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DashenBankShareCompanyCapitalBudgetingDecisionRealWo
rldCaseStudies
Case Description- The capital budgeting decision is one of the customers. The invoice price of the system is
most important financial decisions in business firms. In this case, Br.280,000 subject to 15% non-refundable VAT. It would
Dashen Bank Share Company (DBSC) is considering whether to require Br.18,000 in shipping expenses and Br.25,000 in
invest in a system to modernize its local money transfer services.
installation costs. The system will be depreciated using
To determine if the project is profitable, DBSC must first determine
the weighted average cost of capital to finance the project. The straight line method with 25% annual rate on original cost
simple payback period, discounted payback period, net present of the system. DBSC plans to use the system for four years
value (NPV), internal rate of return (IRR), and modified internal and it is expected to have a salvage value of Br.80,000 after
rate of return (MIRR) techniques are used to study the profitability four
of the project. MIRR is a relatively new capital budgeting
technique, which assumes that the reinvestment rate of the
project’s intermediary cash flows is the bank’s cost of capital. The
stand- alone risk of the project is evaluated with the sensitivity Author: Lecturer, Wolaita Sodo University, Department of Accounting &
analysis and scenario analysis techniques assuming that the new
system would not affect the current market risk of the bank. The
case gives students an opportunity to use the theoretical
profitability and risk analyses techniques explained in their
financial management module and related tutorial classes in a real-
world setting. The case is best suited for Master of Business
administration, Master of Accounting & finance, Master of
Project Management students and is expected to take
approximately four to five hours to complete. The case is
moreover; very useful for Ethiopian Students for thinking how they
can make capital decision in Ethiopian context. Similar case study
were previously developed by Meric et al., is used as a base for
development of this case in Dashen bank Ethiopian with its original
in nature and different solution keys context. It is teachable to
students in Ethiopia and elsewhere in the world. This review of
Finance case Studies is very useful for understanding the concept
of Cost of capital and Capital budgeting techniques.
Keywords: capital budgeting, weighted average cost of
capital, cash flow, payback period, net present value,
internal rate of return, modified internal rate of return,
sensitivity analysis, scenario analysis.
I. Case Information
Finance. e-mail: ufoandualem@gmail.com Br.95,000 in retained earnings this year, which is also
years of use. The bank expects the system will increase the Nesru: Yes, I believe that the bank’s current market value
number of local money transfer customers by 100,000. The capital structure of 30% debt, 10% preferred
company estimates that it will charge on the average Br.5 fee stock and 60% equity is optimal. We have about
per customer for the transfer service in the first year with a available in cash. We should be able to use this year’s
cost of Br.3 per customer, excluding depreciation. retained earnings to finance part of the equity financing
Management forecasts that both the service fee and cost per 19 required for the project. However, we will have to issue
customer will increase by 10% per year due to inflation. some new common shares for the remainder of the
DBSC’s net operating working capital would have to increase necessary equity financing. We can assume a flotation
by 18% of fees earned to deliver the transfer service. The cost of about 10% for the new common shares.
bank is subject to 30% income tax. Mehretu: There are three basic methods of
DBSC’s WACC calculating a firm’s cost of equity when retained
Mehretu, a recent MBA graduate of Addis Ababa earnings are used as equity capital: 1)the capital asset
University, is conducting the capital budgeting analysis for pricing method (CAPM); 2) the discounted cash flow
20 the project. The bank hired him only a few weeks ago as the (DCF) approach; and, 3) the bond-yield-plus-
head of the newly formed Capital Budgeting Analysis riskpremium method. Which of these methods should
Department. In order to evaluate feasibility of the we use in the calculation of our cost of retained
investment in the new system, Mehretu’s first task is to earnings?
estimate DBSC’s WACC. He plans to use the financial data in
Nesru: Although each of these methods has its
Exhibit 1 to estimate the WACC. When DBSC started
merits, I believe that the most appropriate approach
evaluating the project, the following conversation took place
for our bank would be to find an average cost with the
between Mehretu and Ato Nesru. Ato Nesru, the CEO of the
three methods. Besides, we can consider the yield on
bank, is a
the Ethiopian Government TB as risk free return on
London School of Business graduate with a major in investment in the computation of cost of common
financial economics and long years of administrative equity.
experience. Ato Nesru gave only one week to Mehretu for
Mehretu: It may be difficult to estimate cost of borrowing in his estimation of DBSC’s WACC. With the instructions
the current recessionary environment. he received from Ato Nesru and with the help of the
Nesru: We can determine the yield to maturity (YTM) on our financial data in Exhibit 1, Mehretu began the task of
outstanding bonds by using their current market prices. We estimating the bank’s WACC immediately.
can assume that we will be able to issue additional bonds Ato Nesru knew that estimating the bank’s
with this YTM as the cost of borrowing. We should be able to
cost of capital was the first critical step in the capital
place the new bonds without any flotation costs. Therefore,budgeting process. Without this analysis, it would not
we can assume no flotation costs in our calculations. We can
be possible to determine if the new system would be a
re-examine feasibility of the project later before raising funds
profitable investment for DBSC. That is why he had
by using sensitivity analysis to assess the impact of possible
asked Mehretu to estimate the bank’s WACC as the first
changes in interest rates on NPV of the project. task. Ato Nesru was very pleased when he received
Mehretu: Do you think the bank’s current market value Mehretu’s calculation results and the WACC estimate.
capital structure is optimal? Can we use the current He thought that he had made a good decision in hiring
percentages of the capital components as weights in Mehretu as the head of the company’s newly established
calculating the bank’s WACC? Capital Budgeting Analysis Department.
15 years
Remaining maturity
Flotation Costs 0
Market Return 6%
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This exhibit shows the data needed to estimate the bank’s
S WACC. Specifically, it presents the DBSC’s current market value
)
optimal capital structure used to determine in the WACC calculation. It then provides the data required to
calculate the cost of debt, the cost of preferred stock, and the cost of common stock. The figures are computed based on
analysis of investment in Ethiopian banking industry. The amount of new common stock to be issued is provided at the end of
the exhibit.
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Dashen Bank Share Company: Capital Budgeting Decision (Real-World Case Studies)
Analysis of the
Exhibit 2 : Data Mehretu plans to use in calculating the cash flows of the
profitability of the
project and evaluating its profitability
project
Ato Nesru
and Mehretu had the Year 0 Year 1 Year 2 Year 3 Year 4
following
conversation Cost of the new terms of Birr to the
regarding how they system: stockholders of the
should evaluate the bank. It is easier
potential profitability Invoice price of the Br.280,000 to compare the
of the project. new system project’s IRR with the
VAT(15%) 42,000 bank’s WACC to
Mehretu: With the
convince the
fees and cost Shipping 18,000 stockholders that we
estimates I have
can earn a higher
Installation 25,000
percentage return on
obtained from the Total cost of the 365,000 21
the investment than
marketing new
what it would cost to
and system(depreciable
biases)
finance it. I have heard
accounting
Annual 25%
that there is a new
departments in
depreciation rate improved capital
Exhibit 2, we should
budgeting technique
be able to estimate Salvage value 80,000
that measures the
the project’s cash
profitability of a
flows for the four-year Operating fees and project as a percentage
horizon. costs
similar to the IRR
method and it assumes
Number of - 100,000 100,000 100,000 100,000 that the project’s
Nesru: Excellent! How customers intermediary cash
are we going to Fees per - Br.5
flows can be
evaluate the customers
reinvested at the firm’s
Cost per - Br.3
cost of capital as in the
project’s profitability customers NPV method. I believe
to determine if it is Fees earned - Br.500,000
the
feasible? - Br.300,000
Mehretu: The Net Costs
technique is called the
Present Value (NPV ) and Internal Modified Internal Rate of
Rate of Return (IRR) methods are generally used in
Return (MIRR) method.
the evaluation of projects. However, these two methods Mehretu: No problem. We should be able to calculate the
have different assumptions regarding the reinvestment project’s MIRR.
Nesru: Great! I would also like to see the NPV, IRR, simple
rate of the intermediary cash flows. The NPV method
payback period, and discounted payback period results for
the project.
assumes that the intermediary cash flows can be reinvested
at the firm’s cost of capital. However, the IRR method Mehretu: Consider it done!
assumes that the reinvestment rate is the project’s IRR. With the instructions he received from Ato Nesru,
Academicians argue that the reinvestment rate assumption Mehretu immediately started to work on the cash flow
of the NPV method is more realistic. Therefore, they calculations using the data in Exhibit 2 to analyze the
recommend the NPV method. The financial goal of a firm is profitability of the project with the NPV, IRR, MIRR, simple
to maximize market value. The NPV of a project shows its payback period, and discounted payback period methods.
contribution to the market value of the firm.
Nesru: Correct! However, the NPV is expressed in Birr.
It is difficult to explain the profitability of a project in
stand- alone risk evaluation of the project with the a) Description of the Case
sensitivity analysis and scenario analysis techniques. The capital budgeting decision is one of the most
important financial decisions in business firms. In this case,
II. Questions DASHEN BANK (DB) is considering whether to invest in a new
Assuming that you a re Mehretu, answer the system. To determine if the project is profitable, DB must first
following questions: determine the weighted average cost of capital to finance the
project. The simple payback period, discounted payback
1. Calculate Dashen’s WACC using the data in
period, net present value (NPV), internal rate of return (IRR),
Exhibit
and modified internal rate of return (MIRR) techniques are
1. used to study the profitability of the project. MIRR is a
2. Calculate the project’s cash flows using the data in relatively new capital budgeting technique, which assumes
Exhibit 2. Why is it important to take into account the that the reinvestment rate of the project’s intermediary cash
effect of inflation in forecasting the cash flows? Briefly flows is the firm’s cost of capital. The stand- alone risk of the
comment. project is evaluated with the sensitivity analysis and scenario
3. Evaluate the profitability of the project with the analysis techniques assuming that Bank the new product
NPV, IRR, MIRR, simple payback period, and would not affect the current market risk of the company. The 23
discounted payback period methods. Is the project case gives an opportunity to use the theoretical profitability
acceptable? Briefly explain. Why is the NPV method and risk analysis techniques explained in standard finance
superior to the other methods of capital budgeting? Briefly textbooks in a real- world setting. The case is best suited for
explain. Masters of Business Administration and Master of
4. Conduct the stand-alone risk analysis of the project with Accounting is expected to take approximately three to four
the sensitivity analysis and scenario analysis techniques. hours to compete. The case may also be appropriate for
Explain why sensitivity analysis and scenario analysis can undergraduate senior finance majors.
be useful
tools in the capital budgeting decision-making
process when economic and financial conditions are
likely to change in the future.
Answers
Question 1: Calculate Dashen Bank’s WACC using the data in Exhibit-1 Solution 1:
Cost of Debt:
Cost of debt (r d) = 9%, after-tax cost of debt, rdT = rd (1-T) = 9 %( 1-0.3) = 6.3%
Cost of Preferred Stock:
rps = Dps / Pps (1 – F) = (0.09)(Br.100) / (Br.102)(1 - 0.07)
= Br.9 / Br.94.86 = 9.48% Cost of
Common Equity:
CAPM: rs = rRF + (RP M) b = 0.02 + (0.06) (1.2) = 9.2%
DCF: rs = [D0(1 + g) / P0] + g = [Br.1(1 + 0.05) / Br.19.08] + 0.05 = 10.5%
Own-Bond Yield-Plus-Risk Premium:
rs = rd + Bond RP = 0.09 + 0.035 = 12.5%
Cost of retained earnings (average rs):
Av. rs = (9.2% + 10.5% + 12.5%) / 3 = 10.73 %
Question 2: Calculate the project’s cash flows using the data in Exhibit 2. Why is it important to take into account the
effect of inflation in forecasting the cash flows? Briefly comment.
Solution 2: Annual revenue and cost estimates (assume 10% inflation rate):
Year 1 Year 2 Year 3 Year 4
Operating Cash Flows Br.167,375 Br. 181,375 Br. 196,775 Br. 213,715
Net Cash Flows (Br.455,000) Br. 158,375 Br. 172,375 Br. 185,075 Br. 389,415
IRR=43.858% @ this point NPV= 0, because the Sum of PV @ rate minus CF0 =0
The discount rate generally includes an inflation acceptable? Briefly explain. Why is the NPV method premium. If
the cash flows are not adjusted for inflation, superior to the other methods of capital budgeting? the project’s NPV would
be understated. Briefly explain.
Question 3: Evaluate the profitability of the project with Solution 3: The result is computed using the FV/PV the NPV, IRR,
MIRR, simple payback period, and charts, a financial calculator/ an Excel spreadsheet in discounted payback period
methods. Is the project the calculation of the NPV, IRR and MIRR.
Now, assume that the project’s sales revenues using the base WACC calculated in Answer 1). and costs
(excluding depreciation) are 10% lower:
26 Best-Case Scenario : Sales revenues and costs above with 10% higher revenues, 10 % higher costs, (excluding depreciation)
are 10% higher, and WACC is and discounts these cash flows to the present by using
1 percentage point lower. (the cash flows calculated 9.404%-1%=8.404% discount rate (new WACC):
NPV @ 8.404% = Br. 315,014.85 above with 10% lower revenues, 10 % lower costs , and
discounts these cash flows to the present by using
(Woexcluding depreciation) are 10% lower, and WACC is 1 rst-Case Scenario: Sales revenues and costs 9.404%+1%=
10.404% discount rate (new WACC):
σNPV = [(Br.182,353.95- Br. 241,174.25)2 (0.3) + (Br.246, 930.2- Br. 241,174.25)2 (0.5) + (Br. 315,014.85- Br. 241,174.25)2
(0.2)]1/2 = Br.46,314.15
CV(NPV) = Br. 241,174.25/ Br. 46,314.15= 5.207
Sensitivity analysis and scenario analysis can be useful
tools in the capital budgeting decision- making process
when economic and financial
conditions are likely to change in the future.