SNEAKER 2013 CAPITAL BUDGETING Case Study Solution

Answer 1:

Following are the items that will and will not be included in the capital budgeting process of calculating NPV, IRR and payback period of the company which will provide the financial projections for the projects that the company needs to implement in its business for the expansion of its production line.

  1. Building a factory and purchase or installation of the equipment will be added in the estimating the projections of the company through NPV, IRR and payback period. It is a project outflow or investments which a company will invest to undertake the project.
  2. Research and development cost will also be reflected in the financial projections of the projects which the company will undertake to expand its business. These are called the floatation cost which are added in the project cash outflow or initial investment and not adjusted in to the discount rate of the company which is used for the discounting of future cash flow of the company.
  3. Cannibalization will not be included in the capital budgeting cash flow projection for the projects that will be undertaken by the company. The reason for not including cannibalization is these are the cost which are related to other products of the company. Although the introduction of a new product will affect the sales of the previous product line which will be reflected in the financial statements of the company. Moreover, the cash flows projected through capital budgeting process will only involve cash inflows and outflow that are related to the project’s production line which will provide the value of that particular project and its impact on overall financials of the company.
  4. Interest costs are also related in estimating the financial projection through capital budgeting process. The cash flows which are used in the projections through capital budgeting operating cash flows after tax and interest expense. Therefore the interest cost will be deducted and after interest cost amount will be added as a future projected cash flows by the project.
  5. In estimating operating cash flows, the change in working capital account is deducted from the cash flow after interest and tax expense. Hence changes in current asset and current liabilities account will be subtracted in arriving to the cash flow generated by the company. Therefore the impact of change in current asset and current liability account will be reflected in the projections of cash flows generated by the projects.
  6. The cash flows which are undertaken for the financial projections of the company includes cash flow after taxes. Taxes will be deducted and the final available after tax cash flows will be used in arriving at the future financial projections of the company. Hence taxes will create impact in estimating future financial projections.
  7. Cost of goods sold is the amount that will be deducted from the revenue in arriving at the gross profit margin for the company. Hence cost of goods sold will be deducted and net cash flows will used in the financial projection through capital budgeting process.
  8. Advertising and promotion expense are related to the operating expense of that particular project and hence will be deducted from the gross profit of the company in arriving at net profit margin of the company. Therefore the deduction of advertising and promotion expense will be reflected in the future projection of cash flows estimated through capital budgeting process.

Answer 2:

In the following table the NPV, IRR and payback period of the project is provided.

“Sneaker 2013” FCF,NPV and IRR (amounts in $)
Items Initial 2013 2014 2015 2016 2017 2018
Cash Flow for the period/ FCF  $                          (180,000,000)  $                   26,452,000  $                 82,668,000  $                  76,082,000  $                125,582,000  $                 86,234,000  $                152,016,000
               
Net a Cash Flow for the period/ FCF  $                          (180,000,000)  $                   26,452,000  $                 82,668,000  $                  76,082,000  $                125,582,000  $                 86,234,000  $                152,016,000
Discount cash flows  $                          (180,000,000)  $                   23,830,631  $                 67,095,203  $                  55,630,503  $                  82,724,753  $                 51,175,682  $                  81,273,961
NPV  $                            181,730,733            
IRR 21%            
Discount rate 11%            
Payback period  $                          (180,000,000)  $              (153,548,000)  $               (70,880,000)  $                    5,202,000  $                130,784,000  $               217,018,000  $                369,034,000
Total Payback period 2.524            


Answer 3:

Following are the cash flows which will either be added in the cash flow projection of the persistence project or not. Below are the nature of cash flows and the reason are discussed as to whether the cash flow will impact the persistence project or not.

  1. Building and factory cost will not be added in the cash outflow projection incorporated by the company because the company already possess the area in the factory which could be used to implement the persistence project. Although the purchase and installation cost will be incorporated by the company in estimating the final projection through capital budgeting process which will be reflected in the cash flows generated by the capital budgeting method. The equipment cost will be added as the cash outflow in the initial investment of the project.
  2. Research and development cost will also be incorporated in calculating the financial projection of the persistence project as it is the part of this particular project and should be incorporated by the company in estimating future cash flows generated by this particular project.
  3. The cannibalization effect which will occur when the company will undertake the other project for the expansion of its product line. Due to cannibalization the company’s revenue will decline because of the effect of cannibalization which will reduce the sales of the company’s existing products. This effect should not be reflected in the persistence project because the cost occurred through cannibalization effect is not the part of persistence project instead it is an effect of undertaking the persistence project.
  4. Interest cost will cause the impact in the future projected cash flows of financial projection using capital budgeting method. The net cash flows which are calculated in estimating financial projections of the company through capital budgeting method are after interest and tax basis i.e. interest cost will be deducted and the cash after interest expense will be taken in account by the company in financial projection of the project.
  5. The cash flow which are used in estimating the financial projection through capital budgeting method are adjusted for the change in the working capital account. Therefore the change in the current assets and current liabilities account will be incorporated in estimating the financial projections of cash flow generated by the project. This change in working capital account will be deducted which will help us to arrive at cash flows which will be used for estimating NPY, IRR and payback period
  6. Taxes which are the integral part in estimating the net cash flows which are available to the company. The net operating cash flows are after tax cash flows which are used by the company in calculating the financial projection through capital budgeting method.
  7. Cost of goods sold are deducted from the revenue to arrive at the gross profit margin earned by the company. Therefore the cost of goods sold will show impact in the financial projection estimated by the company because final cash flow after deducting all the expenses are used by the company in the projection of future cash flow that will be acquired by the particular project.
  8. Similarly the advertising and promotion expense will also be incorporated in arriving at the net operating cash flows available to the companies. The advertising and promotion expense will reduce the cash generated by the implementation of the particular project therefore it will impact the final cash flows which will be used in the financial projections by the company through capital budgeting method………….

 

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