Solution
Capital Budgeting Assignment FNCE 301 Fall 2020
Toefield Inc. has developed a powerful efficient snow remover that is significantly less polluting than existing snow removers cu
ently on the market. The company spent $2,000,000 developing this product and the marketing department spent another $300,000 to assess the market demand. It would cost $20 million at Year 0 to buy the equipment necessary to manufacture the efficient snow blower. The project would require net working capital at the beginning of each year equal to 20% of sales (NOWC0 = 20%(Sales1), NOWC1 = 20%(Sales2), etc.). The efficient snow blowers would sell for $3,000 per unit, and Toefield believes that variable costs would amount to $790 per unit. The company expects that the sales price and variable costs would increase at the inflation rate of 2% after year 1. The company’s non-variable costs would be $800,000 in Year 1 and are expected to increase with inflation. The efficient snow blower project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the project’s returns are expected to be highly co
elated with returns on the firm’s other assets. The firm believes it could sell 3,500 units per year.
The equipment would be depreciated using a CCA rate of 30%. The estimated market value of the equipment at the end of the project’s 4-year life is its undepreciated capital cost (i.e. book value) at the end of year 4. Toefield has other assets in this asset class. Toefield Inc.’s federal-plus-provincial tax rate is 30%. Its cost of capital is 9% for average risk projects. Low-risk projects are evaluated with a WACC of 6%, and high-risk projects at 12%. Assume that the half-year rule applies to the CCA.
a. Develop a spreadsheet model and use it to find the project’s NPV, IRR, and payback.
Part 1. Input Data (in thousands of dollars except for unit amount)
Equipment cost $ 20,000
Net Operating WC/sales 20%
Yearly sales (in units) 3,500 Tax rate
Sales price per unit WACC
Variable cost per unit Inflation
Non-variable costs CCA rate
Part 2. CCA Schedule
year 1 year 2 year 3 year 4
Beg. UCC
CCA
End UCC
Part 3. Projected Net Cash Flows (Time line of annual cash flows)
Years 0 1 2 3 4
Investment Outlays at Time Zero:
Equipment
Operating Cash Flows over the Project's Life:
Units sold
Sales price
Variable costs
Sales revenue
Variable costs
Non-variable operating costs
Depreciation (equipment)
Oper. income before taxes (EBIT)
Taxes on operating income
Net Operating Profit After Taxes (NOPAT)
Add back depreciation
XXXXXXXXXXOperating cash flow
Working Capital:
Required level of net operating working capital
Required investment in NOWC
Terminal Year Cash Flows:
Net salvage value
Net Cash Flow (Time line of cash flows)
Part 4. Key Output: Appraisal of the Proposed Project
Net Present Value (at 9%)
IRR
MIRR
Payback (See calculation below)
Data for Payback Years
Net cash flow
Cumulative CF
Part of year required for payback: 0.00 0.00 0.00 0.00
b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variables’ values at 10% and 25% above and below their base case values. Include a graph in your analysis.
Evaluating Risk: Sensitivity Analysis
I. Sensitivity of NPV to Changes in Inputs. Here we use an Excel "Data Table" to find NPV for different unit sales, variable costs, WACC, and sales prices, holding other thing constant.
% Deviation 1st YEAR UNIT SALES % Deviation WACC
from Units NPV from NPV
Base Case Sold $0 Base Case WACC 0
-25% 2,625 $0 -25% 6.75% $0
-10% 3,150 $0 -10% 8.10% $0
0% 3,500 $0 0% 9.00% $0
10% 3,850 $0 10% 9.90% $0
25% 4,375 $0 25% 11.25% $0
% Deviation VARIABLE COSTS % Deviation SALES PRICE
from Variable NPV from Sales NPV
Base Case Costs $0 Base Case Price $0
-25% 0.59 $0 -25% 2.25 $0
-10% 0.71 $0 -10% 2.70 $0
0% $0.79 $0 0% $3.00 $0
10% 0.87 $0 10% 3.30 $0
25% 0.99 $0 25% 3.75 $0
% Deviation NON-VARIABLE COSTS Note about data tables. The data in the column input should NOT be input using a cell reference to the column input cell. For example the base case number of units sold in cell B100 should be the number 1000; you should NOT have the formula =D29 in that cell. This is because you'll use D29 as the column input cell in the data table and if Excel tries to iteratively replace cell D29 with the formula =D29 rather than a series of numbers, Excel will calculate the wrong answer. Unfortunately, Excel won't tell you that there is a problem, so you'll just get the wrong values for the data table!
from Fixed NPV
Base Case Costs
Shantanu: Although in most cases, fixed cost might not vary in a firm; it might happen if the firm undertakes significant level of reorganization/ restructuring
$0
-25% 600 $0
-10% 720 $0
0% $800 $0
10% 880 $0
25% 1,000 $0
Deviation NPV at Different Deviations from Base
from Sales Price Variable Non-variable
Base Case Cost Units Sold Cost WACC
-25% $0 $0 $0 $0 $0
-10% $0 $0 $0 $0 $0
0% $0 $0 $0 $0 $0
10% $0 $0 $0 $0 $0
25% $0 $0 $0 $0 $0
Range $ - 0 $ - 0 0 $ - 0 $ - 0
c. Would you recommend that the project be accepted? Explain.
Sensitivity Analysis
Sales price -0.25 -0.1 0.0 0.1 0.25 0.0 0.0 0.0 0.0 0.0 VC -0.25 -0.1 0.0 0.1 0.25 0.0 0.0 0.0 0.0 0.0 Units -0.25 -0.1 0.0 0.1 0.25 0.0 0.0 0.0 0.0 0.0 Non-var. cost -0.25 -0.1 0.0 0.1 0.25 0.0 0.0 0.0 0.0 0.0 WACC -0.25 -0.1 0.0 0.1 0.25 0.0 0.0 0.0 0.0 0.0
NPV