alba graduate business school
Case Study in Capital Budgeting
Dinas Vadel Inc.
Bala Iro Boura Perry Fakitsas Christos Politis Stathis
PART A : DINAS VADEL CASE
1. Define the term “incremental cash flow”. Since the project will be financed in part by debt, should the cash flow analysis include the interest expense? Explain Incremental cash flow refers to the extra cash flow the company will generate from taking on a new project. It is the difference between the company’s cash flow with the project and without the project. In the Divas Vadel case there are several aspects of the expansion project that must be taken into consideration when identifying incremental cash flows. In our case for example the initial investment outlay, cash flows from operations, changes in working capital, terminal cost, opportunity cost and externalities must be taken into account. The cash flow analysis should not include interest expense. In order to calculate the NPV of a project the cash flows are discounted with the cost of capital rate (WACC). The cost of capital rate (WACC) is a weighted average of the costs of debt and common equity. The cost of debt contains the interest expense (Kd). Thus when discounting the cash flows with WACC we are subtracting the interest expenses. If we where to include the interest expenses in our cash flow analysis we would end up double-counting this cost. This would create different results than reality and mislead the final decision. 2. What would happen if the project is financed entirely debt? Explain In general debt is more attractive than equity because it is less expensive money overall. This because the creditors ask for securities (cash collateral or mortgages) and the interest payments are included in the expense accounts thus they are non taxable.
In Dinas Vadel case, other things been equal when the project is financed entirely by debt this would change the WACC. In this case the WACC becomes equal to 6%, which is very “cheap” money. This is for two reasons: i. The cost of debt is lower (10%) compared to the cost of equity (26%). ii. The cost of debt is reduced by the taxes’ rate.
So this would give much better quantitative results for this project. The quantitative results that are affected by the change in capital composition are NPV, MIRR, PI and the Discounted Payback period, because they are the ones that include the WACC in their calculations.
End results are presented below.
Project Quantitative Factors
So concluding, using only debt to finance the project given the fact that the shareholders have not invested capital in this project and the project has a positive NPV and an IRR higher than the WACC the returns of this project after paying off the creditors would be entirely to company’s benefit and add value to the company. However we should keep in mind the possible risks behind financing through debt. Assuming that the firm operates near its optimal capital structure, the decision which will affect the current capital structure may have negative effects. Also using only debt is a contractual obligation with underwriting costs and provisions and regardless if the project turns out to be successful or not, the firm will have to repay the debt. In addition financing through debt also curries risk regarding the uncertainty about interest rates. Finally, depending the overall level of debt that Dinas Vadel company has the management should keep in mind the side effects of borrowing, which may end up in financial distress.
3. Another wine producer had expressed an interest in leasing the same section of the production site for $50,000 a year for 4 years (the proposed deal consists of this annual rent payment only) How would you treat this information in your analysis of the project? Explain. The interest of...
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