978-1259277160 Case Case 19

Phelps Toy Company Case 19

Capital Budgeting and Cash Flow

Purpose: The case gives the student a good opportunity to do cash flow analysis. The use of variable

discount rates based on project risk gives insight into how some corporations adjust for risk exposure.

Also, the use of an appropriate time horizon for analysis is highlighted. Some students may take a special

interest in the case because of the discussion of the profitable world of baseball card collecting.

Relation to the Text: Though the case is closely related to Chapter 12, it should probably follow after

Chapter 13 because of the risk dimensions in the discussion. Some instructors, however, may prefer to

gloss over the latter and present the case after Chapter 12.

Complexity: The case is relatively straightforward and should require approximately 1 hour.

Solutions

1. First determine the expected value of the first year’s sales.

Assumption Sales Probability

Expected

Value

Then project sales for the next 5 years.

Then determine operating expenses and EBDT for the 6 years.

Year Sales Operating expenses (.70) EBDT

Next determine the annual depreciation over the 6 years.

Year Depreciation Percentage Annual

written consent of McGraw-Hill Education.

Base Depreciation Depreciation

1……………………………….. $2,800,000 x .200 = $560,000

Then combine the data into a table similar to Table 12-11.

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

2. The discount rate will be based on the coefficient of variation of the first year’s sales.

The standard deviation was given as $1,226,000 and the expected value is $2,500,000.

The coefficient of variation is:

4904.

000,500,2

000,226,1$ 

VD

s

=

Examining Figure 3 for a coefficient of variation of .4904, the discount rate should be 14 percent.

3. We next determine net present value.

Year

Cash flow

(inflows)

Present Value

Factor (14%)

Present

Value

1…………………………………. $ 685,400 .877 $ 601,096

2…………………………………. 898,640 .769 691,054

3…………………………………. 895,584 .675 604,519

4…………………………………. 964,840 .592 571,185

5…………………………………. 1,050,376 .519 545,145

6…………………………………. 1,090,202 .456 497,132

Present value of inflows ……………………………………… $3,510,131

Present value of inflows…………………………………………….. 3,510,131

written consent of McGraw-Hill Education.

4. A six year time horizon may be too short a time frame to fully assess the project. It assumes there

will be no cash flow from the seventh year on. While many firms utilize a time frame of 5-10 years

written consent of McGraw-Hill Education.