**QUESTION**

Capital Budgeting

1) Exercise The Investments Committee of an important food company is studying the possibility of building a new production line for botteled natural fruit juice. During the last year the company has produced small batchs of the product in a pilot production line and has conduced acceptance tests with selected clients obtaining very promising results. The new production line would be installed in factory facilities that the company already owns and does not use, and will only require some conditioning to install the new equipment.

**Operations Department: Batch Production Line for Bottled Juice Estimates**

-The Chief Operating Officer has provided the following detailed information:

• Equipment and tooling (includes bottelling), 500000 euros. 0.5% prompt payment discount offer available.

• Transportation of equipment, 5000 euros. Includes insurance.

• Incurred costs for the pilot line, 75000 euros. Fee to be paid for project proposal to marketing consultancy included.

• Conditioning of facilities, 25000 euros. Electrical work upgrade.

• Depreciation, 5 years. Straight line depreciation schedule.

• Residual value (selling price) of equipment, 150000 euros. Estimated.

• Fixed Operating costs, 300000 euros. Full annual fixed costs including personnel and maintenance.

• Variable Cost, 0.45 euros per bottle. Juice concentrate + recyclable bottles + packaging.

**Marketing & Sales: Natural Juice Estimates **

- Following the information provided by the Marketing department.

• 1000000 bottles the first year of operations (net after returns).

• 20 percent annual growth every year (units).

• 0.9 euros per bottle (net after promotions & discounts).

**Finance & Administration: Natural Juice Project Estimates**

- Based on the information from Marketing and Operations, the finance and administration department has prepared the following assumptions in order to analyze the investment and prepare a financing proposal.

• The company controller has estimated the requirements of Working Capital for the new operation:

– receivables account amount will be estimated considering 90 average credit days

– payables account amount will be estimated considering 30 average payable days

– the inventory amounts needed to avoid out-of-stock lost sales will be estimated with 30 days of stock for raw materials and 15 days for inventory of finished product. For both cases inventory units are valued at variable cost of 0.45 euros per unit. Net working capital of the first year of operations will be considered an initial investment outlay (year zero), and the investment in working capital will be fully recovered the last year (year 5).

• 5-years horizon project • applicable tax rate of 30 percent

• 75 percent of debt and 25 percent of equity

• the loan to be fully returned in 5 years with an equal payment amortization schedule. Interest rate will be 14 percent with flotation cost of debt of 0 percent.

• the necessary equity will be raised by issuing new stock in the market. The dividend yield will be in line with that of equities with similar beta, 16 percent, and the flotation cost of equity will reach 6.25 percent that will be capitalized and amortized during the whole 5-years-life of the project.

• reinvestment rate is 5 percent.

• risk free rate 3 percent.

• for risk analysis, will consider three scenarios for Net Present Value,

– optimist: 1.15×NPV with a probability of 40 %

– neutral: 1×NPV with a probability of 40 %

– pessimist: 0.85×NPV with a probability of 20 %

• the utility function that will use for the firm is U = NPV2

**Answer the following questions in the task questionnaire by Tuesday 21 of March at 23:59. Upload your excel file with the model and answers in the last question.**

(a) InvestmentProject.SelecttheelementsthatmakeuptheInitialInvestmentOutlayandcalculate the corresponding initial cash flow (cf0). Which is its value?

(b) Investment Project. Working Capital. Whithin the initial investmet outlay, which is the amount needed for working capital?

(c) Investment Project. Which is the investment cash flow generated the last year of operations (year 5), cf5, including the terminal cash flow ?

(d) Financing Project. Which is the Debt Financing Cash flow of the first year of operations, cf1?

(e) Financing Project. Which is the Equity Financing cash flow of the fourth year of operations?

(f) Aggregated Project. Prepare the sequence of cash flows of the aggregated project. The sum of cash flow residuals of your model should be around 670159 euros (check your work in case obtain significantly different). Is the project financially balanced?

(g) Which is the Net Present Value (NPV)? Use as discount rate a cost of capital of 12.37 percent.

(h) Which is the Internal Rate of Return (IRR)?

(i) Which is the Net Terminal Value (NTV)? Assume a reinvestment rate of 5 percent.

(j) Calculate the pay-back period rounded-up to years.

(k) Calculate the profitability index.

(l) Risk Analysis. Which would be the NPV of the project if instead of using the cost of capital of 12.37 uses a discount rate estimated with the Capital Asset Pricing Model (CAPM) considering a risk premium (Market Return - Risk Free Rate) of 15 percent, a risk free rate of 3 percent, and a beta of 1.0?

(m) Risk Analysis. The Certainty Equivalent of an uncertain cash flow is the minimum (certain) amount that an investor is willing to accept in exchange of the uncertain cash flow. Which is the certainty equivalent for the 206162 euros cash flow calculated for the third year of the investment project? Use for your calculation the Risk Adjusted Discount Rate estimated with the CAPM which is 18 percent, and the risk free rate of 3 percent. 2

(n) Scenario Analysis. Considering the optimistic: 115 percent of NPV, neutral: 100 percent of NPV and pessimistic 85 percent of NPV, together with their respective probabilities of 40, 40 and 20 percent, calculate the Expected NPV of the project. Use the NPV calculated with the cost of capital (question 7).

(o) Scenario Analysis. Considering the same three possible scenarios, which is the volatility of the NPV?

(p) Scenario Analysis and Utility Function. The risk preference of the firm is stated by its utility function. The utility of the certainty equivalent is equal to the expected utility of the uncertain value. Which is the certainty equivalent of the NPV?.

(q) Which is the Risk Premium that relates the certainty equivalent of the NPV and the Expected NPV?

(r) Has the investor either a risk averse or a risk seeking profile?

(s) Sensitivity analysis. Which is the break even for units sold? Express as units to be sold in year one and growing at the 20 percent rate annually as stated in the model.

(t) Upload your excel workbook which apart from your data, model and calculations should include one sheet with the answers only.