Project 1: picking projects using capital budgeting

Project 1: Picking Projects Using Capital Budgeting

 

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The large publishing company you work for has built up an excess pile of $150M cash due to better than expected sales and delays in making any new investments in production facilities. As the newly promoted Chief Financial Officer, the CEO has instructed you to find uses of this unneeded cash that will earn the highest return for shareholders; liquidity (ease of convertibility into cash) is not an issue. You may also invest any amount of cash (from $150M to any remaining after investments) into a stock market index expected to earn 8% per year or distribute to shareholders as a dividend (assume they can earn the same 8%). Write to the CEO in a one page summary explaining why the options (not exceeding $150M in cash required) you have chosen are the best. The options are as follows:

 

Option 1: You can team with Amazon in creating your own e-Reader in order to join the movement towards e-books and away from printed copies. Your company has already spent $20M researching the technological requirements and possible market reaction. Amazon requires an upfront investment of $100M to begin design and expects the product to hit the market next year. This will reduce cash flows from traditional book sales by $20M per year. Projected cash flows for this investment are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales $50M $60M $70M $75M $80M $85M

Costs ($30M) ($35M) ($40M) ($40M) ($40M) ($40M)

 

Option 2: Much of the company’s publishing equipment has become worn down and outdated, and investing in new equipment would result in lower costs and quicker delivery times for special orders. You can sell the old equipment today for an after-tax cash inflow of $25M and invest $75M in new equipment that will generate the following cost savings and extra revenue:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales $5M $5M $10M $10M $10M $10M

Costs Savings $15M $15M $10M $10M $5M $5M

 

 

 

 

 

Option 3: There is a small book store chain that would give you a better outlet to sell your books in person while also profiting from the sales of your competitors. You hired an investment bank specializing in acquisitions to help you analyze this possibility and have already paid them $10M for their services. If the acquisition occurs, you will owe the investment bank an additional $10M. Recently the small book store chain gave you their final offer; you can purchase them for $65M in cash. Below are the income effects your firm would realize from acquiring this firm:

 

Year 1 Year 2 Year 3 Year 4 Year 5

Sales $25M $25M $30M $30M $35M

Costs ($15M) ($15M) ($20M) ($20M) ($25M)

 

Requirements: Compute the Payback Period, Net Present Value and Internal Rate of Return for each of the three investment options. Submit the recommendation as a one-page Word document along with an Excel file showing your work as partial credit will be rewarded. My recommendation is to read the description of each option to determine relevant costs and benefits (those that change based on whether you undertake the project or not). Do not consider costs that are incurred regardless of your decision or costs that occurred in the past (sunk costs). Add the relevant costs to the yearly cash flows provided. Explain your reasoning so that I may award you partial credit and offer better feedback.

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