Capital Budgeting

Example 1
Mai Linh is a fashion chain. It is considering introducing a new line of African fashion in its
Mai Linh paid Tuan Bach $0.5mn to research the market. The results suggest that custome
Expected annual sales $30 mn. Purchasing from suppliers in Africa costs $10 mn.
Upfront R&D and marketing expenses $10 mn. No upfront investment needed. No new sh
Additional R&D, advertising, selling, advertising and general costs $5 mn each year.
Annual expenses to operate the current European shops $100 mn. Total current annual sa
African fashion to be trendy in 4 years. Then noone will buy thus Mai Linh will stop selling.
Corporate tax rate 40%. Debt-Equity ratio 1:1. Costs of equity and pre-tax debt are 10% an
Debt-equity ratio to remain constant.
a) Evaluate the project.
b) Suppose that African fashion sales will continue forever after year 4. Evaluate the proje

Evaluation of the Project

STEP 1: ESTIMATE FREE CASH FLOW

a) Estimation of Free cash flows figures in $ mn
Year 0 1 2 3 4
Sales 30 30 30 30
less Costs of Sales 10 10 10 10
Gross Profit 20 20 20 20
less Operating expenses 10 5 5 5 5
EBIT -10 15 15 15 15
less Income tax @40% 0 6 6 6 6
Unlevered Net Income -10 9 9 9 9
Free Cash Flow -10 9 9 9 9
0.111
STEP 2: ESTIMATE THE COST OF CAPITAL PB=1+0.111=1.111year
WACC = 0.5*10+0.5*6*(1-0.4) 8.427
= 6.8 % 7.8904 0.1994
PB=1.1994
STEP 3: CALCULATE NPV
b) NPV = -10+9/1.068+9/1.068^2+9/1.068^3+9/1.068^4
= 19.854
IRR= 81%

PI= 2.9854 298%

PB=
 African fashion in its European shops.
suggest that customers like African fashion.
osts $10 mn.
nt needed. No new shops.
mn each year.
otal current annual sales $500 mn.
i Linh will stop selling.
e-tax debt are 10% and 6% respectively.

4. Evaluate the project.