Capital Budgeting with Staged Entry

Question 1

A – Even though Atlantic Aquaculture already bought the land needed for 300,000 USD, its value today is 900,000 USD. We can therefore conclude the 900,000 USD is an opportunity cost as the land can be sold at this value.

B – In this case it is best for the company to use the option to the land acquisition. By calculating the NPV the option is worth $-852,093.66. Buying the land without the option would bring the company back to $-900,000.00. We used a discount rate of 6%, as this is linked with the appreciation of the land annually. The calculation of the NPV can be found in Appendix A.

Question 2

A – The R&D cash flows are $48,000 annually for the years 1998, 1999 and 2000. In 1996 we are able to shield taxes with the appreciation. At a tax rate of 40% this result in a tax shield worth $144,000.

B – From the case is known that the salvage value will only be taxed when the buildings are actually sold, as long as the asset’s value is half of the book value the sale will go through with. Take note that a 40% tax rate is used to calculate the tax shield.

C – The cash flows are shown in the Appendix B.

Question 3

As can be seen in the Appendix C the large project, while taking into account a rwacc of 9% and the expectation that there will be high demand and high growth opportunities for the firm’s products; the Net Present Value of the firm will be $17,140,000.00. An Internal Rate of Return will be realized of 25.83%. Furthermore the MIRR is calculated as 21.54% and the payback period of the project is 7.05 years. Taking all other factors the same, when the firm is building a small facility, the NPV would be $11,723,000.00, the IRR 23.39%, the MIRR 18.05% and the period in which the costs will be paid back 7.18 years.

Question 4

A – In the Appendix the decision trees are shown and the following elements deserve attention. The nodes start with having high/low demand being 10,000 or 5,000 respectively. There is a 75% chance demand will be high, while 25% probability that demand will be low. The following pair of nodes, given differing probabilities (as can be seen in the Appendix) leads to the yearly cash flows. In de first years it is obvious that the cash flows are negative as the start-up investments have some weight on the cash flows. From 1998 onwards, as sales start to increase and costs decrease the flows of cash are positive. In row three and four the cash flows, given a low demand of 5,000 units sold with their corresponding probabilities. It is clear that the costs definitely outweigh the revenues for the first few years, more than in the ‘best-case’ term in rows one and two. Interesting to see that in the final row, there is only a positive cash flow recorded in the final year of the project. In this case we can explain the NPV values of all probabilities very straightforward. With the given information the cash flows will be negative in case the demand will be low. However we need to make a remark on this simplification of the results. By calculating the expected NPV (which is the sum of the probabilities of each high/low demand occurring times their corresponding NPVs). This gives in the end a positive NPV so investors can assume this project will be successful.

B – The abandonment lines basically represent a situation in which the project is stopped for continuation. What is interesting to notice is that the NPV of the project that continued are lower than the projects where the project was dismantled. Note too that this only applies to the situation in where a low demand is expected. The NPV in those cases when the projects are abandoned is equal to the salvage value of the equipment and buildings.

C – As the flexibility of the project gets smaller, the NPV will get smaller and due to higher volatility the standard deviation will increase.

Question 5

A – Due to the fact that there is an extra...