Case 1 - Canyon Buff’s Chemical EquipmentThis case is a simple capital budgeting exercise that should reinforce your understanding of thefollowing topics:• Incremental unlevered net income• Free cash...

Case 1 - Canyon Buff’s Chemical EquipmentThis case is a simple capital budgeting exercise that should reinforce your understanding of thefollowing topics:• Incremental unlevered net income• Free cash flow• Sensitivity analysis and scenario analysisIntroductionCanyon Buff Corp. has developed a new construction chemical that greatly improves the durabilityand weatherability of cement-based materials. After spending $500,000 on the research of thepotential market for the new chemical, Canyon Buff is considering a project that requires an initialinvestment of $9,000,000 in manufacturing equipment. The equipment must be purchased before the chemical production can begin. For tax purposes,the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zerosalvage value. For simplicity, however, we will continue to assume that the asset can actuallybe used out into the indefinite future (i.e., the actual useful life is effectively infinite). Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). Theyexpect that sales will initially grow at an annual rate of 6% until the end of sixth year. Afterthat, the sales will grow at the estimated 2% annual rate of inflation in perpetuity. The cost of goods sold is estimated to be 72% of sales. The accounting department also estimates that at introduction in Year 0, the new product'srequired initial net working capital will be $6,000,000. In future years accounts receivableare expected to be 15% of the next year sales, inventory is expected to be 20% of the nextyear’s cost of goods sold and accounts payable are expected to be 15% of the next year’scost of goods sold. The selling, general and administrative expense is estimated to be $6,000,000 per year, but$1 million of this amount is the overhead expense that will be incurred even if the projectis not accepted. The market research to support the product was completed last month at a cost of $500,000to be paid by the end of next year. The annual interest expense tied to the project is $1,000,000. Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30% and anaverage tax rate is 20%.2InstructionsI posted an incomplete Excel template for your analysis. You need to figure out how to constructthe pro forma income statements and calculate the incremental unlevered net income. You shouldinclude ONLY the factors that will affect your capital budgeting decision. Revise the templateif necessary.Note that your analysis should be set up so the assumptions that impact the cash flow estimatescan be easily changed to identify the sensitivity of your calculations to these assumptions.There are three sheets in the template. Use the worksheet “NPV” for questions 1 to 4, and the othertwo sheets for questions 5 and 6.Submit your Excel spreadsheet through blackboard. Clearly show your work so that I can traceyour numbers.Questions1. Use Excel to construct six-year pro forma income statements and calculate the incrementalunlevered net income for the first six years.2. Calculate six-year projections for free cash flows. Remember to include cash flows fromthe income statement and depreciation, changes in net working capital, and capitalexpenditures or dispositions.Hint: You need to calculate the level of net working capital (NWC) and change in NWC.Pay attention to the timing of NWC.3. Canyon Buff expects that free cash flow from Year 6 onwards will increase at a constantrate of 2%/year into the indefinite future. Calculate PV(terminal value that captures thevalue of future free cash flows in Year 6 and beyond). That is, calculate the terminal valuefirst, then find its value in Year 0 (today).Hint:We went over this in Lecture Note 6, so let me briefly review the key points:a. Assuming the cash flows grow at a constant rate g after Year N+1, thenYear N TV = (Year N+1 CF)/(r−g) (from growing perpetuity formula).where r is discount rateb. We should discount this Terminal Value back to Year 0.4. Determine the NPV of the project. Remember to net out any initial cash outflows.5. Perform a sensitivity analysis by varying the four parameters as follows:3Parameter Initial Assumption Worst Case Best CaseSales in Year 1 $30,000 $27,000 $33,000NPVSales Growth through Year 6 6% 0% 10%NPVCost of Goods Sold (% of Sales) 72% 77% 67%NPVCost of Capital 20% 23% 17%NPVFor example, vary the parameter “Sales in Year 1” from the worst case $27,000 to the bestcase $33,000, holding all the other parameters fixed (at the level of initial assumptions).Then fill in the highlighted blank boxes for NPV in Excel.Do the same thing for the other three parameters.Suppose you are the financial manager, if you are asked to use limited resources to refinethe assumption on ONLY ONE of the above four parameters, which one should you chooseand why? Write your answer in Excel.6. Perform a scenario analysis by simultaneously varying the two parameters below:Sales Growththrough Year 6% Cost ofGoods Sold NPVScenario 1 (Baseline) 5% 71%Scenario 2 6% 72%Scenario 3 8% 73%Scenario 4 9% 74%Which scenario generates the highest NPV? Write your answer in Excel.
Feb 26, 2021
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