BUS 6573 Module 2 Capital Budgeting and Valuation Model Example

$140 Million for Robots: A Capital Budgeting Model for Plant Automation, With the Acquisition Valued Alongside

Student Name

American College of Education

BUS6573: Enterprise Financial Strategy and Operations

Module 2 Assignment

Instructor Name

August 19, 2030

Introduction

My opening analysis showed that Cumberland Foods, a composite Nashville private-label food maker, faces about $540 million of competing claims on capital over three years but can fund roughly $300 million without new equity. The biggest items on that list are the robotic packaging lines planned for two plants and the purchase of an organic snack company. This paper builds the financial models needed to compare them. It estimates the company's cost of capital, projects the automation program's cash flows and computes three decision measures, then values the acquisition target on the same basis.

Estimating the Cost of Equity

Because the capital asset pricing model was the approach most chief financial officers reported relying on (Graham & Harvey, 2001), it anchors the estimate here, with its limits noted. The inputs are a risk-free rate of 4.2 percent, based on the ten-year Treasury yield; a beta of 0.85, the average of Cumberland's five-year monthly beta and the median of three packaged food peers; and an expected premium of stocks over Treasuries of 5.5 percent, a middle-of-the-road figure among those analysts adopt. Equity therefore costs 4.2 percent plus 0.85 times 5.5 percent, or 8.9 percent. Fama and French (2004) reviewed evidence that the model's predictions fit actual returns poorly, which is why the hurdle rate below includes a margin.

Weighted Average Cost of Capital

Cumberland's debt carries an average interest rate of 5.4 percent, or 4.1 percent after tax at a 24 percent rate. Using market values, equity of $1.32 billion and debt of $520 million give weights of 71.7 and 28.3 percent. The weighted average cost of capital is 0.717 times 8.9 percent plus 0.283 times 4.1 percent, or 7.5 percent. Because the automation program involves new technology and execution risk, the analysis uses a hurdle rate of 8.0 percent, half a point above the company's average cost of capital, and tests other rates in the next module.

Automation Program Assumptions

The program installs robotic packaging and palletizing lines in the Murfreesboro and Cookeville plants at a total cost of $140 million, spent at the start. Engineering estimates, based on vendor quotes and a pilot line, project annual pre-tax savings of $28 million at full operation: $26 million in labor and overtime, $6 million from less scrap and rework, less $4 million of added maintenance and software. Savings reach 60 percent in the first year as lines ramp up and 100 percent thereafter. The equipment is depreciated straight-line over its ten-year life for tax purposes, and its salvage value at the end is estimated at $10 million. Working capital is unchanged.

Annual Cash Flows

Each year's after-tax cash flow equals savings after tax plus the tax saved by depreciation. Depreciation is $14 million a year, so its tax shield is $3.4 million. In the first year, savings of $16.8 million become $12.8 million after tax, giving a cash flow of $16.1 million. In years two through nine, savings of $28 million become $21.3 million after tax, giving $24.6 million a year. In year ten, the $7.6 million after-tax salvage raises the cash flow to $32.2 million. The model assumes savings stay flat in nominal terms, a conservative choice since wage costs are likely to rise.

Net Present Value

Discounting these cash flows at 8.0 percent and subtracting the $140 million investment gives a net present value of $21.0 million. In other words, after recovering its cost and earning the required return, the program is expected to add about $21 million of value for shareholders, or roughly $0.53 per share. A positive net present value at a hurdle rate above the cost of capital supports proceeding, subject to the risks examined in the next module.

Return and Recovery Time

Measured as an internal rate of return, meaning the yield at which its cash flows exactly repay the $140 million, the program earns 11.0 percent, about 3.5 points above the cost of capital. The payback period, the time needed for cumulative cash flows to recover the investment, is about 6.0 years. Graham and Harvey (2001) found that many executives also consult payback despite its known flaws, because it signals how long capital is exposed. A six-year payback on ten-year equipment leaves a moderate cushion, which explains why the next module's sensitivity tests matter.

Break-Even Savings

A useful check is the level of savings at which the program just breaks even. Holding other assumptions constant, the net present value falls to zero if full-year savings are about $23.7 million rather than $28 million, a shortfall of about 15 percent. Since labor savings make up most of the total, the program's value depends heavily on how many positions automation actually replaces and on future wage levels. This sensitivity anticipates the scenario analysis that follows.

Valuing the Acquisition Target

The organic snack brand earns EBITDA of about $17 million, with depreciation of $3 million and capital spending of $4 million a year. Its free cash flow is therefore about $9.6 million after tax. Assuming growth of 3 percent a year indefinitely and a 9.0 percent discount rate, higher than Cumberland's because the brand is smaller and less diversified, the standalone value is $9.6 million times 1.03, divided by 6.0 percent, or about $165 million. Damodaran (2012) emphasized that acquisition prices must be justified by standalone value plus realistic synergies, which here would need a present value of about $45 million to reach the $210 million asking price.

Comparing the Two Investments

On these models, automation creates about $21 million of value for $140 million of capital, while the acquisition at its asking price destroys about $45 million unless synergies of that size materialize. Synergies of $45 million in present value would require roughly $3.6 million a year of pre-tax cost savings or added profit, growing over time, or more than 20 percent of the target's current earnings. Such synergies are possible through shared distribution, but acquirers commonly overestimate them, and the burden of proof should rest on the acquisition.

Model Limitations

The model simplifies in several ways. It uses straight-line depreciation, although accelerated tax depreciation would raise early cash flows and the net present value. It ignores inflation in both savings and costs. It treats the cost of capital as constant over ten years. And the capital asset pricing model inputs carry estimation error. Brealey et al. (2020) noted that discounted cash flow results are only as reliable as their forecasts, which is why the next module tests the key assumptions under scenarios and sensitivity analysis.

Conclusion

At a weighted average cost of capital of 7.5 percent and an 8.0 percent hurdle, Cumberland's $140 million automation program has a net present value of $21.0 million, an internal rate of return of 11.0 percent and a payback of about six years, breaking even if savings fall about 15 percent short. The acquisition target is worth about $165 million standalone against a $210 million price, requiring large synergies to justify. Automation is the stronger investment on these figures, pending the risk testing in the next module.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of corporate finance (13th ed.). McGraw-Hill Education.

Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset (3rd ed.). Wiley.

Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. Journal of Economic Perspectives, 18(3), 25-46. https://doi.org/10.1257/0895330042162430

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7