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
Pessimistic ………………….
$1,100,000
x
.25
$ 275,000
Normal ……………………….
2,000,000
.40
800,000
Optimistic …………………..
3,750,000
.20
750,000
Highly optimistic …………
4,500,000
.15
675,000
1.00
$2,500,000
Then project sales for the next 5 years.
Year 2 ……………………
$2,500,000 x 1.20
=
$3,000,000
Year 3 ……………………
3,000,000 x 1.20
=
3,600,000
Year 4 ……………………
3,600,000 x 1.20
=
4,320,000
Year 5 ……………………
4,320,000 x 1.10
=
4,752,000
Year 6 ……………………
4,752,000 x 1.10
=
5,227,200
Then determine operating expenses and EBDT for the 6 years.
Year
Sales
Operating expenses (.70)
EBDT
Year 1 ………………….
2,500,000
1,750,000
750,000
Year 2 ………………….
3,000,000
2,100,000
900,000
Year 3 ………………….
3,600,000
2,520,000
1,080,000
Year 4 ………………….
4,320,000
3,024,000
1,296,000
Year 5 ………………….
4,752,000
3,326,400
1,425,600
Year 6 ………………….
5,227,200
3,659,040
1,568,160
Next determine the annual depreciation over the 6 years.
Year
Depreciation
Base
Percentage
Depreciation
Annual
Depreciation
1 ……………………………….
$2,800,000
x
.200
=
$560,000
2 ……………………………….
2,800,000
.320
896,000
3 ……………………………….
2,800,000
.192
537,600
4 ……………………………….
2,800,000
.115
322,000
5 ……………………………….
2,800,000
.115
322,000
6 ……………………………….
2,800,000
.058
162,400
Then combine the data into a table similar to Table 12-11.
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
EBDT……………
$750,000
$900,000
$1,080,000
$1,296,000
$1,425,600
$1,568,160
– Depreciation ….
560,000
896,000
537,600
322,000
322,000
162,400
EBT ……………..
190,000
4,000
542,400
974,000
1,103,600
1,405,760
– T (34%)…………
64,600
1,360
184,416
331,160
375,224
477,958
EAT ……………..
125,400
2,640
357,984
642,840
728,376
927,802
+ Depreciation ….
560,000
896,000
537,600
322,000
322,000
162,400
Cash flow ………
$685,400
$898,640
$ 895,584
$ 964,840
$1,050,376
$1,090,202
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.
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
Present value of outflows (cost) ………………………………….
–2,800,000
Net present value………………………………………………………
$ 710,131
Based on the positive net present value of $710,131, the project appears to be feasible. The firm
would be justified in going ahead with the investment.
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