Exam 3 Review

 The ideal evaluation method should: a) include all cash flows that occur during the life of the project, b) consider the time value of money, and c) incorporate the required rate of return on the project. Decision-making Criteria in Capital Budgeting

Payback Period  Definition  Decision rule  Drawbacks  Advantages  Discounted payback period

 NPV = the total PV of the annual net cash flows - the initial outlay. NPV = - IO FCF t FCF t (1 + k) t nt=1  Net Present Value

Decision Rule:  If NPV is >=0, accept.  If NPV is negative, reject.  Features of NPV

Profitability Index PI = IO FCF t (1 + k) n t=1  t NPV = - IO FCF t (1 + k) t n t=1 

 Decision Rule:  If PI is greater than or equal to 1, accept.  If PI is less than 1, reject. Profitability Index

Internal Rate of Return (IRR) NPV = - IO FCF t (1 + k) t n t=1  n t=1  IRR: = IO FCF t (1 + IRR) t

IRR Decision Rule:  If IRR is greater than or equal to the required rate of return, accept.  If IRR is less than the required rate of return, reject.

Modified Internal Rate of Return (MIRR)  Definition  What is the difference with IRR  What is the reinvestment assumption  How to calculate  Decision rule

Relationships of Methods  All three discounted cash flow criteria are consistent and give similar accept-reject decision.  NPV is superior to IRR  Reinvestment assumptions

Useful Guidelines  Use free cash flow rather than accounting profits  Think incrementally  Working capital requirements are considered a cash flow even though they do not leave the company.  Sunk costs are not incremental cash flow  Ignore interest payments and financing flows

Capital Budgeting Steps Evaluate Cash Flows Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project.  Initial outlay  Differential Cash Flows over the life of the project (also referred to as annual cash flows).  Terminal Cash Flows

Evaluate Cash Flows Initial Outlay: What is the cash flow at “time 0?” Initial Outlay: What is the cash flow at “time 0?” (Purchase price of the asset) (Purchase price of the asset) + (shipping and installation costs) (Depreciable asset) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay Net Initial Outlay

Incremental revenue Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes Incremental earnings after taxes + Depreciation reversal Annual Cash Flow Annual Cash Flow For Each Year, Calculate:

Step 1: Evaluate Cash Flows Terminal Cash Flow: What is the cash flow at the end of the project’s life? Terminal Cash Flow: What is the cash flow at the end of the project’s life? Salvage value Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow Terminal Cash Flow

Problems with Project Ranking 1) Mutually exclusive projects of unequal size (the size disparity problem) 2) The time disparity problem with mutually exclusive projects. 3) Mutually exclusive investments with Unequal Lives  Equivalent Annual Annuity (EAA) method and replacement chain

Cost of Debt For the issuing firm, the cost of debt is:  the rate of return required by investors,  adjusted for flotation costs and  adjusted for taxes.

Cost of Preferred Stock  Recall: k p = = k p = =  From the firm’s point of view: k p = = k p = = NPo = price - flotation costs! D Po Dividend Price Dividend Net Price D NPo

Cost of Common Stock There are two sources of Common Equity: 1) Internal common equity (retained earnings). 2) External common equity (new common stock issue).

Cost of Internal Equity 1) Dividend Growth Model k c = + g k c = + g 2) Capital Asset Pricing Model (CAPM) k j = k rf + j (k m - k rf ) k j = k rf + j (k m - k rf ) D 1 Po 

Dividend Growth Model Dividend Growth Model k nc = + g k nc = + g Cost of External Equity D 1 NPo Net proceeds to the firm after flotation costs!

Cost of Common Stock  Issues with dividend growth model  Issues with CAPM

Weighted Cost of Capital  The weighted cost of capital is just the weighted average cost of all of the financing sources.  Use WACC for discount rate for a project only when the project has similar risk to the firm