Case DescriptionThis case is adapted from a similar case study developed by Meric, Dunne, Li and…

Case DescriptionThis case is adapted from a similar case study developed by Meric, Dunne, Li and Meric (2010).Interested students can read and workout the entire case referenced below:Meric, I., Dunne, K., Li, S. F., & Meric, G. (2010). Variety Enterprises Corporation:Capital Budgeting Decision. Review of Business & Finance Case Studies, 1(1), 15-25.The capital budgeting decision is one of the most important financial decisions in business firms.In this case, Dashen Bank Share Company (DBSC) is considering whether to invest in a systemto modernize its local money transfer services. To determine if the project is profitable, DBSCmust first determine the weighted average cost of capital to finance the project. The simplepayback period, discounted payback period, net present value (NPV), internal rate of return(IRR), and modified internal rate of return (MIRR) techniques are used to study the profitabilityof the project. MIRR is a relatively new capital budgeting technique, which assumes that thereinvestment rate of the project’s intermediary cash flows is the bank’s cost of capital. The stand-alone risk of the project is evaluated with the sensitivity analysis and scenario analysistechniques assuming that the new system would not affect the current market risk of the bank.The case gives students an opportunity to use the theoretical profitability and risk analysestechniques explained in their financial management module and related tutorial classes in a real-world setting. The case is best suited for MBA and Master of Accounting students and isexpected to take approximately three to four hours to complete.Keywords: Capital budgeting, weighted average cost of capital, cash flow, payback period,net present value, internal rate of return, modified internal rate of return,sensitivity analysis, scenario analysisCase InformationDBSC is planning to invest in a special system to deliver local money transfer services to itscustomers. The invoice price of the system is Br.280,000 subject to 15% non-refundable VAT. Itwould require Br.18,000 in shipping expenses and Br.25,000 in installation costs. The systemwill be depreciated using straight line method with 25% annual rate on original cost of thesystem. DBSC plans to use the system for four years and it is expected to have a salvage value ofBr.80,000 after four years of use. The bank expects the system will increase the number of localmoney transfer customers by 100,000. The company estimates that it will charge on the averageBr.5 fee per customer for the transfer service in the first year with a cost of Br.3 per customer,excluding depreciation. Management forecasts that both the service fee and cost per customerwill increase by 10% per year due to inflation. DBSC’s net operating working capital would haveto increase by 18% of fees earned to deliver the transfer service. The bank is subject to 30%income tax.4 | P a g eDBSC’s WACCGuta, a recent MBA graduate of Addis Ababa University, is conducting the capital budgetinganalysis for the project. The bank hired him only a few weeks ago as the head of the newlyformed Capital Budgeting Analysis Department. In order to evaluate feasibility of the investmentin the new system, Guta’s first task is to estimate DBSC’s WACC. He plans to use the financialdata in Exhibit 1 to estimate the WACC. When DBSC started evaluating the project, thefollowing conversation took place between Guta and Ato Ali. Ato Ali, the CEO of the bank, is aLondon School of Business graduate with a major in financial economics and long years ofadministrative experience.Guta: It may be difficult to estimate cost of borrowing in the current recessionary environment.Ali: We can determine the yield to maturity (YTM) on our outstanding bonds by using theircurrent market prices. We can assume that we will be able to issue additional bonds withthis YTM as the cost of borrowing. We should be able to place the new bonds withoutany flotation costs. Therefore, we can assume no flotation costs in our calculations. Wecan re-examine feasibility of the project later before raising funds by using sensitivityanalysis to assess the impact of possible changes in interest rates on NPV of the project.Guta: Do you think the bank’s current market value capital structure is optimal? Can we use thecurrent percentages of the capital components as weights in calculating the bank’s WACC?Ali: Yes, I believe that the bank’s current market value capital structure of 30% debt, 10%preferred stock and 60% equity is optimal. We have about Br.95,000 in retained earningsthis year, which is also available in cash. We should be able to use this year’s retainedearnings to finance part of the equity financing required for the project. However, we willhave to issue some new common shares for the remainder of the necessary equityfinancing. We can assume a flotation cost of about 10% for the new common shares.Guta: There are three basic methods of calculating a firm’s cost of equity when retainedearnings are used as equity capital: 1) the capital asset pricing method (CAPM); 2) thediscounted cash flow (DCF) approach; and, 3) the bond-yield-plus-risk-premium method.Which of these methods should we use in the calculation of our cost of retained earnings?Ali: Although each of these methods has its merits, I believe that the most appropriateapproach for our bank would be to find an average cost with the three methods. Besides,we can consider the yield on the Ethiopian Government TB as risk free return oninvestment in the computation of cost of common equity.5 | P a g eAto Ali gave only one week to Guta for his estimation of DBSC’s WACC. With the instructionshe received from Ato Ali and with the help of the financial data in Exhibit 1, Guta began the taskof estimating the bank’s WACC immediately.Ato Ali knew that estimating the bank’s cost of capital was the first critical step in the capitalbudgeting process. Without this analysis, it would not be possible to determine if the new systemwould be a profitable investment for DBSC. That is why he had asked Guta to estimate thebank’s WACC as the first task. Ato Ali was very pleased when he received Guta’s calculationresults and the WACC estimate. He thought that he had made a good decision in hiring Guta asthe head of the company’s newly established Capital Budgeting Analysis Department.6 | P a g eAnalysis of the profitability of the projectAto Ali and Guta had the following conversation regarding how they should evaluate thepotential profitability of the project.Guta: With the fees and cost estimates I have obtained from the marketing and accountingdepartments in Exhibit 2, we should be able to estimate the project’s cash flows for thefour-year horizon.Ali: Excellent! How are we going to evaluate the project’s profitability to determine if it isfeasible?Guta: The Net Present Value (NPV) and Internal Rate of Return (IRR) methods are generallyused in the evaluation of projects. However, these two methods have differentassumptions regarding the reinvestment rate of the intermediary cash flows. The NPVmethod assumes that the intermediary cash flows can be reinvested at the firm’s cost ofcapital. However, the IRR method assumes that the reinvestment rate is the project’s IRR.Academicians argue that the reinvestment rate assumption of the NPV method is morerealistic. Therefore, they recommend the NPV method. The financial goal of a firm is tomaximize market value. The NPV of a project shows its contribution to the market valueof the firm.Ali: Correct! However, the NPV is expressed in Birr. It is difficult to explain the profitabilityof a project in terms of Birr to the stockholders of the bank. It is easier to compare theproject’s IRR with the bank’s WACC to convince the stockholders that we can earn ahigher percentage return on the investment than what it would cost to finance it. I haveheard that there is a new improved capital budgeting technique that measures theprofitability of a project as a percentage similar to the IRR method and it assumes that theproject’s intermediary cash flows can be reinvested at the firm’s cost of capital as in theNPV method. I believe the technique is called the Modified Internal Rate of Return(MIRR) method.Guta: No problem. We should be able to calculate the project’s MIRR.Ali: Great! I would also like to see the NPV, IRR, simple payback period, and discountedpayback period results for the project.Guta: Consider it done!7 | P a g eWith the instructions he received from Ato Ali, Guta immediately started to work on the cashflow calculations using the data in Exhibit 2 to analyze the profitability of the project with theNPV, IRR, MIRR, simple payback period, and discounted payback period methods.Risk AnalysisAfter Guta submitted the cash flow calculations and the project profitability analysis results toAto Ali, they had the following conversation regarding the risk analysis for the project.Ali: The NPV, IRR, MIRR, simple payback and discounted payback results all lookpromising. However, we should also conduct a risk analysis of the project before we goahead with it. Since the project is about modernization of delivery of an existing service,I do not believe that the new project will change the bank’s beta and its overall marketrisk. Therefore, it should be sufficient to evaluate the stand-alone risk of the project.What are the techniques that we can use to assess the stand-alone risk of the project?Guta: Sensitivity analysis is a widely used technique to determine how much a project’s NPVwill change in response to a given change in an input variable. Input variables such as8 | P a g enumber of customers or the cost of capital are often used while holding other thingsconstant.Ali: The number of customers is difficult to forecast with a high degree of accuracy.Therefore, we should conduct a sensitivity analysis with regard to possible changes in theforecasted number of customers. It should be sufficient to evaluate the impact of anincrease or a decrease of 10% in number of customers from our base forecast. The newsystem will be initially employed at about 80% capacity with our base number ofcustomers forecast. Therefore, the unutilized capacity of the system should enable us toaccommodate a 10% increase in the number of customers. We estimate that costs,excluding depreciation, will be 60% of fees per customer. We can assume that this ratiowill not change with the 10% increase or decrease in the number of customers.Guta: No problem. We can conduct a sensitivity analyses for the project’s NPV with regard to a10% deviation from our base number of customers forecast.Ali: Given the current volatile financial environment, the actual WACC figure is also likely todeviate from the expected base level. I would like to know how sensitive the project’sNPV is to an increase or decrease of 1% in the WACC.Guta: No problem. We should be able to conduct a sensitivity analysis for the project withregard to a possible 1% change in the WACC. Another analysis technique for project riskwidely used in practice is scenario analysis. In this technique, the best and worst-caseNPV scenarios are compared with the project’s expected NPV. Do you want us toconduct a scenario analysis of the project as well?Ali: Yes. It would be a good idea. As the best-case scenario, assume that the number ofcustomers will be 10% higher and the WACC will be 1% lower (i.e. initially computedWACC less 1%) than our original estimates. For the worst-case scenario, assume that thenumber of customers will be 10% lower and the WACC will be 1% higher (i.e. initiallycomputed WACC plus 1%). Please calculate the standard deviation and the coefficient ofvariation of the project’s NPV probability distribution with these scenarios. You canassume a probability of 50% for the base NPV forecast, a probability of 20% for the best-case scenario, and a probability of 30% for the worst-case scenario.Guta: No problem. I should be able to submit the risk analysis results to you within a week.With the instructions he received from Ato Ali, Guta immediately started to conduct a stand-alone risk evaluation of the project with the sensitivity analysis and scenario analysis techniques.9 | P a g eQuestionsAssuming that you are Guta, answer the following questions:1. Calculate Dashen’s WACC using the data in Exhibit 1.2. Calculate the project’s cash flows using the data in Exhibit 2. Why is it important to take intoaccount the effect of inflation in forecasting the cash flows? Briefly comment.3. Evaluate the profitability of the project with the NPV, IRR, MIRR, simple payback period,and discounted payback period methods. Is the project acceptable? Briefly explain. Why isthe NPV method superior to the other methods of capital budgeting? Briefly explain.4. Conduct the stand-alone risk analysis of the project with the sensitivity analysis and scenarioanalysis techniques. Explain why sensitivity analysis and scenario analysis can be usefultools in the capital budgeting decision-making process when economic and financialconditions are likely to change in the future.