cost of capital concepts - Pegasus Cc Ucf

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FIN 3403 LECTURE NOTES
COST OF CAPITAL
LEVERAGE
CAPITAL BUDGETING
© R. DIGGLE, JR., CFA
University of Central Florida
FINANCIAL INSTRUMENTS-LEC NOTES PP. 32-33
MONEY MKT < 1
 T-BILLS
 FED FUNDS
 COMML PAPER
 CDS
 MMMFs
 EURODOLLARS
 COMML CREDIT


CAPITAL MKT > 1
YR

TREAS NOTES, BONDS
FED AGENCY BONDS
MUNY BONDS
CORP. BONDS
MTGS / LEASES
PFD STOCK
COMMON STOCK
(RESIDUAL EQUITY)






PRIMARY & SECONDARY
MARKETS

PRIMARY
 NEW
ISSUE --IPO
OR SECONDARY
 PROSPECTUS OR
INDENTURE
REQUIRED FOR
CORP SECURITIES
 OFFERING MEMO
NEEDED FOR
MUNY BONDS
 MUTUAL FUNDS
ARE PRIMARY

SECONDARY
 TRADING
IN
EXISTING
SECURITIES ON
EXCHANGES OR
OTC MARKETS
 DIFFERENCE
BETWEEN NYSE,
ASE AND NASDAQ
COST OF CAPITAL CONCEPTS
FIN 3403 DIGGLE
UNIVERSITY OF CENTRAL
FLORIDA
COST OF CAPITAL DEFINED
TEXT CH 12, LEC
NOTES PP. 20-21
 CAPITAL GOODS
ARE LONG TERM
INVESTMENTS
> 1 YEAR)
 CAPITAL MARKET
INSTRUMENTS FOR
CORPORATIONS
ARE:

LT DEBT
 PREFERRED STOCK
 COMMON STOCK

Cost of Capital is the
OPPORTUNITY
COST or “HURDLE
RATE” of using funds
for new projects.
COC CONCEPTS
COST OF CAPITAL
IS AN IMPORTANT
FIRST STEP IN
CAPITAL
BUDGETING.
 CAPITAL COSTS
ARE BASED ON
MARKET COSTS OF
FINANCING
SOURCES

ALL CAPITAL
COSTS ARE
COMPUTED USING
AFTER TAX COSTS.
 SINCE INTEREST IS
DEDUCTIBLE,
COST OF DEBT IS:
Kd (1-t)
where t = Corp FIT
rate

COC CONCEPTS CONTD.

THE COST OF
PREFERRED STOCK
IS:
Kps = Dps
P0
WHERE: D =
preferred dividend
P = market price of
preferred IN YEAR 0
COST OF COMMON
STOCK (Equity) IS:
Kcs (also called Ks)=
D1 + g
P0
WHERE: D1 = common
stock dividend next
year and P0 is common
price now AND g is
the estimated EPS

COC CONCEPTS CONTD

Cost of NEWLY
issued common stock
is:
Ke = D1 + g
P0 (1-F)
Where F = flotation
costs of new equity
(Secondary offering)
PREFERRED AND
COMMON STOCK
ARE AFTER TAX
COSTS.
 COST OF DEBT
MUST BE
ADJUSTED BY (1-T)
for the corporate
income tax rate

WACC

The average cost of
capital for a
corporation is the
WEIGHTED cost of 3
external capital
sources: LT debt, Pfd
stock and common
stock on an AFTER
TAX basis.
WACC or weighted
average cost of capital
is, therefore, based on
the firm’s capital
structure: SEE Table
12-6 on p. 444
 USUALLY, cost of
L.T. debt is the lowest
cost source of funds.

KINDS OF DEBT
CORPORATIONS
MAY ISSUE MANY
BONDS.
 BOND TYPES:

 FIRST
MORTGAGE
BONDS
(collateralized)
 2ND MTG BONDS
 DEBENTURES
(UNSECURED LT
DEBT)
CORPORATIONS
MAY ISSUE
SEVERAL SERIES
OF BONDS WITHIN
EACH CLASS
 EACH NEW ISSUE
IS SUBORDINATED
TO EARLIER
ISSUES

PRIORITY OF CLAIM
PYRAMID

CORPORATE
LIABILITIES HAVE
A DEFINED
PRIORITY OF
CLAIM TO INCOME
AND ASSETS IN
EVENT OF
LIQUIDATION
(BANKRUPTCY)
CREDITORS
INCLUDING THE
IRS
 1st Mortgage bonds
 2nd mortgage bonds
 Preferred stock
 Common Stock
(RESIDUAL EQUITY)

CORPORATE DEBT
CHARACTERISTICS
ALL interest on debt is
deductible
 Corporate bonds are
$1000 par which is
value at maturity or
redemption
 The stated interest rate
or COUPON rate is
fixed for life of bond

BONDS are issues
with an initial maturity
of 10+ years (usually
to a maximul of 30
years)
 NOTES are issues
with an initial maturity
of 1-10 years.
 BONDS & NOTES
are sold by
INDENTURE

PREFERRED STOCK
CHARACTERISTICS
PREFERRED STOCK
HAS NO
MATURITY. IT IS
LIKE AN
UNLIMITED
MATURITTY BOND.
 PREFERRED STOCK
PAYS A FIXED
DIVIDEND

PAR CAN BE ANY
AMOUNT.
 PREFERRED STOCK
DIVIDENDS ARE
NOT DEDUCTIBLE
TO THE ISSUING
CORPORATION
 INTERCORPORATE
DIVIDEND
EXCLUSION

COMMON STOCK
CHARACTERISTICS
COMMON STOCK
IS OWNERSHIP
CAPITAL OR
“EQUITY”
 PAR CAN BE ANY
AMOUNT AND IS
MEANINGLESS.
 COMMON STOCK
DIVIDENDS are
discretionary.




THE BOARD
DECLARES THE
COMMON DIVIDEND
QUARTERLY BASED
ON PROFITS.
EXCESS PROFIT AFTER
COM DIVDS IS ADDED
TO “RETAINED
EARNINGS”
QUARTERLY
LOWEST PRIORITY
OF CLAIM
COMMON STOCK
CHARACTERISTICS contd.
High growth
companies often do
NOT pay a dividend
preferring to
REINVEST profits
back in the business.
 Reinvested earnings
are called retained
earnings.

The price of common
stock rises with profits
per share called
Earnings per Share or
E.P.S.
 High growth
companies often have
high Price / Earnings
or P/E ratios.

COMMON STOCK
CHARACTERISTICS contd.
THE COST OF
COMMON STOCK
IS USUALLY THE
HIGHEST SOURCE
OF EXTERNAL
CAPITAL.
 THIS COST IS
RELATED TO THE
P/E RATIO however

D1
+g
P0
 EXAMPLE
D0 = $1.00
g = 12%
P0 = $30

D1 = $1.00 x (1 = g)
= $1.12
COMMON STOCK
CHARACTERISTICS contd.

COST OF EXISTING
EQUITY IN
EXAMPLE IS:

$1.12
$30
$1.12 + 12%
$50
+ 12%
= 3.73% + 12% =
15.73%
ASSUME THE
PRICE RISES TO $50
= 2.24% + 12% =
14.24%
COMMON STOCK
CHARACTERISTICS contd.

EXTERNAL EQUITY  SAY A COMPANY
( OR COMMON
PAYS NO DIVIDEND
STOCK) IS
AT ALL BUT IS
USUALLY THE
GROWING AT 20%
HIGHEST COST
D1
+ g = Ks
SOURCE OF
P0
EXTERNAL
Ks = 20% since D1 /P0 is
FINANCING.
zero
COST OF NEW EQUITY:
Secondary offering
D1
+g
P0 (1 - F)
Where F = %
floatation cost of a
new equity
underwriting
 EXAMPLE: D1 =
$1.12, P0= 30,
g= 10% F = 7%


Ks = 1.12
30(.93)
= 1.12
27.9
+10%
+10
= 4.01% +10%
= 14.01%
Why would a CFO NOT use
all debt financing?
ADVANTAGES
 Debt is cheaper
 Cost is fixed
 Interest is deductible
 Debt can be refinanced
if rates decline. This is
called REFUNDING
and must be spelled
out in the indenture.
DISADVANTAGES
 Non payment of ANY
coupon on ANY debt
issue will trigger Ch
11 filing by bond
trustee.
 Debt costs are a
function of prevailing
interest rates at time of
issue for bonds of
similar type & quality.
WACC CALCULATION
SEE TEXT P. 444
 WE WILL USE
BOOK VALUE OF
ASSETS not market.
 MULTIPLY percent
weight of each
component by AFTER
tax cost of capital of
each component.

Notice in example that
WACC = 12.7% and
the common stock
component cost is the
highest. This is
typical.
 What if bonds were
60% of capital cost
and equity was 35%?

WACC CALCULATION
CONTD.
60% X 7% = 4.20%
 5% X 13% = 0.65%
 35% X 16% = 5.60%

WACC = 10.45%
WE LOWERED WACC
BY 2.25%
What could be wrong
with this?
INCREASED USE
OF DEBT
DECREASES WACC
BUT INCREASES
RISK.
 THIS IS CALLED
“FINANCIAL
LEVERAGE” which
is covered in FIN 402.

HOW IS WACC USED IN
CORPORATE FINANCE?
WACC is the
“HURDLE RATE” for
capital budgeting
decisions.
 If company A has a
WACC of 12%, ALL
new investments must
return at least 12% for
the firm to have a
positive ROI.

If company B has a
higher WACC of 15%
it must seek
investments with a
minimum return of
15%.
 WACC therefore
influences the ability
of a company to
compete effectively.

CAPM- CAPITAL ASSET
PRICING MODEL
SEE LEC NOTES P.
20-21 and text P.
441-2
 CAP - M is an
ALTERNATIVE way
of measuring capital
costs.

 Kcs
= Krf+B (Km Krf) see p. 452

CAPM APPROACH
 Risk
free rate
(Treasury yield curve)
 PLUS risk premium
 Estimated market
return Km less Krf
TIMES
 Beta or volatility.
HOW CAN YOU
ACCURATELY
ESTIMATE Km???
ALTERNATIVE METHOD
SEE LECTURE
NOTES
 RISK FREE RATE
Krf +
(Risk premium
reflecting business
risk, interest rate risk
etc.) X Beta
 = E cost of capital
using CAPM


WHAT IS BETA?
Beta or systematic risk
is usually defined as
the price volatility of
one stock vs a market
index like: S&P 500.
Historical betas for
any stock can be found
in Value line
Investment Survey
BETA contd.
Say MSFT stock has a
beta of 1.5.
 This means that if the
market goes up or
down 10%, based on
historical results,
Microsoft will go up
or down 15% or 50%
more.


Beta is a key element
in what is called
MODERN PORTFOLIO
THEORY

If you think the
market is headed
down and you are a
portfolio manager, you
could sell high beta
stocks and buy low
beta stocks.
BETA contd.
Here we see an
example of how
finance theory of the
firm is used by
portfolio managers in
mutual funds.
 HIGH BETA
STOCKS are more
volatile. They are for
more aggressive
investors.

LOW BETA STOCKS
(like utilities) are less
price volatile. We call
them “Widow and
Orphan stocks.”
 CFOs know that use of
leverage will tend to
increase Beta.

SUMMARY
 WACC
is affected by
two factors:
 The cost of each
external source of
capital which is
determined by
timing and
markets
 The Weight given
to each source of
capital
WACC can be
changed by the CFO
by a new issue.
 A low cost debt issue
could likely lower the
WACC.
 Companies scan
global sources of
funds to minimize
capital costs.

PROBS A-12-3 TO 12-5,
12-13

12-3
A. Kd (1-t)=8% (1-.34)
=8%*.64 = 5.12%
B. Ks = D1 + g
P0 (1-F) f = 9%
D1 = 1.10
g = 5% = .05
proceeds = 25(.91)
=22.75
Ks = 1.1/22.75+.05=
9.85%
C. Cost of debt = after
tax coupon cost
Kd (1-T) where T =
marginal FIT rate
= 12 (1-.34) = 7.92%
D. 7/85 =8.24 (ALREADY
AFTER TAX)
E. [3/38] + .04= 11.88%
PROBS A-12-4,12-5, 12-13

12-4A
 D0 -
DPS NOW
 D1 = DPS in 1 year
compounded at g
 1.54/ 27 (1-.06) + g
= 1.54 / 25.38 + .06
= 12.07%

12-5A
 .07
(1-T) = .07 X .82
 = 5.74%

Notice irrelevant
information in problem

12-13A
% cap
ATC
BONDS
21.52%
5.5%
PFD
5.33
13.5%
COMMON 73.16
18.0%
Capitalization structure figured on
book value on balance sheet
$,000 ATC
BONDS $1083 59.565
PFD
$ 268 36.180
COM
$3681 662.58
758.325 / 5032 = 15.07%
see next page
PROBLEM 12 -13a
%
ATC
BONDS $1083 21.52%
5.5%
PFD
268 5.33% 13.5
COM
3681 73.15% 18.0
$5032
WACC = 758.33 / 5032 =15.07%
WEIGHT
59.565
36.180
662.58
758.325
PROB 12-13A ALTERNATIVE
%
BONDS
PFD
COM
21.52%
5.33%
73.15%
WACC = 15.07%
ATC
5.5%
13.5
18.0
(% )(ATC)
1.18%
.72
13.17
15.07
same answer
Ch 13: LEVERAGE, BEP
 CONCEPTS:
 LEVERAGE
IS A TERM REFLECTING
MAGNIFICATION EFFECTS THROUGH
VARIOUS STRATEGIES
 OPERATING LEVERAGE IS DERIVED
FROM VARYING BREAK EVEN POINTS
DUE TO FIXED COSTS
 FINANCIAL LEVERAGE IS DERIVED
FROM USE OF DEBT IN CAP. STRUCTURE
FORMULAS IN EXAM 2
 You
will be given a formula page in Exam
incorporating DOL and DFL and DTC
formulas as well as other TVM formulas.
 You need to know how to APPLY these
formulas in problems
 There are two kinds of formulas (BETWEEN
2 POINTS AND AT ONE POINT OF OUTPUT)
 SEE
SUMMARY ON P. 499--ONE POINT
ACCOUNTING --P&L REVIEW
PLEASE SEE P. 495 + HANDOUT
SALES
less TOTAL VARIABLE COSTS
=REVENUE BEFORE FIXED COSTS (RFBC)
NOTE: RBFC / SALES = CONTRIB MGN
less TOTAL FIXED COSTS
= EBIT (earnings before interest and taxes)
less INTEREST EXPENSE (total)
= PRETAX INCOME
less FIT
ACCOUNTING --P&L REVIEW
PLEASE SEE P. 495
=“NET “ INCOME TO PFD. STOCK
less Dividends on all Preferred stock
= NET INCOME AVAIL. TO COMMON
NI / COMMON SHARES OUT = E.P.S.
(earnings per share)
NET INCOME - COMMON DIVDS =
RETAINED EARNINGS (to balance sheet)
This is called “Plowback”
PRO FORMA P&L - NO PFD
SALES
 LESS VARIABLE COSTS =
 RBFC
cont mgn = RBFC / SALES
 LESS FIXED COSTS
 = EBIT
 LESS INTEREST EXPENSE
 = EBT (pretax income)
 LESS FIT PAID
 = NET INCOME
 NI / SHARES OUT = E.P.S.

Ch 13--OPERATING leverage
 TERMINOLOGY
 FIXED
COSTS
P. 477
 VARIABLE COSTS
P. 478
 BEPU= F / ( P-V)
P. 482 UNITS
FIXED COSTS / UNIT CONTRIB MARGIN
 BEPS = F / (1- VC / S) P. 483 DOLLARS
OPERATING LEVERAGE
FORMULAS
DOL AT ONE POINT OF OUTPUT

DOL = Q (P-V)/ Q (P - V) -F
FORMULA 13-6
P. 488

AN EASIER WAY TO REMEMBER THIS IS:
DOL = RBFC / EBIT (see P&L on p. 495)
DOL BETWEEN TWO POINTS IN OUTPUT

DOL = % CHG IN EBIT / % CHG IN SALES
FINANCIAL LEVERAGE
 Financial
leverage = magnification in EPS
from use of ST or LT debt
FORMULA 1: 2 POINTS
 DFL = % CHG IN E.P.S. / % CHG IN EBIT
FORMULA 2: AT ONE LEVEL OF OUTPUT
 DFL = EBIT / (EBIT - I) I = interest on debt
note: EBIT - I = EBT or pretax income,
THEREFORE: DFL = EBIT / EBT (13-9 p. 499)
FINANCIAL LEVERAGE:
basic concepts

COMPANIES WITH
HIGHLY CYCLICAL
SALES AND
EARNINGS (like
autos) USUALLY
HAVE LOW
FINANCIAL
LEVERAGE
RATIOS. WHY?

COMPANIES WITH
STABLE REVENUES
LIKE UTILITIES
CAN USE HIGH
AMOUNTS OF
DEBT IN THE
FINANCIAL
STRUCTURE.
WHY?
FORMULAS CONTD

BEP = formula 13-3

DOL = formula 13- 6

DFL = formula 13-9

DCL = formula 13-12
SEE P. 499
BEP = F / “unit
contrib. margin”
Q(P - V) / [Q(P - V) -F]
or RBFC / EBIT
 EBIT / EBT (pretax
Income)
 DCL = RBFC / EBT
or
 DCL= (DFL) * (DOL)

FOR EXAM 2
 YOU
WILL BE PROVIDED A FORMULA
PAGE INCLUDING
 TVM
FORMULAS
 COST OF CAPITAL FORMULAS
 LEVERAGE FORMULAS
 YOU
NEED TO KNOW WHICH
FORMULA TO APPLY
 YOU NEED TO BE ABLE TO
CONSTRUCT A PRO-FORMA P&L
PROB 13-26A
A. DOL AT ONE POINT
REVENUE BEFORE
FIXEDCOSTS / EBIT
3MM / 1MM = 3X
B. DFL AT ONE POINT
EBIT / EBIT -I
=IMM / (1MM - .2MM)
=1/.8 = 1.25X
C. DCL = 3 X 1.25 =
3.75 OR
3X EBIT/EBT =
3X 1/.8 = 3.75
D. BEP=F / 1 - [VC / S]
The denominator is
called contribution
margin = 2mm/ 1 [9/12] = 2 / .25 = 8
mm
PROB 13-27A see handout
A. RBFC / EBIT =
8MM / 4MM = 2X
B. EBIT / EBIT - I
= 4/2.5 = 1.6
C. DCL = 2 X 1.6 = 3.2
OR 2 X (4 / 2.5) = 3.2
D. Use formula between
2 points
D % CHG IN EPS /
% CHG SALES = 3.2
0..2 X 3.2 = 64%
E. S = F / CONTRIB
MGN =
4MM / 1- [8MM/16MM]
= 4 / 0.5 = 8MM
LEVERAGE PROBLEM
HANDOUT 13-27A P. 506
 STEPS
 CONSTRUCT
PRO - FORMA P&L
 COMPUTE CONTRIBUTION MARGIN
 SOLVE FOR DOL AND DFL AT A GIVEN
LEVEL OF OUTPUT
 COMPUTE DCL AND BEP
 NOW YOU CAN DETERMINE % CHG IN
EPS FOR ANY CHANGE IN SALES
CAPITAL BUDGETING
THEORY AND CONCEPTS
FIN 3403 - 3404
TEXT CHAPTER 9,10
LECTURE NOTES PP. 20-24-(STUDY THIS CAREFULLY)
What is Capital Budgeting?
 A way
to quantitatively evaluate capital
projects (investments with a life of > 1 year)
 Capital budgeting is used in business,
government, non-profit organizations etc. It
is a way of measuring COST VS BENEFIT.
 CAPITAL BUDGETING IS SIMPLY TVM.
THE TERM IS NEW. THE ANALYTICAL
APPROACH IS FAMILIAR TO YOU
ALREADY!
CAP BUDGETING TERMS

CAPITAL PROJECTS

CASH FLOWAND
OPERATING CASH
FLOW
DEPRECIABLE
BASIS
 COMPUTING
DEPRECIATION

 SL
LEC NOTES P. 24
difference
between accounting
profit and cash flow
 Non-cash charges:
 MACRS
 know
DEPRECIATION
 DEPLETION
 AMORTIZATION

NET INVESTMENT
 SALVAGE VALUE
 EVEN AND
UNEVEN CASH
FLOWS

TERMINOLOGY contd.
CASH FLOW = NET
INCOME AFTER
TAX + NON CASH
CHARGES
 OPERATING CASH
FLOW = NET
INCOME PLUS TAX
SAVINGS ON DEPR,
DEPL & AMORT.
See Income statement
lec notes p. 24

MUTUALLY
EXCLUSIVE
PROJECTS
lec notes p. 21
 INDEPENDENT
PROJECTS
 CAPITAL
RATIONING
 MACRS --see text p.
37 table 1A-3 will be
provided on exam.

CAP BUDGETING
TECHNIQUES

RESPONSIBLE FOR
3 METHODS ONLY:
 PAYBACK
 IRR
 NPV

You are NOT
responsible for
Discounted Payback
modified IRR, or
profitability index
PAYBACK= YEARS
TO RECOVER NET
INVESTMENT
 IRR = the interest rate
or discount rate
equating PV of
outflows with PV of
inflows
 NPV = PV of cash
outflows and inflows
discounted at WACC

ADVANTAGES OF EACH
METHOD
 PAYBACK:
Conceptually simple. Shortest
payback is the best
 IRR: Gives a percentage discount rate that
can be quantified and easily ranked.
 NPV: BEST OVERALL METHOD
Gives the NET PV (PV of inflows LESS PV of
outflows). NPV will be negative if IRR <
WACC or if costs exceed benefits. WACC is
the “hurdle rate” or required rate of return.
METHODS: DISADVANTAGES

PAYBACK p. 22 LN
 Ignores
cash flows
beyond payback period
 Ignores TVM
 Method is arbitrary

IRR
 IRR
is independent of
WACC and does not
consider WACC in its
calculation
 Cash flow spreadsheet
required for multiple

NPV (PREFERRED
METHOD) --When
results give you
conflicting decisions
ALWAYS use NPV as
preferred solution.
 NPV
for multiple cash
flows REQUIRES use
of cash flow
spreadsheet or Excel
spreadsheet
 Must enter WACC to
solve for NPV
CAP BUDGETING INPUTS
COSTS
 NET INVESTMENT
CFO see lec notes p.
26
 COST
+ tax and
installation = DEPR
BASIS
 PLUS Increase in
NWC EQUALS
 NET INVESTMENT
BENEFITS
 CASH INFLOWS
(savings or revenue
from a new project)
 TAX SAVINGS ON
DEPRECIATION
(will discus next
week)
 NPV of salvage value

NPV of return of NWC
PAYBACK
EVEN CASH FLOWS
PAYBACK =NI / CF
EXAMPLE: machine
cost + inst = $50,000
CF = = $15000 per yr for
10 years
PAYBACK
$50000/15000= 3.33
YRS

NOTE THAT IN THIS
EXAMPLE
PAYBACK
IGNORED CASH
FLOWS BEYOND
3.33 YEARS. THIS
INVESTMENT
RETURNED
$150,000 TOTAL
IGNORING TVM.
PAYBACK CONTD.
UNEVEN CASH
FLOWS
Number of years
CUMULATIVE cash
flows = NI
NI(CF0) = $50,000
 CO1 = $15000
 C02 = $12000
 CO3 = $10000
 C04 = $10000
 CO5 = $12000
need to CUMULATE
CO1 TO C0n
see next slide

PAYBACK CONTD
ANNUAL CASH
INFLOWS
 uneven cash flows

 YR
1
 YR 2
 YR 3
 YR 4
 YR 5
$15000
$12000
$10000
$10000
$12000

CUMULATIVE CF
NI = $50000
 $15000
CO1
CO2
CO3
C04
C05


yr 1
 $27000
yr 2
 $37000
yr 3
 $47000
yr 4
 $59000
yr 5
NI = CUM CF IN YR 5
4 + 3000/12000 = 4.25
YRS
INTERNAL RATE OF
RETURN AND NPV
IRR
 Calculates discount
rate which equates
cash inflows with cash
outflows
 Advantages and
disadvantages
 IRR key on calculator
NPV
 Discounts cash
inflows at WACC.
Nets out inflows and
outflows.
 Advantages and
disadvantages. Private
firm.
 NPV key --must know
WACC
USING THE CASH FLOW
SPREADSHEET ON TIBA2+
CLEAR REGISTERS
 PUSH CF KEY
 ENTER CLEAR
WORK TO CLEAR
THIS REGISTER


PRESS ENTER AFTER
EACH ENTRY
ENTER CF0 =-50000
 DOWN ARROW
 CO1 = 15000

FO1 = 1
 CO2 = 12000
 FO2 = 1
 CO3 = 10000
 F03 = 2
 C04 = 12000
 C04 = 1
 SCROLL (UP
ARROW) TO
CHECK INPUTS

TIBA2+cash flow spreadsheet
AFTER YOU HAVE
ENTERED AND
CHECKED INPUTS:
 PRESS NPV
 I=WACC = 11% (this
number may be given
in an exam or may be
linked to a WACC
problem)


ENTER I AS 11 not 0.11
DOWN ARROW
 NPV = PRESS CPT

$-5726.37
 IF NPV IS
NEGATIVE THIS IS
NOT A GOOD
INVESTMENT

IRR KEY 6.0891%
 IRR < WACC

WHAT DOES THE CF
SPREADSHEET DO? SEE TEXT P. 326
You could calculate
NPV on your TVM
keys but it is NOT
recommended.
 The CF spreadsheet
takes the Cash flow of
each lump sum in year
indicated discounted at
I or WACC. This = the
SUM of cash inflows

The CF of inflows is
Subtracted from Net
investment (CF0).
 This is NET cash flow
 If Net cash flow is
negative it means PV
of inflows are less
than PV of outflows.
 net salvage value is a
CF in the last year.

WHAT IS NPV?
 NPV
= PV OF CASH INFLOWS
- PV OF OUTFLOWS
DISCOUNTED AT WACC
IF NPV IS POSITIVE: Inflows exceed
outflows ACCEPT PROJECT
IF NPV IS NEGATIVE: REJECT
WHAT IS THE
PROFITABILITY INDEX?
 You
will not be asked to compute this on an
exam
 PI = NPV OF INFLOWS / PV OF
OUTFLOWS discounted at WACC
 EXPRESSED AS A RATIO
 IF RATIO > 1.0 ACCEPT
SELECTING FROM
MULTIPLE PROPOSALS OR
PROJECTS SEE TEXT P. 328
CLEAR CF
REGISTER
 ENTER DATA FOR
MACHINE OR
PROJECT A
 CF1 = - 10000
 C01 = 3362
 F01 = 4
 IRR = 13%


PROJ B IRR
 CF1
= -10000
 C01 = 0
 FO1 =3
 C02 = 13605
 FO1 =1
IRR = 6.35%
 PROJ C IRR = 19.04%
 SELECT PROJ C

Problems ch 9 pp. 337ff
9-1A IRR USE TVM KEYS
a
P/Y = 1 N = 8
I/Y = 7%
 b N = 10 I/Y = 17%
 c N = 20 I/Y = 13%
 d N = 3 I/Y = 11%

9-2 IRR
a
N = 10 PMT = 1993
solve for I/Y = 15%
 b N = 20 I/Y = 20%
 c 6%
 d 13%

SET END
9-3A IRR UNEVEN
CF- USE WORKSHEET
A. CF0 = -10000
 CO1 = 2000 FO1 =1
 CO2 = 5000 FO1 = 1
 CO3 = 8000 FO1 = 1
 IRR = 18.8%
B. IRR = 30.2%
C. CO1 = 2000 FO1 = 5
 C02 = 5000 F02 = 1
 IRR = 11.2%
Problems ch 9 pp. 337ff
9-4 A use CF worksheet
 clear worksheet
 CF0 = -1950000
 CO1=450000 FO1 = 6
 DO IRR FIRST =
IRR = 10.1725%
 I = 9 NPV = 68663
 PI = 2018664/1950000
= 1.0352 [>1 OK]
 ACCEPT


contd
9-5 A PAYBACK
EVEN CASH FLOWS
a. DO NOT USE WORKSHEET
CF0 = NI = - 80000
CO1 = 20000 F01 = 6
PAYBACK even cf case
= NI / cash flow =
80000/ 20000 = 4 years
b. USE WORKSHEET
Problems ch 9 pp. 337ff
 9-5A CONTD
CLEAR REGISTERS
 CLEAR WORKSHEET

CF0 = -80000
CO1 = 20000
FO1 = 6
IRR(always do IRR first) = 12.98%
I = 10 NPV = 7105
ACCEPT
contd
Problems ch 9 pp. 337ff
contd
EVEN CASH FLOWS PROB 9-6A
PROJECT A
 CFO = -50000
 CO1 = 12000
 FO1 = 6
 IRR = 11.53%
 I = 12 NPV = -663
 REJECT!

PROJECT B
 CFO = -70000
 CO1 = 13000
 FO1 = 6
 IRR = 3.18%
 NPV = -16551
 b is better than A but
reject BOTH

CAPITAL BUDGETING:
ADVANCED CONCEPTS CH 10
 DEPRECIABLE
BASIS (see table 10-4 p.
357--LECTURE NOTES P. 22-24)
 INITIAL OUTLAY OR NET
INVESTMENT (see text p. 354)
 CASH FLOW DIAGRAM (Fig 10-1 p 359)
 NET
INVESTMENT SEE TABLE 10-8, 10-9
 CASH FLOWS (TABLE 10-10)
 TERMINAL CASH FLOW(S)-SEE LECTURE
NOTES AND TABLE 10-6
STEPS IN DETERMINING
CASH FLOWS--see handout
1.
Determine
depreciable basis (DB)
= cost + shipping + tax
and installation
2. Determine net
investment (CF0) =
DB + chg in NWC
3. Calculate depreciation
using straight line or
MACRS table and tax
savings on deprec.
NOTE: MACRS Depreciation = DB times
table %
4. Pro-forma P&L
5. Determine operating
cash flow (net income
+ tax savings on
depreciation)
6. Last year cash flows -see next slide
STEPS IN DETERMINING
CASH FLOWS contd.
DETERMINING OCF = NI + tax savings on
depreciation
1. Do a pro-forma income statement for
MACRS life of asset (see handout or p. 24
of lecture notes)
2. Note that if Pretax is a loss, FIT is a
CREDIT
3. Add in tax savings on depreciation using
MACRS tables
STEPS IN DETERMINING
CASH FLOWS contd.
TERMINAL YEAR
CASH FLOWS--UP
TO 3 ELEMENTS
A. Salvage value after
tax.
B. RETURN OF NWC
C. Operating cash flow
Determining salvage
value after tax:
A. SV less undepreciated
basis in last year of
asset life = amount
subject to tax.
B. Multiply amount in A
times FIT rate.
C. Subtract B from SV
PROBLEM: TERMINAL CF
Salvage value after tax
$25000 SV less ($25000-$2800) x 40%
- 2800 undepreciated balance
= 22200 Amt subject to tax
x 40% =8880 FIT
25000 - 8880 tax = 16120 SV after tax
PROBLEM: TERMINAL CF
 TERMINAL YEAR
CF
SALVAGE VALUE AFTER TAX
+ RETURN OF NWC (inflow)
+ OPERATING CF IN LAST YR
$16120
2000
7800
=
$25920
NOTE: THIS IS A CASH FLOW IN YEAR 3
MACRS

What is it? Modified
Accelerated Cost
Recovery System --part
of 1986 IRS code

MACRS
PERCENTAGES (see
lec notes p. 48) SEE
TEXT PP. 35-38
 EXAM
WILL ONLY
CONSIDER 3,5,7
YEAR PROPERTY
HALF YEAR
CONVENTION
 MACRS is used for
equipment. It is NOT
used for buildings.
Land is NOT
depreciated.

CAP BUDGETING
PROBLEMS
 See
problem handout
 This is a comprehensive problem involving
differential cash flows and using the
MACRS tables. Solve in steps as described.
CAP BUDGETING
PROBLEMS
 102A
P. 371
CASH FLOW CALCULATIONS
NI = $60000 (cost + installation)
SL DEPR = 60000/5 = 12000 per year
Prepare pro forma P&L FOR NEXT TIME
DO IT MY WAY
PREPARE FINAL YEAR CASH INFLOWS
FROM TAX SAVINGS AND SALVAGE
PROB 10-2A P&L
DEPR BASIS
COST
$55000 +
INSTAL
5000
DEPR BASIS $60,000
+ NWC
__0___
NET INV.
$60,000

SL DEPR new = $12000/YR
SL DEPR old = $3000 / yr
*DIFFERENCE= $9000/YR
SAVINGS
< SALARY $20000
< DEFECTS
3000
> MAINT.
(-1000)
>DEPREC * (-9000)
NET PRETAX
SAVINGS
13000
TAX (34%)
- 4420
NET INCOME
8580

10-2A CONTD
CAP BUDGETING
PROBLEMS
 103A
P. 371
SEE HANDOUT
NOTE: Exam may ask you to calculate
“required rate of return” as a WACC
problem FIRST
 COMPREHENSIVE EXAMPLE table
10-8 p. 360
ADDITIONAL STUDY
 PROB
10-11A p. 374
TIME DISPARITY
see handout solution
 PROB 10-12 a
UNEQUAL LIVES
see handout solution
 RANKING See prob 10-14A p. 375
see handout solution
OTHER ISSUES IN CAP
BUDGETING
CAPITAL
RATIONING (this is
the normal or typical
condition)
 PROJECT RANKING
(for “mutually
exclusive” projects
ONLY) TEXT P. 364


SIZE AND TIME
DISPARITY
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