Chapter 6: Investment Decision Rules
Data Case
On October 6, 2004, Sirius Satellite Radio announced that it had reached an agreement with Howard Stern to broadcast his radio show exclusively on their system. As a result of this announcement, the Sirius stock price increased dramatically. You are currently working as a stockanalyst for a large investment firm and XM Radio, also a satellite radio firm, is one of the firms you track. Your boss wants to be prepared if XM follows Sirius in trying to sign a major personality.Therefore, she wants you to estimate the net cash flows the market had anticipated from the signing of Stern. She advises that you treat the value anticipated by the market as the NPV of the signing, then work backward from the NPV to determine the annual cash flows necessary to generate that value. The potential deal had been rumored for some time prior to the announcement. As a result, the stock price for Sirius increased for several days before the announcement. Thus, your boss advises that the best way to capture all of the value is to take the change in stock price from September 28, 2004, through October 7, 2004. You nod your head in agreement, trying to look like you understand how to proceed. You are relatively new to the job and the term NPV is somewhat familiar to you.
To determine the change in stock price over this period, go to Yahoo! Finance (.yahoo.com/”>http://finance.yahoo.com) and enter the stock symbol for Sirius (SIRI). Then click Historical Prices and enter the appropriate dates. Use the adjusted closing prices for the two dates.
To determine the change in value, multiply the change in stock price by the number of shares outstanding. The number of shares outstanding around those dates can be found by going to .google.com/finance”>http://finance.google.com and typing SIRI into the Search window. Next, select the Income Statement link on the left side of the screen, and then select Annual Data in the upper right-hand corner. The Diluted Weighted Average Shares can be found for the 12/31/2004 income statement on that page.
Because the change in value represents the expected NPV of the project, you will have to find the annual net cash flows that would provide this NPV. For this analysis, you will need to estimate the cost of capital for the project. We show how to calculate the cost of capital in subsequent chapters; for now, use the New York University (NYU) cost of capital Web site (.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.htm”>http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.htm). Locate the cost of capital in the far-right column for the Entertainment Tech industry.
Use the cost of capital from the NYU Web site and the NPV you computed to calculate the constant annual cash flow that provides this NPV. Compute cash flows for 5-, 10-, and 15-year horizons.
Your boss mentioned that she believes that the Howard Stern signing by Sirius was actually goodfor XM because it signaled that the industry has valuable growth potential. To see if she appears to be correct, find the percentage stock price reaction to XM (XMSR) over this same period.
Chapter 7: Fundamentals of Capital Budgeting
Data Case
Novo Nordisk A/S is a health care company engaging in the discovery, development, and manufacture of pharmaceutical products. Its specialty is diabetes care and its headquarters are in Bagsvaerd, Denmark. The company sells its products all over the world, including in the United States, Japan, China, Russia, India, and Europe.
As a new member of the capital budgeting division of Novo Nordisk A/S, you have been asked to determine the net cash flows and NPV of a proposed new diabetes drug. The drug is expected to be on the market for three years only, because Novo expects to launch a new and better version of the drug in the near future. If the project is initiated, it will require an expenditure on research and development of 4% of the total amount that Novo spent on research and development in the last financial year. Also, an investment in a new production facility, which is estimated to cost $24 million, will be necessary.
The product revenues for years 1, 2, and 3 are expected to be 0.8%, 0.6%, and 0.4%, respectively, of the total revenue of Novo for the last financial year. The cost of goods sold is projected to be $8 million in years 1 and 2, but only $5 million in year 3. Finally, the selling, general, and administrative costs are assumed to be $3 million in years 1 and 2, but only $2 million in year 3.
In order to obtain the latest financial statement of Novo Nordisk, go to Yahoo! Finance .yahoo.com/”>(http://finance.yahoo.com/) and search for Novo Nordisk by entering the companys ticker symbol, NVO. Go to Financials and download the income statement and the balance sheet. Export them to Excel by right clicking while the cursor is inside each statement. When estimating the project details, use data for the most recent year for which the financial statements are available.
Novo has decided that the investment in the production facility should be depreciated with the straight-line method over the life of the project. Determine the amount of depreciation each year.
Calculate the corporate tax rate that Novo paid for the last financial year.
Use the result of Questions 2 and 3 to calculate the unlevered net income of the project for years 0 to 3.
In years 1 to 3, the inventory of the project is 1.5 million, receivables are 15% of the project revenues, and payables are 20% of the projects cost of goods sold. Assume that the project requires no cash. Find the net working capital for the project for each year 1 to 3. Also, find the change in net working capital for each year when assuming the project is terminated in year 3 and that net working capital has to be settled the year after the project endsthat is, find the change in net working capital for years 1 to 4.
Calculate the free cash flow for years 0 to 4 using Eq. 7.5. Note that you can use the unlevered net income from Question 4.
Find the net present value of the project from the calculated free cash flows when assuming that the cost of capital (CoC) for Novo is 12%. You may use the NPV function in Excel. Include cash flows 1 through 4 in the NPV function and then subtract the initial cost (i.e., add the initial cash flow CF0, which is a negative number).
NPV(CoC ; CF1: CF4) + CF0
For a presentation of the new project to your colleagues in Novos capital budgeting division, make a plot of the NPV as a function of the cost of capital. First, calculate the NPV of the project for a range of different assumptions of cost of capital (e.g., 5%, 10%, 15%, . . ., 40%). Then, plot the calculated NPVs as a function of the corresponding cost of capital. From the figure, note the internal rate of return of the project. Verify your result using Excels IRR function.