Sheet1TFC Capital Budgeting Analysis - Week 6 ScenarioENTER CORRECT DATA IN YELLOW-CODED CELLS($600,000,000)Projected Expansion Cost8.50%WACC012345Year($600,000,000)($2,500,000)$175,000,000$200,000,000$150,000,000$300,000,000Cash flows($602,500,000)($427,500,000)($227,500,000)($77,500,000)0.258Cumulative cash flows$10,681,917NPV9.03%IRR8.88%MIRR4.258Payback years
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FIN534 Week 6 Scenario Script: How to use the Different Capital Budgeting Methods, and Identifying Relevant Cash Flows
Slide #
Scene/Interaction
Narration
Slide 1
Intro Slide
Slide 2
Scene 2
· In Don’s office
· Maybe Fitness Olympic banner
· Situation room
· End of scene
Don: Hi Linda, how was your workout? I knew I would see you exercising before work.
Linda: That is right Don. Our annual Fitness Olympics challenge is coming up and I want to be in shape for it.
Don: I forgot about the company Fitness Olympics.
Linda: Well, I did not forget. Last year our department just missed out on the top honors. This year we are planning on being the winning department. I may even try to recruit our intern!
Don: Great attitude, Linda.
Don: Before the Fitness Olympics, we still have a lot of work to do concerning this expansion project and whether or not we should go with it. Things are starting to move quickly. Recently, I heard from Joe and he wants us to do some capital budgeting analyses on the project. This analysis may be our make or break analysis for the project so we really need to be detailed.
Linda: Okay Don. The intern and I are right on it. I plan on meeting the intern in the “Situation Room”. We dubbed the conference room that name as we are constantly making informed decisions.
Slide 3
Scene 3
· Linda in conference room
·
· Go to next slide
Linda: We have our hands full. The project is getting close to decision making time. Joe and Don want us to analyze the proposed expansion project from a capital budgeting standpoint. Currently, we have completed many internal analyses on TFC. Now, we must look at the viability of the expansion project. Capital budgeting does just that. At the end of it, we should have a better idea of what our recommendation would be.
Linda: Capital budgeting can be done whenever there is an initiative to invest in assets for the long term. Our project is doing just that. We want to be confident in our decision as this project is for the long term and is costly. Don is going to be joining us with the expected cost of the project.
Slide 4
Scene 4
· Don in conference room with papers in hand?
· Show on the papers - seven hundred fifty million dollars
· Go to next slide
Don: Hello all. With this expansion project we will double in asset size. But it comes with a price. The Accounting Department told us that the projected price to expand out West is seven hundred fifty million dollars. I also have the projected cash flow numbers. Now, I need the both of you to determi.
Sheet1TFC Capital Budgeting Analysis - Week 6 ScenarioENTER CORREC.docx
1. Sheet1TFC Capital Budgeting Analysis - Week 6
ScenarioENTER CORRECT DATA IN YELLOW-CODED
CELLS($600,000,000)Projected Expansion
Cost8.50%WACC012345Year($600,000,000)($2,500,000)$175,
000,000$200,000,000$150,000,000$300,000,000Cash
flows($602,500,000)($427,500,000)($227,500,000)($77,500,000
)0.258Cumulative cash
flows$10,681,917NPV9.03%IRR8.88%MIRR4.258Payback
years
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FIN534 Week 6 Scenario Script: How to use the Different
Capital Budgeting Methods, and Identifying Relevant Cash
Flows
Slide #
Scene/Interaction
Narration
Slide 1
Intro Slide
Slide 2
Scene 2
· In Don’s office
· Maybe Fitness Olympic banner
· Situation room
· End of scene
Don: Hi Linda, how was your workout? I knew I would see you
exercising before work.
2. Linda: That is right Don. Our annual Fitness Olympics
challenge is coming up and I want to be in shape for it.
Don: I forgot about the company Fitness Olympics.
Linda: Well, I did not forget. Last year our department just
missed out on the top honors. This year we are planning on
being the winning department. I may even try to recruit our
intern!
Don: Great attitude, Linda.
Don: Before the Fitness Olympics, we still have a lot of work
to do concerning this expansion project and whether or not we
should go with it. Things are starting to move quickly.
Recently, I heard from Joe and he wants us to do some capital
budgeting analyses on the project. This analysis may be our
make or break analysis for the project so we really need to be
detailed.
Linda: Okay Don. The intern and I are right on it. I plan on
meeting the intern in the “Situation Room”. We dubbed the
conference room that name as we are constantly making
informed decisions.
Slide 3
Scene 3
· Linda in conference room
·
· Go to next slide
Linda: We have our hands full. The project is getting close to
decision making time. Joe and Don want us to analyze the
proposed expansion project from a capital budgeting standpoint.
Currently, we have completed many internal analyses on TFC.
Now, we must look at the viability of the expansion project.
3. Capital budgeting does just that. At the end of it, we should
have a better idea of what our recommendation would be.
Linda: Capital budgeting can be done whenever there is an
initiative to invest in assets for the long term. Our project is
doing just that. We want to be confident in our decision as this
project is for the long term and is costly. Don is going to be
joining us with the expected cost of the project.
Slide 4
Scene 4
· Don in conference room with papers in hand?
· Show on the papers - seven hundred fifty million dollars
· Go to next slide
Don: Hello all. With this expansion project we will double in
asset size. But it comes with a price. The Accounting
Department told us that the projected price to expand out West
is seven hundred fifty million dollars. I also have the projected
cash flow numbers. Now, I need the both of you to determine if
we should proceed with the expansion. To do so you will need
to use many capital budgeting techniques to arrive at a highly
confident decision. Good luck! The faith of this expansion and
the future success of TFC depend on your analysis.
Linda: Don, the Intern and I will begin working on this now!
Slide 5
Scene 5
· Linda In conference room (Don not in room)
· Net Present Value
· WACC =10.92%
· Go to next slide
Linda: We have our assignment so let’s starting working
through this analysis. There are many capital budgeting
techniques and the plan is to use some of them for our project as
4. Don said. But, it ultimately comes down to money. If the
project is expected to bring in more cash than its costs, the
project is a go, within reason, that is.
As we have been saying all along, cash is the driving force
behind our decision-making. To analyze our cash flows ,we
need to look at the net present value of our future cash inflows
and outflows including the cost of the project. Since these cash
flows are being expected over time, we need to discount them
back to today so we are valuing everything at the same point in
time. Since we do not know the actual cost for undertaking the
project, we will use our WACC, which is ten and ninety-two
hundredths percent, as our discount rate. We also need our
anticipated cash flows in the future years. This can be difficult
to project, but it is extremely important that these numbers are
as realistic as possible.
From what I was told, the Accounting Department expects cash
flows for this project only to be negative ten million in
projected year one as the company will still be opening up
fitness centers at a high rate. In year two, the cash flow is
projected to be two hundred million, then two hundred fifty
million, three hundred million, and four hundred million,
respectively, for years two through five. A five-year projection
will enable us to see where we will be in the immediate future.
Anything after five years may be difficult to estimate as things
change over time..
Linda: Now that we know all the inputs to our calculation, we
can determine if this expansion project will have a positive net
present value.
While I gather data for our second cash budgeting technique,
can you run the numbers to see what the outcome is?
Slide 6
Scene 6
5. · CYU
Linda would like you to determine the Net Present Value of the
expansion project. Using a 10.92% discount rate and the cash
flows as follows:
Cash Flow Year 0 = $-750,000,000
Cash Flow Year 1 = $ - 10,000,000
Cash Flow Year 2 = $+200,000,000
Cash Flow Year 3 = $+250,000,000
Cash Flow Year 4 = $+300,000,000
Cash Flow Year 5 = $+400,000,000
Using present value calculations for an uneven stream of cash
flows what will the Net Present Value of the project be?
(Round to whole dollars)
Answer: $23,164,711 (can you put a variance in there of $20?)
If right – Great job. This project will generate cash for TFC
If wrong – Nice try. Remember to discount each cash flow back
at 10.92% and then sum all the amounts including the -
$750,000,000
Slide 7
Scene 7
· Net Present Value
· Go to next slide
Linda: Nice work! From the calculations, the net present value
of the project is expected to be over twenty-three million
dollars. Now, that is some great news. But, we have to be
careful here. We are assuming our discount rate to be ten and
ninety-two hundredths, which is in line with our required rate of
return under the WACC. If this rate changes, it can affect the
project’s value.
6. Linda: Having a positive expected net present value indicates
that we should proceed with the project. The capital budgeting
technique is the best choice to use as it tells us the expected
cash value of the project. If the numbers that came back were
negative, we would suggest that we should not proceed with the
project. As you can see, it all depends on cash.
Linda: Even though the Net Present Value measure is the best
one to use, it is good practice if we look at a few of the other
ones.
Slide 8
Scene 8
· Conference Room
· Show calculation from excel
· IRR =11.84%
· Next slide
Linda: Another measure is the Internal Rate of Return, or the
IRR for short. It is the discount rate that makes all the future
cash flows equal to the beginning cash outlay. Basically, it
measures the expected rate of return on the project. If the IRR
is greater than the project’s cost of capital, the shareholders
will benefit by the project.
The calculation can be quite involving if done by hand. Luckily
at TFC, we have a financial calculator that handles the
calculation and leaves the decision making up to us. Our
calculator is showing eleven and eighty-four hundredths percent
as the IRR. This is above our cost of capital of ten and ninety-
two hundredths percent which shows a return higher than cost.
So far everything is pointing toward proceeding with the
project.
Slide 9
Scene 9 –
· Linda in room
7. · Cost of debt
Linda: The third measure, called the Modified Internal Rate of
Return or MIRR is similar to the IRR but it looks at cash
inflows and outflows separately and then together. What I mean
by that is, in order to do the calculations:
First, take all negative cash flows and discount them back to
today.
Then, take all positive cash flows and compound them at our
WACC to our last projected year, which is year five.
At that point we have a present value amount and a future value
amount.
The MIRR is the rate that links the two cash flows, the present
value and future value.
Keep in mind, the present value cash flows are all the negative
cash flows discounted, including today, while the future cash
flows are all the positive cash flows compounded to the future,
which is year five for TFC.
Linda: Let’s now calculate the MIRR.
Slide 10
Scene 10
· CYU
Linda would like you to determine the MIRR of the expansion
project. Using a 10.92% as the discount and compounded rates
to rate and the cash flows as follows:
Cash Flow Year 0 = $-750,000,000
Cash Flow Year 1 = $ - 10,000,000
Cash Flow Year 2 = $+200,000,000
8. Cash Flow Year 3 = $+250,000,000
Cash Flow Year 4 = $+300,000,000
Cash Flow Year 5 = $+400,000,000
Answer: 11.56%
· (If they get it wrong. ) Nice try but remember to compound the
positive cash flows in Years 2,3,4,5 and discount the negative
cash flow in year 1. Add that amount to the beginning cash
outlay. Then find the rate over 5 years
Correct, The formula is to discount negative cash flow in year 1
to year zero and add it to that amount to get $759,015,506.67.
Year 5 total cash flows would be $1,313,276,378.14.
Discounting that back at 5 years would give 11.56%
Slide 11
Scene 11
· Set up the cash flows on a clip board
Cash Flow Year 0 = $-750,000,000
Cash Flow Year 1 = $ - 10,000,000
Cash Flow Year 2 = $+200,000,000
Cash Flow Year 3 = $+250,000,000
Cash Flow Year 4 = $+300,000,000
Cash Flow Year 5 = $+400,000,000
· Show $10,000,000/$400,000,000 =.025 of a year for a total of
4.025 years
· Next Slide
Linda: Great job! Another measure is the Payback Period. We
like to say that this is our most straightforward measure but we
need to be careful with it as it does not assume any rates.
We use this measure when we think our cash balance for the
project will be positive.
9. To do this, we look at the initial cash outlay of seven hundred
fifty million dollars. We also anticipate another cash outlay of
ten million in the first year. In year two is when we plan on
generating some positive cash flows of two hundred million
dollars.
If we just look at it from a net cash perspective after year two
we would have negative five hundred sixty million. The cash
outlays from the beginning of the project and year one would
put us in a deficit of seven hundred sixty million.
By adding the two hundred million in year two our deficit
would be five hundred sixty million. With that same approach,
after year three we would still be at a three hundred ten million
dollar deficit.
After year four we are almost there at a deficit of ten million
dollars. In year five, we anticipate the deficit to go away with
the first ten million of the anticipated four hundred million in
positive cash flows.
When you take that ratio of what is needed to break even or ten
million dollars over the expected cash flow in year five of four
hundred million, the result is point zero two five of a year.
When we put it all together, we can expect to be in the positive
for the project in four point zero twofive years.
So, the project will pay for itself in just over four years.
Linda: This payback period measure has some drawbacks
especially in the area of discounting. We are not factoring in
time but for a quick measurement it is a good one to use. Also,
this measure is not our deciding factor. As you know by now,
our deciding factor is the net present value calculation.
10. Slide 12
Scene 12
· Don in room
· Show results on screen
· Thumbs up!
Don: I left you with the most critical piece of the project.
What were you able to find out?
Linda: Don, I think you will be pleased by our analysis. We
did a number of capital budgeting measures and the results are
as follows:
Net Present Value is positive twenty three million, one hundred
sixty-four thousand, seven hundred eleven dollars.
Internal Rate of Return is eleven and eighty-four hundredths
percent, which is greater than our discount rate.
Modified Internal Rate of Return is eleven and fifty six
hundredths percent.
And the Payback Period is four point zero two five years.
Don: Wow. Great job. I can’t wait to share the results with
Joe. But, before I do. Are you giving us thumbs up on the
project?
Linda: Of course from a financial standpoint we would always
like to do some more analyses, but based on our numbers to
date, Yes!A double thumbs up!
Slide 13
Scene 13
· Linda talking about cash flows
· Put words “Relevant Cash Flows” on board
· Don enters
11. Linda: Great job with the capital budgeting analysis. While we
do four different measures here at TFC, there are others, such as
the Profitability Index and using the discount rate on the
payback period measurement. But in our decision making, it all
comes down to cash flow and the net present value tells us the
cash outlook for the project.
Linda: So I’ve been mentioning cash a lot...... When we started
on the cash budgeting, we were given projected amounts from
the Accounting Department. I’ve even mentioned that there was
much debate on the cash flows. Keep in mind these are
projected cash flows, so a lot of analysis and decision making
goes into it. Probably the most critical part of our expansion
project is projecting the cash flows from it. Our Accounting
Department spent countless hours discussing what should be
included in the analysis and what is not relevant.
Don: That is right Linda. I spent some time in the Accounting
Department when this analysis was being done and some of the
points that were being considered included the following.
First, there is a distinction betweenfree cash flows and
accounting income. Typically accounting income is on an
accrual basis which is different from actual cash flow.
Remember for this project we are only concerned with the cash
flows related to this project and not other areas of TFC.
Second, depreciation needs to be added back into the project. It
is a not cash item that needs to be added back when estimating
cash flows. In fact all non cash charges related to the project
should be added back for cash flow purposes.
Third, we do not deduct any interest charges related to the
project as this was already considered when we determined the
WACC, which is the rate we use to discount all the cash flows.
12. Fourth, change in net operating working capital is a factor.
Any activity related to this expansion project, whether assets or
liabilities, need to be considered. This is one of the areas that
really need to be looked at closely.
Another area involves sunk costs, which are cash outlays that
occurred prior to moving forward with the project and should be
ignored. The Accounting Department determined that all of the
research on the different locations to expand into are sunk costs
and are not included in the net cash flow.
Slide 14
Scene 14
· Don and Linda in room
· Next Slide
Don: These are just a few of the areas that need to be
considered. For the most part, if it is a cash transaction and it
is part of the project, then it should be included in determining
cash flows.
Linda: That is true. And at TFC we have many computer tools
and spreadsheets that we use to aid us in making these cash
flow decisions. That is why we were confident in our analysis.
Don: And I passed that on to Joe. Working together as a team
really helps in decision making.
I can’t wait to see this project move forward. But like any hard
day at work, it is always good to finish it with a workout.
Before we head to the gym, let’s briefly go over what we
accomplished today.
Slide 15
Scene 15
· Summary Slide –
Linda: Another great job by the team at TFC. We covered
many capital budgeting techniques when looking at a project’s
cash flows including the Net Present Value, Internal Rate of
13. Return, Modified Internal Rate of Return, and Payback Period.
While all are important, the Net present Value should be used at
the final deciding factor.
We also looked at identifying relevant cash flows. They should
be those activities that are related to the project now. There are
many software packages that can help in the decision making.
Don: Linda, you and the intern are doing fabulous work. You
two made the determination to proceed with the project but your
work is not done. Enjoy your workout as I have another project
when you are finished.
Slide 16
Scene 16
· Closing slide
Closing slide