capital2compute wacc2compute incremental cashflows1depreciation treatment1inflation2sensitivity analysis2bonustotal12 B u s i n e s s F i n a n c e

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. However, some of the issues that you will need to grapple with are raised in the modules covering Stock Valuation and Capital Markets. Keep in mind that there is a lot of information in the case: regarding each piece of information, ask yourself whether it’s relevant or not and if relevant, how. Keep in mind also that cost of capital is a conceptual quantity that can be measured using several pieces of information. Capital Budgeting is not a mechanistic exercise, not in the forecasting of cashflows and not in the estimation of cost of capital.

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).

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 (We assume that people are interested in real returns. That is, if I invest $100 today for one year and with this money, I can buy 50 meals, my investment means I forgo the ability to have 50 meals worth of enjoyment. As compensation for this and for the risk in the investment, let’s assume I want 51 meals worth in return in one year’s time. This means my real required return is 51/50 -1 or 2%. However, if the price of meals is expected to go up from $2/meal to $2.10 per meal (5% rate of inflation), I will need 51(2.1) = $107.1 in dollar return. This dollar return is called a nominal return. Approximately, then the nominal return is equal to the sum of the real return and the inflation rate. Precisely, (1+i)=(1+r)(1+ p), where i is the nominal rate, r is the real rate and p is the rate of inflation.Since interest rates are also rates of return, we can also talk about nominal interest rates and real interest rates. This is in terms of expectations, but we can also have after-the-fact nominal returns. Thus, if I lent money with the agreement of 7.1% return in nominal terms, expecting a 5% rate of inflation, I would get exactly 2% in real terms if my inflation expectations were borne out. However, if inflation were higher, say, 8%, my returns would be (1.071)/(1.08)-1 or -0.83%. If inflation were lower at 3%, I would get (1.071)/(1.03)-1 or +3.98%.)

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. 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!