FINA 3313 Ch 9, FINA 3313 Ch.10

The investment decision

invest in assets that earn a rate greater than the minimum acceptable hurdle rate

What is the amount of the operating cash flow for a firm with $378,585 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate?

$378,585*0.35 =132504.75 378,585+100,000-132504.75 =346080.25

The primary purpose of capital budgeting is to:

maximize the shareholders wealth

The "gold standard" of investment criteria refers to:

NPV

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 sunk costs associated with the project. -Any opportunity costs associated with the project.

What are advantages of payback period?

-Measures Liquidity, Easy to communicate -Does not require complex calculations -Does not require discount rate

The disadvantages of the IRR period method is that it

-Requires complex calculations -Only works for normal cash flows -Requires a lot of data (estimates of all CFs)

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

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

-discounted cash flow -sensitivity

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

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 $ 22973784 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. (ie, 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. • Att 10, the project is expected to cease being economically viable and the factory (including land) will be sold for $ 4500000 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 (ie. negative taxes).0 What is the project's outflow at t=0? Answer to the nearest whole dollar value.

2,600,000 +22,973,784 =25,573,784.00

Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the 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 a 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 $ 20000000 excluding land, hint: the land is not subject to depreciation). • If the project is undertaken, att=0 the company will need to increase its inventories by $3,500,000, accounts receivable by $ 1500000 and its accounts payable by $2,000,000. This net operating working capital will be recovered at the end of the project's life (t = 10). • 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. • Att= 10, the project is expected to cease being economically viable and the factory (including land) will be sold for $ 4500000 assume land has a book value equal to the original purchase price). • The project's WACC = 10 • Assume the firm is profitable and able to use any tax credits (i.e. negative taxes). What are the after tax proceeds from the sale of the factory (i.e..ATSV)? Round to nearest whole dollar value.

BV=Initial cost-accumulated depreciation BV= 20,000,000-(sum of 9 yrs with a depr. of 2,000,000) BV= 20,000,000-18,000,000 BV= 2,000,000 4,500,000 given from 3rd to last bullet ATSV= SV-Tax*(SV-BV) =4,500,000-[0.35*(4,500,000-2,000,000)] ANSWER=3,625,000

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? Answer in % format

CF0= -5,000 C01=900 FO1=3 CO2= 1400 FO2=3 NPV I=8 enter down arrow Cpt NPV= 183.48 PI= (183.48+5,000)/5,000 PI= 1.03669 PI=103.67%

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 8.22%?

CF0=-100,000 C01=50,000 F01=3 CPT NPV I/Y= 8.22% Down Arrow NPV CPT NPV=28,345.05

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%?

CF0=-50,000 CO1=-10,000 FO1=4 I=10% CPT NPV NPV=-81,698.65 PV= -81,698.65 N=4 I=10 CPT PMT PMT=25,773.54-----ANSWER

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $223 at the end of the next three years and then $1,383 per year for the three years after that. If the discount rate is 7.98% then what is the NPV?

CFO=-5,000 CO1= 223 FO1=3 CO2=1383 FO2=3 Enter NPV I= 7.98% Enter Down arrow CPT NPV= -1,593.19

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

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.

Number of years 0, 1, 2, 3 Cash flows -100000000, -20000000, 80000000, 90000000 Present value @11% -100000000, 18018018.02, 64929794.66, 65807224.32 Therefore, Net Present value =12719000.96 or 12.72 million IRR =15.95%

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?

PV=-10,000 FV=0 PMT=2,000 N=6 CPT I/Y =5.47

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

The cost of capital exceeds the IRR

Compute the payback period for a project that requires an initial outlay of $297,771 that is expected to generate $40,000 per year for 9 years.

Time Amount Cumulative (297,771) (297,771) 1 40,000 (257,771) 2 40,000 (217,771) 3 40,000 (177,771) 4 40,000 (137,771) 5 40,000 (97,771) 6 40,000 (57,771) 7 40,000 (17,771) 8 40,000 22,229 9 40,000 62,229 Look at the last number before going over the 40,000 and the year =7+(17,771/40,000) =7.44

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

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 projects does the BNSF strategic studies team evaluate?

discretionary

The financing decision

Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations

List steps of the capital budgeting process

Step 1: Personal generation Step 2: Review and analysis Step 3: Decision Making Step 4: Implementation Step 5: Follow-up

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

increase bank executive turnover

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

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

The dividend decision

If you can't find investments that make your minimum acceptable rate, return the cash to owners of your b

A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $84,391,290 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 NPV?

CFO=(-84,391,290 CO1=(-20,000,000 FO1=1 CO2= 80,000,000 FO2-1 CO3=90,000,000 FO3=1 NPV I=11% Down arrow CPT NPV=28,327,710.96

What is the net effect on a firm's working capital if a new project requires: $34,867 increase in inventory, $42,427 increase in accounts receivable, $35,000.00 increase in machinery, and a $42,993 increase in accounts payable? Round to nearest dollar amount.

Increase in Inventory: 34,867 Increase in A/R: 42,427 Increase in A/P: 42,993 =34,867+42,427-42,993 =34,301

Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.term-2

Mutually Exclusive

Revenues generated by a new fad product are forecast as follows: Year: 1 Revenues: 44,359 Year:2 Revenues: 40,000 Year: 3 Revenues: 20,000 Year: 4 Revenues: 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 17 Answer to nearest whole dollar amount

Revenue: 44,359.00 -Expense: 22,179.50 (0.5*44,359) -Depreciation: 8,000.00 (40,000/5) =EBIT 14,179.50 -Tax 2,835.90 (0.2*14,179.50) =Net Income 11,343.60 (14,179.50-2,835.90) +Depreciation 8,000.00 =OCF 19,343.60 (11,343.60+8,000) Answer: 19343.60

Aero Motorcycles is considering opening a new manufacturing Fort Worth to meet the demand for a new line of solar-charged facility in motorcycles (who wants to ride on a cloudy day anyway?) The proposed project has the following features: • The firm just spent $300,000 for a 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 $ 20000000 excluding land, hint: the land is not subject to depreciation). • If the project is undertaken at t=0 the company will need to increase its inventories by $3,500,000, accounts receivable by $ 1500000 and its accounts payable by $2,000,000. This net operating working capital will be recovered at the end of the project's life (t = 10). • 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. • Att = 10, the project is expected to cease being economically viable and the factory (including land) will be sold for $ 4500000 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 lie. negative taxes). What is the operating cash flow @t=1? Round to nearest whole dollar value

Sales/Revenues: 8,000,000 ---5th bullet -Expense: 4,000,000 (8,000,000/0.5)---6th bullet -Depriciation: 2,000,000 (20,000,000/10 yr)3*8 bullet =EBT: 2,000,000(sales-expense-dep) -TAX: 700,000 (2,000,000*0.35) =Net Income 1,300,000 (2,000,000-700,000) + Depreciation: 2,000,000 (same as first dep.) =OCF 3,300,000

Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the 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 a 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 $ 20000000 excluding land, hint: the land is not subject to depreciation). • If the project is undertaken, at t=0 the company will need to increase its inventories by $3,500,000, accounts receivable by $ 1500000 and its accounts payable by $2,000,000. This net operating working capital will be recovered at the end of the project's life (t = 10). • 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. • Att = 10, the project is expected to cease being economically viable and the factory (including land) will be sold for $ 4500000 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 (ie. negative taxes) What is the operating cash flow @t=2? Round to nearest whole dollar value

Sales/Revenues: 8,000,000 ---5th bullet -Expense: 4,000,000 (8,000,000/0.5)---6th bullet -Depriciation: 2,000,000 (20,000,000/10 yr)3*8 bullet =EBT: 2,000,000(sales-expense-dep) -TAX: 700,000 (2,000,000*0.35) =Net Income 1,300,000 (2,000,000-700,000) + Depreciation: 2,000,000 (same as first dep.) =OCF 3,300,000

Grill Master Johnnys is thinking about purchasing a new, energy-efficient grill. The grill will cost $53,000.00 and will be depreciated according to the 3-year MACRS schedule. It will be sold for scrap metal after 3 years for $11,750.00. The grill will have no effect on revenues but will save Johnny's $23,500.00 per year in energy expenses. The tax rate is 40%. The 3-year MACRS schedule: Year Depreciation % 1 33.33 2 44.45 3 14.81 4 7.41 What is the total cash flow in year 3?

Tax= 14.81% Initial investment:-53,000 Depreciation: YEAR 1 53,000*33.33%= $ 17,664.90 YEAR 2 53,000*44.45%= $ 23,558.50 YEAR 3 53,000*14.81%= $ 7,849.30 SV: 11,750 Saving: 23,500 R $ 23,500.00 COGS Dep $ 7,849.30 EBIT $ 15,650.70---(23,500-7,849.30) Tax $ 6,260.28---(15,650.70*.40) NI $ 9,390.42----(15,650.70-6,260.28) Dep $ 7,849.30 OCF$ 17,239.72---(9,390.42+ 7,849.30) BV= initial cost- accumulated depreciation BV=53,000-(SUM of $17,664.90+$23,558.50+$7,849.30) BV= $ 3,927.30 ATSV=SV-tax*(SV-BV) ATSV=11,750-0.40*(11,750-3,927.30) ATSV= $ 8,620.92 Total Cash Flow= OCF+ATSV Total cash flow= 17,239.72+8,620.92 ANSWER= $ 25,860.64

Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the 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 a 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 $2,748,044. • The project has an initial cost of $ 20000000 excluding land, hint: the land is not subject to depreciation). • If the project is undertaken, at t=0 the company will need to increase its inventories by $3,500,000, accounts receivable by $ 1500000 and its accounts payable by $2,000,000. This net operating working capital will be recovered at the end of the project's life (t = 10). • 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. • Att= 10, the project is expected to cease being economically viable and the factory (including land) will be sold for $ 4500000 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 (ie negative taxes). What is the project's NPV? Round to nearest whole dollar value.

The land has a current market value of​: 2,748,044 NWC= change in CA- change CL WACC: 10% Year 0 Initial Investment: =-20000000-2,748,044 =($22,748,044.00) NWC: =-(3500000+1500000-2000000) =$ (3,000,000.00) Total cash flow: ($22,748,044.00)+(3,000,000.00) =$ (25,748,044.00) Year 1-9 Initial Investment: 0 NWC: 0 Sale: 8,000,000 Cost/Exp 4,000,000 (8,000,000*0.5) Dep 2,000,000.00 (20,000,000/10) EBT 2,000,000.00 (8,000,000+4,000,000+2,000,000) SV 0 OCF 3,300,000 (2,000,000 [EBT] -0.35*2,000,000[EBT]+2,000,000 [DEP]) TCF 3,300,000 [same as OCF] Year 10 Initial Investment 0 NWC 3,000,000.00 (-(-3,000,000)) Sale 8,000,000 Cost/Exp 4,000,000.00 (8,000,000*0.5) Dep 2,000,000.00 (20000000/10) EBT 2,000,000.00 (8,000,000-4,000,000-2,000,000) SV 4,500,000 (given) OCF 3,300,000.00 (2,000,000 [EBT]-0.35*2,000,000 [EBT]+2,000,000 [Dep]) TCF 9,925,000.00 (3,000,000 [NWC YR10] + 3,625,000 [ATSV]+ 3,300,000 [OCF YR 10]) BV=initial cost- accumulated depreciation =20000000-SUM[depreciation year 1-9)] =20000000-18,000,000 =2,000,000 ATSV=SV-Tax*(SV-BV) =4,500,000[SV YR10]-0.35*(4,500,000 [SV YR10]- 2,000,000 [BV]) =$ 3,625,000.00 CF0 -$22,748,044.00 C01 3,300,000 [TCF Year 1-9] F01 9 C02 9,925,000.00 [TCF year 10] F02 1 NPV function I/Y 10 % [WACC] CPT NPV NPV= -2,916,748.26

Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the 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 a 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​ $20,000,000 (excluding​ land, hint: the land is not subject to​ depreciation). ​• If the project is​ undertaken, at t​ = 0 the company will need to increase its inventories by​ $3,500,000, accounts receivable by​ $1,500,000, and its accounts payable by​ $2,000,000. This net operating working capital will be recovered at the end of the​ project's life​ (t =​ 10). ​• 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). What is the total cash flow at​ t=10? Round to nearest whole dollar value.

The land has a current market value of​= 2,600,000 WACC: 10% YEAR 0 Initial Investment: 20,000,000-2,600,000 =-20,000,000-2,600,000 =-22,600,000 NWC: =-(3500000+1500000-2000000) = -3,000,000 BV= initial cost- accumulated depreciation BV= 20,000,000-(sum of the 9 years depreciation) BV=20,000,000-18,000,000 BV= 2,000,000 ATSV= SV-Tax*(SV-BV) ATSV=4,500,000-0.35*(4,500,000-2,000,000) ATSV=3,625,000 YEAR 10 NWC: 3,000,000 Sale: 8,000,000 Cost/Exp: 4,000,000---8,000,000*0.5 DEP: 2,000,000----- 20,000,0000/10yrs EBIT: 2,000,000---- 8,000,000-4,000,000-2,000,000 SV: 4,500,000-----given OCF:3,300,000--2,000,000-[(0.35*2,000,000)+4,500,000] TCF= OCF+ATSV+NWC TCF: 9,925,000----(3,300,000+3,625,000+3,000,000) ANSWER: 9,925,000

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

True

Capital rationing may be beneficial to a firm if it:

weeds out proposals with weaker or biased NPVs.