Capital Investment Analysis 1 What is the net present value

Capital Investment Analysis:

1. What is the net present value (NPV) for each venture? And based on the principle of mutually exclusivity, which venture(s) should be accepted or rejected? 2. What is the internal rate of return (IRR) for each venture? Given that the company’s cost of capital is 10%, which venture(s) should be accepted or rejected? 3. What are the Payback Periods for each venture? Which venture(s) should we accept given the company’s cutoff period of three (3) years? 4. By using the Capital Asset Pricing Model (CAPM), find the required return on equity for the purchase of House of Napoli Shoes. 5. Examine the proposed bond issue to be used in the acquisition of House of Napoli Shoes and find its cost of debt using the yield to maturity. 6. Given the weights of the equity portion (both preferred and common stock) and debt in the capital structure for the House of Napoli Shoes venture let me know what is Roman’s weighted average cost of capital involving the deal. 7. What do you think are the best financial decision rules that should be used in order to make a correct decision for the three possible ventures? 8. Are there any key questions that should be considered? 9. As CFO, which of the three ventures do you think Roman Manufacturing should pursue and why?

Another piece of the puzzle, and perhaps the most important, are the cash flows each venture could potentially bring to Roman Manufacturing, assuming a 10% discount rate. Lorenzo\'s staff has come up with the following projected cash flows: Year Casual Shoes Athletic Shoes House of Napoli Shoes $500,000 $400,000 $300,000 $500,000 $800,000 $900,000 $1,250,000 $1,500,000 $1,750,000 $2,000,000 $850,000 $850,000 $850,000 $850,000 $850,000 $850,000 $850,000 $850,000 $850,000 $850,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,500,000 $4,500,000 $5,000,000 $5,500,000 $6,000,000 $6,500,000 4 10

Solution

10% Total PV Value 1 Year Casual Shoes Athletic Shoes House of Napoli Shoes PV Factor Casual Shoes Athletic Shoes House of Napoli Shoes 1 ($500,000) $850,000 $1,000,000 1 ($500,000) $850,000 $1,000,000 2 ($400,000) $850,000 $1,500,000 0.909 ($363,600) $772,650 $1,363,500 3 $300,000 $850,000 $2,000,000 0.826 $247,800 $702,100 $1,652,000 4 $500,000 $850,000 $2,500,000 0.751 $375,500 $638,350 $1,877,500 5 $800,000 $850,000 $3,500,000 0.683 $546,400 $580,550 $2,390,500 6 $900,000 $850,000 $4,500,000 0.62 $558,000 $527,000 $2,790,000 7 $1,250,000 $850,000 $5,000,000 0.564 $705,000 $479,400 $2,820,000 8 $1,500,000 $850,000 $5,500,000 0.513 $769,500 $436,050 $2,821,500 9 $1,750,000 $850,000 $6,000,000 0.466 $815,500 $396,100 $2,796,000 10 $2,000,000 $850,000 $6,500,000 0.424 $848,000 $360,400 $2,756,000 NPV $4,002,100 $5,742,600 $22,267,000 Since the ventures are mutually exclusive the one with the highest NPV should be choosen or accepted In this case the highest is depicted by the venture from House of Napoli Shoes 3 The payback period for the three ventures are as follows Casual Shoes Total PV of cash inflows from Year 2 $4,502,100 Initial Investment $500,000 Payback Period 9 Athletic Shoes Total PV of cash inflows from Year 2 $4,892,600 Initial Investment $850,000 Payback Period 5.8 House of Napoli Shoes Total PV of cash inflows from Year 2 $21,267,000 Initial Investment $1,000,000 Payback Period 21.26 4 calculation of Cost of Equity by the CAPM method Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate) Here since we do not have the beta factor 0.03+(0.09-0.03) 0.09 5 The proposed bond issue using the YTM method YTM=[C+(F-P)/n]/(F+P)/2 Where C =coupon rate F=face value of the bond P=Price paid for the bond N=Number of Years of Maturity $250000*3.3%*2 $16,500 16500+(1000-250)/60/(1000+250)/2 26.42 6 Weighted Average Cost of Capital Sources of Capital Cost of capital Proportion Weighted Cost of Capital Equity 9% 25% 2.2500% Bond 26.42% 50% 13.2100% Preferred Stock Issue 7% 25% 1.7500% WACC 17.2100% 7 Based on the above the NPV is the best method to decide which venture to choose .Therefore the Napoli Shoes should be choosen since its NPV is highest. 8 However there are other factors which should be taken into account while evaluating project decisions Incremental Cash Flows Sunk Cost Opportunity Cost Externatlities/Side Effects Tax effects Infaltion effects Effect of working capital on cash flows Leverage Effect 9 As a CFO Napoli shoes should be selected .However there are certain factors which should be also be taken into account as below: The following factors should be considered when calculating the cash flows for the project Mutually exclusive Projects with unequal Lives Capital rationing Project Synergies Project timings