Canyon Buff’s
In this case study: (go into debt details with each question)
1. When calculating incremental unlevered net income, should we include all the expenses mentioned in the case? If not, what expenses should we exclude and why.
2. Is there a big jump of unlevered net income from Year 5 to Year 6? Why?
3. How do you calculate the level of net working capital (NWC)? What is the value of NWC at the end of Year 0, 1, and 6?
Case – Canyon Buff’s Chemical Equipment
This case is a simple capital budgeting exercise of the following topics:
• Incremental unlevered net income
• Free cash flow
• Sensitivity analysis and scenario analysis
Introduction
Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment.
• The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line-depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that
• the asset can actually be use doubt into the indefinite future (i.e., the actual useful life is effectively infinite).
• Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6% until the end of sixth year (e.g., Year 6 sales = (1+6%)* Year 5 sales). After that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity (e.g., Year 7 sales = (1+2%)* Year 6 sales).
• The cost of goods sold is estimated to be 72% of sales for each year.
• The accounting department also estimates that at the introduction in Year 0, the new product’s required initial net working capital will be $6,000,000. In future years (e.g., Year 1 and beyond) accounts receivable are expected to be 15% of the next year sales, inventory is expected to be 20% of the next year’s cost of goods sold and accounts payable are expected to be 15% of the next year’s cost of goods sold.
• The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1million of this amount is the overhead expense that will be incurred even if the project is not accepted.
• The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year.
• The annual interest expense tied to the project is $1,000,000.
• Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30% and an average tax rate is 20%.
