Chapter 7: Fundamentals of Capital Budgeting Data Case ?You have just been hired by Dell Computers in their capital budgeting division. Your first assignment is ?to determine the net cash flows and NPV of a proposed new type of portable computer system similar ?in size to a BlackBerry, a popular gadget with many MBA students, which has the operating power of a ?high-end desktop system. Investments (CAPEX): Development of the new system will initially require an initial investment (CAPEX) equal to 10% of net Property, Plant, and Equipment (PPE) for the fiscal year ended January 30, 2009. The project will then require an additional investment at year 1 equal to 10% of previous year?s net PP&E. Then in year 2 net PP&E increases by 5%, and increases by 1% in the third, fourth, and fifth years. Your investment is the change in net PP&E. ?Revenues (sales): First-year revenues for the new product are expected to be 3% of total revenue ?for Dell?s fiscal year ended January 30, 2009. The new product?s revenues are expected to grow at ?15% for the second year then 10% for the third and 5% annually for the final two years of the ?expected life of the project. ?NWC and depreciation: Your boss has indicated that the operating costs and net working capital ?requirements are similar to the rest of the company and that depreciation is straight-line for capital ?budgeting purposes. ?The product is expected to have a life of five years. Your job is to determine the rest of the cash flows ?associated with this project. Welcome to the ?real world.? Since your boss hasn?t been much help, ?here are some tips to guide your analysis: ?1. ?You are now ready to determine the Free Cash Flow. Compute the Free Cash Flow for each ?year using the following equation: ??Set up the timeline and computation of free cash flow in separate, contiguous columns for ?each year of the project life. Be sure to make outflows negative and inflows positive. Assume that the project?s profitability will be similar to Dell?s existing projects in 2008 (fiscal year ended January 30, 2009) and estimate gross profits (revenues ?costs) each year by using the 2008 (EBITDA/Sales) margin, so that your gross profits for each year are the 2008 EBITDA/sales ?ratio multiplied by your sales in the subsequent years. Determine the annual depreciation by assuming Dell depreciates these assets by the straight-line method over a 10-year life. Depreciation is calculated based on the net PP&E for each year. Assume that you sell the net PP&E at year 6 for its book value. Determine Dell?s tax rate by using the income tax rate in 2008. Calculate the net working capital required each year by assuming that the level of NWC will be a constant percentage of the project?s sales. Use Dell?s 2008 NWC/Sales to estimate the required percentage. (Use only accounts receivable, accounts payable, a. b. c. d. e. and inventory to measure working capital. Other components of current assets and liabilities are harder to interpret and not necessarily reflective of the project?s required NWC?for example, Dell?s cash holdings.) Assume that NWC is required for years 1 to 5. At year 6 you should close your NWC account. To determine the free cash flow, calculate the additional capital investment and the change in net working capital each year. Assume that (1) Equipment is sold at book value at year 6 when the operations cease, and (2) the NWC account is recovered when operations cease. Note: don?t be surprised of your NWC and the change in NWC are negative. f. 3. ?Determine the IRR of the project and the NPV of the project at a cost of capital of 12% using ?the Excel functions. For the calculation of NPV, include cash flows 1 through 6 in the NPV ?function and then subtract the initial cost (i.e., =NPV (rate, CF1:CF5) +CF0). For IRR, include ?cash flows zero through six in the cash flow range.
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