Capital Budgeting

Requirements:
The problem solving timed assignment is composed of two (2) separate practical tasks.
The assignment consists of two individual practical tasks where students are required to
apply capital budgeting techniques and perform a risk analysis on a project.
• Submit your response in an Excel file which should contain two (2) worksheets named
Task 1 and Task 2.
• Each Task worksheet should contain:
✓ the calculations and workings relevant to the specific task, and a
✓ brief a page recommendation/discussion (type in cells or insert pdf/doc
as picture)
• Calculations should be based on excel functions.
• Calculations should be as clear and detailed as possible.
• Graphics should illustrate your argument (even when not specified)
• Only input cells can be typed in a cell, and these should be yellow shaded.
• All answers should be able to be traced back to the input cells or other calculations
using ‘Trace Precedents’ button.
Marking Criteria

  • Calculations and workings: 15 marks
  • Recommendation/discussion: 3.5 marks
  • Appropriate cell reference and writing: 1.5 marks Task #1: Organics Chemicals
    Role and Context
    You are a financial analyst in the capital projects department of Organics Chemicals, a
    speciality chemicals producer of fire-control chemicals, additives, and pesticides based in
    Queensland. Currently, Organics is small in scale, but embarking on a rapid expansion
    and modernization program. It is also expanding its range of products into dyes, rubber
    compounds, and water treatment chemicals. While Organics has a large and expanding
    capital budget, it is currently considering which of two possible projects it should invest
    in, both of which will be used to manufacture furfural and furfural-based derivatives to
    make resins, urethanes, and refining solvents over a 10-year operating period.
    Scenario
    The first project, the Foshan Plant, is a proposed new plant in Guangdong Province,
    China. Organics has been considering this expansion for a few years and believes that
    the combination of low wages, looser environmental protection, and proximity to its
    emerging markets in SE Asia will make this new plant an attractive addition to its existing
    facilities. Specifically, now in 2020, the Foshan Plant will require the purchase of land for
    $2.75 million, with development and construction building costs of $12 million, and
    equipment cost of $6 million. Organics will also need to invest in working capital. The
    change in net working capital is an increase of 7% of yearly forecasted sales for every
    year of the project life. Sales are estimated to be $47.9 million first year of production in
    2021, then increasing by 8% per annum. The cost of goods sold is 65% of sales. Fixed
    costs will be $8 million in 2021, increasing by 5% per year. Both buildings and plant/
    equipment will be depreciated straight line to zero over the 10-year project life. The
    buildings will have no salvage value and the equipment will have 15% salvage value. At
    the end of the project, Organics will rehabilitate the site and sell the land for light industrial
    development for $11.8 million. The Chinese government will provide an incentive by
    charging only 20% tax for the first three years of operation, after which the tax rate for
    income and capital gains will revert to 25% for the rest of project life.
    The second project, the Mackay Plant, is a modification of an existing plant Organics
    already owns in the city of the same name in north Queensland. The Mackay Plant has
    been idle for several years, but with renovation would be well suited to furfural
    production. If not used for the proposed project, Organics will lease out the existing plant
    for $50,000 after tax per year. The estimated development and construction building
    costs will be $11 million this year in 2020, alongside equipment investment of $5 million.
    Organics will again need to invest every year in working capital. The change in net
    working capital is an increase of 5% of yearly sales. Sales are forecasted to be $42 million
    in the first year of production in 2021, increasing by 7% per annum thereafter. Due to the
    stricter environmental controls given the proximity to the Great Barrier Reef, the cost of
    goods sold will be 75% of sales. Fixed costs will be $4 million in 2021, increasing by 4%
    per year. Both buildings and plant/equipment will again be depreciated straight line to
    zero over the 10-year project life. The buildings will have no salvage value and equipment
    will have 15% salvage value. At the end of the project, the Mackay Plant will again revert
    to being idle awaiting potential future developments at no cost. The company tax rate in
    Australia is 30%.
    Task
    Recommend to Organics’ CFO, Ms. Alexandra Robinson, in which of these two
    mutually exclusive projects Organics should invest, if any. Assume Organics has a
    cost of capital of 12% for domestic projects and 16% for international projects.

Task #2: Cascade Water Company
Role and Context
You are a newly hired financial analyst with Cascade Water Company (CWC), a company
operating in most states of Australia, which specialises in bottling purified water sourced
from local water springs. CWC is considering adding to its product mix a ‘healthy’ bottled
vitamin water geared towards children, aimed at improving both its business focus and
the return to shareholders.
Scenario
In their last annual report, CWC showed 32,000,000 ordinary shares outstanding that had
a trading price of $45 per share. CWC has just completed a 7 for 5 split to encourage
more investment in its shares. CWC also has 650,000 bonds outstanding that currently
trade at $950 each. The company’s bonds have 20 years left to maturity, a $1,000 par
value and an 8% coupon rate that pays interest semi-annually. CWC has no preferred
equity outstanding. The equity beta is 1.15. The risk-free rate is 0.75% and the market is
expected to return 8.5%. CWC has a tax rate of 35%.
The initial outlay for the new project is expected to be $2,250,000, which will be
depreciated over 3 years using the straight-line method to a zero-salvage value. Sales are
expected to be 1,300,000 units per year at a price of $2.2 per unit. Variable costs are
estimated to be $0.6 per unit and fixed costs are estimated at $55,000 per year. The
project is expected to have an indefinite life; however, the company has estimated an
after-tax terminal cash flow in year 3 of $4,500,000. For the purpose of this project,
working capital effects are ignored.
CWC’s CEO, Dr Adam Richards, has asked the finance department if they consider such
project to be an acceptable investment. The CFO, Mrs. Kerry Davenport, intends to
evaluate the project based on the net present value approach. She agrees with Dr.
Richards on the major assumptions that will affect these cash flows, but they disagree on
the appropriate discount rate. Dr. Richards believes that they should use the company’s
weighted average cost of capital (WACC), however, the CFO disagrees, arguing that the
bottled water targeted at children has different risk characteristics from the company’s
current products. She argues that the company’s WACC is inappropriate as a discount
rate and they should instead use the ‘pure play’ approach and estimate a cost of capital
based on companies that sell similar type of riskier products. To do this, Mrs Davenport
obtains some data for two comparable companies as follows:
Task
1) The CEO and CFO have decided to rely on your newfound expertise as to provide
a recommendation on the appropriate discount rate to be used in the evaluation of
the new project.
2) Concerned about the forecasting risk of this project, they also ask that you
perform a risk evaluation on the base case NPV in the form of:

  • Sensitivity analysis for sales price, variable costs, fixed costs and unit sales at
    ±10%, ±20%, and ±30% from the base case, showing on a graph which variables are
    most sensitive;
  • Scenario analysis on the following two scenarios:
    a) Worst Case: selling 650,000 units per year at a price of $1.25 and variable cost of
    $0.80 per unit;
    b) Best Case: selling 1,750,000 units per year at a price of $2.75 and variable costs
    of $0.55 per unit.
    3) Finally, advise the CEO and CFO whether this project is an acceptable investment
    taking in consideration the capital budgeting techniques used and the risk analysis
    performed.

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