FIN 505 Fall 2018 - Capital Budgeting and Business Valuation Cases

This document presents a comprehensive case study solution for FIN 505, covering capital budgeting and business valuation. The first case involves evaluating two lathes (Lathe A and Lathe B) using payback period, Net Present Value (NPV), and Internal Rate of Return (IRR) methods to determine the optimal investment. The analysis favors Lathe A due to its lower payback period, higher NPV, and IRR exceeding the cost of capital. The second case focuses on business valuation using discounted cash flow (DCF) analysis. It calculates the weighted average cost of capital (WACC), free cash flow to firm (FCFF), terminal value, enterprise value, and ultimately, the share price of the company. The valuation concludes with a share price of $37.67 based on the calculated enterprise value and equity value.

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FIN 505 – FALL 2018 – Final Individual Assignment

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Answer to Case A: Capital Budgeting
Particulars Years Lathe A Lathe B
Cash Flows
Initial Investment 0 $ (660,000) $ (360,000)
Cash Inflow 1 $ 128,000 $ 88,000
Cash Inflow 2 $ 182,000 $ 120,000
Cash Inflow 3 $ 166,000 $ 96,000
Cash Inflow 4 $ 168,000 $ 86,000
Cash Inflow 5 $ 450,000 $ 207,000
Cost of Capital: 13%
Answer 1: Payback Period
Lathe A
Years Cash Flows Cumulative CF
Initial Investment 0 $ (660,000) $ (660,000)
Cash Inflow 1 $ 128,000 $ (532,000)
Cash Inflow 2 $ 182,000 $ (350,000)
Cash Inflow 3 $ 166,000 $ (184,000)
Cash Inflow 4 $ 168,000 $ (16,000)
Cash Inflow 5 $ 450,000 $ 434,000
Payback Period of Lathe A 4.04
4 years 15 days
(Firer, 2012)
Lathe B
Years Cash Flows Cumulative CF
Initial Investment 0 $ (360,000) $ (360,000)
Cash Inflow 1 $ 88,000 $ (272,000)
Cash Inflow 2 $ 120,000 $ (152,000)
Cash Inflow 3 $ 96,000 $ (56,000)
Cash Inflow 4 $ 86,000 $ 30,000
Cash Inflow 5 $ 207,000 $ 237,000
Payback Period of Lathe A 3.65
4 years 237 days
Answer 2:
Lathe A Net Present Value
Years Cash Flows PVF @ 13% PV @ 13 %
Initial Investment 0 $ (660,000) 1.000 $ (660,000)
Cash Inflow 1 $ 128,000 0.885 $ 113,274
Cash Inflow 2 $ 182,000 0.783 $ 142,533

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Cash Inflow 3 $ 166,000 0.693 $ 115,046
Cash Inflow 4 $ 168,000 0.613 $ 103,038
Cash Inflow 5 $ 450,000 0.543 $ 244,242
NPV Lathe A $ 58,132.88
(Deegan, 2013)
Lathe B Net Present Value
Years Cash Flows PVF @ 13% PV @ 13 %
Initial Investment 0 $ (360,000) 1.000 $ (360,000)
Cash Inflow 1 $ 88,000 0.885 $ 77,876
Cash Inflow 2 $ 120,000 0.783 $ 93,978
Cash Inflow 3 $ 96,000 0.693 $ 66,533
Cash Inflow 4 $ 86,000 0.613 $ 52,745
Cash Inflow 5 $ 207,000 0.543 $ 112,351
NPV Lathe B $ 43,483.24
Lathe A Internal Rate of Return
Years Cash Flows
PVF @
15% PV @ 15 %
PVF @
20% PV @ 20%
Initial
Investment 0
$
(660,000) 1.000
$
(660,000) 1.000
$
(660,000)
Cash Inflow 1
$
128,000 0.870
$
111,304 0.833
$
106,667
Cash Inflow 2
$
182,000 0.756
$
137,618 0.694
$
126,389
Cash Inflow 3
$
166,000 0.658
$
109,148 0.579
$
96,065
Cash Inflow 4
$
168,000 0.572
$
96,055 0.482
$
81,019
Cash Inflow 5
$
450,000 0.497
$
223,730 0.402
$
180,845
$
17,854.27
$
(69,016)
IRR Lathe
A 16.03%
(Brigham and Houston, 2012)
Lathe B Internal Rate of Return
Year
s
Cash
Flows
PVF @
15% PV @ 15 %
PVF @
20%
PV @
20%
Initial
Investment 0
$
(360,000) 1.000
$
(360,000) 1.000
$
(360,000)
Cash Inflow 1
$
88,000 0.870
$
76,522 0.833
$
73,333

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Cash Inflow 2
$
120,000 0.756
$
90,737 0.694
$
83,333
Cash Inflow 3
$
96,000 0.658
$
63,122 0.579
$
55,556
Cash Inflow 4
$
86,000 0.572
$
49,171 0.482
$
41,474
Cash Inflow 5
$
207,000 0.497
$
102,916 0.402
$
83,189
$
22,466.90
$
(23,115)
IRR Lathe
B 17.46%
Answer 3:
On the basis of theoretical decision it is recommended to the company to invest in such
Lathe that yield higher return and give maximum cash flow to the company. Also various factors
such as nature of investment, size, ease of operation and other relevant factors must be consider
before making taking the theoretical decision. It is recommended to the company to choose
Lathe A as it generates higher rate of return and also give maximum cash flows to the company.
On the basis of practical ground it is also suggested to select Lathe A as it has lower
payback period, higher NPV and IRR greater than cost of capital (Baker and Nofsinger, 2010).

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Answer to Case 2: Business Valuation
Answer 1: Cost of Capital WACC
Capital Type Weight of
Capital
Cost of
Capital
(After Tax)
Weighte
d Cost of
Capital
Equity Capital 66.67% 10.00% 6.67%
Debt Capital 33.33% 4.80% 1.60%
WACC 8.27%
(Arnold, 2013)
Answer 2: Calculation of FCFF
Calculation of FCFF
Particulars Years
1 2 3 4 5 5
Amount in Million $
Revenues $ 3,960 $ 4,080 $ 4,200 $ 4,326 $ 4,458
Less: Raw Materials $ (1,782) $ (1,794) $ (1,806) $ (1,860) $ (1,917)
Less: Production Cost
$
(870)
$
(897)
$
(924)
$
(996) $ (1,026)
Less: Other Cost
$
(396)
$
(408)
$
(420)
$
(432)
$
(447)
EBITDA
$
912
$
981 $ 1,050 $ 1,038 $ 1,068
Less: Depreciation
$
(330)
$
(315)
$
(300)
$
(300)
$
(300)
EBIT
$
582
$
666
$
750
$
738
$
768
Less: Tax @ 20%
$
116
$
133
$
150
$
148
$
154
EAT
$
466
$
533
$
600
$
590
$
614
Add: Depreciation
$
330
$
315
$
300
$
300
$
300
EBDAT
$
796
$
848
$
900
$
890
$
914
Less: Investment
$
(300)
$
(300)
$
(300)
$
(300)
$
(300)
Less: Working
Capital
$
(50)
$
(50)
Add: Working Capital
recovery
$
100
FFCF $ $ $ $ $

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446 498 600 590 714
(Ross, Jaffe and Kakani, 2008)
Answer 3: Calculation of Terminal Value
Calculation of Terminal Value (TV)
FCF of last year $ 714.40
Perpetual Growth rate (g) 2%
Discount Rate (WACC) 8.27%
Formula of TV
(FCFn x (1 + g)) /
(WACC – g)
Terminal Value 11627.68
Answer 4: Enterprise Value (Firm Value)
Calculation of Firm Value
Particulars Years
1 2 3 4 5 5
Amount in Million $ TV
Revenues
$
3,960
$
4,080
$
4,200
$
4,326
$
4,458
Less: Raw Materials
$
(1,782)
$
(1,794)
$
(1,806)
$
(1,860)
$
(1,917)
Less: Production Cost
$
(870)
$
(897)
$
(924)
$
(996)
$
(1,026)
Less: Other Cost
$
(396)
$
(408)
$
(420)
$
(432)
$
(447)
EBITDA
$
912
$
981
$
1,050
$
1,038
$
1,068
Less: Depreciation
$
(330)
$
(315)
$
(300)
$
(300)
$
(300)
EBIT
$
582
$
666
$
750
$
738
$
768
Less: Tax @ 20%
$
116
$
133
$
150
$
148
$
154
EAT
$
466
$
533
$
600
$
590
$
614
Add: Depreciation
$
330
$
315
$
300
$
300
$
300
EBDAT
$
796
$
848
$
900
$
890
$
914
Less: Investment $ $ $ $ $

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(300) (300) (300) (300) (300)
Less: Working Capital
$
(50)
$
(50)
Add: Working Capital
recovery
$
100
FFCF
$
446
$
498
$
600
$
590
$
714
$
11,628
PVF @ 8.27% (WACC)
$
1
$
1
$
1
$
1
$
1
$
1
Present Value
$
412
$
425
$
473
$
430
$
480
$
7,815
Firm Value
$
10,034
(Peterson and Fabozzi, 2002)
Answer 5: Calculation of Share Price
Calculation of Share Price
Enterprise Value (Firm Value) $ 10,034.21 Million
Less: Debt Value $ 2,500.00 Million
Equity Value $ 7,534.21 Million
Number of Equity Shares 200 Million
Share Price $ 37.67
(Krantz, 2016)

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References
Arnold, G., 2013. Corporate financial management. Pearson Higher Ed.
Baker, H.K. and Nofsinger, J.R. 2010. Behavioral Finance: Investors, Corporations, and
Markets. John Wiley & Sons.
Brigham, F., and Houston, J. 2012. Fundamentals of financial management. Cengage Learning.
Deegan, C., 2013. Financial accounting theory. McGraw-Hill Education Australia.
Firer, C. 2012. Fundamentals of Corporate Finance. Berkshire.McGraw-Hill.
Krantz, M. 2016. Fundamental Analysis for Dummies. John Wiley & Sons.
Peterson, P,P and Fabozzi,F,J,. 2002. Capital budgeting: theory and practice. John Wiley & sons.
Ross, A., Jaffe, J. and Kakani, R.K. 2008. Corporate Finance. Pearson.