Lecture Notes on Capital Budgeting Example

Overview

• Fine-tuned understanding of capital budgeting with an example
• Examining the Baldwin Company project: producing and selling bowling balls

Initial Considerations

• Test Marketing Cost: $250,000 (sunk cost, ignore in analysis)
• Factory Site: Market value $150,000 (opportunity cost as it's already owned)
• Bowling Ball Machine: Cost $100,000 (direct investment)
• Net Working Capital: $10,000 initial investment (Delta net working capital)
• Production Pattern: Estimated over 5 years with units: 5,000, 8,000, 12,000, 10,000, 6,000
• Product Life: 5 years, possibly due to changing market conditions

Financial Projections

• Price: $20 in the first year, increasing 2% annually
• Production Cost: $10 initially, increasing 10% annually
• Inflation Rate: 5% (irrelevant to the calculations explained later)

Opportunity and Initial Investments

• Opportunity Cost: Lost potential value from not selling the factory site
• Investment Breakdown at Period 0:
  • $100,000 on machinery
  • $10,000 on net working capital
  • $150,000 opportunity cost
• Total Initial Investment (C of 0): -$260,000

Cash Flow and Depreciation

• Timeline: Period 0 to Period 5
• Net Working Capital: Adjusts with sales, modeled as a fixed percentage of sales
• Depreciation: Affects calculations but not cash flow, important for calculating salvage value

Salvage Value and Taxes

• Salvage Value: Market price - tax based on capital gain (market price exceeds book value)
• Tax Calculation: Tax on capital gain from sale of equipment (tax rate assumed at 34%)

Operating Cash Flow (OCF)

• Formula: EBIT + Depreciation - Taxes
• Revenue Estimation: Derived from sales projections (price x quantity)
• Expenses: Operating costs increase annually, depreciation schedules are used

Net Present Value (NPV) Calculation

• Overall Cash Flow: Operating cash flow minus capital spending and net working capital
• Discount Rate (R): 10%
• Decision Making: Invest if NPV is greater than 0

Inflation and Capital Budgeting

• Nominal vs Real Cash Flows: Inflation is inherently considered in discount rates
• Fisher Equation:
  • Nominal rate includes real rate and inflation
  • Simplified: Nominal R ≈ Real R + Inflation
• Practical Implication: Use nominal rates with nominal cash flows or real rates with real cash flows

Conclusion

• Case study provides a simplified view of real-world complexities
• Emphasis on understanding the main approach and process in capital budgeting
• More complex forecasting and detailed analysis in real situations

Note: Always verify details and numbers used in calculations when applying these principles.