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Final Review Preparationfor the final exam Preparation for the final exam.

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Presentation on theme: "Final Review Preparationfor the final exam Preparation for the final exam."— Presentation transcript:

1 Final Review Preparationfor the final exam Preparation for the final exam

2 Review Topics Capital Budgeting Cost of Capital Mergers & Acquisitions International Finance Cases

3 Capital Budgeting Understand the role of capital budgeting techniques in the capital budgeting process. Calculate, interpret, and evaluate the payback period. Calculate, interpret, and evaluate the net present value (NPV). Calculate, interpret, and evaluate the internal rate of return (IRR). Use net present value profiles to compare NPV and IRR techniques. Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach.

4 Capital Budgeting Administrative Steps: Identify Projects Collect Data Analyze Profit and Risk Gain Regulatory Approvals Arrange Financing Implement Control

5 Capital Budgeting NPV vs. IRR Conflicting rankings between two or more projects using NPV and IRR sometimes occurs because of differences in the timing and magnitude of cash flows. This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflowscash inflows received prior to the termination of the project. NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.

6 Capital Budgeting On a purely theoretical basis, NPV is the better approach because: NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR. Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return.

7 Capital Budgeting – Problem 1 Pound Industries is attempting to select the best of three mutually exclusive projects. The initial investment and after- tax cash inflows associated with these projects are shown in the following table: a. Calculate the payback period for each project b. Calculate the NPV of each project, assuming that the firm has a cost of capital equal to 13% c. Calculate the IRR for each project d. Summarize the preferences dictated by each measure and indicate which project you would recommend. Explain why Cash FlowsProject AProject BProject C Initial Investment CFo$60,000$100,000$110,000 Cash Inflows (t=1 to 5)$20,000$31,500$32,500

8 Capital Budgeting – Solution 1 Payback Period: Project A: $60,000 / $20,000 = 3.0 years Project B: $100,000 / $31,500 = 3.2 years Project C: $110,000 / $32,500 = 3.4 years NPV: CF 0 = -60,000, C01 = 20,000, F01 = 5, I = 13% NPVa = $10,345 NPV b = 10,793 NPVc = 4,310 IRR: IRRa = 20% IRR b = 17% IRRc = 15%

9 Capital Budgeting – Problem 2 Russell Industries is considering replacing a fully depreciated machine that has a remaining useful life of 10 years with a newer, more sophisticated machine. The new machine will cost $200,000 and will require $30,000 in installation costs. It will be depreciated under MACRS using a 5-year recovery period. A $25,000 increase in net working capital will be required to support the new machine. The firms managers plan to evaluate the potential replacement over a 4-year period. They estimate that the old machine could be sold at the end of 4 years to net $15,000 before taxes; the new machine at the end of year 4 has a value of $75,000 that is relevant to the proposed purchase of the new machine. The firm is subject to a 40% tax rate.

10 Capital Budgeting – Solution 2 After-tax proceeds from sale of new asset: Proceeds from sale of new machine 75,000 Tax on sale of new machine l (14,360) Total after-tax proceeds-new asset 60,640 After-tax proceeds from sale of old asset Proceeds from sale of old machine (15,000) + Tax on sale of old machine 2 6,000 Total after-tax proceeds-old asset (9,000) + Change in net working capital 25,000 Terminal cash flow 76,640 l Book value of new machine at end of year.4: [1 ( ) × ($230,000)] = $39,100 $75,000 $39,100 = $35,900 recaptured depreciation $35,900 × (0.40) = $14,360 tax liability 2 Book value of old machine at end of year 4: $0 $15,000 $0 = $15,000 recaptured depreciation $15,000 × (0.40) = $6,000 tax benefit

11 Cost of Capital Debt or Equity? Optimal Capital Structure Leverage Cost of Capital Cost of Debt Cost of Equity Cost of Preferred Stock

12 Cost of Capital – Problem (part 1) Edna Reporting Studios Inc, reported earnings available to common stock of $4,200,000 last year. From those earnings, the company paid dividends of $1.26 on each of each $1,000,000 common shares outstanding. The capital structure of the company includes 40% debt, 10% preferred stock and 50% common stock. Its taxed at a rate of 40%. a. If the market price of the common stock is $40 and dividends are expected to grow at a rate of 6% per year for the foreseeable future, what is the cost of financing with retained earnings? b. If under pricing and flotation costs on new shares of common stock amount to $7.00 per share, what is the companys cost of new common stock financing? c. The company can issue $2.00 dividend preferred stock for a market price of $25.00 per share. Flotation costs would amount to $3.00 per share. What is the cost of preferred stock financing?

13 Cost of Capital – Solution (part 1)

14 Cost of Capital – Problem (part 2) d. The company can issue $1,000-par-value, 10% coupon, 5-year bonds that can be sold for $1,200 each. Flotation costs would amount to $25.00 per bond. Use the estimation formula to figure the approximate cost of new debt financing. e. What is the maximum investment that Edna Recording Studios can make in new projects before it must issue new common stock? f. What is the WACC for projects with a cost at or below the amount calculated in part e? g. What is the WACC for projects with a cost above the amount calculated in part e, assuming that the debt across all ranges remains at the percentage calculated in part d?

15 Cost of Capital – Solution (part 2)

16 Mergers & Acquisitions – Problem 1 Tonis Typesetters is analyzing a possible merger with Petes Print Shop. Tonis has a tax loss carry forward of $200,000, which it could apply to Petes expected earnings before taxes of $100,000 per year for the next five years. Using a 34% tax rate, compare the earnings after taxes for Petes over the next 5 years both without and with the merger.

17 Mergers & Acquisitions – Solution 1

18 Mergers & Acquisitions – Problem 2

19 Mergers & Acquisitions – Solution 2

20 International Finance Understand the major factors that influence the financial operations of multinational companies (MNCs). Describe the key differences between purely domestic and international financial statements –consolidation, translation of individual accounts, and international profits. Discuss exchange rate risk and political risk, and explain how MNCs manage them. Describe foreign direct investment, investment cash flows and decisions, the MNCs capital structure, and the international debt and equity market instruments available to MNCs. Discuss the role of the Eurocurrency market in short-term borrowing and investing (lending) and the basics of international cash, credit, and inventory management. Review recent trends in international mergers and joint ventures.

21 International Finance Floating exchange rate key factors: Relative Interest Rates Relative Inflation Rates Relative Economic Growth Rates Exposure to Foreign Currency Risk: Economic Exposure Transactions Exposure Translation Exposure

22 Case Studies For the exam: Netscape IPO National Wind Power Lockheed Martin & Loral Massachusetts Carnegie Bank

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