Description

1. Tech Geek is interested in establishing a valuation estimate and how this estimate was arrived at for their firm. Tech Geek is a constant growth perpetuity with for last year equal to $250M. The growth rate in their has been constant at 4% annually for several years now and is expected to remain so into the future. Tech Geek is financed with 50% debt and 50% equity. Their outstanding debt, originally issued in $1,000 increments, is trading at $800 with 10 years remaining, on average. The debt was originally issued at a coupon rate of 10% annually. Tech Geek equity is also publicly traded. Currently, the standard deviation of the returns on the market portfolio is 12% ( . The covariance between the returns on Tech Geek equity and the returns of the market portfolio is 2.16% (. Finally, the current and

Tech Geek has hired us to explain the valuation process for their firm and provide a current estimate of the overall value of Tech Geek.

2. Tech Geek likes to use IRR (Internal Rate of Return) as their main methodology for answering capital budgeting questions. Explain to Tech Geek why NPV (Net Present Value) is the superior capital budgeting methodology taking care to note the specific problems of nonconventional cash flows and mutually exclusive projects and the use of IRR.

3. Tech Geek has heard this all before about capital budgeting and has shifted to using Modified IRR for its capital budgeting decision making in response. Provide examples and explain to Tech Geek why Modified IRR has its on set of problems when it comes to capital budgeting.

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2019

Assets

Current Assets

Cash

$34,000

Accounts Receivables

$36,200

Inventory

$66,432

Total Current Assets $136,632

Fixed Assets

Net PP&E

Total Assets

OCF

Capex

Change NWC

CFFA

CAPM

Rf

MRP

Beta

E(R)

$84,338

$220,970

$77,274

$53,337

($8,462)

$32,399

2.50%

7.50%

1.9

16.75%

ITech Geek

2018 & 2019 Balance Sheet

2020

2019

Liabilities

Current Liabilities

$43,461

Accounts Payable $44,000

$54,950

Notes Payable

$20,000

Total Current Liabilities

$79,159

$64,000

Long-term Liabilities $106,000

$177,570

Total Liabilities

$170,000

Stockholder’s Equity

Common Stock

$125,159

$23,970

Retained Earnings

$27,000

Total Stockholder’s Equity $50,970

$302,729

Total Liabilities + Equity $220,970

CF creditors

CF stockholders

CFFA

$6,000

$26,399

$32,399

2020

$80,000

$33,400

$113,400

$110,000

$223,400

$24,950

$54,379

$79,329

$302,729

ITech Geek

2019 Income Statement

Revenue

$180,030

Cost of Goods Sold

$84,503

Depreciation

$12,516

Earnings before Interest & Tax

$83,011

Interest Paid

$10,000

Taxable Income

$73,011

Taxes (τ = 25%)

$18,253

Net Income

$54,758

Dividends

Addition to RE

$27,379.13

$27,379.13

COGS Margin

D/E

Current ratio

46.9%

0.74

1.57

Question 1:

Tech Geek is interested in establishing a valuation estimate and how it was arrived at for their

firm. Tech Geek is constant growth perpetuity with 0 for last year equal to $250M. The

growth rate in their has been constant at 4% annually for several years now and is

expected to remain so into the future. Tech Geek is financed with 50% debt and 50% equity.

Their outstanding debt, originally issued in $1,000 increments, is trading at $800 with 10 years

remaining, on average. The debt was originally issued at a coupon rate of 10% annually. Tech

Geek equity is also publicly traded. Currently, the standard deviation of the returns on the

market portfolio is 12% ( = .12). The covariance between the returns on Tech Geek equity

and the market portfolio returns is 2.16% ( , ℎ = .0216). Finally, the current = 2%

and ( ) = 5%.

Tech Geek Financial Statements Analysis.

A review of the income statement reveals that the cogs equal 47% of the total revenuesTech Geek Incorporation. This information suggests that Tech Geek right on track with nearly

half of its stocks being the reason for profitability and revenue generation.

On the other hand, leverage ratios like the debt-to-equity ratio implore that the firm is

cautiously handling most of its debts, good for its stability.

Debt to Equity ratio = Current Debts + Long Term Debts / Shareholders Equity.

= 125,221/322,569

= 0.388

On the part of liquidity, the Current Ratio can be determined using the formula:

Current Ratio = Current Assets/ Current Liabilities

= 177,570/113,400

= 1.565

This is a fair current ratio value suggesting the business is paying its debtors and investors

within the required time. The business can meet its debt obligations.

In the case of the stock or asset turnover, we review Tech Geeks Turnover ratio using the

formula below:

Net Turnover Ratio = Total Revenues/ Total Assets

Total Revenues = 180,030

Total Assets = 302,569

= 180,030/302,569

= 0.595

The ratio resulting from the calculation above represents the turnover ratio for Tech Geek’s

stocks. This suggests that Tech Geek makes revenue and replaces half the entire stock it

possesses in a trading period. This tells us the company has a stable supply of clients and

customers who purchase its services and products.

The following attachments show Forecasted Income Statements and Balance sheets for Tech

Geek Incorporation.

I: Balance Sheet as of 2019 and 2020.

The current ratio for Tech Geek advises that the business has a relatively viable

possibility of settling its debtors. Out of a possible one hundred percent of repaying its debts, the

firm has a probability of 56% to repaying its debts. The current ratio is composed of two

significant variables from the Balance sheet.

1.

Current Assets are made up of Cash balances, accounts receivables, and

Inventories.

2.

Current Liabilities comprise accounts payable and notes payables.

Linking the two variables gives us the current ratio for Tech Geek that we can use to evaluate the

company’s debt settlement capabilities. The assessment of the current ratio contains the most

recent balance sheet values for the company. The balance sheet below was important in

calculating the current ratio for Tech Geek.

Assets

Current Assets

Cash

Accounts Receivables

Inventory

Total Current Assets

Fixed Assets

Net PP&E

Total Assets

OCF

Capex

Change NWC

CFFA

ITech Geek

2019 & 2020 Balance Sheet

2019

2020

Liabilities

Current Liabilities

$34,000

$43,461

Accounts Payable

$36,200

$54,950

Notes Payable

Total Current

$66,432

$79,159

Liabilities

$136,632 $177,570

Long-term Liabilities

Total Liabilities

$84,338

$220,970

$77,274

$53,337

($8,462)

$32,399

$125,159

$302,729

2019

2020

$44,000

$20,000

$80,000

$33,400

$64,000

$113,400

$106,000

$170,000

$110,000

$223,400

$23,970

$27,000

$24,950

$54,379

$50,970

$79,329

Total Liabilities + Equity

$220,970

$302,729

CF creditors

CF stockholders

CFFA

$6,000

$26,399

$32,399

Stockholder’s Equity

Common Stock

Retained Earnings

Total Stockholder’s

Equity

ITech Geek

2019 Income Statement

Revenue

$180,030

Cost of Goods Sold

Depreciation

Earnings before Interest &

Tax

Interest Paid

$84,503

$12,516

$83,011

$10,000

Taxable Income

$73,011

Taxes (τ = 25%)

$18,253

Net Income

$54,758

Dividends

Addition to RE

$27,379.13

$27,379.13

ITech Geek

Income Statement

Year Ending 2020

Net Sales

COG’s

Depreciation

EBIT

Interest paid

Taxable income

$

$

$

$

$

$

180,030

84,503

200

95,327

10,000

85,327

Taxes

Net income

Additional Retained

earnings

Dividends paid

$

$

21,332

63,996

$

$

31,998

31,998

II: Income Statement Analysis

Its revenues have positively impacted the general analysis of Tech Geek for the year

2020. Using Net Sales as base values for the analysis, we see that the companies rate of asset

depreciation is approximately 0.005 percent of the revenues. Forty-seven percent of the revenues

are what the firm uses as cash for the cogs. This implies that there is huge demand in the market

for the organization’s goods and services, or the firm has a colossal market share containing loyal

customers.

Taking the Cogs as a percentage of Net Sales = (COG’s/Net Sales) x 100

= (84,503/180030) x 100

= 0.4693 x 100

=46.93%

ITech Geek

Capital Spending

Year Ending 2020

Ending fixed assets $

124,999

Beginning fixed

assets

$

84,338

Depreciation

$

200

Captial Spending

$

40,861

ITech Geek

Cash Flows From Assets

Year Ending 2020

Operating cash

flows

$

73,796

Capex

$

40,861

NWC

CFFA

$

$

-8,462

41,397

At the end of the trading period of the fiscal year 2020, the firm’s fixed assets make up

69% of the total revenues of Tech Geek Incorporation. The Cash Flow Capex value confirms the

argument that Tech Geek derives most of its monies from the internal sales as the cogs.

Beginning of the fiscal period, fixed assets were at a rate of 46.8% of the company’s revenues.

This shows a distinguished increase in the fixed assets for the firm. Therefore an expanding

business model, which is mainly a result from operating profits.

The calculations above are as shown below:

Percentage of Assets Starting of Fiscal Year 2020= (Beginning Fixed Assets/Net Sales) x 100

= (84,338/180,030) x 100

= 0.4684 x 100

= 46.84%

Percentage of Assets Ending Fiscal Year 2020 = (Ending Fixed Assets/ Net Sales) x 100

= (124,999/180,030) x 100

= 0.6943 x 100

= 69.43%

ITech Geek

Cash Flows

Year Ending 2020

Earnings Before Interest and Taxes

(EBIT)

$

95,327

Depreciation

$

200

Taxes

Operating cash flows

Ending new working capital

Starting NWC

Change in NWC

$

$

$

$

$

21,332

73,796

64,170

72,632

-8,462

III: Changes in Net Working Capital.

The changes in net WC come to attention. The change in working capital is a negative

number, i.e.,(8,462) which proposes the firm is heavily building its new investments in current

assets at the cost of reducing a large portion of its current liabilities. In addition, Tech Geek may

have a credit policy that tightens its further potentials of borrowing. Tech Geek favours paying

its current debts off before taking on other credit facilities in the future. This decreases the

accounts receivables amount and provides cash for the firm to make other open investments in

current assets.

IV: CAPM Evaluation.

In this study our goal to assess the returns that are anticipated from the business’s operations.

Also, we examine the rate of risks that are attached to the securities before an investment move is

made. Then we describe the relationship between the returns from the investment opportunity

and attached risks to portfolio securities. The model compares the expected return to the risk-free

rate of return with an additional premium value based on the beta value for the portfolio.

In order to calculate the expected security returns using CAPM we have to make some

assumptions. First, we assume ITech Geek is operating in the United States and the ten-year

treasury yield at 2.5% applies.

The table below shows expected returns by CAPM model.

Expected Return of a Tech Geek using CAPM formula

U.S. 10-year treasury Yield

Annual excess return for stocks

Beta/Sensitivity

2.50%

7.50%

1.9

Expected Return

16.75%

CAPM = U.S Treasury Yield/ Risk-Free Rate + (Sensitivity/Beta x Excess stock return/ Risk

premium)

= 2.5% + (1.90 x 7.50%)

= 17%

Question 2:

Tech Geek likes to use IRR (IRR) as their primary methodology for answering capital budgeting

questions. Explain to Tech Geek why NPV (NPV) is the superior capital budgeting methodology

taking care to note the specific problems of non-conventional cash flows and mutually exclusive

projects and the use of IRR.

Solution.

Tech Geek’s decision to ensure that its value is assessed using capital budgeting is an

essential idea for the company’s managers. Besides, this idea is vital for the economy due to its

involvement in massive projects with a considerable base of required capital for initiation.

Companies can use the methodology of NPV (NPV) and IRR (IRR) as the primary methods of

evaluating the company value with the investment opportunity available. In addition to this, there

can be the use of a Payback Period and an assessment of Profitability Indices and the Accounting

Rate of Return when evaluating the projects, they look forward to investing into.

In the process where Tech Geek initiates an appraisal of investment projects, preference

is derived towards the IRR, Payback Period (PB), and NPV as primary methods used in defining

the current capital investment projects’ viability. Among the three advised methodologies, NPV

is seen as the most adhered and used methodology in evaluating projects. NPV (NPV) is

commonly used because it takes care of the changing value of real money with relation to time, it

adjusts for risks associated with the investment opportunities.

As is with the company policy, there should be a model to highlight the risks associated

with the projects and outline the necessary changes in the value of money to inflation rates and

other fiscal impacts on the value of money. Tech Geek managers should be in the liking of the

IRR model from the fact that the model helps them consider the actual return of each project. It

is a good model that helps a company- Tech Geek rank projects based on the projects’ risks. On

the other hand, the payback period model is used to make it easy to calculate and evaluate the

results into an understandable figure.

Both models and measurements of (IRR) and (NPV) are majorly used to evaluate capital

budgets for firms. By calculation, NPV refers to the difference that is arrived at when there is

deduction of present inflows of cash value from the outflows for a specified period of time.

Contrastingly, the IRR (IRR) estimates profitability from a list of potential investment

opportunities to make for the firm. When an investment opportunity presents itself for a firm, it

is for the firm to make an informed decision and analysis of the investment opportunity before

deciding whether it will undertake the opportunity or not. The decision is ability of a corporate to

generate economic and financial profitability from the investment opportunity.

Before discussing the various merits that come with using the NPV model to evaluate an

investment’s profitability compared with the IRR model, we can look at the differences or

similarities between the two. First, both IRR and NPV are discounted cash flow methods

employed in the evaluation of investments and other capital budgets. For NPV, when the

resulting difference in cash inflows and cash outflows is above zero, the investment is viable and

worthy of initiating. IRR estimates the profits for projects in question using percentage values

rather than realistic dollar values as used in NPV.

Conflicts between NPV and IRR.

When analysing joint projects, we use both NPV model and the IRR. Resulting values

will have a similar indicator of whether the firm will agree or rule against the investment project.

In the process of comparing the projects, both models will result in conflicting values. There may

be a model like the NPV that will show a project with higher returns and low risks while the

other shows a lower value of the IRR values. Differences most of the time occur due to the

difference in cash inflow patterns into the company and corresponding cash outflows from the

firm for the mutually related projects.

The table below represents the idea discussed above. The point being driven is the idea of

using both models of IRR and NPV for joint projects. In this example, an assumption is made of

the discount rate where it is assumed to be ten percent.

YEAR

PROJECT X

PROJECT Y

0

(5000)

(5000)

1

2,000

0

2

2,000

0

3

2,000

0

4

2,000

0

5

2,000

15,000

NPV

2,581

4,314

IRR

30%

25%

The table above shows that Project X has a higher IRR (30%) than Project Y (25%). On

the other hand, the NPV of Project Y is higher than that of Project X. In the case where the two

projects are not mutual; the conflicting results wouldn’t matter because Tech Geek (The firm)

would have to take into account both projects. Furthermore, for mutually exclusive projects like

our case, the firm needs to make a long-lasting and informed decision on which of the two

conflicting projects the company would invest in the above situation. Where projects are

mutually dependent in an exclusive manner, the project resulting from the highest NPV should

be taken into account. This is due to the inherent assumption attached to reinvestment decisions

and opportunities. In the example above, our informed assumption is that the cash flows will be

available for reinvestment at the same rate equal to the discount rate of 10%. In the NPV

calculation, the informed discount rate at ten percent is compared to the IRR assumption rate at

an approximate value of 29% and 25%. The high reinvestment rate of the IRR seems unrealistic

compared to the rate of the NPV. This makes the NPV results reliable compared to the IRR

values. In our example, project Y should be taken into account.

An example of a mutually exclusive project is that the acceptance of one project means

that the other project is denied. The two models of NPV and IRR result in totally contradicting

results. A project manager for Tech Geek who is fond of IRR and prefers the model may be led

to accept a project proposal that the NPV model asks them to reject.

Conflicts between the two discounted cash flow methods happen due to the differences in

the capital amounts present for the proposed investment projects. The differences in timing and

how cash flows will be awarded to the investment opportunities are why there would be

conflicting information or results from the two capital budgeting models. When the project faces

difficulty in making decisions, there is a fast decision that should be made between jointly

contending projects. Therefore, this is where the NPV methods save the project manager when it

comes to their decision-making process. The project to choose will have to be based on its

considerable net positive value. This will cut on the costs and the affordability of capital.

The functioning of the above models is based on the firm’s obligation of maximizing

stockholder’s equity. The best method to making sure stockholders are fascinated by the

enormous returns on their investments is by making sure that a choice is made on projects that

promise the highest NPV. This project will positively add to the share prices of a company and

help elevate the stockholders’ wealth.

Both models of NPV and IRR are functional capital budgeting tools. They, however, do

not resonate with their results as they can tell different results for two joint projects. This mostly

happens when joint projects have favourable choices. The Tech Geek project manager should

consider employing the NPV because it is the best model for mutually exclusive investment

opportunities.

Question 3:

Tech Geek has heard this before about capital budgeting and has shifted to using Modified IRR

for its capital budgeting decision-making in response. Provide examples and explain to Tech

Geek why Modified IRR has its own set of problems regarding capital budgeting.

While comparing the IRR (IRR) and NPV (NPV) gives the nod for the use of NPV. IRR

has numerous demerits, as it only measures the relative value created in a project or investment

opportunity. The IRR is difficult to evaluate, has predetermined assumptions that are unrealistic,

and is based on reinvestment making. Concerning NPV, the IRR delivers a zero return when

discounted on a sample investment portfolio.

Similar to the IRR, the Modified IRR (MIRR) makes the same assumptions in calculating

the value to be made from an investment opportunity. With MIRR, there is a single terminal

payment made. The model is applied for projects that have comparable levels of investment to

the NPV.

Example 1

An investment opportunity for Tech Geek worth $12,000 with cash returns at $4,400,

$6,500, and $1,300, respectively for three consecutive years. Assuming the cost of capital for

Tech Geek is 10%.

The table below shows the DCF, IRR, and NPV for the investment opportunity. From a

NPV perspective, the project is seemingly viable. The IRR also shows the same information

about its results from the value greater than Tech Geeks assumed cost of capital.

YEAR

0

1

2

3

Investment

Cash Flow

(12,000)

4,400

6,500

1,300

DCF

(12,000)

3063.6

4905.9

2205.4

NPV

IRR

850.0

15%

We can employ various methods in calculating the modified IRR.

By hand (traditionally)

Having the project’s cash flows in return phases with the first year being at the forward.

We compound single cash flows concerning Tech Geek’s cost of capital.

YEAR

0

1

2

3

Investment Cash

Flow ($)

(12,000)

4,400

6,500

1,300

Compounded

cash flow for

year 1 at 10%

4840

Compounded

cash flow for

year 2 at 10%

6600

Cash flow $

(modified)

(12,000)

11,440

Using the extended cash flow in year three, we calculate the discount rate required for a

discounted cash flow model equal to the firm’s outlay.

Therefore;

=

ℎ

(1 + )

We can make a rearrangement of the formula to find the solution for the project as follows:

ℎ

)−1

= √(

3

11440

Therefore; = √(12000) − 1 = 18 %

As noted in the example above, both models of IRR, NPV, and Modified IRR face a

problem that requires different capital investments. This is even major when the funds are

limited, and the projects are related to each other in a mutual order. The modified IRR cannot

provide a solution to mutually agreeing on projects on its own due to the complicated nature of

capital requirements and cash flow conflicts. The three models need to be adjusted using the

incremental analysis method. The problem can be made exemplary when an investment fund

needs past the initially agreed and forecasted period. The NPV is evaluated by hand, as done in

the example above. Using the discounted cash flow method, there is significant reduction in all

cash flows. However, the real cost of capital/ discount rate, is derived from an assumption

initially made out of the model’s discount rates. There is also a reserve that requires the financial

outlay to be separated from the main compounding of the formula used to calculate the modified

IRR. This is to secure the free cash flows but spare the initial cash flow back to the present value.

However, if the proposition happens, then the results from the free cash flow from the project

will be made up of both the investments and returns. The investment phase and the returns phase

returns will have been combined into one single entity.

Example 2

For complex capital-intensive projects. The modified IRR (MIRR) will have to employ

IRR techniques for reliable results initially. Not all of the firm’s projects have a good return

when initiated, as discussed within the conflicts between IRR and NPV. The problem sets in

when the firm’s project stretches beyond the realistic and forecasted phase of years. To ensure

that the problem is non-existent, we are required to divide the project’s forecasted cash flows into

two phases. One is a returns phase that defines the returns expected from the project and an

investment phase that outlines the investments and cash inflows into the firm.

For our project, we will assume that the investment project has an investment period

phase of a year which equals 12 months. The initial payment as an investment principal is $700,

and another value paid twelve months later at $300. The total investment made is thus equal to

$1,000. With the launch of the project and kicking it into operation, the initial return is expected

to kick off when the second-year ends. Moreover, the project needs to have a return or payback

of $400, $600, and finally $300 in the corresponding years that is 3 and 4. Like previously, there

is an assumption that the capital cost is rated at ten percent, just like the project’s discount rate.

Investing Phase

Return Phase

YEAR

0

1

2

3

4

Cash Flow of the Project

(700)

(300)

400

600

300

Modified Cash Flow

(700)

(273)

484

660

300

Investment Phase Present Value

(972)

Return Phase- Future Value

Return Phase Present Value

1,444

986

331

451

205

The resulting IRR is 10.6%.

An evaluation of the investment phase returns in the years 0 to 4 for the projects cash flow is

shown in the above table. When this is modified, the cash flow is shown in the column below the

real values for the project’s cash flows. Using the Modified IRR model. The cash flow (modified)

is evaluated using a reduced method of cash flow. The investment phase of the project is

discounted at the assumed rate of 10%. This results in a Present Value (PV) of $973 as capital

investments. When the return phase is compounded rather than capitalized, the terminal cash

flow gets us $1444. Therefore, the modified IRR is conversely evaluated as follows:

ℎ

)−1

= √(

4

1444

)−1

= √(

973

MIRR= 10.4%

Conclusively, using MIRR is relatively quick in making calculations of IRR. There is,

however, a confusing ideology on the reinvestment rates that are applicable for projects. There is

an assumption for IRR and NPV models with reference to investment opportunity generating

cash flows which are ploughed back to the project to strengthen it. One major disadvantage of

the modified IRR for a project is that it implicates the project’s capability to generate cash flows

in liaison with the forecasted value of the NPV. This is most of the time overstated. The only

merit for the modified IRR is that it is conventionally easier to calculate and evaluate. However,

this is a little gain compared to the loss in the financial significance attached to project valuation.

Therefore, financial outlay should be excluded from calculating the modified IRR using

cash flows discounted at a value equal to the marginal cost of involved capital since the marginal

capital cost defines the sundry cost of obligations being financed to the capital providers for the

project. The NPV (NPV) is usually non-inclusive of the idea because all of its cash flows are

initially discounted before they’re included in the calculation. On the other hand, the IRR (IRR)

fails to attend to outlays because the impromptu timing of cash flows dictates it. The modified

IRR (IRR), on the other hand, makes a discounted value of the negative cash flows and reverses

them back to the present (backdating). This is done using the MIRR model even when the cash

flow statements’ values are both negative and cynical. Therefore, there is a need for the

company- Tech Geek to make an underlying difference between the two models and how they

will have to handle outlays and the corresponding values of the operating cash flows.

Modified IRR (MIRR) is only a good measure of the “best looking” project, depending

on its vast returns. Still, it gives little attention to the risks associated with the projects on the

business itself. Executives who need to understand a specific project’s dynamics will move away

from such a model and embrace the NPV (NPV) instead.

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Explanation & Answer:

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Tags:

corporate finance

Capital Budgeting

valuation estimate

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