Capital Budgeting 2_Updated

Capital Budgeting 2_Updated - Capital budgeting further...

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Unformatted text preview: Capital budgeting: further issues 1 Table of Contents 1. Components of NPV calculations 1.1 Free cash flows, not accounting income 1.2 Sunk costs 1.3 Opportunity costs 1.4 Side effects 1.5 Working capital 1.6 Company tax 1.7 Finance charges 1.8 Incremental cash flows 1.9 Inflation 2. Risk analysis in capital budgeting 3. Projects with unequal lives 4. Real option value consideration in capital budgeting 2 1. Components of NPV calculations • To include – Use free cash flows, not accounting income – Ignore sunk costs – Include opportunity costs – Include side effects – Include working capital – Include taxation – Ignore finance charges (interest and loan repayments) 3 Example 5.1 Compare accounting income and free cash flow for a two ‐ year project using a machine that costs $100m and yields EBDIT of $53m & $65m in years 1 & 2. Depreciation is on a straight ‐ line basis, and the corporate tax rate is 30% _______________________________________________ Step 1: Calculate the net income generated by the project : Year 1 2 EBDIT 53 65 Assuming cost of capital = 10% NPV=$1.9m 1. Components of NPV calculations – 1.1 Free cash flows 1.1 Free cash flows, not accounting income 4 Footnote 1 in p143 is incorrect Less depreciation 50 50 Taxable income 3 15 Less tax (30%) 0.9 4.5 Net income 2.1 10.5 Example 5.1 (cont) Compare accounting income and free cash flow for a two ‐ year project using a machine that costs $100m and yields EBDIT of $53m & $65m in years 1 & 2. Depreciation is on a straight ‐ line basis, and the corporate tax rate is 30% _______________________________________________ Step 2: Calculate the free cash flows generated by the project : Year 1 2 EBDIT 53 65 Capital outlay-100 Assuming cost of capital = 10% NPV= -$3.14m (cont) 1. Components of NPV calculations – 1.1 Free cash flows 5 Tax (30%)-0.9-4.5 Free cash flow-100 52.1 60.5 6 Example 5.1 (cont) Compare accounting income and free cash flow for a two ‐ year project using a machine that costs $100m and yields EBDIT of $53m & $65m in years 1 & 2. Depreciation is on a straight ‐ line basis, and the corporate tax rate is 30% _______________________________________________ Alternative approach: Depreciation tax shield Year 1 2 EBDIT 53 65 1. Components of NPV calculations – 1.1 Free cash flows Less tax @30% 15.9 19.5 After tax income 37.1 45.5 Plus depreciation tax shield (Dep x tax rate (30%) 15 15 Free Cash Flow 52.1 60.5 1.2 Sunk costs • Sunk costs are cash flows that have occurred in the past • These costs are irrelevant in evaluating a project – only future cash flows directly relevant for current projects should be included • Including sunk costs will generally result in underestimating NPV, introducing a bias toward the rejection of value ‐ enhancing projects 7 Example 5.2 A fee of $10,000 has been paid for a feasibility study for a potential project that costs $125,000 and is expected to yield net cash flows of $75,000 in each of the next two years. The discount rate is 10%.of $75,000 in each of the next two years....
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This note was uploaded on 03/09/2012 for the course FINC corporate taught by Professor Kim during the Three '11 term at University of Sydney.

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Capital Budgeting 2_Updated - Capital budgeting further...

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