Valuing Capital Investment Projects
The investment will be depreciated to zero on a straight-line basis for tax purposes. Gee’s marginal corporate tax This case was prepared as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Problem 1 appears in the case, “Introduction to Investment Evaluation Techniques” (HUBS case no. 285-115) by Professor Dwight B. Crane and was revised for inclusion in this case. Problems 3 and 4 appear in the case, “Investment Analysis and Lockheed Trig Star”(HUBS case no. 91-031) by Professor Michael E. Doodles and were also revised for inclusion in this case. Copyright 1997 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means?electronic, mechanical, photocopying, recording, or otherwise ?without the permit session of Harvard Business School. 98-092 rate on taxable income is 40%. None of the projects will have any salvage value at the ND of their respective lives. For purposes of analysis, it should be assumed that all cash flows occur at the end of the year in question. A. Rank Gee’s four projects according to the following four commonly used capital budgeting criteria: Payback period. 2) Accounting return on investment. For purposes of this exercise, the accounting return on investment should be defined as follows: Average annual after-tax profits (Required investment)/2 2.
Internal rate of return. 4) Net present value, assuming alternately a 10% discount rate and a 35% discount rate. Why do the rankings differ? What does each technique measure and what assumptions does it make? If the projects are independent of each other, which should be accepted? If they are mutually exclusive (I. E. , one and only one can be accepted), which one is best? Electronics Unlimited was considering the introduction of a new product that was expected to reach sales of $10 million in its first full year, and $13 million of sales in the second year.
Because of intense competition and rapid product obsolescence, sales of the new product were expected to remain unchanged between the second and third years following introduction. Thereafter, annual sales were expected to decline to two-thirds of peak annual sales in the fourth year, and one-third of peak sales in the fifth year. No material levels of revenues or expenses associated with the new product were expected after five years of sales. Based on past experience, cost of sales for the new product were expected to be 60% of total annual sales revenue during each year of its life cycle.
Selling, general, and administrative expenses were expected to be 23. 5% of total annual sales. Taxes on profits generated by the new product would be paid at a 40% rate. To launch the new product, Electronics Unlimited would have to incur immediate cash outlays of two types. First, it would have to invest $500,000 in specialized new production equipment. This capital investment would be fully depreciated on a straight-line basis over the five-year anticipated life cycle of the new product. It was not expected to have any material salvage value at the end of its depreciable life.
No further fixed capital expenditures were required after the initial purchase of equipment. Second, additional investment in net working capital to support sales would have to e made. Electronics Unlimited generally required ICC of net working capital to support each dollar of sales. As a practical matter, this buildup would have to be made by the beginning of the sales year in question (or, equivalently, by the end of the previous year). As sales grew, further investments in net working capital ahead of sales would have to be made.
As sales diminished, net working capital would be liquidated and cash recovered. At the end of the new product’s life cycle, all 2 Finally, Electronics Unlimited expected to incur tax-deductible introductory expenses f $200,000 in the first year of the new product’s sales. These costs would not be recurring over the product’s life cycle. Approximately $1. 0 million had already been spent developing and test marketing the new product. These expenditures were also one-time expenses that would not be recurring during the new product’s life cycle. 3.
Estimate the new product’s future sales, profits, and cash flows throughout its five- year life cycle. Ass miming a 20% discount rate, what is the product’s net present value? (Except for changes in net working capital, which must be made before the start of each sales ear, you should assume that all cash flows occur at the end of the year in question. ) What is its internal rate of return? Should Electronics Unlimited introduce the new product? You are the CEO of Value-Added Industries, Inc. (VA’). Your firm has 10,000 shares of common stock outstanding, and the current price of the stock is $100 per share.
There is no debt; thus, the “market value” balance sheet of VIA appears as follows: VIA Market Value Balance Sheet Equity Assets You then discover an opportunity to invest in a new project that produces positive net cash flows with a present value of $210,000. Your total initial costs for investing and developing this project are only $110,000. You will raise the necessary capital for will be fully aware of the project’s value and cost, and are willing to pay “fair value” for the new shares of VIA common. 4. What is the net present value of this project?
How many shares of common stock must be issued, and at what price, to raise the required capital? What is the effect, if any, of this new project on the value of the stock of the existing shareholders? Lockheed Trig Star and Capital Budgeting In 1971 , the American aerospace company, Lockheed, found itself in Congressional earnings seeking a $250 million federal guarantee to secure bank credit required for the completion of the L-1011 Trig Star program. The L-1011 Trig Star Airbus was a wide- bodied commercial Jet aircraft with a capacity of up to 400 passengers, competing with the DC-10 trisect and the BAOBAB airbus.
Various estimates of the initial development costs ranged between $800 million and $1 billion. A reasonable approximation of these cash outflows would be $900 million, occurring as follows: End of Year Time “Index” Cash Flow ($ millions) 1967 1968 1969 1970 1971 -$100 -$200 According to Lockheed testimony, the production phase was to run from the end of 1971 to the end of 1977 with about 210 Trig Stars as the planned output. At that production rate, the average unit production cost would be about $14 million per aircraft. The inventiveness’s production costs would be relatively front-loaded, so that the $490 million ($14 million per plane, 35 planes per year) annual production costs could be assumed to occur in six equal increments at the end of years 1971 through 1976 (t=4 through t=9). Revenues million per aircraft. These revenue flows would be characterized by a lag of a year to the production cost outflows; annual revenues of $560 million could be assumed to occur in six equal increments at the end of years 1972 through 1977 (t=5 through t=10).
Inflation-escalation terms in the contracts ensured that any future inflation- based cost and revenue increases offset each other nearly exactly, thus providing no incremental net cash flow. Deposits toward future deliveries were received from Lockheed customers. Roughly nonstarter of the price of the aircraft was actually received two years early. For example, for a single Trig Star delivered at the end of 1972, $4 million of the price was received at the end of 1970, leaving $12 million of he $16 million price as cash flow at the end of 1972.
So, for the 35 planes built (and presumably, sold) in a year, $140 million of the $560 million in total annual revenue was actually received as a cash flow two years earlier. 2 This figure excludes preproduction cost allocations. That is, the $14 million cost figure is totally separate from the $900 million of preproduction costs shown in the table above. 4 Discount Rate Experts estimated that the cost of capital applicable to Locoweed’s cash flows (prior to Trig Star) was in the 9%-10% range.