# Capital Budgeting Case Study

Part A

Introduction

The starting point in solving this problem is the determination of the relevant cash flows. These are simply those cash flows that are affected as a result of implementing the project (Gitman and Zutter, 2012, p.428). Determining what amounts to relevant cash flows often calls for understanding some costs that would not ordinarily be considered as relevant. The \$750,000 already spent in developing a prototype and the \$200,000 spent in conducting a marketing study are clearly not relevant in considering whether to proceed with the project. Such costs are often called sunk costs (Gitman and Zutter, 2012, p.429).

Capital budgeting is only concerned with changes in cash either as expenditure or as revenues. Items such as depreciation that do not have any impact on the moment of cash are thus supposed to be left out in any estimation of the relevant cash flows. The depreciation rate provided in the current example will only be useful in so far as it helps in determining the amount of corporate tax. The table below shows the inputs as given in the task. Most of the other calculations are shown on the attached excel worksheet.

 Inputs: Variable cost per unit \$                      205 Yearly fixed costs \$ 5,100,000 Unit price \$ 485 Initial investment in equipment \$        34,100,000 Depreciable years 7 Srap value of equipment \$          5,500,000 Net working capital as % tage of sales 20% Corporate tax rate 30% Required return 12% Yearly sales units: Year 1 64,000 Year 2 106,000 Year 3 87,000 Year 4 78,000 Year 5 54,000

The \$750,000 and \$200,000 said to have been used in development and marketing have been deliberately left out from the table on the basis that they are not relevant to this decision. There is absolute nothing that EMU Electronics can do about those two items as they remain spent irrespective of whether the project is undertaken. The next table shows a summary of the relevant cash flows. Detailed calculations can be found in the attached excel worksheet.

Table showing the net cash flows

 Y0 Y1 Y2 Y3 Y4 Y5 Net Cash Flow(\$) 34,500,000 4,244,571 14,610,571 16,803,571 14,069,571 22,865,714

The payback period

This is the amount of time its takes for a project to be able to recoup all the money invested in it (Gitman and Zutter, 2012, p.431). Calculating the payback period requires one to include another section for cumulative net cash flows as shown below:

 Net Cash \$      (34,500,000) \$            4,244,571 \$    14,610,571 \$    16,803,571 \$    14,069,571 \$      22,865,714 Cumulative Cash \$      (34,500,000) \$       (30,255,429) \$ (15,644,857) \$      1,158,714 \$    15,228,286 \$      38,094,000

Profitability index

This is often a ratio of the present value of net cash inflows over the present value of net cash out flows. The calculation from the attached excel template shows it to be 1.4.

The internal rate of return (IRR)

Defined as the discount rate that equates the net present value to zero (Gitman and Zutter, 2012, p.430). The figure as computed from our attached excel worksheet is 25%.

The Net Present Value (NPV)

The calculation of this figure from the attached excel worksheet also shows that it is \$14,813,792.

Sensitivity of NPV to price changes and quantities sold

The fact that the IRR is 25% is an indicator that the NPV of the project can still be positive even over a long range of discount rates. This is also a proxy to the ability of the NPV to withstand changes in both prices and quantities sold without necessarily sliding into the negative for a long time.

Whether to produce the new phone

With a payback period of 2.9 years, it does not take long for the project to recover the invested capital which makes it recommendable. The shorter it takes to recover the invested capital the more recommended a project is from the perspective of the payback period.EME should, therefore proceed if looked at from the Payback Period perspective. The same recommendation is also arrived at when looked at from the perspective of NPV which requires proceeding with all projects having positive NPVs and the more than 1 profitability index. Coupled with the fact that the project can remain viable even with a discount rate of 25%, the overall conclusion is that the company should proceed with it.

Affect of sales on other models to analysis

Loses of sales on other models would affect the analysis by requiring that the quantified loses are factored in the estimation of relevant cash flows. Those quantified losses would easily be dealt with as opportunity costs (Gitman and Zutter, 2012, p.432).Their effect is to lower the net cash flows of the project in each year.

Part B

Cost of Capital for Hubbard Computer Ltd

Step 1

(Harvey Norman, 2015, p.59).

 Debt(\$000) Equity(\$000) Book value 290,000 2,556,860

Step 2

 Value Most recent stock price \$5.19 Market value of equity \$5.77Billion Number of shares outstanding 1.11 Billion Most recent annual dividend N/A Beta N/A Whether I can use Dividend Discount Model No since there is no dividend

The yield on a 10-Year Australian government bond as at 29 September 2016 was 1.94 %( Bloomerg, 2016, p.1). You Finance seem not to have had this information and the group had to source it from alternative sources. The figure obtained from bloomerg was confirmed to be correct when checked against information in ASX website (ASX, 2016, p.1).

Under the CAPM, the formula for computing the cost of equity is given as below (Jordan and Miller, 2012, p.403):

Where:

The risk free rate is often taken as the yield on a 10-year government bond which has been found to be 1.94%. It is not necessary to know the expected return on the market given that the pure play firm has a beta of zero. Below are the calculations.

The cost of equity for Harvey Norman is, therefore also 1.94%

Step 3

Calculating the cost of debt

Debt as used in the calculation of the weighted average cost of capital should always mean long-term debt (Gitman & Zutter, 2012, p.362). This is the case since it is the long-term financing that businesses use to finance their long-term projects. Having this in mind would mean that Harvey Norman only has the debt of \$290,000,000 as long-term interest bearing loan.  A weight of 100% must be attributed to this figure as it is 100% of all the long-term debts.

A look at the table for all business lending rates at Westpac reveals that the 6.35% rate attributed to long-term finance products could be equivalent to the rate that Harvey Norman is supposed to pay in respect of the loan(Westpac, 2016,p.1).The weighted average cost of debt is easily calculated since it is equivalent to the figure just selected from Westpac. This is 6.35% before tax.

It does not matter in this particular case whether one uses book or market value weights respectively. This conclusion is drawn from the fact that Harvey Norman only has one type of debt and which is:

Step 4

Calculating the WACC

Using the market value weights

It should be pointed out that the kind of debts held by Harvey Norman is not traded and it is, therefore, impossible to attribute any market value to them. The conclusion from this must, therefore, be that WACC can only be computed from the book value weights.

Using book value weights

Potential problems

The only possible problem with the pure play approach is the selection of a pure play firm. It is not possible for two firms to be similar in all relevant respects. This means that the results of the calculations can only be estimates.

References 