Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

Table 10.3 shows various projections for the investment project. The top two rows list anticipated

selling prices and unit volumes in each of the next six years. Below that appears a series of projected

income statements for the next six years. Top-line revenue equals the product of expected selling price

and unit volume each year. Next, the table subtracts cost of goods sold, selling, general and administrative

(SAG) expenses, and depreciation to arrive at pre-tax profit. Taxes constitute 30% of pre-tax profit.

TABLE 10.3 PROJECTIONS FOR PROTECT IT’S INVESTMENT PROJECT

Year 0 1 2 3 4 5 6

Price per unit $ 13.50 $ 13.50 $ 13.50 $ 13.50 $ 13.50 $ 13.50 $ 13.50

Units 0 4,500 10,000 16,000 22,000 24,000 25,000

Abbreviated project income statement

Revenue $ 0 $60,750 $135,000 $216,000 $297,000 324,000 337,500

Less: Cost of goods sold $ 0 $43,740 $ 97,200 $155,520 $213,840 233,280 243,000

Gross profit $ 0 $17,010 $ 37,800 $ 60,480 $ 83,160 $ 90,720 $ 94,500

Less: Selling, general and

administrative expense

(SG&A expense)

$ 0 $ 6,075 $ 13,500 $ 21,600 $ 29,700 $ 32,400 $ 33,750

Less: Depreciation $ 0 $10,000 $ 10,000 $ 10,000 $ 10,000 $ 10,000 $0

Pretax profit $ 0 $ 935 $ 14,300 $ 28,880 $ 43,460 $ 48,320 $ 60,750

Taxes $ 0 $ 281 $ 4,290 $ 8,664 $ 13,038 $ 14,496 $ 18,225

$After-tax profit $ 0 $ 655 $ 10,010 $ 20,216 $ 30,422 $ 33,824 $ 42,525

Abbreviated project balance sheet

Cash $ 1,000 $ 2,000 $ 2,500 $ 3,000 $ 3,200 $ 3,300 $ 3,500

Accounts receivable $ 0 $ 5,063 $ 11,250 $ 18,000 $ 24,750 $ 27,000 $ 28,125

Inventory $ 4,500 $ 7,594 $ 16,875 $ 27,000 $ 37,125 $ 40,500 $ 42,188

Current assets $ 5,500 $14,656 $ 30,625 $ 48,000 $ 65,075 $ 70,800 $ 73,813

Gross plant & equipment

(P&E)

$ 50,000 $50,000 $ 50,000 $ 50,000 $ 50,000 $ 50,000 $ 50,000

Less: Accumulated

depreciation

$ 0 $10,000 $ 20,000 $ 30,000 $ 40,000 $ 50,000 $ 50,000

Net P&E $ 50,000 $40,000 $ 30,000 $ 20,000 $ 10,000 $ 0 $ 0

Total assets $ 55,500 $54,656 $ 60,625 $ 68,000 $ 75,075 $ 70,800 $ 73,813

Accounts payable $ 2,500 $ 4,374 $ 9,720 $ 15,552 $ 21,384 $ 23,328 $ 24,300

Beneath the income statement appears a series of abbreviated projected balance sheets. Each shows

the project’s total asset requirements (including both current and fixed assets) as well as the financing

available from suppliers in the form of accounts payable. As mentioned previously, any additional

financing the project requires will come from internally generated funds from the already profitable

mobile phone cover business.

To determine whether this is an investment opportunity worth taking, we determine the project’s cash

flows through time and discount them at 15% to calculate the project’s NPV. As part of this calculation,

we have to estimate the value of the endeavour beyond the sixth year. In other words, we have to estimate

the project’s terminal value.