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Case - Canyon Buff’s Chemical Equipment  This case is a simple capital budgeting exercise that should reinforce your understanding of the following topics:  • Incremental unlevered net income • Free cash flow • Sensitivity analysis and scenario analysis   Before solving this case, you must watch the video “Capital Budgeting in-class exercise solution” in the Lecture 6 folder, which provides the basis for this case. You need to finish both lectures 6 and 7 to be able to complete the case study.   Introduction Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment. • The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future (i.e., the actual useful life is effectively infinite).    • Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6\% until the end of sixth year. After that, the sales will grow at the estimated 2\% annual rate of inflation in perpetuity.   • The cost of goods sold is estimated to be 72\% of sales.   • The accounting department also estimates that at introduction in Year 0, the new products required initial net working capital will be $6,000,000. In future years accounts receivable are expected to be 15\% of the next year sales, inventory is expected to be 20\% of the next year’s cost of goods sold and accounts payable are expected to be 15\% of the next year’s cost of goods sold.   • The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1 million of this amount is the overhead expense that will be incurred even if the project is not accepted.   • The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year.   • The annual interest expense tied to the project is $1,000,000.  2    • Canyon Buff has a cost of capital of 20\% and faces a marginal tax rate of 30\% and an average tax rate is 20\%.   Instructions   I posted an incomplete Excel template for your analysis. You need to figure out how to construct the pro forma income statements and calculate the incremental unlevered net income. You should include ONLY the factors that will affect your capital budgeting decision. Revise the template if necessary.   Note that your analysis should be set up so the assumptions that impact the cash flow estimates can be easily changed to identify the sensitivity of your calculations to these assumptions. Never hardcode in excel (see the pdf “Using Excel in Capital Budgeting” on blackboard).   There are three sheets in the template. Use the worksheet “NPV” for questions 1 to 4, and the other two sheets for questions 5 and 6.   Submit your Excel spreadsheet through the blackboard. Clearly show your work so that I can trace your numbers.   Questions  1.  Use Excel to construct six-year pro forma income statements and calculate the incremental unlevered net income for the first six years.  • When calculating incremental unlevered net income, should we include all the expenses mentioned in the case? If not, what expenses should we exclude and why? Clearly and concisely state your reasons in the cell E9 of the excel template. If you just forecast the unlevered net income but don’t given any explanations on why you exclude certain expenses, a penalty of 30 points will deducted from your grade for the case study.  2.  Calculate six-year projections for free cash flows. Remember to include cash flows from the income statement and depreciation, changes in net working capital, and capital expenditures or dispositions.   Hint: You need to calculate the level of net working capital (NWC) and change in NWC. Pay attention to the timing of NWC.  3.  Canyon Buff expects that free cash flow from Year 6 onwards will increase at a constant rate of 2\%/year into the indefinite future. Calculate PV(terminal value that captures the value of future free cash flows in Year 6 and beyond). That is, calculate the terminal value first, then find its value in Year 0 (today).   3   Hint:  We went over this in Lecture Note 6, so let me briefly review the key points: a. Assuming the cash flows grow at a constant rate g after Year N+1, then     Year N TV = (Year N+1 CF)/(r−g)   (from growing perpetuity formula).  where r is discount rate For example, if {FCF6, FCF7, FCF8, …} is a growing perpetuity, then Year 5 TV = Year 6 FCF/(r-g). Similarly, if {FCF7, FCF8, FCF9, …} is a growing perpetuity, then Year 6 TV = Year 7 FCF/(r-g).   b. We should discount this Terminal Value back to Year 0.  4.  Determine the NPV of the project. Remember to net out any initial cash outflows.   5. Perform a sensitivity analysis by varying the four parameters as follows:  Parameter Initial Assumption Worst Case Best Case Sales in Year 1 $30,000  $27,000  $33,000  NPV    Sales Growth through Year 6 6\% 0\% 10\% NPV      Cost of Goods Sold (\% of Sales) 72\% 77\% 67\% NPV      Cost of Capital 20\% 23\% 17\% NPV        For example, vary the parameter “Sales in Year 1” from the worst case $27,000 to the best case $33,000, holding all the other parameters fixed (at the level of initial assumptions). Then fill in the highlighted blank boxes for NPV in Excel (the sheet “Sensitivity Analysis”)  Do the same thing for the other three parameters.  Suppose you are the financial manager, if you are asked to use limited resources to refine the assumption on ONLY ONE of the above four parameters, which one should you choose and why? Clearly state the reason. Write your answer in Excel.  6.  Perform a scenario analysis by simultaneously varying the two parameters below:  4      Sales Growth through Year 6  \% Cost of  Goods Sold NPV Scenario 1 (Baseline) 5\% 71\%  Scenario 2 6\% 72\%  Scenario 3 8\% 73\%  Scenario 4 9\% 74\%     Which scenario generates the highest NPV? Write your answer in Excel.NPV Case - NPV Calculation Assumptions (Amounts in $ Thousands Unless Otherwise Indicated) Initial Capital Expenditure Useful Life of Equipment Annual Depreciation Sales in Year 1 Sales Growth through Year 6 Question: When calculating incremental unlevered net income, what expenses should we exclude and why? Sales Growth Year 6 Onward Answer: Free Cash Flow Year 6 Onward Cost of Goods Sold (\% of sales) Incremental SG&A Expense Market Research Expense Initial Net Working Capital Accounts Receivable \% of Next Year Sales Inventory \% of Next Year COGS Accounts Payable \% of Next Year COGS Interest Expense Tax Rate Cost of Capital Year Year Year Year Year Year Year Unlevered Income Statements 0 1 2 3 4 5 6 Sales Unlevered Net Income Working Capital Calculations Inventory Accounts Receivable Accounts Payable NWC Level Change in NWC CF from Change in NWC Unlevered Cash Flows Unlevered Net Income Add Back: Depreciation CF from Change in NWC CF from Capital Expenditure Free Cash Flow Year 5 Terminal Value (FCFs in Year 6 and beyond) Discount Factor FCF Present Value NPV in which PV(Year 5 Terminal Value) &CG Times,Bold&11Joyces Juice: Solution &CG Times,Regular&11Page &P Sensitivity Analysis Copy your baseline projections to this sheet, so that your sensitivity analysis wont alter your baseline result in the NPV sheet. Sensitivity Analysis Parameter Initial Assumption Worst Case Best Case Sales in Year 1 $30,000 $27,000 $33,000 NPV Sales Growth through Year 6 6\% 0\% 10\% NPV Cost of Goods Sold (\% of Sales) 72\% 77\% 67\% NPV Cost of Capital 20\% 23\% 17\% NPV Question: Suppose you are the financial manager, if you are asked to use limited resources to refine the assumption on ONLY ONE of the above four parameters, which one should you choose and why? (fill in the blanks highlighted in yellow) Answer: Scenario Analysis Copy your baseline projections to this sheet, so that your scenario analysis wont alter your baseline result in the NPV sheet. Scenario Analysis Sales Growth through Year 6 \% Cost of Goods Sold NPV Scenario 1 (Baseline) 5\% 71\% Scenario 2 6\% 72\% Scenario 3 8\% 73\% Scenario 4 9\% 74\% Question: Which scenario generates the highest NPV? (fill in the blanks highlighted in yellow) Answer:Opportunity Costs The opportunity cost of using a resource is the value it could have provided in its best alternative use. E.g. suppose a firm bought a production line which will be placed in a warehouse that the company could have otherwise rented out for $20,000 per year. Should you include this opportunity cost when calculating free cash flow? Example 1 See notes underneath the slide Q: Should you include this opportunity cost when calculating free cash flow? A: Yes, because the firm forgoes $20,000 when choosing to place the production line in the warehouse instead of having it rented out. The opportunity cost would reduce the firm’s incremental sales annually by the amount of $20,000 e.g. if incremental sales =$5,000, then the firm is better off by having the warehouse rented out. The opportunity cost would reduce the firm’s incremental cash flows annually by this amount: $20,000× (1 − Tax Rate) 1 Opportunity Costs If don’t take the project, just rent out the warehouse If take the project, but exclude the opportunity cost when calculating FCFs. Prone to make wrong decisions. Tend to accept this project, but it is a WRONG decision. 2 Years EBIT 0 1 2 3 4 0 20K 20K 20K 20K Years EBIT 0 1 2 3 4 -4K 5K 5K 5K 5K How to Account for Opportunity Costs Should include the opportunity cost when evaluating the project Because the firm forgoes $20,000 when choosing to place the production line in the warehouse instead of having it rented out. How? deduct the opportunity cost from the incremental sales Conclusion from the above timeline: Don’t take the project. Right decision. 3 Years EBIT 0 1 2 3 4 -4K 5K−20K 5K −20K 5K −20K 5K −20K Sunk Costs Sunk costs are costs that have been or will be paid regardless of the decision whether or not the investment is undertaken. Sunk costs should NOT be included in the incremental earnings analysis. Past Research and Development Expenditures Money that has already been spent on R&D is a sunk cost and therefore irrelevant. The decision to continue or abandon a project should be based only on the incremental costs and benefits of the product going forward. Timeline helps 4 See notes underneath the slide For example, suppose after having spent $10,000 on market research, you believe 100\% that your new product will generate an NPV of $100 (e.g., PV(benefits)=5,100, PV(costs)=5,000) Note this already spent market research expense is NOT in the calculation of NPV (or PV(costs)) of the project you haven’t undertaken. Does the market research expense of $10,000 you have already spent affect your decision of the new project? No. That is a sunk cost. Should you take the project? Yes, because the NPV is positive. What if the NPV of the project is just $1? Again this already spent market research expense is NOT in the calculation of NPV of the project. Should you take the project? Yes, because the NPV is positive, so PV(benefits) > PV(costs). Note all the costs fLecture 7: Capital Budgeting Part II Break-even, Sensitivity, and Scenario Analysis Berk, DeMarzo 3rd edition, Chapter 8 Section 8.5 1 Last lecture Capital budgeting: Estimate incremental cash flows in the project. Determine a cost of capital used for discounting Calculate NPV Accept or reject the project Question: There is significant uncertainty in estimating cash flows. How do we know whether the NPV result is accurate? 2 2 Outline Methods to assess uncertainty and evaluate project risk: Sensitivity Analysis Scenario Analysis Break-Even Analysis 3 3 In-class exercise As the finance manager of a company, you are presented with the following project. The company is considering the purchase of a new piece of equipment which would cost $200,000. This equipment will have a five-year useful life and have a salvage value of $0 at the end of the five-year period. It is estimated that the new equipment will be able to produce 10,000 shelves per year. the incremental overhead for running the equipment will be $20,000 per year. they can sell the shelves for $25 each. the cost of sales is $15 per shelf. Net Working Capital requirements for the project are as follows: Year 0 = $10,000 Year 1 = $15,000 Year 2 = $17,000 Year 3 = $15,000 Year 4 = $10,000 The company has a 30\% marginal tax rate and a cost of capital of 15\%. 4 Would you accept this project (support your answer with NPV)? I use the example from our last lecture to illustrate how we can use the three methods to evaluate the uncertainty and the risk of the project. 4 Sensitivity Analysis Sensitivity analysis shows how the NPV varies with a change in one of the assumptions, holding the other assumptions constant. Example: how does the NPV change when the sale price is $20 per unit? or $30? Various cash flow assumptions are used. Best and worst cases are developed and NPVs compared. 5 Suppose your boss is more optimistic (or pessimistic) about the assumptions you made on sale price, the unit of sales, sales growth, or cost of capital (discount rate to discount cash flows), how does the NPV change in one of the assumptions, holding the other assumptions constant? 5 Sensitivity Analysis 6 Parameter Initial Assumption Worst Case Best Case Sale price($/unit) 25 20 30 NPV 21,232 ? ? Units sold (000s) 10 NPV 21,232 Sales growth 0\% NPV 21,232 Cost of capital 15\% NPV 21,232 Based on the baseline (initial) assumptions, NPV=$21,232 (see cell B31 in the sheet “Baseline” of EXCEL file “In-class exercise - DCF analysis”) What is the NPV when sale price is $20 per unit? $30? Answer: Just change the price from $25 (cell B3) to $20, then NPV (cell B31) becomes -96,093. Similarly, when price = $30, then NPV = 138,557 6 Sensitivity Analysis 7 Parameter Initial Assumption Worst Case Best Case Sale price($/unit) 25 20 30 NPV 21,232 -96,093 138,557 Units sold (000s) 10 8 12 NPV 21,232 ? ? Sales growth 0\% -5\% 5\% NPV 21,23Lecture 6: Capital Budgeting Berk, DeMarzo 3rd edition, Chapter 8 Section 8.1-8.4 1 Outline Capital Budgeting To evaluate projects, use Discounted Cash Flow (DCF) Analysis Considerations in DCF Analysis Opportunity Costs, Sunk Costs, Cannibalization … Examples 2 2 Which projects to take? 3 SpaceX Landing See notes underneath the slide The table shows the projects that Elon Musk’s (the CEO of Tesla and SpaceX) companies are taking on. Put yourself in his shoes and think about how you should determine which projects to take on. 3 Capital Budgeting Capital Budget Lists the projects and investments that a company plans to undertake Capital Budgeting Process used to analyze alternative investments and decide which ones to accept Goal: decide to accept or reject a project based on its cash flow and NPV. 4 Capital Budgeting Steps: Estimate incremental cash flows in the project The amount by which a firm’s cash flows are expected to change as a result of the investment decision. Determine a cost of capital used for discounting Calculate NPV Accept or reject the project This process is also called as Discounted Cash Flow analysis (DCF) 5 See notes underneath the slide 1. Example of “Incremental”: Suppose your firm is considering replacing outdated equipment with a new piece of equipment which is more efficient. The sales in the past year is $10,000, and you expect the new equipment will generate sales of $15,000 each year, then the incremental sales in each year is $5,000. Note $5,000 is the incremental sales, not incremental cash flows, because there might be other costs, such as depreciation, and tax benefit of depreciation deduction. Of course, you also have a cash outflow (purchasing equipment) at the beginning. 2. For now, we assume that the cost of capital is given, and we focus on the rest steps, especially the first step (most challenging part), estimating the incremental cash flows. 5 Example 6 See notes underneath the slide Example: Suppose you have an investment opportunity (e.g. purchase equipment), where you need to spend $90,000 (e.g. on equipment) at Year 0 (NOW). The salvage value (see below for definition) at the end of the asset is $0. For simplicity, we assume the project life is the same as the life of asset (3 years). Based on the forecast of sales and costs, change in net working capital, tax rate, and opportunity cost of capital (for discounting), should we accept this project? I want you to think about two things when evaluating a project. The components of cash flows (i.e., what contribute(s) to the cash flows?) 2. How does each factor affect the cash flow and your valuation? For example The more sales you have, all else equal, you should have more cash flows. The higher tax rate, the less cash flows you will receive. How does change in net working capital affect cash flows. Definition: Salvage value is the estimated value of property at the end of its useful life. It is what yo8.2 Determining Free Cash Flow and NPV 245 USING EXCEL Capital Budgeting Using a Spreadsheet Program Capital budgeting forecasts and analysis are most easily performed in a spreadsheet program. Here we highlight a few best practices when developing your own capital budgets. Create a Project Dashboard All capital budgeting analyses begin with a set of assumptions regarding future revenues and costs associated with the investment. Centralize these assumptions within your spreadsheet in a project dashboard so they are easy to locate, review, and potentially modify. Here we show an example for the HomeNet project. Color Code for Clarity In spreadsheet models, use a blue font color to distinguish numerical assumptions from formulas. For example, HomeNet’s revenue and cost estimates are set to a numerical value in year 1, whereas estimates in later years are set to equal to the year 1 estimates. It is therefore clear which cells contain the main assumptions, should we wish to change them at a later date. Maintain Flexibility In the HomeNet dashboard, note that we state all assumptions on an annual basis even if we expect them to remain constant. For example, we specify HomeNet’s unit volume and average sale price for each year. We can then calculate HomeNet revenues each year based on the corresponding annual assumptions. Doing so provides flexibility if we later determine that HomeNet’s adoption rate might vary over time or if we expect prices to follow a trend, as in Example 8.3. Never Hardcode So that your assumptions are clear and easy to modify, reference any numerical values you need to develop your projections in the project dashboard. Never “hardcode,” or enter numerical val- ues directly into formulas. For example, in the computation of taxes in cell E34 below, we use the formula “ = - E21*E33< rather than “ = - 0.40*E33<. While the latter formula would compute the same answer, because the tax rate is hardcoded it would be difficult to update the model if the forecast for the tax rate were to change.1 Case - Canyon Buff’s Chemical Equipment This case is a simple capital budgeting exercise that should reinforce your understanding of the following topics: • Incremental unlevered net income • Free cash flow • Sensitivity analysis and scenario analysis Before solving this case, you must watch the video “Capital Budgeting in-class exercise solution” in the Lecture 6 folder, which provides the basis for this case. You need to finish both lectures 6 and 7 to be able to complete the case study. Introduction Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment. • The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future (i.e., the actual useful life is effectively infinite). • Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6\% until the end of sixth year. After that, the sales will grow at the estimated 2\% annual rate of inflation in perpetuity. • The cost of goods sold is estimated to be 72\% of sales. • The accounting department also estimates that at introduction in Year 0, the new products required initial net working capital will be $6,000,000. In future years accounts receivable are expected to be 15\% of the next year sales, inventory is expected to be 20\% of the next year’s cost of goods sold and accounts payable are expected to be 15\% of the next year’s cost of goods sold. • The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1 million of this amount is the overhead expense that will be incurred even if the project is not accepted. • The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year. • The annual interest expense tied to the project is $1,000,000. 2 • Canyon Buff has a cost of capital of 20\% and faces a marginal tax rate of 30\% and an average tax rate is 20\%. Instructions I posted an incomplete Excel template for your analysis. You need to figure out how to construct the pro forma income statements and calculate the incremental unlevered net income. You should include ONLY the factors that will affect your capital budgeting decision. Revise the template if necessary. Note that your analysis should be set up so the assumptions that impact the cash flow estimates can be easily changed to id