Highland Beverages' Capital Budgeting Exercise Analysis Report

This document presents a comprehensive solution to a capital budgeting exercise for Highland Beverages, a soft drink manufacturing company. The analysis includes the calculation of relevant cash flows for both the existing and proposed new plants. It calculates the Weighted Average Cost of Capital (WACC) using market value weights, and then proceeds to determine the Net Present Value (NPV) and Internal Rate of Return (IRR) of the project based on incremental cash flows. The conclusion drawn is that, based on the given assumptions, the new project should not be undertaken due to a negative NPV and IRR. Furthermore, the solution identifies the discount rate calculation as a key assumption that, if altered (e.g., using book value weights), could significantly impact the project's financial viability. The assignment provides detailed calculations and justifications for each step in the analysis, offering a thorough understanding of the capital budgeting process.

ANSWER TO QUESTION 1
The relevant cash flows to be considered for the project that are relative to the old
plant are presented as follows.
ANNUAL CASH FLOWS Years
2016 2017 2018 2019 2020
Sales Quantity (millions) 15 18 20.7 22.5 26.2
Sales Price 1.29 1.33 1.36 1.40 1.44
Sales 19.31 23.85 28.20 31.50 37.66
Less: Operating costs (60%) 11.59 14.31 16.92 18.90 22.60
Less: Indirect Costs
Administration costs 5.10 5.20 5.31 5.41 5.52
Cost for Feasibility Study 0.50 - - - -
Depreciation 1.00 1.00 1.00 1.00 1.00
Total cost 18.19 20.51 23.23 25.31 29.12
Profit/ (Loss) 1.13 3.34 4.98 6.19 8.54
Tax @40% 0.34 1.00 1.49 1.86 2.56
Profit/ (Loss) after tax 0.79 2.34 3.48 4.33 5.98
Depreciation 1.00 1.00 1.00 1.00 1.00
Cash Inflows 1.79 3.34 4.48 5.33 6.98
Net cash inflows 1.79 3.34 4.48 5.33 6.98

ANSWER TO QUESTION 2
The relevant cash flows to be considered for the project that are relative to the new
plant are presented as follows.
Initial outflows new
plant
Amount
in $
million
Initial outlay 63.00
Net working capital
Total 63.00
ANNUAL CASH
FLOWS Years
2016 2017 2018 2019 2020
Sales Quantity
(millions) 24 28.7 33.5 38.5 42.3
Sales Price 1.29 1.33 1.36 1.40 1.44
Sales 30.90 38.03 45.64 53.90 60.81
Less: Operating
costs (50%) 15.45 19.01 22.82 26.95 30.40
Less: Indirect Costs
Administration costs 5.10 5.20 5.31 5.41 5.52
Cost for Feasibility
Study 0.50 - - - -
Depreciation 1.88 1.88 1.88 1.88 1.88
Total cost 22.93 26.09 30.00 34.24 37.80
Profit/ (Loss) 7.98 11.94 15.64 19.66 23.01
Tax @40% 2.39 3.58 4.69 5.90 6.90
Profit/ (Loss) after
tax 5.58 8.36 10.95 13.76 16.11
Depreciation 1.88 1.88 1.88 1.88 1.88
Cash Inflows 7.46 10.23 12.82 15.64 17.98
Net cash inflows 7.46 10.23 12.82 15.64 17.98

ANSWER TO QUESTION 3
The proper discount rate calculation for the project is presented as follows.
Calculation of WACC (MKT VALUE
WEIGHTS) Capital Strcuture
Market value of
Equity 54000000
AMOUN
T Weights
Market value of
Bonds 115000000 Debt
1000000
00 62.50%
Equity
6000000
0 37.50%
Total 169000000
1600000
00 100%
Cost of Equity
Cost of
debt
Risk free rate of
return 3.50% Interest Expense 8000000
Expected rate of
return 9%
Latest two year
average debt
10750000
0
Beta 1.15
Cost of
debt 7.44%
Cost of Equity 9.83%
Total Equity 3.14%
Total Debt 3.04%
WACC 6.18%

ANSWER TO QUESTION 4
The NPV and the IRR of the project based on the incremental cash flows is presented as
follows.
INCREMENTAL CASH
FLOWS 5.67 6.89 8.34 10.31
11.0
0
Net present value
Year
Optimisti
c
PVF@6.18
%
Presen
t value
0 (63.00) 1.000 (63.00)
1 5.67 0.942 5.34
2 6.89 0.887 6.11
3 8.34 0.835 6.97
4 10.31 0.787 8.11
5 11.00 0.741 8.15
NPV (28.32)
IRR (Optimistic)
Year
Cash
flows
0 (63.00)
1 5.67
2 6.89
3 8.34
4 10.31
5 11.00
-10.99%

ANSWER TO QUESTION 5
Based on the assumptions taken in relation to the projects, the new project should not
be opted for. This is because, the NPV of adopting the new project and simultaneously
abandoning the old project, as calculated on the basis of the incremental cash flows is worked
out be negative i.e. (28.32). Further, the IRR is also worked out be negative of the said
proposal and hence, it is not feasible to go with the new project.
ANSWER TO QUESTION 6
The assumption that can easily be changed and would lead to the modification of the
answer in question 4 and question 5 above, apart from the projected revenue and expense
timing and amounts, tax considerations, or market data; is that the discount rate can be
calculated on the basis of the book value weights, or the capital structure weights instead of
the market value weights. This would lead to the modification of the discount rate and further
modification of the present values for the calculation of NPV and the IRR.