Notes #2

# Notes #2 - Finance 4/23/08 EXAM #1 Short answers 1)...

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Finance 4/23/08 EXAM #1 Short answers 1) a)ocf=EBIT + depreciation –taxes to find EBIT 2007 2008 Sales 7487 9618 -CGS 2713 3284 -dep 484 502 - other 592 728 3698 5104 2007=3731 2008=5087 b)cash flow from assets c)cash flow to creditors #2) x(fvifa,8%,15)= 450,000(pvifa,8%,5) + (100,000/.08) /(1+.08)^5 x=97,504.34 Capital Budgeting Vfirm=f(I, F, D) I=Investing Decision “Capital” Money Judge: Forecasted return vs. required return (k) If Forecasted return > required return (k) Acceptable Project “passed criteria” If Forecasted return < required return (k) Reject Project “fails criteria” How do we do this? Estimate Project Cash Flows Calculate accept vs. reject decision How?

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Example: Replacement Problem Should the firm replace a piece of equipment with a newer model? Should firm accept or reject the project? Step 1) Determine the Cash Flows Step 2) Determine whether the firm should accept or reject the project. (several methods could be used.) Step 1 – Determine the Cash flows Initial Outlay – CFo Includes – Cost of purchasing new machine - Transactions cost - Cost of changing around the factory so it fits - Sale of old machine - Taxes - Other costs associated with readying new machine CFo=\$26,000 (outflow) Incremental Cash flows – CFt - Periodic Cash inflows (or outflows) expected from the implementation of the new asset. This arises out of operational flows from the project such as increased revenues or decreased expenses. CFt=\$5,800/yr Terminal CF – - An additional ca flow that occurs only in the final year of the projects estimated life. This arises from such things as sale of machine, tax effects, etc. - New asset has an expected life of 10 years, Old asset had an expected life of 15 years and was purchased 5 years ago (10 years remaining). Terminal CF=\$14,000 0 1 2 3 4 5 6 7 8 9 10 26K 5800 5800 5800 5800 5800 5800 5800 5800 5800 5800+ 14,000=19,800 Step 2) Determine whether the firm should accept or reject the project Method 1) Payback Method – determining how many years it takes to recover the initial outlays with the estimated cash inflows. Payback CFo -26,000 CF1 5,800 -20,200
CF2 5,800 -14,400 CF3 5,800 -8,600 CF4 5,800 -2,800 CF5 5,800 +3,000 Recovered Initial outlay somewhere between Year 4 and Year 5 Payback = Year before full recovery + (Unrecovered Cost at start of year/Cash flow during year) Payback = 4 + (2800/5800) = 4.48 = about 4 and a half years If required payback = 6 years then we accept Method 2) Discounted Payback Method – determining how many years it takes to recover the initial outlay with the estimated DISCOUNTED cash inflows. Disc. Payback CFo -26,000 CF1 5,272.73 -20,727.27 CF2 4,793.39 -15,933.88 CF3 -11576.25 CF4 -7614.77 CF5 -4013.43 CF6 -739.48 CF7 2976.32 +2236.84 Payback = 6 + (739.48/2976.32) = 6.25 = 6 and a quarter years Method 3) Internal Rate of Return (IRR) – the discount rate that equates the PV of expected cash inflows with the PV of expected cash outflows. PV out= PV in

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## This note was uploaded on 08/31/2009 for the course DRXL 100 taught by Professor All during the Spring '09 term at Drexel.

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Notes #2 - Finance 4/23/08 EXAM #1 Short answers 1)...

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