Capital Budgeting Techniques Case Study

Details of Capital Budgeting Techniques Case Study

McCormick Plant Proposal

As you know from Project 4, McCormick & Company is considering building a new factory in Largo, Maryland. McCormick & Company decided to offer $4,424,000 to obtain the land for this project. The new factory will require an initial investment of $350 million to build the new plant and purchase equipment.

You have been asked to continue your work from project 4 with a full analysis of the proposed factory, including the start-up costs, the projected net cash flows from operations, the tax impact of depreciation, and the cash flow impacts of changes in working capital.

The investment will be depreciated as a modified accelerated cost recovery system (MACRS) seven-year class asset. The correct depreciation table is included below.

The company will need to finance some of the cash to fund $17 million in accounts receivable and $14 million in Inventory starting at year zero. The company expects vendors to give free credit on purchases of $15 million (accounts payable). The CFO wants you to consider the net cash outflows for working capital as well as the cash outflows for the plant, equipment, and land in year zero.

Note: The $17 million for accounts receivable and the $14 million for Inventory are cash outflows. The $15 million for accounts payable is a cash inflow.

The CFO has indicated that this net working capital will be recovered as a cash inflow in year 21. She also estimates that the company will be able to sell the factory, equipment, and land in year 21 for $40 million.

The company estimates that the cash flows from operations will be as shown in Table 2. Note: Only the cash flows related to operations (years 1-20) will generate accounting profits and thus taxable income (or losses).

Use the WACC that you recommended in question 5 of the Cost of Capital tab for the discount rate.

Capital Budgeting Techniques Case Study Questions:

What will be the depreciation for tax purposes each year? Complete Table 1 below to answer this question. Note: the total deprecation for tax purposes will be $350 million.
Create an after-tax cash flow timeline for the proposed factory in Table 2 below. Note: The CFO estimates that operations for the company will be profitable on an on-going basis. As a result, any accounting loss on this specific project will provide a tax benefit for the company overall in the year of the loss.
Calculate the NPV and IRR using the data from Table 2. Should the project be accepted?

The following questions will be used to assist in evaluating the proposed project’s risk.

The CFO is particularly concerned about the potential impact of future tax increases and that the expenses may have been systematically understated. In order to undertake an objective evaluation of the project’s risk, she asks you to prepare a second analysis with a less favorable set of assumptions. She asks, “What would happen to the NPV and IRR calculations if the cash outflow for expenses comes in 2% higher than estimated for the entire life of the project and if the tax rate increases to 50% (combined Federal and Maryland state rates) starting in year 4?” Create an after-tax cash flow timeline for the proposed factory with these new assumptions in Table 3 below.
Calculate the NPV and IRR using the data from Table 3.
Considering all of your work in questions 1 through 5, should the project be accepted? Discuss the risk and the potential reward of this project for McCormick.

Capital Budgeting Techniques Case Study

Answer Questions Below:

	Table 1
	MACRS
	Depreciation	$350
Year	7 Year class	Depreciation (in millions)
1	14.29%	$ 50.02
2	24.49%	$ 85.72
3	17.49%	$ 61.22
4	12.49%	$ 43.72
5	8.93%	$ 31.26
6	8.92%	$ 31.22
7	8.93%	$ 31.26
8	4.46%	$ 15.61

			Table 2
	A	B	C	D	E	F	Year 0
Year	Cash from Revenue in $Millions	Cash outflow, expenses in $Millions	Depreciation in $Millions	Taxable Income in $ Millions	Tax in $Millions 27.5% rate	After tax Cash Flow In $Millions
0	$ –	$370.42		$ (370.42)	$ (101.87)	$ (268.56)	land			4,424,000
1	$ 1,800.00	$ 1,728.00	$ 50.02	$ 21.99	$ 6.05	$ 65.95	Factory			350,000,000
2	$ 1,900.00	$ 1,824.00	$ 85.72	$ (9.72)	$ (2.67)	$ 78.67	Cash Receivable	17,000,000
3	$ 2,000.00	$ 1,920.00	$ 61.22	$ 18.79	$ 5.17	$ 74.83	Inventory	14,000,000
4	$ 2,100.00	$ 2,016.00	$ 43.72	$ 40.29	$ 11.08	$ 72.92	cash outflow		31,000,000
5	$ 2,200.00	$ 2,112.00	$ 31.26	$ 56.75	$ 15.60	$ 72.40	accounts payable	15,000,000
6	$ 2,300.00	$ 2,208.00	$ 31.22	$ 60.78	$ 16.71	$ 75.29	cash inflow		15,000,000
7	$ 2,400.00	$ 2,304.00	$ 31.26	$ 64.75	$ 17.80	$ 78.20	working capital			-16,000,000
8	$ 2,500.00	$ 2,400.00	$ 15.61	$ 84.39	$ 23.21	$ 76.79
9	$ 2,600.00	$ 2,496.00		$ 104.00	$ 28.60	$ 75.40	Total Investment in year 0			370,424,000
10	$ 2,700.00	$ 2,592.00		$ 108.00	$ 29.70	$ 78.30
11	$ 2,600.00	$ 2,496.00		$ 104.00	$ 28.60	$ 75.40
12	$ 2,500.00	$ 2,400.00		$ 100.00	$ 27.50	$ 72.50	year 21
13	$ 2,400.00	$ 2,304.00		$ 96.00	$ 26.40	$ 69.60	recovered net working capital			16,000,000
14	$ 2,200.00	$ 2,112.00		$ 88.00	$ 24.20	$ 63.80	Land, factory and equipments			21,000,000
15	$ 2,000.00	$ 1,920.00		$ 80.00	$ 22.00	$ 58.00	Total cash received in year 21			37,000,000
16	$ 1,800.00	$ 1,728.00		$ 72.00	$ 19.80	$ 52.20
17	$ 1,500.00	$ 1,440.00		$ 60.00	$ 16.50	$ 43.50
18	$ 1,200.00	$ 1,152.00		$ 48.00	$ 13.20	$ 34.80
19	$ 800.00	$ 768.00		$ 32.00	$ 8.80	$ 23.20
20	$ 400.00	$ 384.00		$ 16.00	$ 4.40	$ 11.60
21	$ 37.00			$ 37.00	$ 10.18	$ 26.83

NPV	$612.92		The project should be accepted since the NPV is greater than zero hence a potential profit of $624.99 will be made
IRR	27%		Also, the IRR (27%) is greater than the risk free rate (3%) and the cost of debt (4%)


			Table 3
	A	B	C	D	E	F
Year	Cash from Revenue in $Millions	Cash outflow, expenses in $Millions	Depreciation in $Millions	Taxable Income in $ Millions	Tax in $Millions 27.5% rate in years 1 , 2, 3 and 50% there after	After tax Cash Flow In $Millions
0	$ –	$ 377.83	$ –	$ (377.83)	$ (103.90)	$ (273.93)
1	$ 1,800.00	$ 1,762.56	$ 50.02	$ (12.57)	$ (3.46)	$ 40.90
2	$ 1,900.00	$ 1,860.48	$ 85.72	$ (46.20)	$ (12.70)	$ 52.22
3	$ 2,000.00	$ 1,958.40	$ 61.22	$ (19.62)	$ (5.39)	$ 46.99
4	$ 2,100.00	$ 2,056.32	$ 43.72	$ (0.04)	$ (0.02)	$ 43.70
5	$ 2,200.00	$ 2,154.24	$ 31.26	$ 14.50	$ 7.25	$ 38.51
6	$ 2,300.00	$ 2,252.16	$ 31.22	$ 16.62	$ 8.31	$ 39.53
7	$ 2,400.00	$ 2,350.08	$ 31.26	$ 18.67	$ 9.33	$ 40.59
8	$ 2,500.00	$ 2,448.00	$ 15.61	$ 36.39	$ 18.20	$ 33.81
9	$ 2,600.00	$ 2,545.92	$ –	$ 54.08	$ 27.04	$ 27.04
10	$ 2,700.00	$ 2,643.84	$ –	$ 56.16	$ 28.08	$ 28.08
11	$ 2,600.00	$ 2,545.92	$ –	$ 54.08	$ 27.04	$ 27.04
12	$ 2,500.00	$ 2,448.00	$ –	$ 52.00	$ 26.00	$ 26.00
13	$ 2,400.00	$ 2,350.08	$ –	$ 49.92	$ 24.96	$ 24.96
14	$ 2,200.00	$ 2,154.24	$ –	$ 45.76	$ 22.88	$ 22.88
15	$ 2,000.00	$ 1,958.40	$ –	$ 41.60	$ 20.80	$ 20.80
16	$ 1,800.00	$ 1,762.56	$ –	$ 37.44	$ 18.72	$ 18.72
17	$ 1,500.00	$ 1,468.80	$ –	$ 31.20	$ 15.60	$ 15.60
18	$ 1,200.00	$ 1,175.04	$ –	$ 24.96	$ 12.48	$ 12.48
19	$ 800.00	$ 783.36	$ –	$ 16.64	$ 8.32	$ 8.32
20	$ 400.00	$ 391.68	$ –	$ 8.32	$ 4.16	$ 4.16
21	$ 37.00	$ –	$ –	$ 37.00	$ 18.50	$ 18.50

NPV	$154.71
IRR	12%


	Considering the working in part 3 and part 5, the project is can be said to be profitable
	This is because the NPV is greater than zero and the IRR is greater than both the Cost of ebt and the risk free rate
	However, the project is highly risky.
	The changes in expenses and tax rates led to a decrease in NPV from $612.92 to $154.71 and a decrease in IRR from 27% to 12%.