  ### Capital Budgeting: Dell Company In Tutorial Library

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### TITLE: Capital Budgeting: Dell Company

#### CLASS / COURSE: Finance

QUESTION DESCRIPTION:

Given the situation below, complete the analysis in steps 1, 2, and 3, text pages 207-208, and prepare a 4-5 page report showing the computations and conclusions. Determine the cash flows associated with this project. The operating costs and net working capital requirements are similar to the rest of the company and that depreciation is straightline for capital budgeting purposes.

Dell Company is considering adding a new product line and needs to determine the net cash flows and NPV of the proposed product line. Development of the new product will require an initial investment equal to 10% of net Property, Plant, and Equipment (PPE) for the fiscal year ended 2008. The project will then require an additional investment equal to 10% of initial investment after the first year of the project, a 5% increase after the second year, and a 1% after the third, fourth, and fifth years. The project is expected to have a life of five years. First-year revenues for the new product are expected to be 3% pf total revenues for Dell Company fiscal year ended 2008. The new product's revenues are expected to grow at 15% for the second year, 10% for the third, and 5% annually for the final two years of the expected life of the project.

1)  Obtain Dell's financial statements.  Download the annual income statements, balance sheets, and cash flow statements for the last four fiscal years from www.marketwatch.com(Enter Dell's ticker symbol and then go to “financials.”  Export statements into excel.

2)  Determine the Free Cash Flow.  Compute the free cash flow for each year using the following equation:

free cash flow=  unlevered net income/ (revenues-costs- depreciation) x (1-Rc)

+Depreciation – CapEx- NWC

Set up the timeline and computation of free cash flow in separate, contiguous columns for each year of the project life.  Be sure to make outflows negative and inflows positive.

a.  Assume that the project's profitability will be similar to Dell's existing projects in 2005 and estimate (revenues-costs) each year by using the 2005 EBITDA/Sales profit margin.

b.  Determine the annual depreciation by assuming Dell depreciates these assets by the straight-line method over a 10-year life.

c.  Determine Dell's tax rate by using the income tax rate in 2005

d.  Calculate the net working capital required each year by assuming that the level of NWC will be a constant percentage of the project's sales.  Use Dell's 2005 NWC/Sales to estimate the required percentage.  (Use only accounts receivables, accounts payable, and inventory to measure working capital.  Other components of current assets and liabilities are harder to interpret and not necessarily reflective of the project's required NWC-e.g., Dell's cash holdings).

c.  To determine the free cash flow, calculate the additional capital investments and the change in net working capital each year.

3)  Determine the IRR of the project and the NPV of the project at a cost of capital of 12% using the Excel function.  For the calculations of NPV, include cash flows 1 through 5 in the NPV function and then subtract the initial cost (i.e. = NPV (rate, CF1: CF5) + CF0). For IRR, include cash flows zero through five in the cash flow range.

Capital Budgeting

Use Excel to estimate cash flows and cash outflows.

Have Excel set up as follow:

Year                            0       1       2       3       4       5

Revenues

Year 1 revenues will be 3% of Dell total revenues at Feb. 3, 2008. Dell income statement can be found in Yahoo Finance using annual data. The amount is \$55,908,000. But 3% of that amount. Year 2 revenues will be 1.15 of Year 1 revenues or an increase of 15%. Year 3 revenues will be 1.10 of Year 2 revenues or an increase of 10% from year 2. Year 4 revenues will be 1.05 of year 3 revenues or an increase of 5% from year 3. Year 5 revenues will be 1.05 of year 4 revenues or an increase of 5% from year 4.

Next, find Dell profit margin which has been 8.48% in recent years. Once you find PM, compute Dell Operating Income for each of the next 5 years = Revenues x PM

Operating Income                 0       1       2       3       4       5

Next compute capital expenditure, starting with initial investment today, Year 0.

Capital expenditure               0       1       2       3       4      5

Capital expenditure Year 0 = 10% of Property, Plant & equipment of Dell in Balance Sheet at Feb. 3, 2008

Capital expenditure Year 1 represents 1.10 of capital expenditure Year 0 or an increase of 10% from Year 0. Capital expenditure year 2 represents 1.05 of capital expenditure Year 1 or an increase of 5% from Year 1. Capital expenditure Year 3 represents 1.01 of capital expenditure Year 2 or an increase of 1% from Year 2. Capital 4 represents 1.01 of capital expenditure Year 3 or an increase of 1% from Year 3. Capital expenditure Year 5 represents 1.01 of capital expenditure Year 4 or an increase of 1% from year 4.

Next Calculate Change in capital expenditure

Change in Capital Expenditure                0       1       2       3       4       5

Change in Capital expenditure Year 0 will be the same as capital expenditure calculated above.

Change in capital expenditure Year 1 = Capital expenditure year 1 – capital expenditure year 0

Change in capital expenditure Year 2 = Capital expenditure year 2 – capital expenditure year 1

Change in capital expenditure Year 3 = Capital expenditure year 3 – capital expenditure year 2

Change in capital expenditure Year 4 = Capital expenditure year 4 – capital expenditure year 3

Change in capital expenditure Year 5 = Capital expenditure year 5 – capital expenditure year 4

Next Compute Depreciation for each of the next 5 years: straight-line method and the asset have 10 useful life. Use the amount of capital expenditure to compute depreciation. PLEASE DO NOT USE CHANGE IN CAPITAL EXPENDITURE BUT THE AMOUNT OF CAPITAL EXPENDITURE

Depreciation Year 1 = Capital expenditure year 0/10

Depreciation Year 2 = Capital expenditure year 1/10

Depreciation Year 3 = Capital expenditure year 2/10

Depreciation Year 4 = Capital expenditure year 3/10

Depreciation Year 5 = Capital expenditure year 4/10

Next Compute investment in NWC. To compute investment in NWC, you need the following ratio:

1.(Account Receivables year 2008 + Inventory 2006)/Sales 2006. Let call this CA/Sales

2.Account Payable 2008/Sales 2008

The two ratios will be used to compute the investments in NWC. The ratios will not change.

NWC                           0       1       2       3       4       5

NWC year 0 = 0

NWC Year 1 = Revenues Year 1 x [(CA/Sales) – (AP/Sales)]

NWC Year 2 = Revenues Year 2 x [(CA/Sales) – (AP/Sales)]

NWC Year 3 = Revenues Year 3 x [(CA/Sales) – (AP/Sales)]

NWC Year 4 = Revenues Year 4 x [(CA/Sales) – (AP/Sales)]

NWC Year 5 = Revenues Year 5 x [(CA/Sales) – (AP/Sales)]

Change in NWC            0       1       2       3       4       5

Change in NWC Year 1 = NWC Year 1 – NWC Year 0 (year 0 = 0)

Change in NWC Year 2 = NWC Year 2 – NWC Year 1

Change in NWC Year 3 = NWC Year 3 – NWC Year 2

Change in NWC Year 4 = NWC Year 4 – NWC Year 3

Change in NWC Year 5 = NWC Year 5 – NWC Year 4

Next Compute the Recovery of investment in NWC in Year 5 = Change NWC Year 1 + Change in NWC Year 2 + … + Change in NWC Year 5. This means adding the changes from Year 1 through year 5, make it positive even though the changes were negative.

Next calculate the FCF           0       1       2       3       4       5

FCF Year 0 is made up of capital expenditure year 0

FCF Year 1 through year 4 = Operating Income(1 – Tax rate) + Depreciation(Tax rate) – Change in capital Expenditure – Change in NWC.

FCF Year 5 = Operating Income(1 – Tax rate) + Depreciation(Tax rate) – Change in capital Expenditure – Change in NWC – Recovery in NWC.

Tax Rate = 21.91%

With a cost of capital of 12%, compute the NPV and IRR using the FCF above.

Should this project be accepted? If so, why? If not, why?

SOLUTION DESCRIPTION: Completed Solution is attached. Click on Buy button and then download file to get full solution.

SUBJECTS / CATEGORIES:
1. Finance
2. Financial Management
3. Accounting
4. Corporate Finance

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