evaluate a capital budgeting case study 2
A private school is considering the purchase of six school buses to transport students to and from school events. The initial cost of the buses is $600,000. The life of each bus is estimated to be 5 years, after which time the vehicles would have to be scrapped with no salvage value. The school’s management team has derived the following estimates for annual revenues and cost for the next 5 years.
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
|
Revenues |
$330,000 |
$330,000 |
$350,000 |
$380,000 |
$400,000 |
|
Driver costs |
$33,000 |
$35,000 |
$36,000 |
$38,000 |
$40,000 |
|
Repairs and maintenance |
$8,000 |
$13,000 |
$15,000 |
$16,000 |
$18,000 |
|
Other costs |
$130,000 |
$135,000 |
$140,000 |
$136,000 |
$142,000 |
|
Annual depreciation |
$120,000 |
$120,000 |
$120,000 |
$120,000 |
$120,000 |
The buses would be purchased at the beginning of the project (i.e., in Year 0) and all revenues and expenditures shown in the table above would be incurred at the end of each relevant year.
Because schools are exempt from taxes, the school’s corporate tax rate is 0 percent. A business consultant has advised management that they should use a weighted average cost of capital (WACC) of 10.5% to evaluate this project.
- Prepare a table showing the estimated net cash flows for each year of the project. Explain all steps involved in your calculation of the Year 1 estimated net cash flow.
- Calculate the project’s Payback Period. Explain in your own words, all steps involved in the calculation process.
- Calculate the project’s Internal Rate of Return (IRR). Explain in your own words, all steps involved in the calculation process.
- Calculate the project’s Net Present Value (NPV). Explain in your own words, all steps involved in the calculation process.
Which of the three evaluation techniques that you computed (i.e., payback period, IRR and NPV), should the firm use to make its decision of whether or not to accept this project? Why did you choose this technique? Is one of these techniques better than the others and if so, why?
Finally, what are some risk factors inherent in this capital budgeting analysis? Make a list of at least three items that could cause the outcome of this project to be substantially worse than management currently expects (as reflected in their revenue and cost estimates, WACC estimate, etc.). Fully explain each of the risk factors you identify.
Firm Investment and Stakeholder Choices: A Topâ€Down Theory of Capital Budgeting
ANDRES ALMAZAN
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Johnson, N., Pfeiffer, T., & Schneider, G. (2017). Two-stage capital budgeting, capital charge rates, and resource constraints. Review of Accounting Studies, 22(2), 933–963.