 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
 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

FIN 3403 DIGGLE
UNIVERSITY OF CENTRAL
FLORIDA

 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.

 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

 THE COST OF
PREFERRED STOCK
IS:
K ps
= D ps
P
0
WHERE: D = preferred dividend
P = market price of preferred IN YEAR 0
 COST OF COMMON
STOCK (Equity) IS:
K cs
(also called K s
)=
D
P
0
1
+ g
WHERE: D
1
= common stock dividend next year and P
0 is common price now AND g is the estimated EPS growth rate

 Cost of NEWLY issued common stock is:
K e
= D
1
+ g
P
0
(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

 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.

 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

 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)

 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
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
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

 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.

 THE COST OF
COMMON STOCK
IS USUALLY THE
HIGHEST SOURCE
OF EXTERNAL
CAPITAL.
 THIS COST IS
RELATED TO THE
P/E RATIO however
 D
1
+ g
P
0
 EXAMPLE
D
0
= $1.00
g = 12%
P
0
= $30
D1 = $1.00 x (1 = g)
= $1.12

 COST OF EXISTING
EQUITY IN
EXAMPLE IS:
 ASSUME THE
PRICE RISES TO $50
$1.12 + 12%
$30
= 3.73% + 12% =
15.73%
$1.12 + 12%
$50
= 2.24% + 12% =
14.24%

 EXTERNAL EQUITY
( OR COMMON
STOCK) IS
USUALLY THE
HIGHEST COST
SOURCE OF
EXTERNAL
FINANCING.
 SAY A COMPANY
PAYS NO DIVIDEND
AT ALL BUT IS
GROWING AT 20%
D
1
P
0
+ g = Ks
Ks = 20% since D
1 zero
/P
0 is

 D
1
+ g
P
0
(1 - F)
Where F = % floatation cost of a new equity underwriting
 EXAMPLE: D1 =
$1.12, P0= 30, g= 10% F = 7%
 Ks = 1.12 +10%
30(.93)
= 1.12 +10
27.9
= 4.01% +10%
= 14.01%

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.

 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%?

 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.

 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
 SEE LEC NOTES P.
20-21 and text P.
441-2
 CAP - M is an
ALTERNATIVE way of measuring capital costs.
 K cs
= K rf
+B (K m
K rf
) see p. 452
-
 CAPM APPROACH
 Risk free rate
(Treasury yield curve)
 PLUS risk premium
 Estimated market return K m
TIMES less K rf
 Beta or volatility.
HOW CAN YOU
ACCURATELY
ESTIMATE Km???

 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

 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.

 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.

 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.

 12-3
A. Kd (1-t)=8% (1-.34)
=8%*.64 = 5.12%
B. Ks = D1 + g
P
0
(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%

 12-4A
 D
0
- DPS NOW
 D
1
= 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

% ATC WEIGHT
BONDS $1083 21.52% 5.5%
PFD
COM
268 5.33% 13.5
3681 73.15% 18.0
$5032
WACC = 758.33 / 5032 = 15.07%
59.565
36.180
662.58
758.325

% ATC (% )(ATC)
BONDS 21.52% 5.5% 1.18%
PFD
COM
5.33% 13.5
73.15% 18.0
.72
13.17
15.07
WACC = 15.07% same answer

 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

 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

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

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”

 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.

 TERMINOLOGY
 FIXED COSTS P. 477
 VARIABLE COSTS P. 478
 BEP
U
= F / ( P-V) P. 482 UNITS
FIXED COSTS / UNIT CONTRIB MARGIN
 BEP
S
= F / (1- VC / S) P. 483 DOLLARS

DOL AT ONE POINT OF OUTPUT
 DOL = Q (P-V)/ Q (P - V) -F P. 488
FORMULA 13-6
 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 = 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)

 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?

SEE P. 499



BEP = formula 13-3
DOL = formula 13- 6
DFL = formula 13-9
 DCL = formula 13-12

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)

 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

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

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

 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

FIN 3403 - 3404
TEXT CHAPTER 9,10
LECTURE NOTES PP. 20-24 --
(STUDY THIS CAREFULLY)

 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!

 CAPITAL PROJECTS
 CASH FLOWAND
OPERATING CASH
FLOW
 DEPRECIABLE
BASIS
 COMPUTING
DEPRECIATION
 SL
LEC NOTES P. 24
 MACRS
 know difference between accounting profit and cash flow
 NET INVESTMENT
 SALVAGE VALUE
 Non-cash charges:
 DEPRECIATION
 DEPLETION
 AMORTIZATION
 EVEN AND
UNEVEN CASH
FLOWS

 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.

 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

 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.

 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 cash flows
 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

COSTS
 NET INVESTMENT
CF
O
26 see lec notes p.
 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

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.

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

 ANNUAL CASH
INFLOWS
 uneven cash flows
 YR 1 $15000 CO1
 YR 2 $12000 CO2
 YR 3 $10000 CO3
 YR 4 $10000 C04
 YR 5 $12000 C05
 CUMULATIVE CF
NI = $50000



$15000
$27000
$37000
 $47000
 $59000 yr 1 yr 2 yr 3 yr 4 yr 5
 NI = CUM CF IN YR 5
 4 + 3000/12000 = 4.25
YRS

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

 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

 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

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.

 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

 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

 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

SET END
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%
 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%

contd
 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
 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

contd
 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
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

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

1. Determine
NOTE: MACRS Deprecdepreciable basis (DB) iation = DB times
= cost + shipping + tax table % and installation 4. Pro-forma P&L
2. Determine net investment (CF0) =
DB + chg in NWC
5. Determine operating cash flow (net income
+ tax savings on depreciation)
3. Calculate depreciation using straight line or
MACRS table and tax savings on deprec.
6. Last year cash flows -
-see next slide

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

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

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

 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

 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.

 See problem handout
 This is a comprehensive problem involving differential cash flows and using the
MACRS tables. Solve in steps as described.

 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

 DEPR BASIS
COST
INSTAL
$55000 +
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

 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

 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

 CAPITAL
RATIONING (this is the normal or typical condition)
 PROJECT RANKING
(for “mutually exclusive” projects
ONLY) TEXT P. 364
 SIZE AND TIME
DISPARITY