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FIN 3403 LECTURE NOTES COST OF CAPITAL LEVERAGE CAPITAL BUDGETING © R. DIGGLE, JR., CFA University of Central Florida

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FINANCIAL INSTRUMENTS- -LEC NOTES PP. 32-33 u MONEY MKT < 1 u T-BILLS u FED FUNDS u COMML PAPER u CDS u MMMFs u EURODOLLARS u COMML CREDIT u CAPITAL MKT > 1 YR u TREAS NOTES, BONDS u FED AGENCY BONDS u MUNY BONDS u CORP. BONDS u MTGS / LEASES u PFD STOCK u COMMON STOCK (RESIDUAL EQUITY)

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PRIMARY & SECONDARY MARKETS u PRIMARY u NEW ISSUE --IPO OR SECONDARY u PROSPECTUS OR INDENTURE REQUIRED FOR CORP SECURITIES u OFFERING MEMO NEEDED FOR MUNY BONDS u MUTUAL FUNDS ARE PRIMARY u SECONDARY u TRADING IN EXISTING SECURITIES ON EXCHANGES OR OTC MARKETS u DIFFERENCE BETWEEN NYSE, ASE AND NASDAQ

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COST OF CAPITAL CONCEPTS FIN 3403 DIGGLE UNIVERSITY OF CENTRAL FLORIDA

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COST OF CAPITAL DEFINED u TEXT CH 12, LEC NOTES PP. 20-21 u CAPITAL GOODS ARE LONG TERM INVESTMENTS > 1 YEAR) u CAPITAL MARKET INSTRUMENTS FOR CORPORATIONS ARE: u LT DEBT u PREFERRED STOCK u COMMON STOCK Cost of Capital is the OPPORTUNITY COST or “HURDLE RATE” of using funds for new projects.

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COC CONCEPTS u COST OF CAPITAL IS AN IMPORTANT FIRST STEP IN CAPITAL BUDGETING. u CAPITAL COSTS ARE BASED ON MARKET COSTS OF FINANCING SOURCES u ALL CAPITAL COSTS ARE COMPUTED USING AFTER TAX COSTS. u SINCE INTEREST IS DEDUCTIBLE, COST OF DEBT IS: Kd (1-t) where t = Corp FIT rate

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

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COC CONCEPTS CONTD u 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) u PREFERRED AND COMMON STOCK ARE AFTER TAX COSTS. u COST OF DEBT MUST BE ADJUSTED BY (1-T) for the corporate income tax rate

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WACC u 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. u WACC or weighted average cost of capital is, therefore, based on the firm’s capital structure: SEE Table 12-6 on p. 444 u USUALLY, cost of L.T. debt is the lowest cost source of funds.

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KINDS OF DEBT u CORPORATIONS MAY ISSUE MANY BONDS. u BOND TYPES: u FIRST MORTGAGE BONDS (collateralized) u 2ND MTG BONDS u DEBENTURES (UNSECURED LT DEBT) u CORPORATIONS MAY ISSUE SEVERAL SERIES OF BONDS WITHIN EACH CLASS u EACH NEW ISSUE IS SUBORDINATED TO EARLIER ISSUES

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PRIORITY OF CLAIM PYRAMID u CORPORATE LIABILITIES HAVE A DEFINED PRIORITY OF CLAIM TO INCOME AND ASSETS IN EVENT OF LIQUIDATION (BANKRUPTCY) u CREDITORS INCLUDING THE IRS u 1st Mortgage bonds u 2nd mortgage bonds u Preferred stock u Common Stock (RESIDUAL EQUITY)

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CORPORATE DEBT CHARACTERISTICS u ALL interest on debt is deductible u Corporate bonds are $1000 par which is value at maturity or redemption u The stated interest rate or COUPON rate is fixed for life of bond u BONDS are issues with an initial maturity of 10+ years (usually to a maximul of 30 years) u NOTES are issues with an initial maturity of 1-10 years. u BONDS & NOTES are sold by INDENTURE

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PREFERRED STOCK CHARACTERISTICS u PREFERRED STOCK HAS NO MATURITY. IT IS LIKE AN UNLIMITED MATURITTY BOND. u PREFERRED STOCK PAYS A FIXED DIVIDEND u PAR CAN BE ANY AMOUNT. u PREFERRED STOCK DIVIDENDS ARE NOT DEDUCTIBLE TO THE ISSUING CORPORATION u INTERCORPORATE DIVIDEND EXCLUSION

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COMMON STOCK CHARACTERISTICS u COMMON STOCK IS OWNERSHIP CAPITAL OR “EQUITY” u PAR CAN BE ANY AMOUNT AND IS MEANINGLESS. u COMMON STOCK DIVIDENDS are discretionary. u THE BOARD DECLARES THE COMMON DIVIDEND QUARTERLY BASED ON PROFITS. u EXCESS PROFIT AFTER COM DIVDS IS ADDED TO “RETAINED EARNINGS” QUARTERLY u LOWEST PRIORITY OF CLAIM

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COMMON STOCK CHARACTERISTICS contd. u High growth companies often do NOT pay a dividend preferring to REINVEST profits back in the business. u Reinvested earnings are called retained earnings. u The price of common stock rises with profits per share called Earnings per Share or E.P.S. u High growth companies often have high Price / Earnings or P/E ratios.

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

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COMMON STOCK CHARACTERISTICS contd. u COST OF EXISTING EQUITY IN EXAMPLE IS: $1.12 + 12% $30 = 3.73% + 12% = 15.73% u ASSUME THE PRICE RISES TO $50 $1.12+ 12% $50 = 2.24% + 12% = 14.24%

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

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

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Why would a CFO NOT use all debt financing? ADVANTAGES u Debt is cheaper u Cost is fixed u Interest is deductible u Debt can be refinanced if rates decline. This is called REFUNDING and must be spelled out in the indenture. DISADVANTAGES u Non payment of ANY coupon on ANY debt issue will trigger Ch 11 filing by bond trustee. u Debt costs are a function of prevailing interest rates at time of issue for bonds of similar type & quality.

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WACC CALCULATION u SEE TEXT P. 444 u WE WILL USE BOOK VALUE OF ASSETS not market. u MULTIPLY percent weight of each component by AFTER tax cost of capital of each component. u Notice in example that WACC = 12.7% and the common stock component cost is the highest. This is typical. u What if bonds were 60% of capital cost and equity was 35%?

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WACC CALCULATION CONTD. u 60% X 7% = 4.20% u 5% X 13% = 0.65% u 35% X 16% = 5.60% WACC = 10.45% WE LOWERED WACC BY 2.25% What could be wrong with this? u INCREASED USE OF DEBT DECREASES WACC BUT INCREASES RISK. u THIS IS CALLED “FINANCIAL LEVERAGE” which is covered in FIN 402.

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HOW IS WACC USED IN CORPORATE FINANCE? u WACC is the “HURDLE RATE” for capital budgeting decisions. u If company A has a WACC of 12%, ALL new investments must return at least 12% for the firm to have a positive ROI. u If company B has a higher WACC of 15% it must seek investments with a minimum return of 15%. u WACC therefore influences the ability of a company to compete effectively.

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

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ALTERNATIVE METHOD u SEE LECTURE NOTES u RISK FREE RATE Krf + (Risk premium reflecting business risk, interest rate risk etc.) X Beta u = E cost of capital using CAPM u 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

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BETA contd. u Say MSFT stock has a beta of 1.5. u 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. u Beta is a key element in what is called MODERN PORTFOLIO THEORY u 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.

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BETA contd. u Here we see an example of how finance theory of the firm is used by portfolio managers in mutual funds. u HIGH BETA STOCKS are more volatile. They are for more aggressive investors. u LOW BETA STOCKS (like utilities) are less price volatile. We call them “Widow and Orphan stocks.” u CFOs know that use of leverage will tend to increase Beta.

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SUMMARY u WACC is affected by two factors: u The cost of each external source of capital which is determined by timing and markets u The Weight given to each source of capital u WACC can be changed by the CFO by a new issue. u A low cost debt issue could likely lower the WACC. u Companies scan global sources of funds to minimize capital costs.

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PROBS A-12-3 TO 12-5, 12-13 u 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%

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PROBS A-12-4,12-5, 12-13 u 12-4A u D 0 - DPS NOW u D 1 = DPS in 1 year compounded at g u 1.54/ 27 (1-.06) + g =1.54 / 25.38 +.06 = 12.07% u 12-5A u.07 (1-T) =.07 X.82 u = 5.74% u Notice irrelevant information in problem u 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$108359.565 PFD$ 268 36.180 COM $3681 662.58 758.325 / 5032 = 15.07% see next page

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PROBLEM 12 -13a % ATC WEIGHT BONDS $1083 21.52% 5.5%59.565 PFD 268 5.33%13.536.180 COM3681 73.15%18.0 662.58 $5032 758.325 WACC = 758.33 / 5032 =15.07%

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PROB 12-13A ALTERNATIVE % ATC (% )(ATC) BONDS 21.52% 5.5%1.18% PFD 5.33%13.5.72 COM 73.15%18.0 13.17 15.07 WACC = 15.07%same answer

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Ch 13: LEVERAGE, BEP u CONCEPTS: u LEVERAGE IS A TERM REFLECTING MAGNIFICATION EFFECTS THROUGH VARIOUS STRATEGIES u OPERATING LEVERAGE IS DERIVED FROM VARYING BREAK EVEN POINTS DUE TO FIXED COSTS u FINANCIAL LEVERAGE IS DERIVED FROM USE OF DEBT IN CAP. STRUCTURE

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FORMULAS IN EXAM 2 u You will be given a formula page in Exam incorporating DOL and DFL and DTC formulas as well as other TVM formulas. u You need to know how to APPLY these formulas in problems u There are two kinds of formulas (BETWEEN 2 POINTS AND AT ONE POINT OF OUTPUT) u SEE SUMMARY ON P. 499--ONE POINT

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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

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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”

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PRO FORMA P&L - NO PFD u SALES u LESS VARIABLE COSTS = u RBFCcont mgn = RBFC / SALES u LESS FIXED COSTS u = EBIT u LESS INTEREST EXPENSE u = EBT (pretax income) u LESS FIT PAID u = NET INCOME u NI / SHARES OUT = E.P.S.

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Ch 13--OPERATING leverage u TERMINOLOGY u FIXED COSTS P. 477 u VARIABLE COSTS P. 478 u BEP U = F / ( P-V) P. 482 UNITS FIXED COSTS / UNIT CONTRIB MARGIN u BEP S = F / (1- VC / S) P. 483 DOLLARS

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OPERATING LEVERAGE FORMULAS DOL AT ONE POINT OF OUTPUT u DOL = Q (P-V)/ Q (P - V) -FP. 488 FORMULA 13-6 u AN EASIER WAY TO REMEMBER THIS IS: DOL = RBFC / EBIT (see P&L on p. 495) DOL BETWEEN TWO POINTS IN OUTPUT u DOL = % CHG IN EBIT / % CHG IN SALES

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FINANCIAL LEVERAGE u Financial leverage = magnification in EPS from use of ST or LT debt FORMULA 1: 2 POINTS u DFL = % CHG IN E.P.S. / % CHG IN EBIT FORMULA 2: AT ONE LEVEL OF OUTPUT u DFL = EBIT / (EBIT - I) I = interest on debt note: EBIT - I = EBT or pretax income, THEREFORE: DFL = EBIT / EBT (13-9 p. 499)

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FINANCIAL LEVERAGE: basic concepts u COMPANIES WITH HIGHLY CYCLICAL SALES AND EARNINGS (like autos) USUALLY HAVE LOW FINANCIAL LEVERAGE RATIOS. WHY? u COMPANIES WITH STABLE REVENUES LIKE UTILITIES CAN USE HIGH AMOUNTS OF DEBT IN THE FINANCIAL STRUCTURE. WHY?

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FORMULAS CONTD SEE P. 499 u BEP = formula 13-3 u DOL = formula 13- 6 u DFL = formula 13-9 u DCL = formula 13-12 u BEP = F / “unit contrib. margin” Q(P - V) / [Q(P - V) -F] or RBFC / EBIT u EBIT / EBT (pretax Income) u DCL = RBFC / EBT or u DCL= (DFL) * (DOL)

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FOR EXAM 2 u YOU WILL BE PROVIDED A FORMULA PAGE INCLUDING u TVM FORMULAS u COST OF CAPITAL FORMULAS u LEVERAGE FORMULAS u YOU NEED TO KNOW WHICH FORMULA TO APPLY u YOU NEED TO BE ABLE TO CONSTRUCT A PRO-FORMA P&L

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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

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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

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LEVERAGE PROBLEM HANDOUT 13-27A P. 506 u STEPS u CONSTRUCT PRO - FORMA P&L u COMPUTE CONTRIBUTION MARGIN u SOLVE FOR DOL AND DFL AT A GIVEN LEVEL OF OUTPUT u COMPUTE DCL AND BEP u NOW YOU CAN DETERMINE % CHG IN EPS FOR ANY CHANGE IN SALES

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

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What is Capital Budgeting? u A way to quantitatively evaluate capital projects (investments with a life of > 1 year) u Capital budgeting is used in business, government, non-profit organizations etc. It is a way of measuring COST VS BENEFIT. u CAPITAL BUDGETING IS SIMPLY TVM. THE TERM IS NEW. THE ANALYTICAL APPROACH IS FAMILIAR TO YOU ALREADY!

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

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TERMINOLOGY contd. u CASH FLOW = NET INCOME AFTER TAX + NON CASH CHARGES u OPERATING CASH FLOW = NET INCOME PLUS TAX SAVINGS ON DEPR, DEPL & AMORT. See Income statement lec notes p. 24 u MUTUALLY EXCLUSIVE PROJECTS lec notes p. 21 u INDEPENDENT PROJECTS u CAPITAL RATIONING u MACRS --see text p. 37 table 1A-3 will be provided on exam.

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CAP BUDGETING TECHNIQUES u RESPONSIBLE FOR 3 METHODS ONLY: u PAYBACK u IRR u NPV u You are NOT responsible for Discounted Payback modified IRR, or profitability index u PAYBACK= YEARS TO RECOVER NET INVESTMENT u IRR = the interest rate or discount rate equating PV of outflows with PV of inflows u NPV = PV of cash outflows and inflows discounted at WACC

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ADVANTAGES OF EACH METHOD u PAYBACK: Conceptually simple. Shortest payback is the best u IRR: Gives a percentage discount rate that can be quantified and easily ranked. u 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.

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METHODS: DISADVANTAGES u PAYBACK p. 22 LN u Ignores cash flows beyond payback period u Ignores TVM u Method is arbitrary u IRR u IRR is independent of WACC and does not consider WACC in its calculation u Cash flow spreadsheet required for multiple cash flows u NPV (PREFERRED METHOD) --When results give you conflicting decisions ALWAYS use NPV as preferred solution. u NPV for multiple cash flows REQUIRES use of cash flow spreadsheet or Excel spreadsheet u Must enter WACC to solve for NPV

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CAP BUDGETING INPUTS COSTS u NET INVESTMENT CF O see lec notes p. 26 u COST + tax and installation = DEPR BASIS u PLUS Increase in NWC EQUALS u NET INVESTMENT BENEFITS u CASH INFLOWS (savings or revenue from a new project) u TAX SAVINGS ON DEPRECIATION (will discus next week) u NPV of salvage value u NPV of return of NWC

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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 u NOTE THAT IN THIS EXAMPLE PAYBACK IGNORED CASH FLOWS BEYOND 3.33 YEARS. THIS INVESTMENT RETURNED $150,000 TOTAL IGNORING TVM.

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PAYBACK CONTD. UNEVEN CASH FLOWS Number of years CUMULATIVE cash flows = NI u NI(CF0) = $50,000 u CO1 = $15000 u C02 = $12000 u CO3 = $10000 u C04 = $10000 u CO5 = $12000 need to CUMULATE CO1 TO C0n see next slide

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

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INTERNAL RATE OF RETURN AND NPV IRR u Calculates discount rate which equates cash inflows with cash outflows u Advantages and disadvantages u IRR key on calculator NPV u Discounts cash inflows at WACC. Nets out inflows and outflows. u Advantages and disadvantages. Private firm. u NPV key --must know WACC

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USING THE CASH FLOW SPREADSHEET ON TIBA2+ u CLEAR REGISTERS u PUSH CF KEY u ENTER CLEAR WORK TO CLEAR THIS REGISTER u PRESS ENTER AFTER EACH ENTRY u ENTER CF0 =-50000 u DOWN ARROW u CO1 = 15000 u FO1 = 1 u CO2 = 12000 u FO2 = 1 u CO3 = 10000 u F03 = 2 u C04 = 12000 u C04 = 1 u SCROLL (UP ARROW) TO CHECK INPUTS

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TIBA2+cash flow spreadsheet u AFTER YOU HAVE ENTERED AND CHECKED INPUTS: u PRESS NPV u I=WACC = 11% (this number may be given in an exam or may be linked to a WACC problem) u ENTER I AS 11 not 0.11 u DOWN ARROW u NPV = PRESS CPT u $-5726.37 u IF NPV IS NEGATIVE THIS IS NOT A GOOD INVESTMENT u IRR KEY 6.0891% u IRR < WACC

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WHAT DOES THE CF SPREADSHEET DO? SEE TEXT P. 326 u You could calculate NPV on your TVM keys but it is NOT recommended. u 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 u The CF of inflows is Subtracted from Net investment (CF0). u This is NET cash flow u If Net cash flow is negative it means PV of inflows are less than PV of outflows. u net salvage value is a CF in the last year.

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WHAT IS NPV? u 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

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WHAT IS THE PROFITABILITY INDEX? u You will not be asked to compute this on an exam u PI = NPV OF INFLOWS / PV OF OUTFLOWS discounted at WACC u EXPRESSED AS A RATIO u IF RATIO > 1.0 ACCEPT

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SELECTING FROM MULTIPLE PROPOSALS OR PROJECTS SEE TEXT P. 328 u CLEAR CF REGISTER u ENTER DATA FOR MACHINE OR PROJECT A u CF1 = - 10000 u C01 = 3362 u F01 = 4 u IRR = 13% u PROJ B IRR u CF1 = -10000 u C01 = 0 u FO1 =3 u C02 = 13605 u FO1 =1 u IRR = 6.35% u PROJ C IRR = 19.04% u SELECT PROJ C

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Problems ch 9 pp. 337ff SET END 9-1A IRR USE TVM KEYS u a P/Y = 1 N = 8 I/Y = 7% u b N = 10 I/Y = 17% u c N = 20 I/Y = 13% u d N = 3 I/Y = 11% u 9-2 IRR u a N = 10 PMT = 1993 solve for I/Y = 15% u b N = 20 I/Y = 20% u c 6% u d 13% u 9-3A IRR UNEVEN CF- USE WORKSHEET A. CF0 = -10000 u CO1 = 2000 FO1 =1 u CO2 = 5000 FO1 = 1 u CO3 = 8000 FO1 = 1 u IRR = 18.8% B. IRR = 30.2% C. CO1 = 2000 FO1 = 5 u C02 = 5000 F02 = 1 u IRR = 11.2%

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Problems ch 9 pp. 337ff contd u 9-4 A use CF worksheet u clear worksheet u CF0 = -1950000 u CO1=450000 FO1 = 6 u DO IRR FIRST = IRR = 10.1725% u I = 9 NPV = 68663 u PI = 2018664/1950000 = 1.0352 [>1 OK] u ACCEPT u 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

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Problems ch 9 pp. 337ff contd u 9-5A CONTD u CLEAR REGISTERS u CLEAR WORKSHEET CF0 = -80000 CO1 = 20000 FO1 = 6 IRR(always do IRR first) = 12.98% I = 10 NPV = 7105 ACCEPT

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Problems ch 9 pp. 337ff contd EVEN CASH FLOWS PROB 9-6A u PROJECT A u CFO = -50000 u CO1 = 12000 u FO1 = 6 u IRR = 11.53% u I = 12 NPV = -663 u REJECT! u PROJECT B u CFO = -70000 u CO1 = 13000 u FO1 = 6 u IRR = 3.18% u NPV = -16551 u b is better than A but reject BOTH

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CAPITAL BUDGETING: ADVANCED CONCEPTS CH 10 u DEPRECIABLE BASIS (see table 10-4 p. 357--LECTURE NOTES P. 22-24) u INITIAL OUTLAY OR NET INVESTMENT (see text p. 354) u CASH FLOW DIAGRAM (Fig 10-1 p 359) u NET INVESTMENT SEE TABLE 10-8, 10-9 u CASH FLOWS (TABLE 10-10) u TERMINAL CASH FLOW(S)-SEE LECTURE NOTES AND TABLE 10-6

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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 Deprec- iation = 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

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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

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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

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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

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PROBLEM: TERMINAL CF u TERMINAL YEAR CF SALVAGE VALUE AFTER TAX $16120 + RETURN OF NWC (inflow) 2000 + OPERATING CF IN LAST YR 7800 = $25920 NOTE: THIS IS A CASH FLOW IN YEAR 3

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MACRS u What is it? Modified Accelerated Cost Recovery System --part of 1986 IRS code u MACRS PERCENTAGES (see lec notes p. 48) SEE TEXT PP. 35-38 u EXAM WILL ONLY CONSIDER 3,5,7 YEAR PROPERTY u HALF YEAR CONVENTION u MACRS is used for equipment. It is NOT used for buildings. Land is NOT depreciated.

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

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CAP BUDGETING PROBLEMS u 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

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PROB 10-2A P&L u 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 u SAVINGS < SALARY $20000 < DEFECTS 3000 > MAINT. (-1000) >DEPREC * (-9000) NET PRETAX SAVINGS 13000 TAX (34%) - 4420 NET INCOME8580

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10-2A CONTD

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CAP BUDGETING PROBLEMS u 103A P. 371 SEE HANDOUT NOTE: Exam may ask you to calculate “required rate of return” as a WACC problem FIRST u COMPREHENSIVE EXAMPLE table 10-8 p. 360

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ADDITIONAL STUDY u PROB 10-11A p. 374 TIME DISPARITY see handout solution u PROB 10-12 a UNEQUAL LIVES see handout solution u RANKING See prob 10-14A p. 375 see handout solution

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

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