- Due Date: 03/06/2018 00:00
- selam Abay
- Willing to pay: $visa
- Accounting Homework Help

Case Description

This case is adapted from a similar case study developed by Meric, Dunne, Li and Meric (2010).

Interested students can read and workout the entire case referenced below:

Meric, I., Dunne, K., Li, S. F., & Meric, G. (2010). Variety Enterprises Corporation:

Capital Budgeting Decision. Review of Business & Finance Case Studies, 1(1), 15-25.

The capital budgeting decision is one of the most important financial decisions in business firms.

In this case, Dashen Bank Share Company (DBSC) is considering whether to invest in a system

to modernize its local money transfer services. To determine if the project is profitable, DBSC

must first determine the weighted average cost of capital to finance the project. The simple

payback period, discounted payback period, net present value (NPV), internal rate of return

(IRR), and modified internal rate of return (MIRR) techniques are used to study the profitability

of the project. MIRR is a relatively new capital budgeting technique, which assumes that the

reinvestment rate of the project’s intermediary cash flows is the bank’s cost of capital. The stand-

alone risk of the project is evaluated with the sensitivity analysis and scenario analysis

techniques assuming that the new system would not affect the current market risk of the bank.

The case gives students an opportunity to use the theoretical profitability and risk analyses

techniques explained in their financial management module and related tutorial classes in a real-

world setting. The case is best suited for MBA and Master of Accounting students and is

expected to take approximately three to four hours to complete.

Keywords: Capital budgeting, weighted average cost of capital, cash flow, payback period,

net present value, internal rate of return, modified internal rate of return,

sensitivity analysis, scenario analysis

Case Information

DBSC is planning to invest in a special system to deliver local money transfer services to its

customers. The invoice price of the system is Br.280,000 subject to 15% non-refundable VAT. It

would require Br.18,000 in shipping expenses and Br.25,000 in installation costs. The system

will be depreciated using straight line method with 25% annual rate on original cost of the

system. DBSC plans to use the system for four years and it is expected to have a salvage value of

Br.80,000 after four years of use. The bank expects the system will increase the number of local

money transfer customers by 100,000. The company estimates that it will charge on the average

Br.5 fee per customer for the transfer service in the first year with a cost of Br.3 per customer,

excluding depreciation. Management forecasts that both the service fee and cost per customer

will increase by 10% per year due to inflation. DBSC’s net operating working capital would have

to increase by 18% of fees earned to deliver the transfer service. The bank is subject to 30%

income tax.

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DBSC’s WACC

Guta, a recent MBA graduate of Addis Ababa University, is conducting the capital budgeting

analysis for the project. The bank hired him only a few weeks ago as the head of the newly

formed Capital Budgeting Analysis Department. In order to evaluate feasibility of the investment

in the new system, Guta’s first task is to estimate DBSC’s WACC. He plans to use the financial

data in Exhibit 1 to estimate the WACC. When DBSC started evaluating the project, the

following conversation took place between Guta and Ato Ali. Ato Ali, the CEO of the bank, is a

London School of Business graduate with a major in financial economics and long years of

administrative experience.

Guta: It may be difficult to estimate cost of borrowing in the current recessionary environment.

Ali: We can determine the yield to maturity (YTM) on our outstanding bonds by using their

current market prices. We can assume that we will be able to issue additional bonds with

this YTM as the cost of borrowing. We should be able to place the new bonds without

any flotation costs. Therefore, we can assume no flotation costs in our calculations. We

can re-examine feasibility of the project later before raising funds by using sensitivity

analysis to assess the impact of possible changes in interest rates on NPV of the project.

Guta: Do you think the bank’s current market value capital structure is optimal? Can we use the

current percentages of the capital components as weights in calculating the bank’s WACC?

Ali: Yes, I believe that the bank’s current market value capital structure of 30% debt, 10%

preferred stock and 60% equity is optimal. We have about Br.95,000 in retained earnings

this year, which is also available in cash. We should be able to use this year’s retained

earnings to finance part of the equity financing required for the project. However, we will

have to issue some new common shares for the remainder of the necessary equity

financing. We can assume a flotation cost of about 10% for the new common shares.

Guta: There are three basic methods of calculating a firm’s cost of equity when retained

earnings are used as equity capital: 1) the capital asset pricing method (CAPM); 2) the

discounted cash flow (DCF) approach; and, 3) the bond-yield-plus-risk-premium method.

Which of these methods should we use in the calculation of our cost of retained earnings?

Ali: Although each of these methods has its merits, I believe that the most appropriate

approach for our bank would be to find an average cost with the three methods. Besides,

we can consider the yield on the Ethiopian Government TB as risk free return on

investment in the computation of cost of common equity.

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Ato Ali gave only one week to Guta for his estimation of DBSC’s WACC. With the instructions

he received from Ato Ali and with the help of the financial data in Exhibit 1, Guta began the task

of estimating the bank’s WACC immediately.

Ato Ali knew that estimating the bank’s cost of capital was the first critical step in the capital

budgeting process. Without this analysis, it would not be possible to determine if the new system

would be a profitable investment for DBSC. That is why he had asked Guta to estimate the

bank’s WACC as the first task. Ato Ali was very pleased when he received Guta’s calculation

results and the WACC estimate. He thought that he had made a good decision in hiring Guta as

the head of the company’s newly established Capital Budgeting Analysis Department.

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Analysis of the profitability of the project

Ato Ali and Guta had the following conversation regarding how they should evaluate the

potential profitability of the project.

Guta: With the fees and cost estimates I have obtained from the marketing and accounting

departments in Exhibit 2, we should be able to estimate the project’s cash flows for the

four-year horizon.

Ali: Excellent! How are we going to evaluate the project’s profitability to determine if it is

feasible?

Guta: The Net Present Value (NPV) and Internal Rate of Return (IRR) methods are generally

used in the evaluation of projects. However, these two methods have different

assumptions regarding the reinvestment rate of the intermediary cash flows. The NPV

method assumes that the intermediary cash flows can be reinvested at the firm’s cost of

capital. However, the IRR method assumes that the reinvestment rate is the project’s IRR.

Academicians argue that the reinvestment rate assumption of the NPV method is more

realistic. Therefore, they recommend the NPV method. The financial goal of a firm is to

maximize market value. The NPV of a project shows its contribution to the market value

of the firm.

Ali: Correct! However, the NPV is expressed in Birr. It is difficult to explain the profitability

of a project in terms of Birr to the stockholders of the bank. It is easier to compare the

project’s IRR with the bank’s WACC to convince the stockholders that we can earn a

higher percentage return on the investment than what it would cost to finance it. I have

heard that there is a new improved capital budgeting technique that measures the

profitability of a project as a percentage similar to the IRR method and it assumes that the

project’s intermediary cash flows can be reinvested at the firm’s cost of capital as in the

NPV method. I believe the technique is called the Modified Internal Rate of Return

(MIRR) method.

Guta: No problem. We should be able to calculate the project’s MIRR.

Ali: Great! I would also like to see the NPV, IRR, simple payback period, and discounted

payback period results for the project.

Guta: Consider it done!

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With the instructions he received from Ato Ali, Guta immediately started to work on the cash

flow calculations using the data in Exhibit 2 to analyze the profitability of the project with the

NPV, IRR, MIRR, simple payback period, and discounted payback period methods.

Risk Analysis

After Guta submitted the cash flow calculations and the project profitability analysis results to

Ato Ali, they had the following conversation regarding the risk analysis for the project.

Ali: The NPV, IRR, MIRR, simple payback and discounted payback results all look

promising. However, we should also conduct a risk analysis of the project before we go

ahead with it. Since the project is about modernization of delivery of an existing service,

I do not believe that the new project will change the bank’s beta and its overall market

risk. Therefore, it should be sufficient to evaluate the stand-alone risk of the project.

What are the techniques that we can use to assess the stand-alone risk of the project?

Guta: Sensitivity analysis is a widely used technique to determine how much a project’s NPV

will change in response to a given change in an input variable. Input variables such as

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number of customers or the cost of capital are often used while holding other things

constant.

Ali: The number of customers is difficult to forecast with a high degree of accuracy.

Therefore, we should conduct a sensitivity analysis with regard to possible changes in the

forecasted number of customers. It should be sufficient to evaluate the impact of an

increase or a decrease of 10% in number of customers from our base forecast. The new

system will be initially employed at about 80% capacity with our base number of

customers forecast. Therefore, the unutilized capacity of the system should enable us to

accommodate a 10% increase in the number of customers. We estimate that costs,

excluding depreciation, will be 60% of fees per customer. We can assume that this ratio

will not change with the 10% increase or decrease in the number of customers.

Guta: No problem. We can conduct a sensitivity analyses for the project’s NPV with regard to a

10% deviation from our base number of customers forecast.

Ali: Given the current volatile financial environment, the actual WACC figure is also likely to

deviate from the expected base level. I would like to know how sensitive the project’s

NPV is to an increase or decrease of 1% in the WACC.

Guta: No problem. We should be able to conduct a sensitivity analysis for the project with

regard to a possible 1% change in the WACC. Another analysis technique for project risk

widely used in practice is scenario analysis. In this technique, the best and worst-case

NPV scenarios are compared with the project’s expected NPV. Do you want us to

conduct a scenario analysis of the project as well?

Ali: Yes. It would be a good idea. As the best-case scenario, assume that the number of

customers will be 10% higher and the WACC will be 1% lower (i.e. initially computed

WACC less 1%) than our original estimates. For the worst-case scenario, assume that the

number of customers will be 10% lower and the WACC will be 1% higher (i.e. initially

computed WACC plus 1%). Please calculate the standard deviation and the coefficient of

variation of the project’s NPV probability distribution with these scenarios. You can

assume a probability of 50% for the base NPV forecast, a probability of 20% for the best-

case scenario, and a probability of 30% for the worst-case scenario.

Guta: No problem. I should be able to submit the risk analysis results to you within a week.

With the instructions he received from Ato Ali, Guta immediately started to conduct a stand-

alone risk evaluation of the project with the sensitivity analysis and scenario analysis techniques.

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Questions

Assuming that you are Guta, answer the following questions:

1. Calculate Dashen’s WACC using the data in Exhibit 1.

2. Calculate the project’s cash flows using the data in Exhibit 2. Why is it important to take into

account the effect of inflation in forecasting the cash flows? Briefly comment.

3. Evaluate the profitability of the project with the NPV, IRR, MIRR, simple payback period,

and discounted payback period methods. Is the project acceptable? Briefly explain. Why is

the NPV method superior to the other methods of capital budgeting? Briefly explain.

4. Conduct the stand-alone risk analysis of the project with the sensitivity analysis and scenario

analysis techniques. Explain why sensitivity analysis and scenario analysis can be useful

tools in the capital budgeting decision-making process when economic and financial

conditions are likely to change in the future.