f13-3 Concept

After-tax salvage value:

salvage value-T(salvage value - book value)

Advantages of Payback Period Disadvantages of Payback Period

Measures Liquidity Easy to communicate Does not require all CFs Does not require discount rate Does not require complex calculations Can be used to compare mutually exclusive projects Does not measure value Does not fully adjust for TVM Does not fully adjust for risk No clear accept/reject decision Ignores later CFs

Advantages of IRR Disadvantages of IRR

More intuitive than NPV Gives a clear accept/reject decision for independent projects Uses all Cash flows Does not require a discount rate (for calculation) Adjusts for TVM and therefore risk (in comparing to hurdle rate that adjusts for risk) Requires complex calculations Requires a lot of data (estimates of all CFs) Only works for normal cash flows Requires discount rate (for decision) Does not always work for mutually exclusive projects

Which of the following changes, if of a sufficient magnitude, could turn a negative NPV project into a positive NPV project?

A decrease in the fixed costs

Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

Mutually Exclusive

The "gold standard" of investment criteria refers to:

NPV

Scenario analysis Sensitivity analysis

concerns what happens to a firm's NPV in different possible outcomes. looks specifically at how NPV changes when we change one of the variables that we input into out NPV calculations

According to the article, "Sunk cost fallacy: Throwing good money after bad," how can banks limit losses from bad loans?

increase bank executive turnover

Book value:

initial cost - accumulated depreciation.

Capital rationing may be beneficial to a firm if it:

weeds out proposals with weaker or biased NPVs.

MACRS Depreciation expense for year i:

(initial cost)(MACRS percentage for year i).

You purchase a fixed asset for $30,000 and it will be depreciated to a book value of $10,000 after three years. What is the depreciation expense in the first year? What is the depreciation tax shield in the first year if the tax rate is 20%? Depreciation tax shield ?

(30,000−10,000)/3= 6,666.67 .2(6,666.67) = $1,333.33.

You purchase a fixed asset for $30,000. What is the depreciation expense in the first year, using the 3-year MACRS method? What is the depreciation tax shield in the first year if the tax rate is 20%?

(30000)(0.3333) = $9,999 (The MACRS percentages are rounded to 4 decimal places. The depreciation expense would actually be $10,000) 10,000

What is the net effect on a firm's working capital if a new project requires: $46,986 increase in inventory, $36,173 increase in accounts receivable, $35,000.00 increase in machinery, and a $48,873 increase in accounts payable? Round to nearest dollar amount.

(46,986 + 36,173) - 48,873= 34,286

You purchase a truck for $30,000 and depreciate it with the straight-line method to $10,000 book value after three years. If you actually sell of after the third year for $12,000 in salvage value then what is the after-tax salvage value? The tax rate is 20%.

12000-.2(12000-10000) = 12000-(.2)(2000) = 12000-400 = $11,600

Three basic components of cash flow projects:

1.Initial investment: the relevant cash outflow for a proposed project at time zero. 2.Operating cash inflows: the incremental after-tax cash inflows resulting from the implementation of a project during its life. 3.Terminal cash flow: the after-tax non-operating cash flow occurring in the final year of a project. It is usually attributable to the liquidation of the project.

Compute the payback period for a project that requires an initial outlay of $153,425 that is expected to generate $40,000 per year for 9 years.

153,425/40,000 = 3.84

Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet demand for a new line of solar charged motorcycles​ (who wants to ride on a cloudy day​ anyway?) The proposed project has the following​ features; ​• The firm just spent​ $300,000 for marketing study to determine consumer demand​ (@ t=0). ​• Aero Motorcycles purchased the land the factory will be built on 5 years ago for​ $2,000,000 and owns it outright​ (that is, it does not have a​ mortgage). The land has a current market value of​ $2,600,000. ​• The project has an initial cost of​ $25,963,956 (excluding​ land, hint: land is not subject to​ depreciation). ​​• If the project is​ undertaken, the company will realize an additional​ $8,000,000 in sales over each of the next ten years.​ (i.e. sales in each year are​ $8,000,000) ​• The company's operating cost​ (not including​ depreciation) will equal​ 50% of sales. ​• The company's tax rate is 35 percent. ​• Use a​ 10-year straight-line depreciation schedule. ​• At t​ = 10, the project is expected to cease being economically viable and the factory​ (including land) will be sold for ​$4,500,000 (assume land has a book value equal to the original purchase​ price). ​• The project's WACC​ = 10 percent ​• Assume the firm is profitable and able to use any tax credits​ (i.e. negative​ taxes) .0 What is the​ project's outflow at​ t=0? Answer to the nearest whole dollar value.

2,600,000 + 25,963,956= 28,563,956

What is the equivalent annual cost for a project that requires a $50,000 investment at time-period zero, and a $10,000 annual expense during each of the next 4 years, if the opportunity cost of capital is 10%?

25,773.54

What is the amount of the operating cash flow for a firm with $334,901 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate?

334,901 * .35= 117,215.35 334,901 + 100,000 - 117,215.35= 317,685.65

Suppose the capital budget in the lecture example worksheet in Video #11 was $100,000. What is the NPV of the best project(s)?

45,000

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $900 at the end of the next three years and then $1400 per year for the three years after that. If the discount rate is 8% then what is the PI?

5,000+183.485,000/5,000 = 1.0367 1.0367*100 = 103.67

Depreciation tax shield:

= T(depreciation expense)

Your firm currently produces stand-alone GPS trackers and communicators. You forecast that you will sell $150,000 of Mp3 players next year. However, your firm has plans to start producing smartphone-compatible GPS communicator devices as well. If you produce the smartphone devices then your projected sales will be $110,000 for stand-alone GPS devices and $70,000 for smartphone devices. Because the smartphone device includes a GPS communicator, you expect that some customers will not buy the stand-alone device if they also buy the smartphone device. What is the total increase in sales that you should consider for this project? What is the side effect for existing sales that should be considered?

Accepting the project will lead to total sales of $110,000+$70,000=$180,000 compared to only $150,000. Therefore the incremental sales are $30,000. The side effect is that stand-alone device sales will decrease from $150,000 to $110,000. The side-effect represents a decrease in sales of $40,000 for the existing product.

A corporation is contemplating an expansion project. The CFO plans to calculate the project's NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the corporation's cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows?

Any opportunity costs associated with the project.

You are considering the following three mutually exclusive projects. The required rate of return for all three projects is 14%. Year 0 A $ (1,000) B $(5,000) C $(50,000) 1 A $ 300. B $ 1,700. C $ 0 2 A $300. B $ 1,700. C $15,000 3 A $ 600 B $1,700 C $ 28,500 4 A $300 B $1,700 C$ 33,000 What is the IRR of the best project?

C 14.23 (the closest to 14% w highest NPV)

What is the internal rate of return for a project with an initial outlay of $10,000 that is expected to generate cash flows of $2,000 per year for 6 years?

CFo= -10,000 CO1= 2,000 FO1= 6 CPT IRR= 5.47

What is the NPV of a project that costs $100,000.00 and returns $50,000.00 annually for three years if the opportunity cost of capital is 9.98%?

CFo= -100,000 CO1= 50,000 FO1= 3 I= 9.98 CPT NPV= 24,386.39

A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $100 million now, and then spend $20 million in one year. In two years it will receive $80 million, and in three years it will receive $90 million. If the cost of capital for the project is 11 percent, what is the project's IRR? % terms to 2 decimal places and without the % sign.

CFo= -110M C01= -20M FO1= 1 CO2= 80M FO2= 1 CO3= 90M FO3= 1 I= 11 CPT IRR= 15.95

A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $111,946,048 now, and then spend $20 million in one year. In two years it will receive $80 million, and in three years it will receive $90 million. If the cost of capital for the project is 11 percent, what is the project's NPV?

CFo= -111,946,048 C01= -20M FO1= 1 CO2= 80M FO2= 1 CO3= 90M FO3= 1 CPT NPV= 772,952.96

What is the profitability index for Project A with a cost of capital of 8%? Project A ($42,000.00) $14,000.00 $14,000.00 $14,000.00 $14,000.00 $14,000.00 Project B ($45,000.00) $28,000.00 $12,000.00 $10,000.00 $10,000.00 $10,000.00

CFo= -42,000 CO1= 14,0000 FO1= 5 CPT NPV= 13,897.94 PI= 13,897.94 + 42,000/42,000= 1.33

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $900 at the end of the next three years and then $1400 per year for the three years after that. What is the IRR? If the discount rate is 8% then should the firm accept or reject the project?

CFo= -5000 CO1= 900 FO1= 3 CO2= 1400 FO2= 3 CPT IRR = 9.09

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $900 at the end of the next three years and then $1400 per year for the three years after that. If the discount rate is 8% then what is the NPV? Should the firm accept or reject the project?

CFo= -5000 CO1= 900 FO1= 3 CO2=1 400 FO2= 3 I= 8 CPT NPV = 183.48 The NPV is positive so we accept the project.

Straight-line depreciation method:

Depreciation expense = (𝑖𝑛𝑖𝑡𝑖𝑎𝑙cos𝑡−𝑠𝑎𝑙𝑣𝑎𝑔𝑒𝑣𝑎𝑙𝑢𝑒)/𝑛𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑦𝑒𝑎𝑟𝑠

You purchase a truck for $30,000 and depreciate it using the 3-year MACRS percentages. If you actually sell of after the third year for $12,000 in salvage value then what is the after-tax salvage value? The tax rate is 20%.

Depreciation expense for year 1 = (30000)(0.3333) = $9,999 Depreciation expense for year 2 = (30000)(0.4444) = $13,332 Depreciation expense for year 3 = (30000)(0.1482) = $4,446 Accumulated depreciation = 9,999 + 13,332 + 4,446 = 27,777. Book value = initial cost - accumulated depreciation = 30,000 - 27,777 = $2,223 After-tax salvage value = salvage value-T(salvage value - book value) = 12000-.2(12000-2223) = 12000-(.2)(9777) = 12000-1955 = $10,045. The firm would end up paying taxes of $400 on the salvage value of $12,000, so the after-tax salvage value would be $11,600.

It should not usually be clear whether we are describing independent or mutually exclusive projects in the following chapters because when we only describe one project then it can be assumed to be independent

FALSE

NPV assumes intermediate cash flows are reinvested at the cost of equity, while IRR assumes that they are reinvested at the cost of capital

FALSE

Net present value (NPV) is a sophisticated capital budgeting technique; found by adding a project's initial investment from the present value of its cash inflows discounted at a rate equal to the firm's cost of capital.

FALSE

Advantages of NPV Disadvantages of NPV

Gives a clear accept/reject decision Uses all Cash flows Adjusts for risk (with discount rate) Adjusts for TVM Requires complex calculations Requires a lot of data (estimates of all CFs and r) Dollar value is not always intuitive

The general parts of any capital budgeting problem problem will be:

Identify the relevant CFs. Compute the initial investment (CF0). Compute the after-tax OCFs for each period of the project. Compute any additional non-operating CFs, such as changes in NWC or after-tax salvage value. Estimate the appropriate discount rate. Compute NPV and/or IRR. Decide to accept or reject the project.

Match those following concepts for first principle: The investment decision The financing decision The dividend decision

Invest in assets that earn a return greater than the minimum acceptable hurdle rate Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations If you can't find investments that make your minimum acceptable rate, return the cash to owners of your business

Tax shield approach:

OCF = (revenues -expenses)(1-T) + T(Depreciation)

Relevant Cash FLows

Relevant cash flows are incremental - meaning they are project-specific and are only incurred when a project is undertaken. Relevant cash flows include opportunity costs but not sunk costs. Relevant cash flows can be classified as arising from, capital spending, changes in net working capital, and operations.

Revenues generated by a new fad product are forecast as follows: Year Revenues 1 $48,501 2 40,000 3 20,000 4 10,000 Thereafter 0 Expenses are expected to be 50% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of $40,000 in plant and equipment that will be depreciated using the straight-line method over 5 years. The firm recently spent $2,000 on a study to estimate the revenues of the new product. The tax rate is 20%. What is the operating cash flow in year 1? Answer to nearest whole dollar amount.

Revenue 48,501 expense (48,501/2). - 24,250.50 Depr. (40,000/5). - 8,000 EBIT. = 16,250.50 Tax (16,250.50*.2). - 3,250.10 Net Income. =. 13,000.40 Depr. +. 8,000 OCF. = 21,000.40

Your firm forecasts revenues of $80,000 next period and $50,000 in expenses. Depreciation expense is estimated to be $15,000 and the tax rate will be 20%. What are the forecasts for Net Income and Operating Cash Flow? There is no interest expense.

Revenue 80000 CGS. - 50000 Depreciation - 15000 EBT. = 15000 tax @ 20%. - 3000 NI. = 12000 depreciation. + 15000 OCF = 27000

Which of the following statements is correct for a project with a negative NPV?

The cost of capital exceeds the IRR

List steps of the capital budgeting process

Step 1- Proposal generation Step 2- Review and analysis Step 3- Decision making Step 4- Implementation Step 5-Follow-up

The Internal Rate of Return (IRR) is the discount rate that equates the NPV of an investment opportunity with $0

TRUE

The multiple IRR problem occurs when the signs of a project's cash flows change more than once.

TRUE

The president of COMPU corp. has asked you to evaluate the proposed acquisition of a new computer network system. After an extensive analysis (for which the company paid a consultant $5,000), the company has settled on the Osborne BigBrain 4000. The BigBrain has a price of $80,000, and will be usable for a four-year period, at which point it will have a $30,000 salvage value. Depreciation is by the straight-line method. Purchase of the BigBrain will require an increase in net working capital of $6,000 at time 0 (which will be recaptured at the end of the project). Last year, the company paid $20,000 for training their IT staff for the possibility of using the BigBrain. Because of the increased capabilities of the computer, the company will be able to generate additional before-tax annual revenues of $60,000. However, the system will also increase annual operating costs by $10,000. The firm's marginal tax rate is 40 percent, and the project's cost of capital is 16 percent. What is the NPV for this project? What is the IRR?

The $5,000 is a sunk cost. It was already paid and can be ignored. The $80,000 cost of buying fixed asset (computer) is capital spending at time=0. Depreciation Expense: = $12,500. The $30,000 salvage value is a cash flow at the end of the project. The $6,000 change in NWC is an opportunity cost at the beginning and end of the project. Next, compute the after-tax operating cash flows: Revenues 60,000 Expenses - 10,000 Depreciation - 12,500 EBT = 37,500 Tax - 15,000 NI = 22,500 Depreciation + 12,250 OCF = 35,000 Last, compute the NPV and IRR. Using a financial calculator: CF0 = -80,000-6,000 = -86,000 CO1 = 35,000 FO1 = 3 CO2 = 35,000+30,000+6,000 I=16% CPT NPV = $31,818.80 CPT IRR = 31.50%

internal rate of return (IRR)

The internal rate of return (IRR) is defined as the discount rate that gives an NPV of zero.

Twelve years ago your company paid $30,000 for a new truck. Last year the company paid $4,000 to repair the truck's engine. The truck has a book value of $15,000 and could probably be sold for that much. If used for the firm's next project, the truck will be used until it is worth nothing at all, and its book value will be depreciated to zero. What is the relevant cost of using the truck for the firm's next project?

The original price of $30,000 is not relevant. The $4,000 for the new engine is a sunk cost and can also be ignored. The $15,000 represents the opportunity cost of using the truck and should be considered as a relevant CF. Therefore, the relevant cost is $15,000.

Jon Stevens, BNSF Vice President and Controller describes the capital spending process primarily as

a means to ensure regulatory compliance a balancing act that requires careful evaluation of the costs and benefits of each project

If a 20% reduction in forecast sales would not extinguish a project's profitability, then sensitivity analysis would suggest:

deemphasizing that variable as a critical factor.

What types of analyses do the BNSF strategic studies team conduct?

discounted cash flow sensitivity

What types of projects does the BNSF strategic studies team evaluate?

discretionary

Identify which of these are the relevant cash flows when considering a capital budgeting project:

lost rent from retail facility remodeling expenses for new store increase in inventory expected salvage value of manufacturing equipment

The primary purpose of capital budgeting is to:

maximize the shareholders' wealth.