Fundamentals of Corporate Finance
Question 1
Main assumptions
Rate of inflation for the four years =3.25%
Market sizing
Original equipment manufacturer
Production: 6.2 million cars annually
Growth rate 2.5% per a year
Market share:11%
Replacement market
Production: 32 million tires
Growth rate: 2%
Market share: 8%
Revenue calculations
Annual price growth 100%+1%+3.25%= 104.25%
OEM market growth index 100%+2.5% = 102.5%
Replacement market growth index 100%+2% = 102%
ORIGINAL EQUIPMENT MANUFACTURER
Year 1
Year 2
Year 3
Year 4
price per a unit
$ 41.0000
$41*104.25% =$42.7425
$42.7425 *104.25% =$44.5591
$44.5591 *104.25% =$46.4528
Total manufactured cars
6,200,000.0000
6,200,000.0000* 102.5% =6,355,000.0000
6,355,000.0000*102.5% =6,513,875.0000
6,513,875.0000*
102.55 =6,676,721.8750
Total number of tires needed
6,200,000.0000*4 =24,800,000.0000
6,355,000.0000*4 =25,420,000.0000
6,513,875.0000 *4 =26,055,500.0000
6,676,721.8750* 4 =26,706,887.5000
Market share/tires sold
24,800,000.0000*11%= 2,728,000.0000
25,420,000.0000* 11% =2,796,200.0000
26,055,500.0000*11% =2,866,105.0000
26,706,887.5000*11% =2,937,757.6250
Sales revenue
2,728,000.0000 *$41 =$111,848,000.0000
2,796,200.0000*$42.7425= $119,516,578.5000
2,866,105.0000*$44.5591 =$127,710,933.9134
2,937,757.6250 *46.4528 =$136,467,114.8198
REPLACEMENT MARKET
Year 1
Year 2
Year 3
Year 4
price per a unit
$62.0000
$62.0000*104.25% =$64.6350
$64.6350*104.25% =$67.3820
$67.3820 *104.25% =$70.2457
Total Market size
32,000,000.0000
32,000,000.0000 *102% =32,640,000.0000
32,640,000.0000*102% =33,292,800.0000
33,292,800.0000*102% =33,958,656.0000
Market share/ units sold
32,000,000.0000 *8% =2,560,000.0000
32,640,000.0000*8%
=2,611,200.0000
33,292,800.0000*8% =2,663,424.0000
33,958,656.0000*102% =2,716,692.4800
Sales revenue
2,560,000.0000 *$62 =$158,720,000.0000
2,611,200.0000*64.6350 =$168,774,912.0000
2,663,424.0000*$67.3820 = $179,466,802.6752
2,716,692.4800*$70.2457= $190,836,024.6247
Total sales revenue
$111,848,000.0000 + $158,720,000.0000 =270,568,000.0000
$$119,516,578.5000 + $168,774,912.0000
=288,291,490.5000
$$127,710,933.9134 + 179,466,802.6752 =307,177,736.5886
$$136,467,114.8198 + $190,836,024.6247 =327,303,139.4445
Expenses calculation
Assumptions
Variable costs growth index 104.25%
Marketing cost growth index 103.25%
Variable costs
Year 1
Year 2
Year 3
Year 4
Cost per a unit
$18.0000
$18.0000*104.25% =$18.7650
$18.7650*104.25% =$19.5625
$19.5625* 104.25% =$20.3939
OEM units
2,728,000.0000
2,796,200.0000
2,866,105.0000
2,937,757.6250
Replacement market units
2,560,000.0000
2,611,200.0000
2,663,424.0000
2,716,692.4800
Total units manufactured
2,728,000.0000 +2,560,000.0000 =5,288,000.0000
2,796,200.0000 + 2,611,200.0000 =5,407,400.0000
2,866,105.0000 + 2,663,424.0000 =5,529,529.0000
2,937,757.6250 + 2,716,692.4800 =5,654,450.1050
Variable costs
5,288,000.0000*$18 =$95,184,000.0000
5,407,400.0000 *$18.7650 =101,469,861.0000
5,529,529.0000* $19.5625 =108,171,480.1816
5,654,450.1050* $20.3939 =115,316,399.0212
Marketing and Admin costs
$ 25,000,000.0000
$25,000,000.0000 *103.25% =$25,812,500.0000
$25,812,500.0000* 103.25% =$26,651,406.2500
$26,651,406.2500 * 103.25% =$27,517,576.9531
Depreciation calculation
Initial cost of equipment $120,000,000
Salvage value $65,000,000
Life of asset 4 years
Deprecation annually
FREE CASH FLOW FOR YRAR 0 TO 4
Year 0
Year 1
Year 2
Year 3
Year 4
Revenues
$270,568,000.0000
$288,291,490.5000
$307,177,736.5886
$327,303,139.4445
Cost of goods sold
($95,184,000.0000)
($101,469,861.0000)
($108,171,480.1816)
($115,316,399.0212)
Gross profit
$175,384,000.0000
$186,821,629.50
$199,006,256.4070
$211,986,740.4233
Cash operating expenses
($25,000,000.0000)
($25,812,500.0000)
($26,651,406.2500)
($27,517,576.9531)
Depreciation
($13,750,000.0000)
($13,750,000.0000)
($13,750,000.0000)
($13,750,000.0000)
Net operating income
$136,634,000.0000
$147,259,129.50
$158,604,850.1570
$170,719,163.4702
Taxes 35%
$47,821,900.0000
$51,540,695.3250
$55,511,697.5549
$59,751,707.2146
Net operating profit
$88,812,100.0000
$95,718,434.18
$103,093,152.6020
$110,967,456.2556
Add back depreciation
$13,750,000.0000
$13,750,000.0000
$13,750,000.0000
$13,750,000.0000
operating cash flow
$102,562,100.0000
$109,468,434.1750
$116,843,152.6020
$124,717,456.2556
Less Capital expenditure
($120,000,000.0000)
Less Net working capital
($11,000,000.0000)
($67,642,000.0000)
($72,072,872.6250)
($76,794,434.1472)
($81,825,784.8611)
Add salvage value
$65,000,000.0000
Return of Working capital
($11,000,000.0000)
Free cash flow
($131,000,000.0000)
$34,920,100.0000
$37,395,561.5500
$40,048,718.4549
$96,891,671.3945
Question 2
In capital budgeting, depreciation is considered only to the extent that is affects taxable income and thus the amount of tax liability. It is, however, a non-cash expense. This means that there is no real transfer of cash and thus it does treated as a negative cash flow and has no effect on the free cash flow (Bertoni, Colombo & Croce, 2010).
On the other hand, depreciation is tax deductible. This means that it is recognized as an expense. It is thus subtracted from the gross income to get the net operating income before tax. This provides a depreciation tax shield because the taxable income is less the depreciation charge. It is however, added back to get the operating cash flows.
Question 3
I would use 12% as the discount rate for the project
The additional risk associated with SuperTread is a non-systematic. These risks are specific to an industry or a company and do not affect all market players as a whole. The 2% additional risk is specific to SuperTread tires and does not affect the other tires produced by the company.
Unlike systemic risks, non-systemic risks are not accounted for in the rate of return. They are mitigated through investment diversification. They however form part of the total risk of a particular investment (Savvides, 1989).
Question 4
Net present Value
Year 0 cash flows
NPV = ($131,000,000) + ++ + = $20,072,468.9940
The net present value is the value of all future cash flows expected from the investment discounted to the present period less the initial capital investment. It is an estimate of the change in value of a company with the adoption of a new project. A positive NPV of $20,072,468.9940 indicates that the project is profitable since there is residue left after subtracting the initial capital investment (Bierman & Smidt, 2007).
Payback period
Period/Year
cash flow
Accumulated cash flow
0
$ (131,000,000.0000)
$ (131,000,000.0000)
1
$ 34,920,100.0000
$ (96,079,900.0000)
2
$ 37,395,561.5500
$ (58,684,338.4500)
3
$ 40,048,718.4549
$ (18,635,619.9951)
4
$ 96,891,671.3945
$ 78,256,051.3994
= = 3.1923
Payback period is 3 years 2 months. The company desires a payback period of less than 3 3 years and thus based on this appraisal method, the investment should be rejected.
The payback period estimates how long it would take for the initial investment to be recovered from the net cash flows that the project generates. The Acceptable payback period is set by the company and thus varies from one company to another. The shorter the payback period the more desirable the investment. This method of appraisal however does not consider the time value of money and favors projects whose cash flows are more closer to the onset of the project than later on.
Discounted payback period
Period/Year
cash flow
Discounting factor
Discounted cash flows
Accumulated cash flow
0
$ (131,000,000.0000)
1
$ (131,000,000.0000)
$ (131,000,000.0000)
1
$ 34,920,100.0000
0.892857143
$ 31,178,660.7143
$ (99,821,339.2957)
2
$ 37,395,561.5500
0.797193878
$ 29,811,512.7152
$ (70,009,826.5705)
3
$ 40,048,718.4549
0.711780248
$ 28,505,886.7464
$ (41,503,939.8240)
4
$96,891,671.3945
0.635518078
$ 61,576,408.8181
$ 20,072,468.9940
Payback period is 3 years 8 months which is within the 4-year discounted payback period that is acceptable by the company.
The discounted payback period indicates the amount of time it would take to recover the initial investment from discounted cash flows generated by the investment (Gervais, 2011). It takes into consideration the time value of money.
Internal rate of return
NPV at 12% discount rate is $20,072,468.9940
NPV at a higher discount rate
NPV = ($131,000,000) + ++ + = ($199,252.2048)
IRR= 12% + = 0.179402
IRR= 17.9410%
The internal rate of return is the rate that equates the net present value of all future cash flows to zero. The fact that it is an internal rate means that this appraisal method does not take into consideration external factors such as inflation. It presents the percentage earnings per an investment unit invested and thus allows investors to compare potential investments based on the yield to be realized (Magni, 2010).
With an IRR of 17.9410%, the project is viable because the rate is higher than the discounting rate, which stands at 12%.
Profitability index
= [ ++ + ] /$131,000,000 =1.1532
A positive profitability index of 1.1532 means the project is viable and the company should invest. This index shows the ratio of discounted cash flows to the initial investment. The ratio quantifies the amount of value per unit that the investment yields.
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