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Unformatted text preview: Capital Budgeting
Reading: Text Chapters 13 and 12 (disregard MCC stuff in 12) Some Recent Examples I
02 April 2002: "On Monday evening, Hyundai announced its decision to locate the company's first American auto plant in Montgomery. The facility, which is expected to begin production in 2005, will employ 2,000 workers and, at peak, will produce some 300,000 vehicles a year. It's cost is projected to be in excess of $1 billion. The Alabama Legislature last month approved a $118million package of incentives to encourage Hyundai to locate its assembly plant near Montgomery." Some Recent Examples II
02 Mar, 2003: SEOUL, (AFP)  Hyundai Motor Group said it has selected Slovakia as its new production base in Europe, as the largest carmaker in South Korea expands overseas sales to tide over a domestic slump. The 700 million euro (868.7 million dollars) plant will be built in Zilina by 2006 to produce 200,000 small and mediumsize cars annually, the group's subsidiary, Kia Motors, said. Construction of the plant will begin this year, it said, adding Slovakia had offered better incentives than Poland. The plant would create about 2,400 new jobs in Slovakia. Some Recent Examples III
01 Jun, 2004: SEOUL (Reuters)  Hyundai Motor Co, South Korea's top auto maker, said on Tuesday it had been in talks to set up its first assembly line in Brazil, to avoid import taxes as it ramps up sales in South American markets. "Now we are in negotiations with the Brazilian government on the size of investment and other details." High tariffs on imports in the South American countries were the biggest reason why Hyundai wanted to have a production line in the region, he added. Some Recent Examples IV
SEOUL, South Korea, Feb. 17, 2005 Hyundai Motor Co. has announced it will build a second assembly plant in India. Hyundai Motor Co. Chairman and CEO Chung MongKoo made the announcement during an inspection tour of the company's manufacturing complex in the southeastern port city of Chennai. The new Hyundai Motor India Ltd. (HMIL) plant will have an annual capacity of 150,000 units and will be constructed on a 74.2 million square foot site adjacent to the existing facility at Chennai. Construction of the new plant is set to begin in April of this year and is expected to be completed by 2007. When the second plant is online, HMIL's annual manufacturing capacity at Chennai will be increased to a total of 400,000 units. Steps in Evaluating a Project
1. Determine the cost/purchase price of project 2. Estimate expected incremental aftertax cash flows 3. Estimate a discount rate/cost of capital 4. Calculate the project's Net Present Value (NPV) or Internal Rate of Return (IRR) 5. Monitor progress "expect what you inspect". Part I: Evaluation Criteria
Net Present Value (NPV): The present value of expected future cash flows minus the initial investment.
CFn CF1 CF2 NPV = CF0 + + + ... + 2 n (1 + k ) (1 + k ) (1 + k ) CFt = t t = 0 (1 + k ) n Rule: Undertake all positive NPV projects. Evaluation Criteria (II)
Internal Rate of Return (IRR): The constant discount rate for which the project's NPV would be zero.
CF1 CF2 CFn CF0 + + + ... + =0 1 2 n (1 + IRR ) (1 + IRR ) (1 + IRR ) CFt (1 + IRR ) t = 0 t =0
n Rule:
Decide on a hurdle rate. Accept all projects with IRR > hurdle rate. Simple Example
You are managing a small factory that makes electrical components. You are considering expanding your line of products and have a variety of options. Assume that the appropriate discount rate is constant at k=10%. The alternatives have the following cash flows:
I0 Proj. A Proj. B Proj. C Proj. D Proj. E 100 100 50 100 200 CF1 45 36 23 0 0 CF2 45 36 23 0 0 CF3 45 36 23 0 0 CF4 0 36 0 180 350 Simple Example (II)
Project A: NPV:
CFt (1 + k ) t = t =0
n IRR:
n CFt (1 + IRR ) t = 0 t =0 Criteria Comparison
NPV Proj A Proj B Proj C Proj D Proj E 11.91 14.12 7.20 22.94 39.05 IRR .1665 .1637 .1801 .1583 .1502 Part II: NPV Discount Rate
Discount Rate/Cost of Capital must reflect systematic risk of the investment project being considered. Problem: how can you measure systematic risk? Second best solution: Calculate the current cost of capital for the firm as a whole. Reflects systematic risk of firm. Appropriate if new project is similar to existing business of firm. Relatively easy to calculate cost of capital in an efficiently functioning market. Projects having a positive NPV calculated using the cost of capital for the firm as a whole will generate enough wealth to make all investor groups happy. Cost of Capital
Weighted Average Cost of Capital (WACC): WACC = wd k d (1  ) + w ps k ps + ws k s
Weights (wd, wce, wpe) represent % of funding. Should reflect firm's optimal capital structure. Relative market values are best proxy. k's represent required rates of return. ytm for debt. DCF estimate for preferred stock using DDM CAPM or DDM, or bond yield plus premium estimate for common stock. Example (I)
Assume that corporate taxes are 35% and that a firm is financed with the following securities: Market Market value of common stock = $50m, =1.3, no dividend, krf = 4.5% value of debt (bonds) = $25m, M=$1,000, c=6%, Vd=$985, Maturity = 30 years. Market value of preferred stock = $3.5m, price=$35, dividend=$3.10 per share. Example (I)
Market Value of Firm: Weights: Returns: Example (I) WACC = wd k d (1  ) + w ps k ps + ws k s Example (II)
Corporate taxes are 35%. Firm is financed with the following securities: Common Equity: 10,000,000 shares price per share = $50 =.85 200,000 bonds face value per bond = $1000 market price per bond= $1075 coupon rate = 7.5%, 5 years to maturity Debt: Example (II)
Market Value of Firm: Weights: Returns: Example (II) WACC = wd k d (1  ) + w ps k ps + ws k s Is WACC Always Appropriate? When is WACC appropriate? Complication # 1: New business line Complication #2: Internal versus external capital. Part III: Estimating Cash Flows
1. Use cash flows not accounting earnings. 2. Make sure cash flows are incremental. Account for externalities by comparing firm with the project versus without Disregard sunk costs. Include the opportunity cost of using existing equipment, facilities, personnel etc. Include nonobvious indirect costs required to support the new project. 3. Factor in inflation. 4. Make sure cash flows are after tax. 5. Ignore financing costs (i.e. interest expense). The Recipe
1. 2. Compute initial investment (CF0) Compute incremental revenues & expenses Include depreciation Exclude interest expense 3. 4. 5. Deduct taxes Add back depreciation Account for additional investments in later periods Additional CAPX for expansion Additions to Net Working Capital to support growth 6. Compute a terminal/salvage value. Example (III)
Consider a project with the following characteristics: Equipment cost: $500,000 Incremental Revenue: yr1: $400,000 yr2: $600,000 yrs 35: $1,000,000 Additional salaries and materials: yr1: $400,000 yr2: $500,000 yrs 35: $700,000 Straight line depreciation, 5 year life. Tax rate 35%. Cost of Capital: 15% Example (III)
0 1 2 3 4 5 I0 Revenue Expenses Depreciation Income (before tax) Tax +Depreciation After tax CF PV @ 15% Step 1: Initial Investment
Initial investment (CF0):
New PP&E. Installation expenses + shipping. Special training. Tax credits. Aftertax inflow from sale of old equipment (if any). Net Working Capital Step 2: Revenues  Expenses
Incremental Revenues & Expenses:
Actual revenues & expenses of new project. Cannibalization / Synergies. Opportunity cost of services provided to or by existing operations. Depreciation. Actual overhead expenses. Disregard sunk costs and interest expenses. Step 3: Taxes
Use the firm's marginal tax rate.
Income Range 050,000 50,00175,000 75,00110,000,000 >10,000,000 Surtaxes 100,000335,000 15,000,00018,333,333 5% 3% Tax Rate 15% 25% 34% 35% Step 4: Add Back Depreciation
Depreciation: What happens when money is spent on long lived plant and equipment? Straight line depreciation: Depreciation expense is equally divided over the life of the asset. Modified Accelerated Cost Recovery (MACRS): Assets are grouped into one of eight classes. Each class depreciated over a set number of years. Depreciation is frontloaded. Depreciation Example
Your company has just purchased a machine for $100,000. It is in the 5 year dep. class. What is straight line depreciation per year? Using MACRS
Year 1 2 3 4 5 6 Depreciation $20,000 $32,000 $19,000 $12,000 $11,000 $6,000 Which method: maximizes earnings? Minimizes taxes? Step 5: Additional Investments
1. Additional CAPX 2. Net Working Capital: Cash + Inventories + Accounts Receivable  Accounts Payable
NWC is a temporary cost, however, it ties up $! Step 6: Terminal Value
Terminal Value: Grab bag for all remaining cash flows occurring at the end of the project: Assume assets have book value=0 (fully depreciated) but can be sold for $10,000. Assume assets have book value of $6,000 and can be sold for $10,000. Assume assets have book value of $6,000 and can be sold for $2,000. Example
MSW Inc. is considering the introduction of a new product: the TurboWidget.... TW's were developed at an R&D cost of $1M. New machines to produce TW's cost $2M, have a life of 15 yrs and an expected scrap value of $50K. Company will use straight line depreciation, 10 yrs. TW will be painted using an already existing painting machine with excess capacity that costs $30K to run regardless of output. Additional salaries required = $40K per year. Expected sales = $400K, but sales of regular widgets will be cannibalized by $20K. Additional working capital of $200K is needed over project life. Tax rate = 35%. The Recipe (Again)
1. 2. Compute initial investment (I0) Compute incremental revenues & expenses Include depreciation Exclude interest expense 3. 4. 5. Deduct taxes Add back depreciation Account for additional investments in later periods Additional CAPX for expansion Additions to Net Working Capital to support growth 6. Compute a terminal/salvage value. Spreadsheet
Yr 0 Yr 1 Yr 2 Yr 3 ... Yr 10 Yr 11 ... Yr 15 MSW'S Cost of Capital
Assume MSW's capital structure is as follows: Common Stock: 20,000,000 shares @ $18 per share. Beta = 1.5 Riskfree rate = 4.5% 200,000 bonds selling at par of $1,000 per bond. Coupon rate = yieldtomaturity = 6%, n = 15 years. Debt: Calculate WACC
Weights: ke: kd: Calculate NPV, IRR CFt NPV = = t t = 0 (1 + k ) n CFt IRR : =0 t t = 0 (1 + IRR ) T Another Example: Cash Flows
You work for a steel company in Columbia. The CEO is contemplating adding a special assembly line that would make topend softball bats using a new aluminum extrusion process. The following details about the proposed project have been provided to you. Equipment cost: $10 million Installation cost: $2 million R&D previously spent in developing the extrusion process: $ 5 million Expected life of assembly line: 4 years. Depreciation method: straight line Expected Salvage Value: $2 million Sales: $6.5 million per year Raw material costs: $1.5 million per year Worker Salaries: $1 million per year Required Net Working Capital: $2 million Marginal tax rate: 35% Another Example: WACC
Estimate your firm's Weighted Average Cost of Capital. Assume that the current riskfree rate of interest is 1.25%, the market risk premium is 7%, and the corporate tax rate is 35%. Debt: Total book value: $15 million Total market value: $17 million Coupon rate: 7% Yield to Maturity: 6% Preferred Stock: Total book value: $4 million Total market value: $5 million Price per share: $20 Dividend per share: $1.80 Common Stock: Total book value: $20 million Total market value: $23 million Beta = 1.3 Summary
Use the NPV rule to evaluate projects
CFt NPV = (1 + k ) t t =0
n WACC = wd k d (1  t ) + w ps k ps + ws k s
Follow the 6 step recipe for cash flows. Use WACC to estimate the cost of capital: ...
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This note was uploaded on 02/14/2011 for the course FINA 363 taught by Professor Masoudie during the Fall '10 term at South Carolina.
 Fall '10
 Masoudie
 Finance

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