MT480 Unit 8 Capital Budgeting Analysis Example

$13.46 Million Against 15.10 Percent: An MT480 Unit 8 Capital Budgeting Analysis of Two Projects That Rank Differently

[Student Name]

Purdue University Global

MT480: Corporate Finance

Unit 8 Capital Budgeting Analysis

[Instructor Name]

[Date]

Brandywine Hollow Mushrooms, its projects and every figure are composite; the sources cited are real.

The Two Projects

Brandywine Hollow, the course's composite Pennsylvania grower, is weighing two projects for next year's capital budget. Both are attractive on their own. The question is which deserves priority if the company can take on just one large build this year, and whether both should go ahead.

The expansion is a new growing house complex: twelve climate-controlled growing rooms, a compost wharf and the heating, cooling and humidity systems that run them. It costs $104 million in buildings and equipment plus $3.5 million of working capital for spawn, compost materials and receivables, a total outlay of $107.5 million.

The retrofit replaces the boilers that supply steam for compost pasteurization with a heat-recovery system, cutting natural gas use. It costs $21.5 million and saves about $4.3 million a year after tax for ten years.

The Expansion's Cash Flows

At full output, the new complex produces 22.4 million pounds of mushrooms a year. Output ramps up over two years, reaching 60 percent of capacity in the first year and 90 percent in the second, because new growing rooms take several crops to reach their best yields. The mushrooms sell at a blended $1.72 a pound to retail packers and processors, against $0.83 a pound of variable cost for compost, spawn, picking labor, packaging and energy. Fixed costs add $3.9 million a year.

The buildings and equipment are depreciated straight-line over twenty years, $5.2 million a year. At full output, revenue minus variable cost is about $19.94 million; less fixed costs, $16.04 million before depreciation; less depreciation, $10.84 million of operating profit. After the 24 percent tax, operating profit is about $8.24 million, and adding back depreciation gives operating cash flow of about $13.435 million a year. The first year's cash flow is about $7.38 million and the second year's about $11.92 million. In year twenty, the $3.5 million of working capital is recovered.

The Retrofit's Cash Flows

The retrofit's cash flows are simpler: $21.5 million today and $4.3 million a year of after-tax savings for ten years, the life of the heat-recovery equipment. Its savings are fairly certain, since they depend on gas use the grower already measures, while the expansion's cash flows depend on prices, yields and the ramp.

Three Measures

The analysis uses the 8.5 percent hurdle rate the grower applies to growth projects, above the 7.96 percent cost of capital estimated in Unit 7, to allow for the added risk of new capacity.

Net present value. Discounting the expansion's twenty years of cash flows at 8.5 percent and subtracting the outlay gives about $13.455 million. The retrofit's ten years of savings, discounted at 8.5 percent, are worth about $28.21 million, minus its $21.5 million cost, about $6.714 million.

Internal rate of return. The rate that makes the expansion's net present value zero is about 10.08 percent. The retrofit's is about 15.10 percent.

Payback. The expansion recovers its outlay in about 8.57 years. The retrofit recovers its $21.5 million in exactly five years.

On two of the three measures, the retrofit looks better. On the one that measures value, the expansion is worth twice as much.

Why the Measures Disagree

The disagreement comes from scale and timing. The retrofit is small and pays back quickly, so its percentage return is high even though the dollars involved are modest. The expansion is five times larger and its cash flows arrive over twenty years, so its rate of return is lower but it creates more value in dollars. Internal rate of return and payback both ignore scale, and payback ignores everything after the payback year, including the expansion's last eleven years of cash flow.

The retrofit earns the higher rate; the expansion earns the larger fortune.

The Crossover Rate

The incremental cash flows, the expansion's minus the retrofit's year by year, have an internal rate of return of about 9.38 percent. That is the crossover rate: the expansion is worth more at any rate under 9.38 percent, and the retrofit is worth more at any rate over it. The grower's hurdle rate, 8.5 percent, sits below the crossover, so the expansion ranks first.

Equivalent Annual Value

The projects also have different lives, twenty years against ten, which could distort a comparison of net present values. Converting each to an equivalent annual value, the level annual amount over its life with the same present value, removes that problem. The expansion's equivalent annual value is about $1.422 million a year over twenty years; the retrofit's about $1.023 million over ten. The ranking holds.

If Only One Can Go Ahead

The grower may face capital rationing this year: its bank has indicated it would prefer to finance one large project at a time, and management capacity is also limited. Ross et al. (2022) describe a profitability index, net present value per dollar invested, as a way to rank projects when capital is limited. The retrofit returns about $0.31 of value per dollar invested and the expansion about $0.13, so if capital alone were the constraint and projects could be scaled, the retrofit would come first. But neither project can be scaled, and the expansion's absolute value is twice the retrofit's. Where the choice is between two whole projects, the one with the larger net present value wins, and the index is useful mainly for ranking many smaller projects within a fixed budget.

The Decision

The expansion should rank first, because it adds the most value. Brealey et al. (2020) argue that net present value is the measure consistent with maximizing shareholder wealth, and Graham and Harvey (2001) found that most large companies use it, though many also look at internal rate of return and payback. The retrofit, however, is not a rejected alternative. It has a positive net present value, a quick payback and certain savings, and it does not compete for the same construction crews or management attention. If the grower can finance both, it should do both. If it must choose one this year, it should choose the expansion and schedule the retrofit next.

Limits

The expansion's value depends heavily on price, cost, construction cost and the ramp; Unit 10 calculates how far each could move before the decision reverses. The analysis also assumes the expansion is financed in a way that does not change the cost of capital, which Unit 9 examines.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of corporate finance (13th ed.). McGraw-Hill Education.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2022). Fundamentals of corporate finance (13th ed.). McGraw Hill.