Weekly Puzzle #3

Instructor's Note:
The questions in this assignment track Example #1 in the "Sample Questions for Capital Budgeting" (posted in
You can see the worked solution there; this assignment shows you how these problems look in Excel.

Question #1: Compass Minerals

Compass Minerals has hired you as a consultant to evaluate its new project:

It believes that the initial costs of this project will be as follows:

Initial Capital Expenditure : $120m
Initial Investment in Net Working Capital (inventories, etc): $5m

The company has also already done an environmental impact study for this project, for which it paid $2m, but is
(perhaps you can help them figure it out?)

They have gathered the following information to help you calculate this project's cash flows:

Data for Revenues

Expected sales volumes: Tons of salt produced per year = 0.5m
Estimated Price = $50 per ton
Note: the company expects the first revenues from this project to occur at the end of year 1

Data for Costs

Variable Production Costs per unit = $10/ton
Note: this suggests that variable costs should be 20% or revenues for this company (can you figure out why
Fixed Production Costs = $0
Translation: this project has no fixed costs
Depreciaable life of asset = 20 years
Accounting standard applied: straight line depreciation
Initial Property, Plant, & Equipment : $120m
Resulting depreciation: $6m/year

Working Capital

Net Working Captial = $5m/year

Note that our initial cost estimate already includes this number, as management expects to build up invento
And the company ought to be able to reclaim this working capital when the project is shut down.
 Taxes
Average Tax rate = 20%

The following questions walk you through an analysis of this project:

a) What is the initial cost of this project?

Inital Cost ($m): 125

b) Explain your reasoning for part (a): what information did you use in your answer?
Answer: Initial Capital Expenditure + Initial Investment in Net Working Capita

c) Fill in the following table of revenue estimates:

We can estimate revenues for this project as follows: Estimated Revenues = Tons of Salt Produced per year

Time Period 0 1 2 3
Expected Sales Volumes (m) 0.5 0.5 0.5
Estimated Price/ton $50.00 $50.00 $50.00
Expected Revenues ($m) $25.00 $25.00 $25.00

d) Fill in the following table of cost estimates:

We can estimate costs for this project as follows: Estimated Costs = Tons of Salt Produced per year x Expect
Alternately: we could also recignize that variable costs are 20% of revenues, and estimate them as follows:

Time Period 0 1 2 3
Expected Sales Volumes (m) 0.5 0.5 0.5
Estimated Cost/ton $10.00 $10.00 $10.00
Variable Costs ($m) $5.00 $5.00 $5.00
Fixed Costs ($m) - - -
Cash Operating Expenses $5.00 $5.00 $5.00

*Note: this measure does NOT include depreciation, we will calculate that separately below.

e) Use the information from parts (c) & (d) to fill in the following table of EBITDA estimates:

Time Period 0 1 2 3
Expected Revenues ($m) 25 25 25
 LESS Cash Operating Expenses (5) (5) (5)
EBITDA 20 20 20

Note: EBITDA stands for "Earnings Before Interest, Taxes, Depreciation & Amortization" and is a "non-GAAP"

f) Now use the information we've been given about depreciation to fill in the following table of "EBIT" estim

We can calculate "EBIT" as follows: EBIT = EBITDA - Annual Depreciation

Note: depreciation was given in this problem, but if we needed to calculate it you could do so as follows: str

Time Period 0 1 2 3
EBITDA 20 20 20
LESS Annual Depreciation ($m) (6) (6) (6)
EBIT (ie, operating profits) 14 14 14

Note: EBIT stands for "Earnings Before Interest &Taxes" and is a "non-GAAP" measure of operating profits

g) Notice that there are now two interesting ways we can estimate this company's Operating Cash Flow. Let

Method 1: Operating Cash Flow = [EBITDA x (1-tax rate)] + [Depreciation x tax rate]
Comment: this calculation recognizes that the only reason we care about depreciation in finance is that it r

Time Period 0 1 2 3
EBITDA 20 20 20
Depreciation 6 6 6
tax rate 20% 20% 20%
Operating Cash Flow 17.2 17.2 17.2

Method 2: Operating Cash Flow = [EBIT x (1-tax rate)] + Depreciation

Comment: this calculation recognizes that the only reason we care about depreciation in finance is that it r

Time Period 0 1 2 3
EBIT 14 14 14
Depreciation 6 6 6
tax rate 20% 20% 20%
Operating Cash Flow 17.2 17.2 17.2

*Reality check: did these two methods produce the same result?

h) And we can finally produce a table of free cash flow estimates for this project!
 Time Period 0 1 2 3
Operating Cash Flow - 17.2 17.2 17.2
Less Change in Net Working Capital - - - -
Less Capital Spending - - - -
Free Cash Flow of Project - 17 17 17

Note: you can calculate the the change in working capital and capital spending by referencing the balance s
Change in Net Working Captial = Net Working Capital in current year - Net Working Capital from previous ye
Capital Investment = Gross PP&E in current year - Gross PP&E from previous year

Balance Sheet Data For Reference

Gross PP&E ($m) 120 120 120 120
Net PP&E ($m) 120 114 108 102
Net Working Capital ($m) 5 5 5 5

i) Also notice that we could have collected all this information in just a few tables! The only reason this too

Use all of the information you calculated above to fill in the following tables

Income Statement Measures ($m) 0 1 2 3

Expected Revenues - 25 25 25
LESS Cash Operating Expenses - 5 5 5
LESS Depreciation - 6 6 6
EBIT (ie, operating profit) - 14 14 14

Non-GAA) Cash Flow Measures ($m) 0 1 2 3

NOPAT = EBIT x (1-t) - 11 11 11
PLUS Depreciation - 6 6 6
Operating Cash Flow - 17 17 17

LESS change in Net Working Capital - - - -

LESS capital Investment - - - -
Free Cash Flow - 17 17 17

Balance Sheet Measures ($m) 0 1 2 3

Net Working Capital 5 5 5 5
 Gross PP&E 120 120 120 120
LESS Accumulated Depreciation - (6) (12) (18)
Net PP&E 120 114 108 102

We can now finally do some basic analysis on this project:

(i) What is the Net Present Value of this project's free cash flow, if we value them using a required rate of re
Note: you must answer using a formula, "hard-coded" answers will not be accepted. But you may calculate

NPV of project's free cash flows: $146.85

(j) What is the IRR of this project's free cash flow?

Note: you must answer using a formula, "hard-coded" answers will not be accepted. But you may calculate

IRR of project's free cash flows:

(k) What is the payback period of this project, just in case Compass wants to know?
Note: you may solve this problem in whatever way makes the most sense to you.

Payback Period of Project:

(l) Will this investment create value for compass minerals, if we evaluate it using a required rate of return of
Answer/Explanation:

(m) Would you recommend that Compass Minerals approve this project? Answer yes/no, and explain your re
Answer/Explanation:
Capital Budgeting" (posted in the review folder on D2L).
oblems look in Excel.

t, for which it paid $2m, but isn't sure whether to include this in their initial cost estimate.

end of year 1

mpany (can you figure out why?)

ent expects to build up inventories, etc before production begins.

roject is shut down.
estment in Net Working Capital

ons of Salt Produced per year x Expected Price/ton

4 5 6 7 8 9 10 11 12
0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
$50.00 $50.00 $50.00 $50.00 $50.00 $50.00 $50.00 $50.00 $50.00
$25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00

alt Produced per year x Expected Cost

and estimate them as follows: Variable Costs = 0.2 x Revenues (for each year)

4 5 6 7 8 9 10 11 12
0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
$10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00
$5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00
- - - - - - - - -
$5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00

parately below.

DA estimates:

4 5 6 7 8 9 10 11 12
25 25 25 25 25 25 25 25 25
 (5) (5) (5) (5) (5) (5) (5) (5) (5)
20 20 20 20 20 20 20 20 20

rtization" and is a "non-GAAP" measure of cash operating profits

ollowing table of "EBIT" estimates

you could do so as follows: straight-line depreciation = Initial Capital Expenditure/lifespan of project [ie, $120m/20 years=$6m/

4 5 6 7 8 9 10 11 12
20 20 20 20 20 20 20 20 20
(6) (6) (6) (6) (6) (6) (6) (6) (6)
14 14 14 14 14 14 14 14 14

measure of operating profits

ny's Operating Cash Flow. Let's compare them!

preciation in finance is that it reduces a company's cash taxes!

4 5 6 7 8 9 10 11 12
20 20 20 20 20 20 20 20 20
6 6 6 6 6 6 6 6 6
20% 20% 20% 20% 20% 20% 20% 20% 20%
17.2 17.2 17.2 17.2 17.2 17.2 17.2 17.2 17.2

preciation in finance is that it reduces a company's cash taxes!

4 5 6 7 8 9 10 11 12
14 14 14 14 14 14 14 14 14
6 6 6 6 6 6 6 6 6
20% 20% 20% 20% 20% 20% 20% 20% 20%
17.2 17.2 17.2 17.2 17.2 17.2 17.2 17.2 17.2
 4 5 6 7 8 9 10 11 12
17.2 17.2 17.2 17.2 17.2 17.2 17.2 17.2 17.2
- - - - - - - - -
- - - - - - - - -
17 17 17 17 17 17 17 17 17

g by referencing the balance sheet values below

orking Capital from previous year

120 120 120 120 120 120 120 120 120

96 90 84 78 72 66 60 54 48
5 5 5 5 5 5 5 5 5

bles! The only reason this took so much space is that we were working through the problem slowly:

4 5 6 7 8 9 10 11 12
25 25 25 25 25 25 25 25 25
5 5 5 5 5 5 5 5 5
6 6 6 6 6 6 6 6 6
14 14 14 14 14 14 14 14 14

4 5 6 7 8 9 10 11 12
11 11 11 11 11 11 11 11 11
6 6 6 6 6 6 6 6 6
17 17 17 17 17 17 17 17 17

- - - - - - - - -
- - - - - - - - -
17 17 17 17 17 17 17 17 17

4 5 6 7 8 9 10 11 12
5 5 5 5 5 5 5 5 5
 120 120 120 120 120 120 120 120 120
(24) (30) (36) (42) (48) (54) (60) (66) (72)
96 90 84 78 72 66 60 54 48

em using a required rate of return of 10%?

cepted. But you may calculate this in whatever way makes the most sense to you.

cepted. But you may calculate this in whatever way makes the most sense to you.

0.1

ng a required rate of return of 10%?

er yes/no, and explain your reasoning.

 13 14 15 16 17 18 19 20
0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
$50.00 $50.00 $50.00 $50.00 $50.00 $50.00 $50.00 $50.00
$25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00

13 14 15 16 17 18 19 20
0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
$10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00
$5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00
- - - - - - - -
$5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00 $5.00

13 14 15 16 17 18 19 20
25 25 25 25 25 25 25 25
 (5) (5) (5) (5) (5) (5) (5) (5)
20 20 20 20 20 20 20 20

ect [ie, $120m/20 years=$6m/year]

13 14 15 16 17 18 19 20
20 20 20 20 20 20 20 20
(6) (6) (6) (6) (6) (6) (6) (6)
14 14 14 14 14 14 14 14

13 14 15 16 17 18 19 20
20 20 20 20 20 20 20 20
6 6 6 6 6 6 6 6
20% 20% 20% 20% 20% 20% 20% 20%
17.2 17.2 17.2 17.2 17.2 17.2 17.2 17.2

13 14 15 16 17 18 19 20
14 14 14 14 14 14 14 14
6 6 6 6 6 6 6 6
20% 20% 20% 20% 20% 20% 20% 20%
17.2 17.2 17.2 17.2 17.2 17.2 17.2 17.2
 13 14 15 16 17 18 19 20
17.2 17.2 17.2 17.2 17.2 17.2 17.2 17.2
- - - - - - - (5)
- - - - - - - -
17 17 17 17 17 17 17 22

120 120 120 120 120 120 120 120

42 36 30 24 18 12 6 -
5 5 5 5 5 5 5 -

13 14 15 16 17 18 19 20
25 25 25 25 25 25 25 25
5 5 5 5 5 5 5 5
6 6 6 6 6 6 6 6
14 14 14 14 14 14 14 14

13 14 15 16 17 18 19 20
11 11 11 11 11 11 11 14
6 6 6 6 6 6 6 6
17 17 17 17 17 17 17 20

- - - - - - - -
- - - - - - - -
17 17 17 17 17 17 17 20

13 14 15 16 17 18 19 20
5 5 5 5 5 5 5 -
120 120 120 120 120 120 120 120
(78) (84) (90) (96) (102) (108) (114) (120)
42 36 30 24 18 12 6 -