Capital Budgeting Case

 

Finance 316-Capital Budgeting Case-Fall 2013

Directions:

Answer questions 1 – 5 and turn in a hard copy of your answers at the beginning of class on Thursday November 1

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th. No late submissions will be accepted.

I strongly suggest that you use excel or Google sheets for most of the analysis. Please type answers to the questions in this word document and attach each spreadsheet as appendices at the back.

To keep things fair for all students, I will not be answering individual questions about the case before it is due. However, I will answer any clarifying questions in class on Tuesday so everyone can hear the answer together.

You are allowed to work alone or with one other person, whichever you prefer.

Good luck!

Planetary Resources

Throughout recent history, mankind has mined natural resources from the ground. Your boss, Peter Diamandis, wants people to stop looking down for minerals, and start looking up. He points out that even within our own solar system there is a single asteroid, 241 Germania, that has $95.8 trillion of mineral wealth inside it (at today’s prices). This is a figure nearly as large as the annual GDP of the entire world. That particular asteroid is a little too big and a little too far away, but there are lots of smaller accessible asteroids with loads of platinum. He proposes building a private space program to capture some high value asteroids and bring them back to earth to mine the platinum.

Building a spaceship is not something you do on a shoestring budget, so the question is whether bringing one of these things back to earth is a positive NPV project. A related question is whether bringing an asteroid back to earth might have some unintended consequence. As it turns out, asteroids have landed on earth before, just ask the dinosaurs. Ignoring the haters that claim this concept may not be a good idea, he is considering starting an asteroid mining company named “Planetary Resources” to harvest these minerals and has asked you to help him analyze the project.

The timeline for the proposed business is as follows: In Year 0 (i.e., this year), Dr. Diamandis would begin acquiring the necessary labor and assets to set up operations. In Years 1 and 2, they will continue building the spaceship and in years 3 through 7 the business would be in full operation, collecting asteroids full of platinum and bringing them back to earth. He plans to sell the spaceships to NASA at the end of Year 7. In Year 8 nothing will happen except he will collect all the outstanding working capital. He will then move on to some other revolutionary idea, perhaps building a colony on Mars with Elon Musk.

Over the past year, Dr. Diamandis has racked up $2 million in consulting fees for a report with all the relevant figures for this project. The bill from McKinsey and Co. is currently sitting on his desk and is due today. The report suggests that he can build a spaceship for $140 million. 10% of the cost would be spent up front (today) and the other 90% would be equally split between years one and two. It is expected that NASA will pay $150 million when they purchase it after year 7. After it is built, the spaceship will be straight-line depreciated to zero over 20 years. There is one other piece of equipment they’ll need which are the asteroid baskets. They plan to buy two of these in year two for $10 million each. Repeatedly reentering the earth’s atmosphere tends to take a toll on the baskets, so they are only expected to last five years before they are worthless and will be straight line depreciated over that period.

The current price for platinum is $1450/oz and the consulting report predicts that the company will to be able to sell platinum at this price from the first asteroid they bring back. They expect to get four pounds of platinum from every ton of asteroid. Also, it may be helpful to know that there are 16 ounces in a pound and 2000 pounds in a ton. Here’s the problem: flooding the world market with platinum is likely to have an effect on prices. The consultants estimate that the price of platinum will drop 20% with every additional asteroid that is brought back.

The plan is to pick up one asteroid per year after the spaceship is built. The first asteroid is estimated to weigh 1492 tons. With each additional asteroid they will get a little more ambitious and will try to increase the size by 10% from the previous one. The tax rate is 35%, and the required rate of return for this type of business is 13% per year.

The majority of the expenses are related to operating and maintaining the spaceships. They convinced all their workers to take a percentage of sales for compensation, and these variable costs are expected to be 18% of same-year sales. They are treating things like fuel and maintenance as fixed costs since they won’t vary with sales, and they expect these costs to be $40 million per year once the space ships start operations. Working capital requirements (including accounts receivable and inventory) are expected to be 0 until they start operations, then $50 million in the year they bring back the first asteroid, increasing 10% each year thereafter, and back to $0 by the end of Year 8.

Name(s):

1) Based on the assumptions in the attached case description, calculate the NPV of this project. If you are stuck on how to start, take a look at the 4M Industries slide from the capital budgeting lecture. It will remind you of the general format, although you will need to make some adjustments to fit the details in this case. Additionally, you should create a separate schedules to show me how you calculated (i) revenue and (ii) the after-tax salvage value of the spaceships. Based on your calculations, is the project worth doing? (55 points)

2) Dr. Diamandis asks for some sensitivity analysis. What happens to NPV if the price of fuel goes up midway through the project causing fixed costs to be (i) 5%, (ii) 10%, or (iii) 15% higher than originally projected in years 5 through 7? How much does NPV change in each case? (10 points)

3) Suppose Dr. Diamandis meets a scientist that claims to have discovered how to turn water into hydrogen fuel. This is useful information because most asteroids have tons of ice in them so fuel costs would go down substantially. The scientist offers to sell the patent to Planetary Resources for $90 million, payable immediately, and it would drop fixed costs to $20 million for all years of operation. You can think of this purchase as a capital expenditure, and the patent will be amortized beginning in the first year over its 15 year legal life. After year 7, the firm would sell the patent to NASA for book value. Is this something you would recommend to Dr. Diamandis? Why or why not? Include a new spreadsheet and a couple sentences below. (15 points)

4) If the scientist described in question 3 was willing to accept payment in two equal installments at the end of years 2 and 3 instead of all up front, what is the new NPV of the project? In other words, the purchase of the patent would still happen today, but you could wait to pay him. Should you buy the patent under these terms? (10 points)

5) If your CPA said she found a way to depreciate the spaceship over 10 years instead of 20 years, does this matter for your NPV analysis? If so, show how, and if not, explain why not. (10 points)

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