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ICN ECOLE DE MANAGEMENT
Master ICN 2
2010-2011
Financial Management
Tutorial n1
Course ID on MyFinanceLab
XL0I-S1TD-801Z-00F2
Investment decision and capital budgeting
S. Mbarek
V. Moskalu
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Financial management is
Financing decisions
Investing decisions (=capital budgeting) by equity or debt, allows to analyze
alternative investments and to know which one to accept/to reject.Three steps: Evaluate your project NPV, Choose your decision criterion,
Risk management like solvency risk, liquidity risk, foreign exchange, investment rate.
Some basic principles in financial management = To think in monetary cash flows + To think
in time value of money (compounding and discounting the expected cash flows)
Case 5 Etang de la Comtesse
Etang de la comtesse company, located in the Vosges, is specialized in fish farming. It plans
to expand its product range and plans to implement a packaging line. Technical departmentconsider that investment expenditure would be 7,000,000 euros. This new machine could be
installed in a building belonging to the company. This machine will be depreciated over 4
years and after this period, its residual value may be considered null.
Commercial department set at 30 the unit price of the new product. This price will increaseby 3% per year. Production engineer estimated production costs at 5 per year and the
workers are paid 10 per hour. These wages should increase by 2% per year. The company
is currently subject to the income tax (at 33%), it also uses a discount rate of 9%.
Estimations :
2011 2012 2013 2014
Quantities sold 50 000 100 000 125 000 100 000
Number of hours of production 15 000 25 000 30 000 28 000
Advise the company by offering an assessment of the NPV and the discounted payback period.
Discuss the assumptions and results.
Project: Assumptions
- Investment 7 000 000 euros
- 4 years
- 30 euros/unit + 3%/year
- Production costs 5euros/product/year
- Salaries 10 euros/hour + 2%/year
- Income tax 33%
- Discount rate 9%
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2011 2012 2013 2014
price 30 30,9 31,827 32,78181
Quantities (in
thsd)
50 100 125 100
CA 1500 3090 3978,375 3278,181
Wage/hour 10 10,2 10,404 10,61206N of hours (in
thsd)
15 25 30 28
Total wages 150 255 312,12 297,13824
Production costs 250 500 625 500
Investment 7000
Depreciation ( 7000/4) = 1750
Taxe rate 0,33
WACC 0,09
2010 2011 2012 2013 2014
sales 1500 3090 3978,375 3278,181
Production
costs
250 500 625 500
Wages 150 255 312,12 297,13824
EBITDA 110 2335 3041,255 2481,04276
Depreciation 1750 1750 1750 1750
EBIT -650 585 1291,255 731,04276
Tax -214,5 193,05 426,11415 241,2441108Net income -435,5 391,95 865,14085 489,798692
Depreciation 1750 1750 1750 1750
Cash flows 1314,5 2141,95 2615,14085 2239,7986492
Discounted
CF
1205,9633 1802,8364 2019,3685 1586,7298
Discounted
rate
1,09 1,19 1,3 1,41
NPV (Discounted CF investment) = - 385,10
The NPV is negative so we have to reject the project. Instead the firm will lose money.
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Case No. 4 Company Olima
A company producing plastic parts for automobiles plans to expand ( = capacity investment)
by exporting a part of its production to Russia. Commercial department believes that the
market penetration would be quick as indicated by the important development of the
company's business.
Year 2011 2012 2013 2014 2015
Sales withoutexport
10,000 11,000 13,000 15,000 17,000
Sales withexport
11,000 12,000 15,500 18,000 20,000
Units: Thousands of Euros
This additional activity would not alter the operating conditions of the company. These canbe summarized as follows: EBIT 14% of sales, Income Tax rate 33% and a NWC. 35% of
turnover
This decision requires an increase in the production capacity of the company. The new
equipment requires an investment of 100,000 euros depreciated over five years usingthe straight line method. Eventually, the residual value may be considered as null.
The company currently uses a discount rate of 9%.
Advise this company.
Project: Assumptions
- Investment 100 K
- EBITDA 14% of sales
- NWC 35% of sales
- Tax rate 33%
- Depreciation 20 K
2011 2012 2013 2014 2015
Sales amount 10 000 11 000 13 000 15 000 17000
EBITDA 1400 1540 1820 2100 2380
NWC 3500 3850 4550 5250 5950Sales with exp 11000 12000 15500 18000 20000
EBITDA 2 1540 1680 2170 2520 2800
NWC 2 3850 4200 5425 6300 7000
Incremental
earnings
140 140 350 420 420
Incremental
NWC
350 350 875 1050 1050
Cash Flows calculation
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2010 2011 2012 2013 2014 2015
Incremental
EBITDA
140 140 350 420 420
Depreciation 20 20 20 20 20
EBIT 150 255 312,12 297,13824 297,13824
Tax 110 2335 3041,255 2481,04276 2481,04276Net income 1750 1750 1750 1750 1750
Depreciation -650 585 1291,255 731,04276 731,04276
-214,5 193,05 426,11415 241,2441108 241,2441108
Cash flows -435,5 391,95 865,14085 489,798692 489,798692
NWC 1750 1750 1750 1750 1750
Incremental
NWC
1314,5 2141,95 2615,14085 2239,7986492 2239,7986492
1205,9633 1802,8364 2019,3685 1586,7298 1586,7298
Cash flows
Discountingfactor 1,09 1,19 1,3 1,41 1,54
Discounting
CF
NPV (Discounted CF investment) =
The NPV is negative so we have to reject the project. Instead the firm will lose money.
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Case No. 1 Company Locmarie
At the end of year N, Locmaries director is considering launching a new product whose life
is estimated at 5 years. This project requires an initial investment of 210 K in machines
(depreciated over 7 years using a straight-line basis ). A company that specializes in market
studies worked for two months on the project, the cost of this study ( 3K) is paid during theyear N-1. The company releases earnings currently. The sales forecast for year N+1 wouldbe 400 K and should increase 9% per year thereafter.
The construction of buildings (cost of 360K depreciated over 10 years) should be on a landbelonging to the company that is now estimated at 39K. Its value should increase by 6%
annually.
Variable costs represent 40% of the selling price. An advertising campaign should be
launched in N+1 to promote sales. Its cost would reach 33 K .
The need for working capital represents 20% of sales the following year. The tax rate is 33
1/3 %. The cost of capital for the project is 16%. The resale value of the building and
machinery after 5 years is estimated at 234 K .
Calculate the NPV of the project and the IRR. Should he make the investment?
Project: Assumptions
- Capital expenditures (= dpenses)
Machines Investment 210K (depreciated over 7 years => 30K)
Buildings construction 360K (depreciated over 10 years => 36K)
Land belonging to the company 39K increasing by 6%/Year
(residual value in 5 years => 52,1908K)
=609K
- Study 3K (paid N-1) Not to integrate! Already paid even if you reject the project or
not
- Sales N+1 400K and then a 9% increase/year
- Variable costs 40% of selling price
- Advertising campaign 33K (launched N+1)
- Working capital need 20% of sales- Taxe rate 1/3%
- Cost of capital 16% discounting factor 1,6
- Sales value of buldings and machines after 5 years 234K
! Not the same as Book value (valeur comptable) = (360-36x5) (210 -30x5)= 240K
N N+1 N+2 N+3 N+4 N +5
investment 609
sales 400 436 475,24 518,0116 564,6326
Var costs 160 174,4 190,0960 207,2046 225,8531
Fixed costs 33EBITDA 207 261,6 285,1440 310,8070 338,7796
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(sales-costs)
Depreciation
(30 + 36)
66 66 66 66 66
EBIT
(EBITDA-
depreciation)
141 195,6 219,1440 255,8070 272,7796
Tax 46,95
30
65,1348 72,9750 81,5207 90,8356
Net income 94,04
70
130,4652 146,1690 163,2862 181,9440
Cash flows
(net income
+
depreciation)
180,0
470
196,4652 212,1690 229,2862 247,8440
NWC
(=BfR)
(20% sales
next year)
80 87,2 95,0480 103,6023 112,9265 0
Incremental
NWC
(NWC N+1
NWC N)
7,2 7,8480 8,5543 9,3242 (112,9265
)
(80)
recovered
NWC
Cash Flows
(CF
incremental
NWC)
152,8
470
188,6172 203,6147 219,9620 360,8705 206,1908
234
residual
value of
buildings
&
machines
52,1908
residual
value of
land
Discounted
CF ( CF/1,6)
131,7
647
140,1723 130,4473 121,4831 171,8151 84,6294
NPV
(discounted
CF
-investment )
261,
3126
Calculating
Internal Rate
of Return = 0
20
or
21%
The NPV is positive.
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The IRR is about 20 or 21%. The IRR is bigger than the cost of capital (=16%) so we can
accept the project.
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The case studies n1, 4 and 5 must be prepared for the tutorial of Tuesday 21st,
September 2010
It is strongly recommended to do the training exercises to get familiar with capital
budgeting calculations
Exercise 1
A company can choose between two exclusive projects. They are characterized by the
following flows:
Year Project A Project B
0 -100 -100
1 50 70
2 70 753 40 10
Calculate the NPV for a cost of capital of 10% and 20%. Conclude.
Exercise No. 2
The Financial department of a company is considering the replacement of an industrial
project. This project can be characterized by the following flows:
T=0 T from 1 to 7 T=8
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Cash flows - 1000 +200 +500
Given that the weighted average cost of capital of this company is 12%, calculate the NPV of
this project. What is its significance?
What effect would a reduction in the depreciation period of the machine on the NPV?
Exercise 3
A company has to choose between two projects, valued on a 2-year life long basis, taking into
account the two following assumptions:
A1: Activity remains stable or slightly increases (probability: 0.60)
A2: The activity tends to decline (probability: 0.4)
First project: Total Initial investment : I = 6000 k
Second project: Initial investment is limited with possible extension after one year: an initialinvestment of 3,000 k at date 0 and 4,000 k at date 1 if the hypothesis A1est verified;
The decision tree is given to you below.
The cost of capital is 10%
Should we make the extension T = 1 for project 2?
Compute the expected NPV for the Project 1.
Tree Project 1:
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Project tree 2 :
ECF : Expected Cash FlowsP : Probability
Invest : -
6000
ECF 500
500
ECF 3500
500
ECF 3000
ECF 2500P=40%
P=60%
P=40%
P=60%
P=60%
ECF = 2000
000
P=40%
ECF =
1 000
t=0t=2 to
6
t=1
11
-3000
P = 60%
ECF = 1500
1111111150
0
extention
n
No extension
P= 0,6
P=0,4
F
T
E
=
P
0,
6
=
0,
6
P=0,6
P=0,4
ECF = 4,500
000
FTE = 500
ECF= 2000
ECF=1750
ECF=100
ECF=500
ECF=2000
P= 40%
P=0,4
P=0,6
P=0,6
p=0,6
P=0,4
T=1 t=2 to t=6
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Case No. 2 Company Baberlec
Given the success of one of its products, Barbelec is considering a new location. Continued
sales growth depends, however, on economic conditions. The first year there is 65% chance
that the demand is high, in which case there will be 75% chance that it remains high the
following years. However, if the initial demand is low, it remains low thereafter in 60% of
cases.
The firm is studying two possibilities:
The first solution involves the construction of a plant with large capacity which would require
an investment of 750K. The production capacity would be sufficient to meet demand 10years ahead.
The second solution lies in the choice of a small capacity plant costing only 250 K . It
would, however, not meet demand if economic conditions are very good. Management
believes, however, that if demand is strong, they have the opportunity to build an extension at
the end of the first year. This extension will cost 180 K .
We consider the investment over two periods, the second period is associated with cash flows
generated by the investment between the 2nd and the 10th year in present values. The discount
rate is 7%.
The flows are as follows:
Cash flow for year 1
>
Demand High low
Big factory 800 -150
Small factory 230 20
Cash flows for years 2-10
Demand High/high High/low Low/high Low/low
Gig factory 1 700 150 1 100 -1 000
Small (without
extension)
740 400 680 30
Small (with
extension)
1 400 210
Draw the tree corresponding to the decision taken by the company.
Case No. 3 Reider
Reider is considering an major investment project requiring an initial outflow of 150 Keuros.
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This investment will take effect over the next ten years. However, commercial department
considers that the effects of this investment are linked to economic conditions and in
particular the settlement of a customer in the industrial area of the company. Currently, the
relocation decision is not taken yet and it would be effective only in one year.
Commercial department had considered that in the case of an implementation of the client, the
net cash flows could be estimated at 19,000 euros. However, if implantation does not occur,
the net cash flows would be only 12,000 euros.
The CFO is wondering: Should I invest? If yes, when?
He asks you to prepare a rationale for this decision.
Rq. Discount rate: 8%.
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