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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.
1.
To determine the change in stock price over this period, go to Yahoo! Finance
(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.
Date
Oct 7, 2004
Oct 6, 2004
Oct 5, 2004
Oct 4, 2004
Oct 1, 2004
Sep 30, 2004
Sep 29, 2004
Sep 28, 2004
2.
Open
3,98
4,26
3,34
3,24
3,23
3,14
2,88
2,74
High
4,16
4,29
3,35
3,31
3,35
3,22
3,02
2,77
Low
3,91
3,67
3,28
3,21
3,12
3,12
2,86
2,60
Close
4,00
3,87
3,35
3,24
3,14
3,20
3,02
2,65
Volume
206,666,500
343,630,900
72,087,700
64,923,100
69,406,300
94,501,100
105,622,600
39,418,900
Adj Close*
4,00
3,87
3,35
3,24
3,14
3,20
3,02
2,65
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
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 12/31/2007 income statement on
that page.
http://www.google.com/finance?q=NASDAQ:SIRI&fstype=ii
3.
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
4.
5.
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
(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.
1. In order to obtain the latest financial statement of Novo Nordisk, go to Yahoo!
Finance (http://finance.yahoo.com/) and search for Novo Nordisk by entering
the company’s 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.
2. 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.
3. Calculate the corporate tax rate that Novo paid for the last financial year.
4. Use the result of Questions 2 and 3 to calculate the unlevered net income of the
project for years 0 to 3.
5. 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 project’s 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 ends—that is, find the change in
net working capital for years 1 to 4.
6. 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.
7. 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
8. For a presentation of the new project to your colleagues in Novo’s 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 Excel’s IRR function.