Question 1. Mini-Case – Capital Budgeting with Applications of NPV and CAPM
BBB, Inc. is a pharmaceutical company, which has a new investment opportunity to expand its existing business. The new investment has the following financial information and forecasts:
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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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Year 5
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Growth Rate of EBIT
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20%
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20%
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20%
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20%
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20%
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EBIT
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0
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80
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EBITYear1*(1+20%) = 96
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EBITYear2*(1+20%) = 115.20
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EBITYear3*(1+20%) =138.24
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EBITYear4*(1+20%) = 165.89
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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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35% of EBIT
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Depreciation
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0
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20% of EBIT
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20% of EBIT
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20% of EBIT
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20% of EBIT
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20% of EBIT
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Investments (= Capital Expenditure + NWC Change)
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600
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0
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0
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0
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0
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0
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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 NO debt (i.e., because of debt = 0, firm’s cost of capital = cost of equity = RE). Assume that the firm has the following information of their cost of capital (from year 0 to year 5):
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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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1.25
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Based on the above information, calculate the NPV of new investment project to expand its existing business. Your answers should be organized with the following steps:
Step (1) Calculate the FCF of the investment project for each year 0 to year 5;
Step (2) Calculate the discount rate of the firm/project (hint: apply CAPM);
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:
Step (5) - Part 1
Perform sensitivity analysis using alternative value of Growth Rate of EBIT = 40% (instead of using 20% Growth Rate in the original assumptions). Using the new value of Growth Rate of EBIT = 40%, perform sensitivity analysis by re-computing the NPV in Step (3) above. Based on your new estimates of NPV, discuss whether you should accept or reject the project. Provide explanation of your choice.
Step (5) - Part 2
Perform sensitivity analysis using alternative value of Beta = 2.50. Using the value of Beta = 2.50, perform sensitivity analysis by re-computing the NPV in Step (3) above. Based on your new estimates of NPV, discuss whether you should accept or reject the project. Provide explanation of your choice.