Capital Budgeting Analysis

BA 620 Managerial Finance

Group Problem Set 2 (125 points)

This problem Set is based on materials covered in modules 5, 6, and 7. It is designed

for you to demonstrate your understanding and be able to apply basic capital budgeting

concepts, working capital management, dividend policy, and international financial

management.

Part 1: Capital Budgeting Analysis

Adams, Incorporated would like to add a new line of business to its existing retail

business. The new line of business will be the manufacturing and distribution of animal

feeds. This is a major capital project. Adams, Incorporated is aware you an in an MBA

program and would like you to help analysis the viability of this major business venture

based on the following information:

• The production line would be set up in an empty lot the company owns.

• The machinery’s invoice price would be approximately $200,000, another

$10,000 in shipping charges would be required, and it would cost an additional

$30,000 to install the equipment.

• The machinery has useful life of 4 years, and it is a MACRS 3-year asset.

• The machinery is expected to have a salvage value of $25,000 after 4 years of

use.

• This new line of business will generate incremental sales of 1,250 units per year

for 4 years at an incremental cost of $100 per unit in the first year, excluding

depreciation. Each unit can be sold for $200 in the first year. The sales price

and cost are expected to increase by 3% per year due to inflation.

• Net working capital would have to increase by an amount equal to 12% of sales

revenues. The firm’s tax rate is 40%, and its overall weighted average cost of

capital is 10%.

Required:

1. If the company spent $40,000 last year in the upkeep of the empty lot, should this

cost be included in the analysis? Why or why not?

2. Disregard the assumptions in part 1 above. What is the machinery’s depreciable

basis? What are the annual depreciation expenses?

3. Calculate the annual sales revenues and costs (other than depreciation).

4. Construct annual incremental operating cash flow statements.

5. Estimate the required net working capital for each year based on sales for the

following year. Working capital will be recovered at the end of year 4.

6. Calculate the after-tax salvage cash flow.

7. Calculate the net cash flows for each year. Based on these cash flows, what are

the project’s NPV, IRR, Profitability Index (PI), and payback?

8. Can you use the Payback method to decide whether this is a good project or

not? Why or why not?

9. Interpret what NPV, IRR, and Profitability Index (PI) mean. Based on your

interpretation, do these indicators suggest the new business line should be

undertaken?

Part 2: Working Capital Management

1. Adams Stores, Inc. is trying to determine the effect of its inventory turnover ratio and days
sales outstanding (DSO) on its cash flow cycle. Adams’ sales last year (all on credit) were
$150,000, and it earned a net profit of 6%. It turned over inventory 7.5 times, during the year
and its DSO was 36.5 days. Its annual cost of goods sold was $121,667. The company had
fixed assets totally $35,000. Adams’ payable deferral period is 40 days.

A. Calculate Adams’ cash conversion cycle
B. Calculate assets turnover and return on assets (ROA)
C. As one of the managers at Adams Stores, Inc, you believe the annual inventory turnover

can be raised to 9 times without affecting sales. What would Adams’ cash conversion
cycle, total assets turnover, and ROA have been if the inventory turnover had been 9 for
the year?

2. Assume the company work for reported sales of $10 million and an inventory turnover of 2.
The company is now adopting a new inventory system as part of its working capital
management. If the new system is able to reduce the company’s inventory level and increase
inventory turnover ratio to 5 while maintaining the same level sales, how much cash will be
freed up as a result of the new inventory system.

Part 3: Dividend Policy:

Assume that you were recently hired by a national consulting firm, which has been asked to
help Adams, Stores, Inc. prepare for its public offering. Prepare a presentation in which you
review the theory of dividend policy and discuss the following:

A. The terms “irrelevance,” “bird-in-the-hand,” and “tax preference” have been used to
describe three major theories regarding the way dividend payouts affect a firm’s value.
Explain what these terms mean, and briefly describe each theory.

B. What do the three theories indicate regarding the actions management should take with
respect to dividend payout?

C. What are stock repurchases? Discuss the advantages and disadvantages of a firm’s
repurchasing its own shares.

D. What are stock dividends and stock splits? What are the advantages and disadvantages
of stock dividends and stock splits?

Part 4: International Financial Management

Citrus, Inc. is a medium-sized producer of citrus juice drinks in Florida. Until now, the company
has confined its operations and sales to the United States, but its CEO, Heidi Sims, wants to
expand into Europe. The first step would be to set up sales subsidiaries in Spain and Sweden,
then to set up a production plant in Spain, and, finally, to distribute the product throughout the
European Union. The firm’s financial manager, George Benson, is enthusiastic about the plan,
but he is worried about the implications of the foreign expansion on the firm’s financial
management process. He has asked you, the firm’s most recently hired financial analyst, to
develop a 1-hour tutorial package that explains the basics of multinational financial
management. The tutorial will be presented at the next board of director’s meeting. To get you
started, Benson has supplied you with the following list of questions.

A. What is a multinational corporation? Why do firms expand into other countries?
B. Discuss at least six major factors which distinguish multinational financial management

from financial management as practiced by a purely domestic firm. (Please consider
doing additional research on this question and document your findings).

C. Discuss exchange rate risk as they relate to multinational corporations.
D. Describe the current International Monetary System. How does the current system differ

from the system that was in place prior to August 1971? (Please consider doing
additional research on this question and document your findings).

E. What is the difference between spot rates and forward rates? When is the forward rate
at a premium to the spot rate? At a discount? (Please consider doing additional
research on this question and document your findings).

F. From a managerial point of view, discuss how your responses above will help Citrus, Inc.
as they plan to expand overseas.

Specific Instructions:

1. Complete and submit your assignment no later than the last day of Module 7.
2. Include only the names of your group members who participated in this

assignment when you submit.
3. Submit only one copy per group.
4. If you use Excel for any of your calculations, please submit the Excel worksheet.

Be sure to label your Excel worksheet appropriately. Use Word for your
discussions. Please DO NOT use any other format such PDF, etc. Use APA

throughout including in-text citations and references.
5. After you complete the assignment, please give each member opportunity to

review the final paper before you submit it. You are jointly responsible for any

error made.

Side Note: Please note that this is not the type of assignment where the assignment is

divided and each student completes the part that is assigned. Each person in your

group need to participate fully in the completion of this assignment. This is the only way

each group member can master and be able to use the concepts in this assignment.

After you complete the assignment, please give each member opportunity to review the

final paper before you submit it. You are jointly responsible for any error made.