Question 1. Mini-Case – Capital Budgeting and WACC
CCC, Inc. is a Telecom company, which has the following financial information and forecasts for capital budgeting decision:
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Year 0 (present)
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Year 1
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Year 2
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Year 3
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Year 4
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Growth Rate of EBIT
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15%
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15%
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15%
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15%
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EBIT
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0
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270
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EBITYear1*(1+15%)
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EBITYear2*(1+15%)
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EBITYear3*(1+15%)
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Tax
(as % of EBIT)
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0
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35% of EBIT
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35% of EBIT
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35% of EBIT
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35% of EBIT
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Depreciation
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0
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12% of EBIT
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12% of EBIT
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12% of EBIT
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12% of EBIT
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Investments (= Capital Expenditure +
NWC Change)
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850
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65
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65
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75
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75
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Note:
FCF of the project (for each year) = Operating Cash Flows - Investments
Operating Cash Flows = EBIT * (1 – Tax) + Depreciations
Assume that this firm has Debt = 100 and Equity = 400. Assume that the firm has the following information of their cost of capital (from year 0 to year 4):
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Riskfree rate (Rf)
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4%
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Expected market return (Rm)
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10%
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Beta
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1.55
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Cost of Debt/YTM (Rd)
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6%
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Corporate Tax Rate (t)
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35%
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Based on the above information, calculate the NPV of this investment project. Your answers should be organized with the following steps:
Step (1) Calculate the FCF of the investment project for each year 0 to year 4;
Step (2) Calculate the discount rate of the firm/project (hint: apply WACC);
Step (3) Calculate the Net Present Values of the project using FCF and discount rate from Steps (1) and (2) above.
Step (4) Based on your estimated NPV, discuss whether you should accept or reject the project. Provide explanation of your choice.
Step (5) Sensitivity Analysis (to analyze Capital Structure Decision): The company is considering a new Capital Structure policy, which will increase the Debt from 100 to 300. In order words, the new capital structure will have Debt = 300 and Equity = 400.
Perform sensitivity analysis using the new capital structure of Debt = 300 and Equity = 400. Using the new capital structure decision, perform sensitivity analysis by re-computing the NPV in Step (3) above (except for Debt and Equity, other information/assumptions remain the same). Based on your new estimates of NPV, discuss whether you should accept or reject the project. Provide interpretations of the results of the sensitivity analysis: will you recommend the new capital structure decision? Why or why not.