Growth Enterprise , Inc.

(GEI)

Project Type of cash flow Year 0 Year 1 Year 2 Year 3

A. Investment -$10,000 0 0 0
Revenue 0 $21,000 0 0
Operating expense 0 $11,000 0 0
Lifespan 1
Depreciation $10,000
Free Cash Flow $10,000
B. Investment -$10,000 0 0 0
Revenue 0 $15,000 $17,000 0
Operating expense 0 $5,833 $7,833 0
Lifespan 2
Depreciation $5,000 $5,000
Free Cash Flow $7,500 $7,500
C. Investment -$10,000 0 0 0
Revenue 0 $10,000 $11,000 $30,000
Operating expense 0 $5,555 $4,889 $15,555
Lifespan 3
Depreciation $3,333 $3,333 $3,333
Free Cash Flow $4,000 $5,000 $10,000
D. Investment -$10,000 0 0 0
Revenue 0 $30,000 $10,000 $5,000
Operating expense 0 $15,555 $5,555 $2,222
Lifespan 3
Depreciation $3,333 $3,333 $3,333
Free Cash Flow $10,000 $4,000 $3,000

1-a). Calculate Payback of each project and rank the four projects in order of preference based on payback approach (

Project Initial Outlay Year 1 Year 2 Year 3 Payback Period

A $10,000 $0 $0 1
Outstandin -10000 $0 $0 $0
B $7,500 $7,500 $0 0.33 1.33
Outstandin -10000 -$2,500 $5,000 $5,000
C $4,000 $5,000 $10,000 0.10 2.1
Outstandin -10000 -$6,000 -$1,000 $9,001
D $10,000 $4,000 $3,000 1
Outstandin -10000 $0 $4,001 $7,001

Payback period is 1 year for project A, 1.33 years for project B, 2.1 years for project C and 1 year for project D

1-b). Calculate IRR of each project and rank the four projects in order of preference based on IRR (2 points).

A B C D
Initial Outl -$10,000 -$10,000 -$10,000 -$10,000
Year 1 $10,000 $7,500 $4,000 $10,000
Year 2 $0 $7,500 $5,000 $4,000
Year 3 $0 $0 $10,000 $3,000
IRR 0.00% 31.88% 33.53% 42.75%

1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the projects in order of preference

A B C D
Year 0 -$10,000 -$10,000 -$10,000 -$10,000
Year 1 $10,000 $7,500 $4,000 $10,000
Year 2 $0 $7,500 $5,000 $4,000
Year 3 $0 $0 $10,000 $3,000
NPV -$909.09 $3,016.88 $5,282.24 $4,651.32

1-d). If the projects are independent of each other, which should be accepted? If they are mutually exclusive, which on

If the projects are independent of each other, projects B, C, and D should be accepted because they have a
positive IRR and NPV that is greater than the cost of capital.

If the projects are mutually exclusive and only one can be accepted, Project D should be accepted because it
has the highest IRR, shortest payback time, and second-highest NPV, just behind project C.
ased on payback approach (1 point).

Payback Period
years

years

years

years

1 year for project D

on IRR (2 points).
ojects in order of preference (2 points)

mutually exclusive, which one is best? Explain why. (1 point)

ause they have a

ccepted because it
C.
Electronics Unlimited (EU)
Sales
Year 1 $10,000,000
Year 2 $13,000,000
Year 3 $13,000,000
Year 4 $8,667,000
Year 5 $4,333,000
Cost of Sales 60% of sales
SGA Expenses 23.50% of sales
Tax Rate 40%
New Specialized Equipment $500,000
Net Working Capital 27% of sales
Introductory expenses
Year 1 $200,000
Life of equipment 5 years

2-a) Estimate the new product's cash flows (3 points)

Year 0 1 2
Sales $10,000,000 $13,000,000
Cost of Sales $6,000,000 $7,800,000
SGA Expense $2,350,000 $3,055,000
Depreciation $100,000 $100,000
Introductory Expense $200,000
Income before tax $1,350,000 $2,045,000
Tax $540,000 $818,000
Net Income $810,000 $1,227,000
Operating Cash Flow $910,000 $1,327,000
Working Capital $2,700,000 $3,510,000 $3,510,000
Change in Working Capital -$2,700,000 -$810,000 $0
Equipment -$500,000
Total cash flows -$3,200,000 $100,000 $1,327,000

2-b) Assuming a 20% cost of capital, what is the products net present value? What is its internal rate of return? Shoul

Cost -$3,200,000
Free Cash Flow
Year 1 $100,000
Year 2 $1,327,000
Year 3 $2,496,910
Year 4 $2,068,213
Year 5 $1,638,877
Cost of Capital 20%
Net Present Value $905,862.19
IRR 29.55%

EU should introduce the new product because the NPV is positive and the IRR is greater than the cost of capital. The
NPV means that the project generates a surplus after all costs, including financing costs. The IRR of 29.55% is higher
20% cost of capital implying that the rate of return on the project is more than the desired rate.
 3 4 5
$13,000,000 $8,667,000 $4,333,000
$7,800,000 $5,200,200 $2,599,800
$3,055,000 $2,036,745 $1,018,255
$100,000 $100,000 $100,000

$2,045,000 $1,330,055 $614,945

$818,000 $532,022 $245,978
$1,227,000 $798,033 $368,967
$1,327,000 $898,033 $468,967 Net income + depreciation
$2,340,090 $1,169,910 $0
$1,169,910 $1,170,180 $1,169,910 Working capital recovered

$2,496,910 $2,068,213 $1,638,877

s its internal rate of return? Should EU introduce the new product? Explain why? (2 points).

ater than the cost of capital. The positive

osts. The IRR of 29.55% is higher than the
sired rate.
Value-Added Industries, Inc. (VAI)
3-a) What is the net present value of this project (1 point)?

Present Value of Cash Flow $210,000

Initial Investment -$110,000
NPV $100,000

3-b) How many shares of common stock must be issued, and at what price to raise the required capital? (1 point)

Number of shares outstanding 10,000

Market value of shares $100
Existing value of shares $1,000,000
NPV $100,000
Total Value $1,100,000
Value per share $110
Amount to be raised $110,000
Number of shares to be issued 1000

To raise the required capital, VAI should issue 1000 shares of common stock at $110 each.

3-c) What is the effect, if any, of this new project on the value of the stock of existing shareholders? (1 point)

The new project has increased the value of existing stock from $100 to $110 per share.
required capital? (1 point)

hareholders? (1 point)
 FIN 500 Assignment 4, due 08/21/11, 9:00 pm California time Total points 14

This assignment provides you an opportunity to practice estimating cash flow for capital
budgeting projects (chapter 12), using the common approaches in capital budgeting
(chapter 13) such as payback, internal rate of return and net present value in choosing
project , using Excel functions such as irr() and npv() to calculate IRR and NPV. To
complete this assignment, students need to get familiar with course content in chapter 12
and chapter 13.

Problems in this assignment are chosen from Harvard Business Schools Case on Valuing
Capital Project and are revised by the instructor. This assignment should be done as an
individual work. Your completed Assignment 4 should be saved and submitted as an
Excel workbook file, i.e., .xls file. The filename should begin assign4, then your last name
and first letter of your first name. For example, if Allen Smith completes this assignment,
he should name this assignment as assign4SmithA, save and submit it as an Excel
workbook file (.xls file). 10% of this assignment points will be deducted if its not
named or formatted as required.

There are three problems in this assignment, each problem has several questions.

1. Growth Enterprise , Inc. (GEI) has $40 million that it can invest in any or all of the
capital investment projects (A, B, C, D), which have cash flows as shown in the
following table.
Table 1. Comparison of Project Cash Flows ($ thousand dollars)
Project Type of Year 0 Year 1 Year 2 Year 3
cash flow
A. Investment -$10,000 0 0 0
Revenue 0 $21,000 0 0
Operating 0 $11,000 0 0
expense

B. Investment -$10,000 0 0 0
Revenue 0 $15,000 $17,000 0
Operating 0 $5,833 $7,833 0
expense

C. Investment -$10,000 0 0 0
Revenue 0 $10,000 $11,000 $30,000
 Operating 0 $11,000 0 0
expense

B. Investment -$10,000 0 0 0
Revenue 0 $15,000 $17,000 0
Operating 0 $5,833 $7,833 0
expense

C. Investment -$10,000 0 0 0
Revenue 0 $10,000 $11,000 $30,000
Operating 0 $5,555 $4,889 $15,555
expense

D. Investment -$10,000 0 0 0
Revenue 0 $30,000 $10,000 $5,000
Operating 0 $15,555 $5,555 $2,222
expense
All revenues and operating expenses can be considered cash items.

Each of these projects is considered to be of equivalent risk. The investment will be depre
to zero on a straight- line basis for tax purpose. For simplicity, the depreciation per year

1-a). Calculate Payback of each project and rank the four projects in order of preference
based on payback approach (1 point).

1-b). Calculate IRR of each project and rank the four projects in order of preference
based on IRR (2 points).

1-c). Assuming a 10% discount rate, calculate the NPV of the four projects and rank the
projects in order of preference (2 points)

1-d). If the projects are independent of each other, which should be accepted? If they are
mutually exclusive, which one is best? Explain why. (1 point)

Hint: You need to estimate the free cash flows (FCF) to the firm first, FCF = EBIT(1 tax
rate) + depreciation Gross fixed asset expenditure change in net operating working
lifornia time Total points 14

estimating cash flow for capital

oaches in capital budgeting
net present value in choosing
calculate IRR and NPV. To
with course content in chapter 12

usiness Schools Case on Valuing

signment should be done as an
be saved and submitted as an
begin assign4, then your last name
Smith completes this assignment,
and submit it as an Excel
s will be deducted if its not

oblem has several questions.

on that it can invest in any or all of the four

ich have cash flows as shown in the

housand dollars)
1 Year 2 Year 3

0 0
000 0 0
000 0 0

0 0
000 $17,000 0
33 $7,833 0

0 0
000 $11,000 $30,000
000 0 0

0 0
000 $17,000 0
33 $7,833 0

0 0
000 $11,000 $30,000
55 $4,889 $15,555

0 0
000 $10,000 $5,000
555 $5,555 $2,222

ed cash items.

lent risk. The investment will be depreciated

simplicity, the depreciation per year for a

four projects in order of preference

projects in order of preference

PV of the four projects and rank the

hich should be accepted? If they are

(1 point)

to the firm first, FCF = EBIT(1 tax

change in net operating working
 2. Electronics Unlimited (EU)was considering the introduction of a new product that
had 5 years of life and was expected to generate sales in Year 1 through 5 as the
following:
Year 1 Year 2 Year 3 Year 4
$10,000, 000 $13,000,000 $13,000,000 $8,667,000

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 was 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, EU 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 of the new product. There would be no salvage
value left for the equipment 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
been made. EU generally required 27 cents of net working capital to support each
dollar of sales. That is, change in net working capital is 27% of change in sales. As a
practical matter, the buildup of working capital would have to be made at the
beginning of the sales year in question (or, equivalently, by the end of the previous
year). For example, Sales in year 2 were expected to be $13,000 thousand, $3,000

Finally, EU expected to incur tax-deductible introductory expenses of $200,000 in the

first year of the new products sales. Such cost would not be recurring over the
products life cycle. Approximately $800,000 had already been spent developing and
testing marketing the new product.

2-a) estimate the new products cash flows. (3 points)

2-b) Assuming a 20% cost of capital, what is the products net present value? What is
its internal rate of return? Should EU introduce the new product? Explain why? (
points).

Note: Except for the change in net working capital, which must be made before the
testing marketing the new product.

2-a) estimate the new products cash flows. (3 points)

2-b) Assuming a 20% cost of capital, what is the products net present value? What is
its internal rate of return? Should EU introduce the new product? Explain why? (
points).

Note: Except for the change in net working capital, which must be made before the
3. You are the CEO of Value-Added Industries, Inc. (VAI). Your firm has 10,000
shares of common stock outstanding, and the current price of the stock is $100 per
share. The firm does not have any debt. You discover an opportunity 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 this investment by issuing new equity. All
potential buyers of your common stock will be fully aware of the projects value
and cost, and are willing to pay fair value for the new share of VAI common
stock.

3-a) What is the net present value of this project (1 point)?

3-b) How many shares of common stock must be issued, and at what price to raise the
required capital? (1 point). Hint: the stock price should reflect the value created by
the investment opportunity.

3-c) What is the effect, if any, of this new project on the value of the stock of existing