Capital

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Capital Budgeting
Assignment #2
Breana N. Rainge

23. Bauer Industries is an automobile manufacturer. Management is currently evaluating a proposal to build a plan that will manufacture lightweight trucks. Bauer plans to use a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental free cash flow projections (in millions of dollars):

| Year 0| Year 1-9| Year 10|
Revenues| | 100.0| 100.0|
-Manufacturing expenses (other than depreciation)| | -35.0| -35.0| -Marketing expenses| | -10.0| -10.0|
-Depreciation| | -15.0| -15.0|
=EBIT| | 40.0| 40.0|
-Taxes (35%)| | -14.0| -14.0|
=Unlevered net income| | 26.0| 26.0|
+Depreciation| | +15.0| +15.0|
-Increases in net working capital| | -5.0| -5.0|
-Capital expenditures| -150.0| | |
+Continuation value| | | +12.0|
=Free cash flow| -150.0| 36.0| 48.0|

A. For this base-case scenario, what is the NPV of the plant to manufacture lightweight trucks? B. Based on input from the marketing department, Bauer is uncertain about its revenue forecast. In particular, management would like to examine the sensitivity of the NPV to the revenue assumptions. What is the PV of the project if revenues are 10% higher than forecast? What is the NPV is revenues are 10% lower than forecast? C. Rather than assuming that cash flows for this project are constant, management would like to explore the sensitivity of its analysis to possible growth in revenues and operating expenses. Specifically, management would like to assume that revenues, manufacturing expenses, and marketing expenses are as given in the table for year 1 and grow by 2% per year every year starting in year 2. Management also plans to assume that the initial capital expenditures (and therefore depreciation), additions to working capital, and continuation value remain as initially specified in the table. What is the NPV of this project under these alternative assumptions? How does NPV change if the revenues and operating expenses grow by 5% per year rather than by 2%? D. To examine the sensitivity of this project to the discount rate, management would like to compute the NPV for different discounts rates. Create a graph, with the discount rate on the x-axis and the NPV on the y-axis, for discount rates ranging from 5% to 30%. For what ranges of discount rates does the project have a positive NPV?

a.The NPV of the estimate free cash flow is

b.Initial Sales90100110
NPV20.557.394.0
c.Growth Rate0%2%5%
NPV57.372.598.1
d.NPV is positive for discount rates below the IRR of 20.6%.

Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization’s long-term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). This valuation requires estimating the size and timing of all the incremental cash flows from the project. These future cash flows are then discounted to determine their present value. These present values are then summed, to get the NPV. See also Time value of money. The NPV decision rule is to accept all positive NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the highest NPV (GE). NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if Rt is a positive value, the project is in the status of discounted cash inflow in the time of t. If Rt is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean...
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