Excelerite Capital Budget Project

You need to help EIS decide whether to go ahead with the Pathrite system or not. Provide all relevant information and analysis,including a computation of the net present value and internal rate of return of the Pathrite system project.

This case is about capital budgeting.

Note that you should use the weighted average cost of capital formula to compute the cost of capital, viz. WACC = (proportion of equity in the firm’s liability structure)(cost of equity capital) + (proportion of debt in the firm’s liability structure)(cost of debt capital)(1-marginal tax rate).

The write-up should be in Word (with an accompanying Excel spreadsheet showing the computations) and should be emailed to me.

Here are some hints on how to go about doing the case:

You first need to come up with the basic incremental cashflows. That involves simply computing the after-tax earnings year-by-year and adding back depreciation.

The treatment of inflation has to be consistent with the discount rate used. You can treat all the cashflows as nominal cashflows, incorporating inflation and then you don’t have to do anything about the inflation rate given. However, the constant assumed savings makes that unlikely. So if the savings are treated as savings, unadjusted for inflation, the right thing to do is to inflate the savings at the rate of inflation. However, it is important to keep in mind that tax savings do not increase at the rate of inflation. Also, the discount rate for nominal cashflows has to be a nominal rate, not an inflation-adjusted real rate. (See the notes on Real Rates, Nominal Rates and Inflation in Module 5 also.)

Depreciation, as noted in the case, follows the half-year life convention, which says that EIS could start depreciating in year zero, as long as the purchase had occurred in year zero (but I am not necessarily looking for this much sophistication).

The key thing in the computation of the discount rate is the realization that there are many ways of computing the cost of equity and the cost of debt. For the cost of debt, the bond yield could be used or the yield on comparably rated bonds could be used. The 8% coupon rate is not the cost of debt unless the debt is sold at par, in which case it would be the yield, as well.

For the cost of equity, you can use the CAPM, but that is only one method. You could also use the Gordon growth model formula, which says that r = D/P + g (this will be discussed in more detail in Module 9). You could also look at the actual historical average return.

Finally, I expect you to think about sensitivity. Taking the expected cashflows is not recognizing the sensitivity of the realized NPV to the actual cashflows. Looking at the NPV separately under the different scenarios allows us to look at the probability of ending up with a negative realized NPV, which you don’t get by simply using the expected cashflows in your computation.

Here is the rubric that I will use to grade you. From this you can also get an idea of what I am looking for. Doing the bare minimum will not get you many points!

Aspect Assigned Max
Compute cost of equity 2
Compute debt cost of capital 2
Compute WACC 2
Compute incremental cashflows 1
Depreciation treatment 1
Inflation 2
Sensitivity Analysis 2
Bonus
Total 12
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