Corporate Finance

Solution for Assignment 2

Question 1

Galt Motors currently produces 500, 000 electric motors a year and expects output levels to re-
main steady in the future. It buys armatures from an outside supplier at a price of $2.50 each.
The plant manager believes that it would be cheaper to make these armatures rather than buy
them. Direct in-house production costs are estimated to be only $1.80 per armature. The neces-
sary machinery would cost $700,000 and would be obsolete in 10 years. This investment would be
depreciated to zero for tax purposes using a 10-year straight line depreciation. The plant manager
estimates that the operation would require additional working capital of $40,000 but argues that
this sum can be ignored since it is recoverable at the end of the ten years. The expected proceeds
from scrapping the machinery after 10 years are estimated to be $10,000. Galt Motors pays tax at
a rate of 35% and has an opportunity cost of capital of 14%.
What decision should Galt Motors take regarding manufacturing the armatures in house?

A. Proceed with in house manufacture since NPV is negative

B. Proceed with in house manufacture since NPV is positive

C. Reject in-house manufacture since NPV is negative

D. Reject in-house manufacture since IRR is greater than 14%

Answer: B

Explanation: B) CF (0) = −700, 000 − 40, 000 = −740, 000

CF (1 − 9) = 500, 000 × ($2.50 − $1.80) × (1 − 0.35) + .35 × 700, 000/10 = 252000
CF (10) = 500, 000 × ($2.50 − $1.80) × (1 − 0.35) + .35 × 700, 000/10 + 40, 000 + (1 − 0.35) ∗ 10000 =
298500

NPV = 587004.23$

Question 2

Two years ago the Krusty Krab Restaurant purchased a grill for $50,000. The owner, Eugene
Krabs, has learned that a new grill is available that will cook Krabby Patties twice as fast as the
existing grill. This new grill can be purchased for $80,000 and would be depreciated straight line
over 8 years, after which it would have no salvage value. Eugene Krab expects that the new grill
will produce EBITDA of $50,000 per year for the next eight years while the existing grill produces

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EBITDA of only $35,000 per year. The current grill is being depreciated straight line over its useful
life of 10 years after which it will have no salvage value. All other operating expenses are identical
for both grills. The existing grill can be sold to another restaurant now for $30,000. The Krusty
Krab’s tax rate is 35%. If the Krusty Krab’s opportunity cost of capital is 12%, what is the NPV for
upgrading to the new grill?

Answer

CF0 = −80, 000 + 30, 000 + .35(40, 000 − 30, 000) [tax write off old grill sold at loss]= −46, 500

Incremental EBITDA = 50, 000 − 35, 000 = 15, 000

Incremental Depreciation = 80, 000/8 − 50, 000/10 = 5, 000
Incremental cash flow (years 1 - 8)= (15, 000 − 5, 000) × (1 − .35) + 5, 000 = 11, 500
CF0 = −46, 500, CFj = 11, 500 for j = 1, ..., 8 , r = 0.12, compute NPV = 10, 627.86

Question 3

The Sisyphean Corporation is considering investing in a new cane manufacturing machine that
has an estimated life of three years. The cost of the machine is $30,000 and the machine will be
depreciated straight line over its three-year life to a residual value of $0.
The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are esti-
mated to grow by 10% per year each year through year three. The price per cane that Sisyphean
will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to
manufacture of $9 each.
Installation of the machine and the resulting increase in manufacturing capacity will require
an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation
needs to hold one year in advance: 2% of its annual sales in cash, 4% of its annual sales in accounts
receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The
firm is in the 35% tax bracket.
Calculate the total Free Cash Flows for each of the three years for the Sisyphean Corporation’s
new project.

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Answer:

Incremental Earnings Forecast

Year 1 2 3
Units 2,000 2,200 2,420
Sales (units × $18) 36,000 39,600 43,560
Cost of Good Sold (units × $9) 18,000 19,800 21,780
Gross Profit 18,000 19,800 21,780
Depreciation ($30,000 / 3) 10,000 10,000 10,000
EBIT 8,000 9,800 11,780
Income tax at 35% 2,800 3,430 4,123
Unlevered net income 5,200 6,370 7,657
Add back Depreciation 10,000 10,000 10,000
Cash Flows from Operations 15,200 16,370 17,657

Networking Capital Forecast

Year 1 2 3
Sales (units × $18) 36,000 39,600 43,560
Cash (2% of sales) 720 792 871.2
Accounts Receivable (4% of sales) 1440 1584 1742.4
Inventory (9% of sales) 3240 3564 3920.4
Accounts Payable (6% of sales) 2160 2376 2613.6
NWC (Cash + Inventory+ AR - AP) 3240 3564 3920.4
Change (investment) in NWC -3240 -324 -356.4 3920.4

Investment in machine -30,000

Total Free Cash Flows -33,240 14,876 16,013.6 21,577.4

Question 4

Zensation is a luxury cosmetics brand which considers introducing a new perfume, VitaS. Set-
ting up the production of the new product will require up-front investment of 1 million dollars.
After that sales are expected to be 2 million dollars per year or 6 million dollars per year with
equal probability. The profit margin (defined here as EBIT/Sales) will 80% with probability 70%
or 40% with probability 30%.
Investment in net working capital will amount to 10% of sales and depreciation to 30% of
CAPX. The latter will be 5% of Sales with 50% probability and 10% of Sales with 50% probability.
The new project will completely displace the sales of the existing VitaM perfume. Sales,
CAPX/Sales and margin are mutually statistically independent. Furthermore, once their first

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value is realized, they will stay constant over time. For VitaM, current Sales are 10 million dollars
and they are projected to decline by 20% for sure every year. The profit margin will stay at 20%
every year, no new investment (or disinvestment) in net working capital will be made and capital
expenditure will equal depreciation.
Corporate taxes are 20% and Zensation discounts cash flows at 10% rate. Find the probability
distribution of the VitaS project.

Answer:

First pin down the value of the VitaM project:

Next year sales will be 10 ∗ (1 − 0.2) = 8 million dollars

Next year EBIT will be 8 ∗ 0.2 = 1.6 million dollars

Next year FCF will be 1.6 ∗ (1 − 0.2) = 1.28. From then on cash flows will decline by 20%.

The present value of the FCF of the VitaM project is : 1.28/(0.1 + 0.2) = 4.267 million dollars

To calculate the value of the VitaS project, we create scenarios over the different random vari-
able realizations, we assign probabilities to them and calculate the VitaS incremental value within
each one of them.

Prob Sales Margin CAPX/Sales FCF

0.5*0.7*0.5=0.175 2 80% 0.05 1.01
0.5*0.7*0.5=0.175 6 80% 0.05 3.03
0.5*0.3*0.5=0.075 2 40% 0.05 0.37
0.5*0.7*0.5=0.075 6 40% 0.05 1.11
0.5*0.7*0.5=0.175 2 80% 0.1 0.94
0.5*0.7*0.5=0.175 6 80% 0.1 2.82
0.5*0.3*0.5=0.075 2 40% 0.1 0.3
0.5*0.7*0.5=0.075 6 40% 0.1 0.9

Scenario 1:

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 FCF = 2 ∗ 0.8 ∗ (1 − 0.2) − 0.05 ∗ 2 ∗ (1 − 0.3) − 0.1 ∗ 2 = 1.01

PV ( FCF ) = 10.1
Incremental value of VitaS= 10.1 − 1 − 4.267 = 4.833

Scenario 2:

FCF = 6 ∗ 0.8 ∗ (1 − 0.2) − 0.05 ∗ 6 ∗ (1 − 0.3) − 0.1 ∗ 6 = 3.03

PV ( FCF ) = 30.3
Incremental value of VitaS= 30.3 − 1 − 4.267 = 25.033

Scenario 3:

FCF = 2 ∗ 0.4 ∗ (1 − 0.2) − 0.05 ∗ 2 ∗ (1 − 0.3) − 0.1 ∗ 2 = 0.37

PV ( FCF ) = 3.7
Incremental value of VitaS= 3.7 − 1 − 4.267 = −1.567

Scenario 4:

FCF = 6 ∗ 0.4 ∗ (1 − 0.2) − 0.05 ∗ 6 ∗ (1 − 0.3) − 0.1 ∗ 6 = 1.11

PV ( FCF ) = 11.1
Incremental value of VitaS= 11.1 − 1 − 4.267 = 5.833

Scenario 5:

FCF = 2 ∗ 0.8 ∗ (1 − 0.2) − 0.1 ∗ 2 ∗ (1 − 0.3) − 0.1 ∗ 2 = 0.94

PV ( FCF ) = 9.4
Incremental value of VitaS= 9.4 − 1 − 4.267 = 4.133
Scenario 6:

FCF = 6 ∗ 0.8 ∗ (1 − 0.2) − 0.1 ∗ 6 ∗ (1 − 0.3) − 0.1 ∗ 6 = 2.82

PV ( FCF ) = 28.2
Incremental value of VitaS= 28.2 − 1 − 4.267 = 22.933

Scenario 7:

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 FCF = 2 ∗ 0.4 ∗ (1 − 0.2) − 0.1 ∗ 2 ∗ (1 − 0.3) − 0.1 ∗ 2 = 0.3

PV ( FCF ) = 3
Incremental value of VitaS= 3 − 1 − 4.267 = −2.267

Scenario 8:

FCF = 6 ∗ 0.4 ∗ (1 − 0.2) − 0.1 ∗ 6 ∗ (1 − 0.3) − 0.1 ∗ 6 = 0.9

PV ( FCF ) = 9
Incremental value of VitaS= 9 − 1 − 4.267 = 3.733

Overall the distribution of the VitaS project is:

Prob Incremental VitaS value

0.075 -2.27
0.075 -1.57
0.075 3.73
0.175 4.13
0.175 4.83
0.075 5.83
0.175 22.93
0.175 25.03