F402 In-Class Exercise - Capital Budgeting

September 8, 2020

1. New Product. S&S Fitness Company is considering adding a line of treadmills for out-of-
shape dogs. The project will require an initial investment of $440,000 in new machinery that
has a life of 4 years. Depreciation will be charged on a straight-line basis to 0. S&S
estimates the worn-out equipment to be worth about $20,000 at the end of 4 years. Projected
revenues are $600,000 for next year, and will grow at the forecasted inflation rate of 3% in
each of the following three years, after which S&S Fitness will end the project. The
projected cost-of-goods-sold excluding depreciation is 50% of revenues, and the tax rate is
40%. S&S has arranged an attractive $440,000 bank loan at 6% and plans to use this source
of financing since it is considerably less than his cost of capital of 9%. The project makes
use of other resources that his firm already has:

 Two employees of the firm, each with a salary of $40,000 a year and who are currently
employed by another division, will be transferred to this project. The other division has
no alternative use for them, but they are covered by a union contract that will prevent
them from being fired for two years (during which they would be paid their current
salary).
 The project will use excess capacity in the current packaging plant. While this excess
capacity has no alternative use now, it is estimated that the firm will have to invest
$180,000 in a new packaging plant in year 2 as a consequence of this project using up
excess capacity instead of year 4 as originally planned. This equipment is depreciated
straight-line to a zero salvage value over two years.
 The project will use other equipment transferred from another facility owned by the firm.
This equipment has a resale value of $200,000 and a book value of $100,000. If the
equipment is kept rather than sold, its remaining book value can be depreciated next year.
When the project ends in year 4, the equipment will have a salvage value of $80,000.

Find the NPV of the project.

2. Expansion: New Store. Greiner’s Sushi Bar and Bait Shops are a small chain of shops with
an unusual marketing strategy. At the front of each store is a sushi bar; given the uncertain
demand for sushi and its short shelf life, Greiner prepares and sells the restaurant waste as
fishing bait from an area adjacent to the restaurant. As he loves to say: “Today’s plate is
tomorrow’s bait!”

Dan Greiner, CEO, is thinking of adding an additional store and has asked for your help in
evaluating the desirability of the investment. His estimates of the costs and benefits of the
new store are drawn from the experience of his five existing stores. The building will be
leased for a five years; the company will have to make investment in the building and fund
the start up process. Please evaluate the investment strategy by calculating a net present
value using a discount rate of 10%.

Start up investment:

Furniture and fixtures: $55,000

Inventory: $10,000
Advertising $1000

Operating benefits:

Operating profit before taxes ($2,000) in year 1;

and depreciation (EBITDA): $10,000 in year 2;
$25,000 in years 3 to 5

Depreciation: Furniture and fixtures straight line depreciated over 5 years;

Residual value of $5,000 after 5 years.

Other information: Corporate tax rate is 40%

Calculate a NPV using the above information and make a recommendation regarding the start
up.
3. Acquisition Valuation. We are considering the acquisition of a small company that serves
as one of our current suppliers. Revenues are currently $30 million and are expected to grow
at 5% per year for the next 10 years. Operating expenses, excluding depreciation, average
85% of revenues. Fixed assets are fully depreciated and in good shape, except for a $1.5
million expenditure planned for year 5. This will be depreciated straight line over five years.
Working capital tends to be proportional to revenues at 8% of sales. At the end of the
explicit forecast horizon, we estimate that free cash flows will grow at 4% a year in
perpetuity. The WACC for this business is 11%. What is the value of this company?