MBA702 Practical Application
Setup:
Julliard Corp. has several new projects that look attractive, but some are riskier than the firm’s past projects. Julliard has received a major inflow of cash from a venture capital firm, in exchange for 25% of the firm’s closely held stock. The VC firm has asked Julliard managers to “run the numbers” to examine both the market outlook and the expected returns on each of the projects they are considering. The cash infusion will not cover all the proposed projects; Julliard and its new investors need to know which projects should be approved.
- Based on Julliard’s earnings history over the past 15 years, which have covered various states of the economy, the venture capital execs want Julliard to estimate their overall returns. Given the following estimates of economy over the next several years, determine Julliard’s expected rate of return. (6 pts)
Note, this type of development firm has much higher than normal returns under normal and boom conditions. The probability of each state of the economy reflects the current situation, not necessarily historic market conditions for the firm.
| State of the Economy | Current Probability of State of the Economy | Rate of Return if State Occurs |
| Boom | 10% | 20.00% |
| Normal | 60% | 12.00% |
| Recession | 45% | -15.00% |
Expected return for “average” company project (based on assumed economic probabilities) =
- Historically, Julliard projects have had an average beta of 1.2, which indicates the higher risk levels for the firm. Assuming the market risk premium (MRP) currently estimated to be 7.5% and the risk-free rate is 2.10%, what is the required return for an “average” Julliard project using based on its average project beta? Show the average required return to 2 decimal places (x.xx%). (6 pts)
Expected return for “average” company project (based on current estimated MRP) =
- The potential projects that Julliard is considering have the following expected cash flows. Each project has its own unique risk and as such, the beta on each project is given. Using the data from #2 for the risk-free rate and market risk premium, what is the required percentage return for each of the projects? Show the required returns to 2 decimals, that is xx.xx%. You will use these rates when analyzing each project in the next part of the assignment, these are the required rates of return for Problems 4-6). (8 pts)
| #3 | Project A | Project B | Project C | Project D |
| Beta | 0.8 | 1.1 | 1.2 | 1.3 |
| Req. return (show work) |
|
NOTE: When a firm has projects that differ in risk (beta) than the “average” for the company, then the firm’s overall required return (from Problem 2) isn’t applicable. Each project needs to provide a return greater than or equal to its unique risk-adjusted required return. THE RATES CALCULATED FOR PROJECTS A – D IN #3 ARE THE REQUIRED RETURNS FOR EACH FOR THE FOLLOWING:
Use for Problems 4-7. For each project, calculate the NPV, IRR, profitability index (PI) and the payback period. For each capital budgeting decision tool, indicate if the project should be accepted or rejected, assuming that each project is independent of the others. Important Note: The venture capital folks, when considering payback period, have a firm maximum payback period of three years. This3-year payback period has no impact on other capital budgeting analysis techniques, each is to be considered on its own. In other words, yes, all cash flows need to be considered for NPV, IRR, and PI.
Expected cash flows for the four potential projects that Julliard is considering as shown below (each project ends when its cash flows end):
| Year | Project A | Project B | Project C | Project D |
| 0 | -$7,000,000 | -$9,500,000 | -$8,000,000 | -$7,000,000 |
| 1 | $1,500,000 | $3,000,000 | $2,000,000 | $2,500,000 |
| 2 | $2,000,000 | $3,000,000 | $2,000,000 | $2,500,000 |
| 3 | $2,500,000 | $3,500,000 | $1,500,000 | $2,100,000 |
| 4 | $2,500,000 | $3,000,000 | $1,500,000 | $500,000 |
| 5 | $1,500,000 | $500,000 | $1,000,000 | $500,000 |
| 6 | $500,000 | $1,000,000 | $500,000 | |
| 7 | $250,000 | $1,000,000 | $500,000 | |
| 8 | $500,000 | |||
| 9 | $500,000 | |||
| 10 | $500,000 |
I have provided a suggested template for your final answers. Below the grid is where you should show all your required backup calculations (this means your cash flow register inputs, the interest rate, PI calculation and cumulative cash flows for payback). If you are working this in Excel, feel free to submit your Excel sheet, where the equations in the cells will provide the required backup. Be sure to clearly indicate the required rate of return for each project (you calculated each in Problem 3).
Remember that each capital budgeting method should be calculated and analyzed on a stand-alone basis.
| Year | Project A | Project B | Project C | Project D | ||
| Points | Req. Return (use 2 decimals xx.xx%) | |||||
| 6 | 4a | NPV (to nearest $1) | ||||
| 2 | 4b | NPV accept/reject | ||||
| 4 | 5a | IRR (xx.xx%) | ||||
| 2 | 5b | IRR accept/reject | ||||
| 4 | 6a | PI (show 2 decimals, x.xx) | ||||
| 2 | 6b | PI accept/reject | ||||
| 4 | 7a | Payback Period (x.x years) | ||||
| 2 | 7b | Payback accept/reject | ||||
If you need more room to show your work, just add space in this document or put at the end (but be sure your academic coach can easily find your work for each section).