# Capital Budgeting

You have just been hired by Internal Business Machines Corporation (IBM) in their capital budgeting division. Your first assignment is to determine the free cash flows and NPV of a proposed new type of tablet computer similar in size to an iPad but with the operating power of a high-end desktop system.

Development of the new system will initially require an initial capital expenditure equal to 10% of IBM’s Property, Plant, and Equipment (PPE) at the end of the latest fiscal year for which data is available. The project will then require an additional investment equal to 10% of the initial investment after the first year of the project, a 5% increase after the second year, and a 1% increase after the third, fourth, and fifth years. The product is expected to have a life of five years. First-year revenues for the new product are expected to be 3% of IBM’s total revenue for the latest fiscal year for which data is available. 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. Your job is to determine the rest of the cash flows associated with this project. 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. Since your boss hasn’t been much help (welcome to the “real world”!), here are some tips to guide your analysis:

1. Obtain IBM’s financial statements. (If you really worked for IBM you would already have this data, but at least you won’t get fired if your analysis is off target.) Download the annual income statements, balance sheets, and cash flow statements for the last four fiscal years from Yahoo! Finance (finance.yahoo.com). Enter IBM’s ticker symbol and then go to “financials.”
2. You are now ready to estimate the Free Cash Flow for the new product. Compute the Free Cash Flow for each year using Eq. 8.5:

Free Cash Flow = Unlevered Net Income
(Revenues − Costs − Depreciation) × ( 1 − τ c ) + Depreciation − CapEx − Δ N W C

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.

a. Assume that the project’s profitability will be similar to IBM’s existing projects in the latest fiscal year and estimate (revenues − costs) each year by using the latest EBITDA/Sales profit margin. Calculate EBITDA as EBIT + Deprecation expense from the cash flow statement.
b. Determine the annual depreciation by assuming IBM depreciates these assets by the straight-line method over a five-year life.
c. Determine IBM’s tax rate by using the current U.S. federal corporate income tax rate.
d. 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 IBM’s NWC/Sales for the latest fiscal year to estimate the required percentage. (Use only accounts receivable, accounts payable, 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, IBM’s cash holdings.)
e. To determine the free cash flow, deduct the additional capital investment and the change in net working capital each year.
f.
3. Use Excel to determine the NPV of the project with a 12% cost of capital. Also calculate the IRR of the project using Excel’s IRR function.
4. Perform a sensitivity analysis by varying the project forecasts as follows:
a. Suppose first year sales will equal 2%–4% of IBM’s revenues.
b. Suppose the cost of capital is 10%–15%.
c. Suppose revenue growth is constant after the first year at a rate of 0%–10%.

Note: Updates to this data case may be found at www.berkdemarzo.com.

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# Capital Budgeting

A quaint but well-established coffee shop, the Hot New Café, wants to build a new café for increased capacity. Consider the following financial aspects of this endeavor:

• Expected sales are \$800,000 for the first 5 years.
• Direct costs, including labor and materials, will be 50% of sales.
• Indirect costs are estimated at \$200,000 a year.
• The cost of the building for the new café will be a total of \$850,000, which will be depreciated straight line over the next 5 years.
• The firm’s marginal tax rate is 38%, and its cost of capital is 10%.

For this assignment, you need to develop a capital budget. It is important to know what the café managers should consider within their capital budget. You must also define the key terms necessary to understand capital budgeting. In this assignment, please show all work, including formulae and calculations used to arrive at financial values.

You must answer the following using the information above:

• Prepare a capital budget for the Hot New Café with the net cash flows for this project over a 5-year period.
• Calculate the payback period (P/B) and the net present value (NPV) for the project.
• Answer the following questions based on your P/B and NPV calculations:
• Do you think the project should be accepted? Why?
• Define and describe net present value (NPV) as it pertains to the new cafe.
• Assume the company has a P/B (payback) policy of not accepting projects with a life of over 3 years. Do you think the project should be accepted? Why?

Your submitted assignment must include the following:

• A double-spaced, 2-page Word document that contains answers to the questions.
• You must include a Microsoft Excel spreadsheet for your calculations.
• Either the Word document or the Excel spreadsheet must have all of your calculation values, your complete calculations, any formulae that you used, the sources you wish to cite, and your answers to the questions listed in the assignment guidelines.