Chapter8b+notes

# Chapter8b+notes - Chapter 8 (Contd) Fundamentals of Capital...

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Chapter 8 (Cont’d) Fundamentals of Capital Budgeting

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Spring 2009 2 Focusing Question Your car broke down last week. You took it to the auto shop and the mechanic charged \$5,000 to fix it. You estimated that the market value of the car would be \$7,000 if it was still running so you agreed to pay for the repair. However, yesterday your car broke down again. You took it back to the auto shop and this time the mechanic asked for \$3,000 to fix it. What will you do and why?
Spring 2009 3 Outline Capital Budgeting Forecasting Incremental Earnings Replacement Decisions Determining Free Cash Flows Tax Shield Approach Analyzing the Project Indirect Effects

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Spring 2009 4 Learning Objectives 1. Compute depreciation tax shield and apply the tax shield approach to directly determine a given project’s incremental free cash flows. 2. Compute the after-tax salvage value of selling a machine. 3. Explain the common pitfalls that arise in identifying a project’s incremental free cash flows including opportunity costs, project externalities and sunk costs. 4. Evaluate a replacement decision by computing the incremental cash flows. 5. Describe the methods that can be used to assess the sensitivity of a project’s NPV to changes in the assumptions.
Spring 2009 5 Calculating Free Cash Flow Directly ± Depreciation tax shield = τ c × Depreciation The cash flow effect of depreciation is reducing taxes. ± Tax Shield Approach This approach focuses on the tax savings to the firm resulted from depreciation expenses. ² Particularly useful when major FCF are the cost of equipments, e.g., in replacement decision.

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Spring 2009 6 Calculating Free Cash Flow Directly ± Incremental Free Cash Flows = (Revenues – Costs Depreciation) (1 – t c ) + Depreciation Net Capital Expenditures – Δ NWC ± Tax Shield Approach: Free Cash Flow = (Revenues – Costs) (1 – τ c ) + c × Depreciation Net Capital Expenditures – Δ NWC ± FCF for years 2-4 for HomeNet: 1. Unlevered net income + depreciation = \$1920 + \$1500 = \$3420 2. Tax shield approach = \$(7500 – 2800)(1 – 0.4) + (\$1500 * 0.4) = \$3420
Spring 2009 7 Calculating Free Cash Flow Directly 1 Year 2 2 Revenues 13,000 3 Cost of Goods Sold -5,500 4 Gross Profit 7,500 5 Selling, General & Admin -2,800 6 Depreciation -1,500 7 EBIT 3,200 8 Income Tax at 40% -1,280 9 Unlevered Net Income 1,920 ± FCF in year 2 for HomeNet Project:

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Spring 2009 8 Calculating the NPV ± At a cost of capital of 12%: HomeNet’s NPV = \$2,862 mil () (1 ) = + t t t FCF PV FCF r 1 Year 0 1 2 3 4 5 13 Incremental Free Cash Flow -7,500 2,295 3,420 3,420 3,420 1,725
Spring 2009 9 Cash Flows in a Typical Project

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Spring 2009 10 More Adjustments to Free Cash Flow ± Liquidation or Salvage Value ² Book value of the asset = purchase price – accumulated depreciation ² If the sale price (SV) is different from the book value (BV), there will be a tax effect.
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## This note was uploaded on 04/03/2010 for the course FINA FINA111 taught by Professor Lynnpi during the Spring '09 term at HKUST.

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Chapter8b+notes - Chapter 8 (Contd) Fundamentals of Capital...

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