C APITAL B UDGETING 1

PROBLEM 1:

Hick Limited is considering investing in a new project, for which the following information is
available:
£000

Initial investment 450

Life of project 4 years

Estimated annual cash flows:

Year 1 150
Year 2 300
Year 3 100
Year 4 100

Residual value 30

The rate of corporation tax is 30%.

Required:

Evaluate the financial viability of the above project using the following techniques:
i) payback
ii) the accounting rate of return
iii) net present value (assuming a cost of capital 10%)
iv) internal rate of return

Clearly state the assumptions made.

SOLUTION 1:

a.

 Time value of money relates to the idea that £ 1 today is not equal in value to £1 in the
future
 Time value of money is said to have three components
o The impatience to consume or pure time value of money
o Inflation
o Risk
 Therefore it is not appropriate to simply add or compare £s from different time periods
 Future £s are therefore translated into present value

b.

(i) Cash flow Cumulative

 Investment = (450,000) (450,000)
 Year 1 = 150,000 (300,000)
 Year 2 = 300,000 0
 Therefore payback equals 2 years

(ii)

 ARR is based on profits which = cash flow - depreciation

 Straight line depreciation = (450,000 - 30,000)/4 = £105,000 p.a.
 Using annual basis of ARR
 Year 1 = (45/450) x 100% = 10%
 Year 2 = (195/345) x 100% = 56.5%
 Year 3 = (-5/240) x 100% = -2%
 Year 4 = (-5/135) x 100% = -3.7%
 Using total investment basis of ARR
 {[(45+195 - 5 - 5)/4]/450}xl00% = 57.5/450 = 12.8%
 Using average investment basis of ARR
 {57.5/[(450 + 30)/2]} =24%

(iii)

Year Cash flow Discount PV

factor
0 (450) 1 -450.00
1 150 0.909 136.35
2 300 0.826 247.80
3 100 0.751 75.10
4 130 0.683 88.79
NPV 98.04
 (iv)

Try discount rate of 25%

Year Cash flow Discount PV

factor
0 (450) 1 (450.0)
1 150 0.800 120.0
2 300 0.640 192.0
3 100 0.512 51.2
4 130 0.410 53.3
NPV (33.5)

Using linear interpolation (or graphical method) IRR can be estimated:

98.04+33.5 = 98.04
0.25-0.1 (x - 0.1)

Rearranging gives:

(x - 0.1) = 98.04 x 0.15

98.04 + 33.5

Therefore x = 0.11 + 0.1 = 21 % approx.

c. See textbook and lecture notes.

PROBLEM 2:

A project requires an initial investment of £120,000 and is expected to produce the following net
cash inflows:

Year 1 £50,000
Year 2 £25,000
Year 3 £25,000
Year 4 £25,000
Year 5 £30,000

The discount rate is 8%

Required

Evaluate the financial viability of this project using the following methods:
a) payback
b) accounting rate of return
c) net present value
d) internal rate of return

SOLUTION 2:
a.
(i) Cash flow Cumulative
 Investment = (120,000) (120,000)
 Year 1 = 50,000 (70,000)
 Year 2 = 25,000 (45,000)
 Year 3 = 25,000 (20,000)
 Year 4 = 25,000 5,000 payback
 Therefore payback = 3.8 years (3 years + 20,000/25,000)

(ii)

 ARR is based on profits which = cash flow - depreciation

 Straight line-depreciation = (120,000)/5 = £24,000 p.a.
 Using annual basis of ARR
 Year 1 = (26/120) x 100% = 21.7%
 Year 2 = (1/96) x 100% = 1.0%
 Year 3 = (1/72) x 100% = 1.4%
 Year 4 = (1/48) x 100% = 2.1%
 Year 5 = (6/24) x 100% =25.0%
 Using total investment basis of ARR
 { [(26+1+1+1+6)/5]/120}X100% = 7/120 = 5.8%
 Using average investment basis of ARR
  {7 / [(120)/2]} = 11.7%

(iii)

Year Cash flow Discount PV

factor
0 (120) 1 -120.0
1 50 0.926 46.3
2 25 0.857 21.4
3 25 0,794 19.8
4 25 0.735 18.4
5 30 0.681 20.4
NPV 6.3

(iv)

Try discount rate of 15%

Year Cash flow Discount PV

factor
0 (120) 1 -120.0
1 50 0.870 43.5
2 25 0.756 18.9
3 25 0.658 16.4
4 25 0.572 14.3
5 30 0.497 14.9
NPV -12.0

Using linear interpolation (or graphical method) IRR can be estimated:

6.3 + 12.0 6.3

=
0.15−0.08 (x−0.08)

Rearranging gives:

6.3 x 0.07
(x - 0.08) =
6.3 + 12.0

Therefore x = 0.08 + 0.024 = 10.4% approx.

 C APITAL B UDGETING 2

PROBLEM 1:

Project Poldavia

A building materials company has identified an opportunity to invest in a new cement plant in
Poldavia, details of which are provided below:

Initial investment required €40m (to be depreciated over 20 years)

Net sales expected in Year 1
Sales growth rate
Operating profit margin
Tax rate
Working capital investment
Cost of capital
€100m
5% per annum for the first 5 years/zero growth
thereafter
10% for the first 3 years and 12% thereafter
(excluding depreciation)
30% .
10% of the following year's Net Sales (required
at the start of each year)
8.5%

The amount of sustaining capital expenditure required is estimated to be equal to the amount of
depreciation charged per annum.

The Poldavia plant will initially impact on the business of the Company's plant in nearby
Polgaria. It is estimated that the lost exports to Poldavia will result in lost contribution (before
tax) to the Polgarian plant of €8m in year 1, €8m in year 2 and €3m in year 3.

The investment will partly be financed by a 10-year bank loan of €30m at an interest rate of 5%
before tax.

In addition to the €40m capital investment required, a number of feasibility and market
research studies have already been carried out at a total cost of €2m.

Requirement

Calculate the net present value of this investment. (You may assume that the new Poldavia
plant will have an infinite life, even though it will be depreciated over 20 years for accounting
and tax purposes).
 SOLUTION 1:

Project Poldavia

Net Present Value Analysis

All amounts in €'000

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Stabilised

Net Sales 105,000 110,250 115,763 121,551

Sales growth % 100,000 121,551
5% 5% 5% 5%
Operating Profit (OP) before 10,000 10,500 11,025 13,892 14,586 14,586
depreciation OP margin (ex
depn)% 10% 10% 10% 12% 12% 12%

Lost Contribution (8,000) (8,000) (3,000)

Depreciation (2,000) (2,000) (2,000) (2,000) (2,000) (2,000)

Operating Profit Before Tax 0 500 6,025 11,892 12,586 12,586

Tax (30%) 0 (150) (1,808) (3,568) (3,776) (3,776)

NOPAT 0 350 4,217 8,324 8,810 8,810

Initial investment
(40,000)
Add depreciation 2,000 2,000 2,000 2,000 2,000 2,000
Less sustaining capex, (2,000) (2,000) (2,000) (2,000) (2,000) (2,000)

Working capital change (10,000) (500) (525) (551) (579) 0 0

(working 1)
Free cash flow
Terminal value (working 2) (50,000) (500).. (175) 3,666 7,745 8,810 8,810
103,647
Total amount to discount (50,000) (500) (175) 3,666 7,745 112,457

Discount rate 1 0.922 0.849 0.783 0.722 0.665

Present value (50,000) (461) (149) 2,870 5,592 74,784

Net Present Value 32,636

Workings:

1. Change in working capital

Year0 Year1 Year 2 Year 3 Year 4 Year 5

Net Sales 100,000 105,000 110,250 115,763 121,551

Working capital required 10,000 10,500 11,025 11,576 12,155 12,155

Change in workingcapital 10,000 500 525 551 579 0

2. Terminal value

Terminal value = stabilized cash flow x (1 + growth rate)/ (discount rate - growth rate)

In this case, perpetuity growth rate = 0

Therefore:

Terminal value =8,810/0.085 = 103,647

PROBLEM 2:

Emperor's Clothes Fashions (ECF)

ECF can invest £5 million in a new plant for producing invisible makeup. The plant has an
expected life of 5 years, and expected sales are 6 million jars of makeup a year. Fixed costs are
£2million a year, and variable costs are £1 per jar. The product will be price at £2 per jar. The
plant will be depreciated straight-line over 5 years to a salvage value of zero. The opportunity
cost of capital is 10%, and the tax rate is 40%.

a. What is project NPV under these base-case assumptions?

b. What is NPV if variable costs turn out to be £1.20 per jar?

c. What is NPV if fixed costs turn out to be £1.5 million per year?

d. At what price per jar would project NPV equal zero?

SOLUTION 2:

ECF

Revenue = Price x quantity = £26 million = £12 million

Total costs = Variable cost + fixed cost = ( £ 1  6 million) + £2 million = £8 million
Depreciation expense = £5 million/5 years = £1 million per year
Therefore, profit per annum before tax = £12m - £8m - £1m = £3m
Therefore, tax charge per annum = £3m x 40% = £1.2m
Profit after tax = £3m - £1.2m = £1.8m

After tax cash flow = profit after tax + depreciation = £1.8m + £1 m = £2.8m
a. NPV = -£5 million + [£2.8 million x annuity factor (10%, 5 years)]
= -5 + (2.8  3.791) = £5.6 million

b. If variable cost = £1.20, then total costs increase to:

(£1.20  6 million) + £2 million = £9.2 million
Profit before tax per annum = £12m - £9.2m - £1 m = £1.8m
Profit after tax = 60% x £1.8m = £1.08 million
After tax cash flow = £1.08m + £1 m = £2.08m
NPV = -£5 million + [£2.08 million x 3.791] = £2.9 million

c. If fixed costs = £1.5 million, total costs fall to:

(£1  6 million) + £1.5 million = £7.5 million
Profit before tax per annum = £12m - £7.5m - £1 m = £3.5m
Profit after tax = 60% x £3.5m = £2.1 m
Cash flow = £2.1m + £1m = £3.1m
NPV = -£5 million + [£3.1 million x 3.791] = £6.8 million

d. Call P the price per jar. Then:

Revenue = P  6 million
Expense = ( £ 1 x 6 million) + £2 million = £8 million
Given depreciation is tax deductible, these results in a tax saving of £1m x 40%= £0.4m
Therefore, cash flow after tax per annum can be expressed as follows:
Cash flow = [(60% x (6P - 8)] + (0.4) = 3.6P - 4.4
NPV = -5 + [(3.6P - 4.4) x annuity factor (10%, 5 years)]
= -5 + [(3.6P - 4.4) x 3.791] = -21.680 + 13.648P
Therefore, NPV = 0 when P = £1.59 per jar
PROBLEM 3:

Diamond Ltd

Diamond Ltd has £1m to invest and have identified the following four projects:

Project Investment Outlay Net Present Value

A £400,000 +£100,000
B £600,000 +£125,000
C £300,000 +£90,000
D £250,000 +£40,000

Required

Assuming each project is infinitely divisible and the projects are not mutually exclusive, in
which projects should Diamond Ltd invest?

SOLUTION 3:

Diamond Ltd

Rank projects on basis of NPV per £ of investment required

Project Investment Outlay Net Present Value NPV per £ Ranking

A £400,000 +£100,000 £0,25 2

B £600,000 +£125,000 £0.208 3
C £300,000 +£90,000 £0.3 1
D £250,000 +£40,000 £0.16 4

Allocate available funds accordingly

Project Funds used NPV

C £300,000 £90,000
A £400,000 £100,000
B £300,000 (balance) £62,500 (=½ 125,000)
£1,000,000 £252,500
 C APITAL B UDGETING 3

You are the international financial analyst of a UK MNC. The finance director has asked you to consider the
proposal to acquire a subsidiary in the United States (US) which manufactures personal computers (PCs).
To assess the project, you have been given the following details:

1) An initial capital outlay (for plant and equipment) of USD45 million is to be provided by the UK
MNC at the current spot rate of USD1.6000 to one pound. A further, USD25 million will be
required for working capital and will be borrowed from a local (US) bank. The interest on the loan
is at 10% p.a. The principal of the loan will be repaid in seven years.

The local debt is expected to increase the parent's debt level by an equivalent amount of pounds.
The foreign subsidiary will be sold at the end of the third year in which case the acquiring firm will
take responsibility for the repayment of the loan. Working capital will not be liquidated. The sale of
the subsidiary is expected to generate USD45 million after capital gains taxes. The UK MNC
requires an all-equity nominal rate of return of 15 per cent on the project. This rate is already
adjusted for the country risk associated with the project.

2) The expected turnover and variable costs arising from the sale and production of the PCs are as
follows:

Year Turnover Variable cost

1 USD 20,000 USD1,300

2 USD19,150 USD3,550
3 USD25,900 USD2,800

(Figures in thousands of USD)

These are assumed to arise at the end of each year.

3) Fixed overheads (excluding depreciation) are estimated to be USD 5 million per year. Plant and
equipment will be depreciated over 7.2 years on a straight-line basis.

4) The foreign exchange rate forecasts of the USD against the pound at the end of each year are as
follows: Year 1: USD 1.6500; Year 2: USD 1.6300; and Year 3: USD 1.6800.

5) The local corporation tax is 30%. In addition, a withholding tax of 10% is imposed on all cash flows
that are remitted to the parent. The UK government will allow the tax credit on remitted cash flows
and will not impose an additional tax. All net cash flows that are generated by the subsidiary's
operations will be remitted to the parent at the end of each year and the subsidiary will maintain the
level of its working capital to support ongoing operations.

Required:

Calculate: the adjusted-net present value of the project,

Suggested Solution

Note that most of the calculations have been performed using a spreadsheet; there will therefore be some problems with
rounding errors when (say) a calculator is used.

a) Year 0 1 2 3
Revenue 20,000,000 19,150,000 25,900,000
Variable cost 1,300,000 3,550,000 2,800,000
Fixed cost 5,000,000 5,000,000 5,000,000
Depreciation 6,250,000 6,250,000 6,250,000
Before tax earnings 7,450,000 4,350,000 11,850,000
Host Govt tax @30% 2,235,000 1,305,000 3,555,000
Earnings after tax 5,215,000 3,045,000 8,295,000
Add depreciation 6,250,000 6,250,000 6,250,000
Amount to be remitted 11,465,000 9,295,000 14,545,000
To parent after W/holding tax @10% 10,318,500 8,365,500 13,090,500
Salvage value 45,000,000
Capital outlay (45,000,000)
NCF in USD (45,000,000) 10,318,500 8,365,500 58,090,500
FX rates 1.6000 1.6500 1.6300 1.6800
NCF in GBP (28,125,000) 6,253,636 5,132,209 34,577,679
DF 1.000 0.870 0.756 0.658
PV in GBP (28,125,000) 5,437,945 3,880,687 22,735,385
Cumulative PV (28,125,000) (22,687,055) (18,806,368) 3,929,017
Base-case (all-equity) NPV in GBP 3,929,017