NETCO case

Capital budgeting report

Capital Budgeting Report

Introduction

At present the boat Cynthia II no longer has economic value for NETCO meaning that either an overhaul of said boat has to be financed or a new boat should be purchased. Therefore, an NPV budget decision has to be computed in order to determine which alternative, an overhaul of the current boat or the purchase of a new one, is most profitable. To compare the profitability of these two options we used the difference between the present values of both options and computed only one Net Present Value. Evidently, the incremental costs and revenues of the purchase of the new boat minus the incremental costs and revenues of the overhaul of the Cynthia II should be taken into consideration.

Assumptions

Several aspects of both buying decisions were unclear. Therefore, we had to make the following assumptions in order to be able to complete our calculations: All cash flows are in nominal terms, meaning that 3% inflation is included. Year 0 corresponds with 2009, year 1 with 2010 etc.

We compared the depreciation of the new boat with the depreciation of the overhauled Cynthia II, therefore the depreciation is the difference between the depreciation of both options. We calculated depreciation according to the MACRS method, including a 10 year economic life time for both boats. We assumed that the training costs are €75000.

We did not include the interest expense in the cash flows, because we wish to evaluate the earning contributions from the projects on their own, separate from the financing decision. We assumed a discount rate of 13.5%, which is the sum of a yield to maturity on Treasury Bonds of 3,5% and a risk premium of 10% (since the yield to maturity is estimated at 3-4%, we assumed an average of 3.5%). The amount at "Purchase of equipment" is the difference between the purchase of the new boat (€2000000) and the overhauling of the Cynthia II (€600000), which yields a negative cash flow of - € 1,400,000. We assumed that changes in the NWC are 0; since the money obtained by the submission of bonds is spent immediately on the new boat. Estimations predict that the scrap parts of the overhauled Cynthia II can be sold for € 40.000 after 15 years. Adjusted for a tax loss and for inflation this would come down to a present value of € 46427.429. Furthermore, the sale of the new boat would yield €400,000, resulting in a Net Present Value of € 464274.2901, corrected for both a tax loss and inflation. The difference between these two options is € 464274,2901 - € 46427.429 = € 417846.86

Which is the salvage cash flow at the end of the 15th year.

Calculations

There are no incremental revenues in year 0, 2009, thus it has a value of 0 during this time period. In y ear 1 incremental revenues are equal to 100,000 but this value, as well as in the following years, must be corrected for inflation. Therefore the value of incremental revenues from year 1 onwards is equal to:

Incremental Revenues = XXX × (1+Interest Rate) year

Incremental Revenues =100000 × 1.03n

Incremental Revenues in Year 1 = 100000 × 1.031 = 103000

There are no incremental costs throughout the entire time period therefore we can calculate Incremental gross profit with the following formula:

Incremental Gross Profit = Incremental Revenues + Incremental Costs

Incremental Gross Profit in Year 1 = 103000 + 0 = 103000

(Incremental costs are represented by negative cash flows, whereas gain on/less incremental costs are represented by a positive cash flow.)

In year 0 there is no cash flow for selling, general and administrative expenses, since the boat is only bought at the end of 2009 (31 December).

Selling. General and Administrative Expenses = Operating Expenses New Boat – Operating Expenses of the Overhauled Cynthia II

Given the fact that operating expenses for the new boat are negative € 141,000 and that the values must be...