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What are the role of cash flows in capital budgeting and why should NPV be the appropriate decision rule?

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Case Instruction and Hints – Sneaker 2013

Instruction

On a relative note, this case analysis and report are more like a “large” homework exercise than a “typical” case with more complicated structure and a range of choice of parameters. In this case, you will use the capital budgeting techniques we learned in the course (especially Session 4) to generate the annual net cash flows for the Sneaker 2013 project that New Balance is considering to invest in (You can ignore the analysis of the Persistence project which is also included in the case material). You will then calculate the net present value (NPV) of the project and make recommendations based on that.

Your report should clearly demonstrate the annual estimated cash flows and explain briefly how you arrive at those cash flows. Your write-up should contain a brief discussion about the role of cash flows in capital budgeting and why NPV should be the appropriate decision rule for this project.

The purpose of the exercise is to capture some fundamental points on the cash flow estimation in capital budgeting that this course tries to make. As such, you should limit yourself to produce a report of two to five pages of text. You can include as many exhibits as you need in an appendix.

The required margins should be one inch and a 10- to 12-point font for the text. Your exhibits can use any margins/fonts that you like.

Notes to case materials: 1. Gross margin (page 2) = Gross profit/Sales, where Gross profit = Sales – Costs of goods sold

2. CAGR (page 3) is short for Compound Annual Growth Rate, which is the average annual compounded growth rate over multiple years. For example, if in 2011 the investment is worth $10,000 and in 2018 it is worth $20,000, then the CAGR is calculated from the following equation: $20,000 = $10,000 * (1+CAGR)(2018-2011) = $10,000 * (1+CAGR) 7 So, CAGR = ($20,000/$10,000)^(1/7) – 1 = 2^(1/7) – 1 = 10.41%

Hints:

1. Should the following be included in Sneaker 2013’s capital budgeting cash flow projection? Why or why not?

a. Building a factory and purchase/installation of the equipment b. R&D costs c. Cannibalization of other sneaker sales d. Interest costs e. Changes in current asset/current liabilities accounts f. Taxes g. Cost of goods sold h. Advertising and promotion expenses i. Depreciation expenses

2. Think about the following questions while estimating the cash flows and prepare your report:

a. What is the project’s initial (year 0) investment outlay? b. What are the project’s annual (years 2013-2018) net operating cash flows? c. What is the project’s terminal (2018) non-operating net cash flow? d. Does Sneaker 2013 appear viable from a quantitative standpoint?

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