Kellogg: a mini capital budgeting case **a++ graded**

THE TASK

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Kellogg’s board of directors is meeting tomorrow to decide whether or not to go ahead with the proposed plant construction In Bangalore, India. The board requires a comprehensive report on the economic viability of the proposed project. If it decides to go ahead with the project, a decision has to be made as to how to finance the project. The board is currently considering two options – the issue of new common stock at a cost of 15% or the issue of 15-year bonds at a net before-tax cost of 10%.

 

Steve Johnson, CFO of Kellogg who has been with the company for a long time, feels that both the project investment and financing should be carried out in tandem. As such, he feels that the required rate of return on the new capital investment would depend on how it is financed. In other words, if Kellogg chooses to go with the equity, the ROR here should be 15%; and if debt is used, then the relevant debt cost should be used.

 

On the other hand, his young deputy, Brangelina Aniston who has an MBA from Stanford Graduate School of Business, feels strongly that investment and financing decisions should be kept separate, and that the project’s required rate of return should be based on the risk of the project. As an analyst, your task is to evaluate Kellogg’s proposed new investment and assess if the project should be accepted.

 

 

GUIDE TO THE TASK

 

Having just completed 612 Finance, you are confident you are up to the task of evaluating the proposed new plan investment in its entirety. Reflecting on what you have learnt in the course, you decide that, at the very least, you need to calculate the following:

 

  • Estimate Net Investment Cost at time 0.

 

 

  • Estimate Incremental After-tax Cash Flows in Years 1 through 5.

 

  • Using data from the latest income statement and balance sheet, compute the relevant cost of debt.

 

  • Using data from the latest income statement and balance sheet, compute the relevant cost of equity. (For this part, assume all funds for the project are raised internally.)

 

  • Estimate the Required Rate of Return for the project using

– the Security Market line Equation of the Capital Asset Pricing

   Model and

                 – Weighted Average Cost of Capital

x

  • Compute the Net Present Value (NPV), Internal Rate of Return (IRR) and the Modified IRR (MIRR) of the project.

 

  • Re-calculate the NPV’s, IRR’s and the MIRR’s for the two exchange rate scenarios given below:

 

Scenario A

t = time           1                    2                           3                   4                        5

                        Rs. 45/US$   Rs. 47.50/US$   Rs. 50/US$   Rs. 52.5/US$   Rs. 55/US$

           

Scenario B

t = time           1                    2                           3                   4                        5

                        Rs. 45/US$   Rs. 42.50/US$   Rs. 40/US$   Rs. 38/US$      Rs. 36/US$

 

  • Using the historical Indian rupee exchange rates, provide a (subjective) forecast of the Indian rupee versus US dollar during the investment horizon of 0–5 years. (A website on exchange rates can be found here.) Give your opinion as to whether exchange rate expectations provide ‘auspicious’ support for Kellogg’s proposed investment at the present time.

 

  • Reconcile the divergent views of Johnson and Aniston, and incorporate the right approach in your analysis wherever appropriate.

 

  • Convert the cash flows to US dollars and provide your answers also in US dollars.

 

 

Note:The long-run average return on the S&P 500 Index is 12.4%. T-bills and T-bill rates can be found here. Information on beta of Kellogg can be obtained at Yahoo Finance or MSN Money pages. Include charts and tables, where appropriate. Clearly state your assumptions and provide detailed calculations, where necessary.

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