatpage.

http://www.google.com/finance?q=NASDAQ:SIRI&fstype=ii

Adj Close*
4,00
3,87
3,35
3,24
3,14
3,20
3,02
2,65

3.

BecausethechangeinvaluerepresentstheexpectedNPVoftheproject,youwillhavetofindthe
annualnetcashflowsthatwouldprovidethisNPV.Forthisanalysis,youwillneedtoestimatethecost
ofcapitalfortheproject.Weshowhowtocalculatethecostofcapitalinsubsequentchapters;fornow,
usetheNewYorkUniversity(NYU)costofcapitalWebsite
(http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.htm).Locatethecostofcapital
inthefarrightcolumnfortheEntertainmentTechindustry.

4.

UsethecostofcapitalfromtheNYUWebsiteandtheNPVyoucomputedtocalculatetheconstant
annualcashflowthatprovidesthisNPV.Computecashflowsfor5,10,and15yearhorizons.

5.

YourbossmentionedthatshebelievesthattheHowardSternsigningbySiriuswasactuallygoodfor
XMbecauseitsignaledthattheindustryhasvaluablegrowthpotential.Toseeifsheappearstobe
correct,findthepercentagestockpricereactiontoXM(XMSR)overthissameperiod.

Chapter 7: Fundamentals of Capital Budgeting

Data Case
NovoNordiskA/Sisahealthcarecompanyengaginginthediscovery,development,andmanufactureof
pharmaceuticalproducts.ItsspecialtyisdiabetescareanditsheadquartersareinBagsvaerd,Denmark.The
companysellsitsproductsallovertheworld,includingintheUnitedStates,Japan,China,Russia,India,and
Europe.
AsanewmemberofthecapitalbudgetingdivisionofNovoNordiskA/S,youhavebeenaskedtodeterminethe
netcashflowsandNPVofaproposednewdiabetesdrug.Thedrugisexpectedtobeonthemarketforthree
yearsonly,becauseNovoexpectstolaunchanewandbetterversionofthedruginthenearfuture.Iftheproject
isinitiated,itwillrequireanexpenditureonresearchanddevelopmentof4%ofthetotalamountthatNovospent
onresearchanddevelopmentinthelastfinancialyear.Also,aninvestmentinanewproductionfacility,whichis
estimatedtocost$24million,willbenecessary.
Theproductrevenuesforyears1,2,and3areexpectedtobe0.8%,0.6%,and0.4%,respectively,ofthetotal
revenueofNovoforthelastfinancialyear.Thecostofgoodssoldisprojectedtobe$8millioninyears1and2,
butonly$5millioninyear3.Finally,theselling,general,andadministrativecostsareassumedtobe$3million
inyears1and2,butonly$2millioninyear3.

1. In order to obtain the latest financial statement of Novo Nordisk, go

to Yahoo! Finance (http://finance.yahoo.com/) and search for Novo
Nordisk by entering the companys ticker symbol, NVO. Go to
Financials and download the income statement and the balance
sheet. Export them to Excel by right clicking while the cursor is
inside each statement. When estimating the project details, use data
for the most recent year for which the financial statements are
available.
2. Novo has decided that the investment in the production facility
should be depreciated with the straight-line method over the life of
the project. Determine the amount of depreciation each year.
3. Calculate the corporate tax rate that Novo paid for the last financial
year.

4. Use the result of Questions 2 and 3 to calculate the unlevered net

income of the project for years 0 to 3.
5. In years 1 to 3, the inventory of the project is 1.5 million, receivables
are 15% of the project revenues, and payables are 20% of the
projects cost of goods sold. Assume that the project requires no
cash. Find the net working capital for the project for each year 1 to
3. Also, find the change in net working capital for each year when
assuming the project is terminated in year 3 and that net working
capital has to be settled the year after the project endsthat is, find
the change in net working capital for years 1 to 4.
6. Calculate the free cash flow for years 0 to 4 using Eq. 7.5. Note that
you can use the unlevered net income from Question 4.
7. Find the net present value of the project from the calculated free
cash flows when assuming that the cost of capital (CoC) for Novo is
12%. You may use the NPV function in Excel. Include cash flows 1
through 4 in the NPV function and then subtract the initial cost (i.e.,
add the initial cash flow CF0, which is a negative number).
NPV(CoC;CF1:CF4)+CF0

8. For a presentation of the new project to your colleagues in Novos

capital budgeting division, make a plot of the NPV as a function of
the cost of capital. First, calculate the NPV of the project for a range
of different assumptions of cost of capital (e.g., 5%, 10%, 15%, . . .,
40%). Then, plot the calculated NPVs as a function of the
corresponding cost of capital. From the figure, note the internal rate
of return of the project. Verify your result using Excels IRR function.