Proforma Income Statement - Capital Budgeting

Let's return to the proforma income statement we created for Microsoft's Z Box (info given below) that we did in Week 2 and complete the analysis to determine if the project is desirable.

Using the spreadsheet you constructed in Week 2 and the cost of capital calculations you computed in Week 8 to determine if Microsoft should continue with the Z Box project.Use the following capital budgeting techniques.

1.Payback period

2.Net present value

3.Internal rate of return

Now let's test the sensitivity of the project to some changes in the assumptions.

4.Take the cost of capital you previously computed (in week 8) and add 2% to the value (for example, if WACC was 12%, make it 14%) and recalculate NPV. What happens to IRR?Is the project still desirable?

5.Suppose the cost of goods sold percentage rises by 3%.Compute the payback period, NPV and IRR.Use the original WACC you computed.

6.How sensitive is NPV to the changes made in 4 and 5?

Suppose Microsoft has decided to introduce a new game playing console, the Z Box.Before they launch the Z Box, they conducted an analysis to see if the Z Box would be a desirable investment.The company estimated that it would sell 2.5 million Z Box's per year at a price of $800 for the next six years. After the first year of sales, the quantity sold will increase by 3% per year for the remaining life of the project.

The initial capital outlay is determined to be $1.9 billion and a $800 million outlay in net working capital (NWC) would also be required.Assume that there is a one-time investment in NWC and that this will be recovered at the end of the project.

Assume that the equipment used will be depreciated using the MACRS 7 year schedule and that the equipment has a salvage value of zero.At the end of year 6, the equipment will be sold for its book value.Also, assume that that the tax rate is 21%.

Cost of Capital

Let's return to the case involving Microsoft's project for the Z Box.In Week 2, we estimated the cash flows, which is the first step in analyzing project.We now need to estimate Microsoft's cost of capital in order to continue our analysis of the project.

Use the 10-year Treasury Bond rate as the risk free rate and assume that the market risk premium is 8% to find Microsoft's cost of equity.Assume that Microsoft's bonds are rated AAA and that Microsoft's corporate tax rate is 21%.Assume that Microsoft's bonds have no flotation costs, but the cost of issuing equity is 4.t%.Find Microsoft's weighted average cost of capital.Assume that the project will be financed with internal funds.You will need to find additional financial information from the Wall Street Journal and online at sites likehttp://finance.yahoo.comto complete calculation.

Useful video

Capital budgeting using the proforma income statement.

https://www.youtube.com/watch?v=IQRlXiXBjcE

THIS IS THE WORK THAT I COMPLETED LAST WEEK (MAY NOT BE ALL CORRECT)

WeightsMSFT Market Capitalization (E) (Trillion) 1,201,000,000,000

Debt (D) 5,516,000

Equity Weight E/(E+D)99.999541%

Debt Weight D/(E+D)0.0004593%

Cost of Equity

Bets 1.09

Risk Free Rate (10 Yr Treasury) 0.70%

Market Risk Premium 8%

Cost of Equity9.42%

Cost of Debt

AAA Bond Yield (Debt Rate)3.16%

Corporate Tax Rate21%

After Tax Cost of Debt2.50%

WACC9.4200%