CapitalManagement

Case Assignment for CapitalManagement

Due Date: Friday, December 11th by 5:00PM CST

Turn in via appropriate BB folder

Goal and Key Points:In this case, you are to provide an objective and detailed capital budgeting analysis for a fictional investment. This is a difficult and time consuming case, so plan accordingly. Re-think your analysis before writing the executive summary. Don’t consult another person nor the internet, but you should refer to your notes and textbook.

Scenario:

Your firm produces several types of truck tires and sells them to regional tire retailers. At the moment, upper management is considering an investment in equipment that will enable the production of a new line of truck tires. Your sales team believes that the base-case scenario for units sold from this new type of tires is 50,000 tires per year.

It is expected that each new tire will sell for $105. Cash expenses as a % of sales equal 60%. The product line should last for 10 years. The new tire line will require an upfront investment of $1,500,000 in equipment. You will depreciate the equipment to $0 using the 7-year MACRS schedule (see last page of this document).

The new tire line will require an upfront investment in net working capital of $250,000 (assume full recovery at project termination). At the end of the project, the equipment is expected to be sold for $100,000. The firm’s marginal tax rate is30%.

At present, your firm has a single bond issue outstanding. This bond offers a coupon interest rate of 5% and a yield to maturity of 7%. The prime borrowing rate is currently 3.5%. In addition, your firm has a Beta of 0.90. The return on the market portfolio of equity securities is expected to remain level at 10%. The risk-free rate is currently 2.5%. Lastly, your firm currently has a balanced capital structure (i.e., 70% debt and 30% equity).

Part 1: Base Estimation

Using the base specifications provided above:

1. Estimate the annual operating cash flows for the investment.
2. Calculate the investment’s NPVand IRR.
3. Calculate the break-even number of tires sold.

Part 2: Risk Analysis

Next, you decide to inject some realism into the analysis. Key variables that are uncertain include:

1. Cash Expense Ratio: The base-case scenario is 60%. The best-case scenario is 45% and the worst-case scenario is 85%. You believe that each scenario is equally likely.
2. Units sold: The base-case scenario is 50,000 tires sold, the best-case scenario is 60,000 tires sold and the worst-case scenario is 45,000 tires sold. You believe that each scenario is equally likely.

Using these base specifications

1. Estimate the best-case, worst-case, and base-case NPVs and IRRs.
2. Next, use these values to calculate the expected value of the NPV and IRR.
3. Last, use these values to calculate the standard deviation of the NPV and IRR.

Part 3:

Write an executive summary describing your findings from Parts 1 and 2. As a starting point, you should interpret each capital budgeting measure. You should also describe the known risks associated with the investment and the impact of these risks on the feasibility of the investment (from Part 2). In addition to the specific risks addressed in Part 2, discuss other risks that are also embedded in this investment (but that you cannot quantify, as I have not provided you with any additional assumptions).  That is, what are the “known unknowns”? Your executive summary should conclude with an overall recommendation on the investment.

How long should the executive summary be? That is up to you. You should carefully review your executive summary to ensure that your writing is consistent with the basic writing principles covered in Business Communications. Some may want to visit the Writing Center on campus for help.

Miscellaneous:

• Grade breakdown: 75% for analysis and 25% for executive summary
• Items to turn in include 1) Executive summary, 2) the annual pro-formas for the Part 1-Base Assumptions only, and 3) tables showing the capital budgeting measures requested for both Parts 1 and 2.

MACRS Property Class