Project 4: Analyzing Capital Budgets for Organizational Projects: At IPS, besides having mastered the work of allocating costs and deciding on optimum levels of production, your position as CFO also requires you to make various decisions that involve cash flows at different points in time, for which you have to use Time Value of Money (TVM) analysis. TVM also is the basis of rational capital budgeting decisions such as Net Present Value (NPV) and Internal Rate of Return (IRR). Project requirements: Each question needs to be explained in an analysis on how you came to that answer, it also requires each questions calculation to be shown in an Excel Spreadsheet (not just the final numbers) Submit a spreadsheet showing your calculations in Excel and provide a narrative analysis in Word. Please note that “narrative” in this Project does not mean audio, it rather means a presentation of the results of your analysis using words and the important numbers. Your narrative analysis should summarize the results of your analysis and make recommendations for the benefit of the company. Project 4 Rubric: • 3.1 Identify numerical or mathematical information that is relevant in a problem or situation. • 3.2 Employ mathematical or statistical operations and data analysis techniques to arrive at a correct or optimal solution. • 3.3 Analyze mathematical or statistical information or the results of quantitative inquiry and manipulation of data. • 3.4 Employ software applications and analytic tools to analyze, visualize, and present data to inform decision-making. • 10.3 Determine optimal financial decisions in pursuit of an organization’s goals. • 10.4 Make strategic managerial decisions for obtaining the capital required for achieving organizational goals. “We need your input!” As the CFO of IPS, you are responsible for managing the IPS employee pension fund. Like any pension fund, yours has physical and financial assets and liabilities. You must decide how the pension fund money will be invested. Your decisions will affect the well-being of your firm and its employees. As a successful fund manager, you know that an understanding of the time value of money is key. You urge your staff to investigate the investment potential of a variety of financial products and services including money markets, real estate, stocks, and insurance products. Your goal is to realize the maximum benefit for your clients. Since IPS is still a relatively small company, you are also responsible for decisions on product viability and financing. While your staff is investigating pension fund investments, you get the following email message from the CEO. “Remember the production analysis you did on the Android01? I need you to put together an analysis of the suitability of the project. Crunch the numbers and give me an idea of the value of the project. Thanks for your help!” You’ve barely had time to think about what you’ve read when you get another message from the CEO. “Meant to ask you about the cost of capital. If we do decide to move forward with the Android01 project, we’ll need to determine our best source of capital. As far as I can tell, we have three options: • a loan from the bank • collaboration with another firm • liquidation of securities owned by IPS Compare the three financing options and estimate NPVs and IRRs from the costs and expected cash flows. Just include that in your analysis. Thanks again!” This project will require you to determine the suitability of a candidate project using capital budgeting techniques based on time value of money, and take care to distinguish between different forms of costs and revenues. You will determine the long-term capital requirements needed to support the organization and analyze different methods of financing. Begin with “Step 1: Time Value of Money Calculations” 1 Time Value of Money Calculations As the manager of the pension fund, considering different investment options will help you make better decisions for your company and your clients. Please respond to the following questions, providing supporting data and showing your calculations. Before starting your calculations, review the following materials: • time value of money analysis and The Time Value of Money • valuing perpetuities and annuities and Discounted Cash Flow Applications • amortizing a loan Question 1: If the pension plan invests $95 million today in 10-year US Treasury bonds ( a riskless investment with guaranteed return) at an interest rate of 3.5 percent a year, how much will it have by the end of year 10? Question 2: If the pension plan needs to accumulate $14 million in 13 years, how much must it invest today in an asset that pays an annual interest rate of 4 percent? Question 3: How many years will it take for $197 million to grow to be $554 million if it is invested in an account with a quoted annual interest rate of 5 percent with monthly compounding of interest? Question 4: The pension plan also invests in physical assets. It is considering the purchase of an office building today with the expectation that the price will rise to $20 million at the end of 10 years. Given the risk of this investment, there should be a yield of 10 percent annually on this investment. The asking price for the lot is $12 million. What is the annual yield (internal rate of return) of the investment if the purchase price is $12 million today and the sale price 10 years later is $20 million? Should the pension plan buy the office building given its required rate of return? Question 5a: The pension plan is also considering investing $70 million of its cash today at a 3.5 percent annual interest for five years with a commercial bank. How much will the $70 million grow to at the end of 5 years? Question 5b: Now take the amount of your answer in Ques 5a, and assume this money is invested in an annuity due with the first payment made at the beginning of the 6th year. The annuity due makes a total of 15 yearly (equal) payments. How much will the annual payments be from years 6 to 20, if the rate at which these payments are discounted is also 3.5 percent? Question 6: The pension plan is about to take out a 10-year fixed-rate loan for the purchase of an information management system for its operations. The terms of the loan specify an initial principal balance (the amount borrowed) of $4 million and an APR of 3.75 percent. Payments will be made monthly. What will be the monthly payment? How much of the first payment will be interest, and how much will be principal? Use the Excel PMT function to provide the answers to these questions. 2 Basic Capital Budget Analysis As the manager of the pension fund, you are frequently targeted by software companies peddling investment simulation software. You have finally narrowed down your choice to two applications. You need to analyze the options by calculating NPV, IRR and Payback Period based on their purchase price and savings to your company over time. Your staff has prepared a cash-flow table to help you. Year zero shows the purchase price of each application, and the figures listed for years 1-3 represent the savings to the company in successive years. Year Application I Application II 0 (today) -$1.5 million -$1 million 1 $0.8 million $0.5 million 2 $0.7 million $0.24 million 3 $0.3 million $0.6 million You are considering three possible scenarios. Question 7: If the payback period is two years, which application should be selected? Question 8: If the required rate of return is 15 percent, which application should be selected? Question 9: If the selection criterion is IRR, which application should be selected? Respond to the questions 7, 8, and 9 above by submitting a single, integrated report that shows your supporting data and calculations. Finally, provide a recommendation and rationale for purchasing either Application I or Application II. 3 Capital Budgeting—Decide Which Projects to Complete Another one of your responsibilities as CFO is to determine the suitability of new and current products. Your CEO has asked you to evaluate Android01. That task will require you to combine data from your production analysis from Project 2 with data from a consultant’s study that was done last year. Information provided by the consultant is as follows: • initial investment: $120 million composed of $50 million for the plant and $70 million net working capital (NWC) • yearly expenses from year 1 to year 3: $30 million • yearly revenues from year 1 to year 3: $0 • yearly expenses from year 4 to year 10: $55 million • yearly expected revenues from year 4 to year 10: $95 million • yearly expenses from year 11 to year 15: $60 million • yearly expected revenues from year 11 to year 15: $105 million • You are to calculate NPV using the “expected values”. The actual cash flow may be variable (risky) and that is the reason why the discount rate is greater than the riskless rate. This concludes the information provided by the consultant. You also have the following information: • Assume that both expenses and revenues for a year occur at the end of the year. NWC pays the bills during the year, but has to be replenished at the end of the year. • Android01 is expected to cannibalize the sales of Processor01 while also reducing the variable costs for the production of Processor01. From years 4 to 10, revenues are expected to fall by $5M, whereas variable costs will go down by $1 million. Processor01 is to be phased out at the end of the 10th year. • At the end of the 15th year, the plant will be scrapped for a salvage value of $10 million. NWC will be recovered. Question 10: Calculate the expected cash flows from the Android01 project based on the information provided. Question 11: Calculate the NPV for a required rate of return of 6.5 percent. Also, calculate the IRR and the Payback Period. Before starting your calculations, review the following materials on NPV, IRR and Payback Period. Also review: Capital Budgeting Cost of Capital 4 Cost of Capital The firm decides to raise $30 million by selling equity and debt. The investment bankers hired by your firm contact potential investors and come back with the following numbers: • Debt that pays $1 million coupons a year and $18 million maturity value after 10 years will sell for $20 million. • Equity that pays expected dividends of $1.2 million starting next year and growing at a rate of 3 percent per year thereafter sells for $10 million. Question 12: Calculate the cost of debt, equity, and the WACC. Before starting your calculations, review the following materials: • cost of capital and choice of financing • equity, debt, and preferred stock 5 Financing Options Your firm has decided to spin off Android01 and Processor01 as a separate firm. The owners of the new firm will be equity holders and debt holders. After speaking with potential investors, investment banks have identified two possible capital structures (structure of equity and debt ownership): • Debt holders receive debt that pays them coupons of $2 million a year, and $30 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate of 4 percent. Equity holders receive expected dividends of $3 million starting from year 5, and growing at a rate of 4 percent per year (a growing perpetuity). They price the equity using a discount rate of 7.5 percent. • Debt holders receive debt that pays them coupons of $1 million a year, and $12 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate of 3.5 percent. Equity holders receive expected dividends of $3.9 million starting from year 5, and growing at a rate of 4.5 percent per year (a growing perpetuity). They price the equity using a discount rate of 7 percent. Your firm receives all the proceeds from the sale debt and equity. Since the firm is selling debt and equity, it wants to sell using the capital structure that provides them with the most money (sum of whatever debt and equity sells for). Prepare a Capital Budgeting and Cost of Capital report that answers the following Question 13. Question 13: Which particular capital structure should be chosen for the spin-off? Here the firm is the seller of a physical asset for which it gets all the money today. Therefore, you do not have to calculate NPV etc. It is not making an investment it is receiving money by selling the subsidiary. You have to calculate the price at which debt sells and the price at which equity sells. You have to calculate the price of debt using the annuity formula and the price of equity using the growing perpetuity formula. Then add the two to get total money raised by selling subsidiary. Whichever financing gives more total money, should be the preferred financing. Before starting your calculations, review the following materials: • cost of capital and choice of financing • equity, debt, and preferred stock