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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