lecture 17&18

lecture 17&18 - THE BASICS or CAPITAL BUDGETING -...

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Unformatted text preview: THE BASICS or CAPITAL BUDGETING - What is the Capital investment Decision? - Project Evaluation Models 00 Focus on: Payback Period NPV IRR MIRR - Comparing Payback Period, IRR, and NPV What is Caital Budetin and Wh is it Imortant? - ' capital investments: QLVQ/flcii-‘(WQS {3:1 hadn‘t dawn-midi, assets ’ Why are these important decisions? 1. scarce fi 2. they define the fwne of business FIN 301 AB — Fail 2011 "anc'al rF-‘Sources for assets which cannot be liquidated easily e — Richard T. Bliss. Bull”? and Terry D. Nixm, Mm" Eli'- % _ Steps in the Capital Budgeting Process Identify and estimate current and expected future cash flows. 1 2 Establish a decision rule (NPV, IRR, etc.) 3. Evaluate and rank the proposed projects. 4 Make a decision and monitor results. Project Types Mutuaily exclusive - a project whose selection depends on whether or not another project is selected independent — a project whose selection does not depend on whether or not another project is selected Project Evaluation Models Payback period or PBP Net Present Value or NPV internal Rate of Return or IRR 99°F”? As always, only cash flow matters! Emeftt ‘ E {by 4P3 baCk Period — the expected number of yea investment. @SWim Gums {graffiti mystic) Modified internal Rate of Return or MlRR 149 rs it takes to recover a project’s initial © - Richard T. Bliss. Robson University and Terry D. Nixon, Miami University FIN 301 AB - Felt 2011 45,000 Example: You have a project with the following forecasted cash flows: lea; Cash Flow 0 -$40,000 1 $20,000,, 2 $15,000, “55"” 3 $10,000 4 $ 5,000 What is the project’s payback period? 3. 4 3-900 to .000 123 ‘t (5 Year Proi. A pro-'- 3 0 '390:000 -$90,000 1 $90,000 $65,000 2 $45,000 3 4 S it“ I ,f, 13.0%“) _“——--. 4'5 .060 1 My FIN 301A,B - Fall 2011 15f! [Lame ‘7 ‘EMfiV‘hmE—gfigfl Deficiencies of the Payback Period method - ignores the time value of money“ or I155 “[514 a no consideration of cash flows occurring afler'thgpayhack period - . no economic rationale for target payback periods gulp} edwq i (I? - Calculate the Payback Period for Example 3, Example 4, and the Practice problems from the previous Lecture Net Present Value — the most theoretically correct model for evaluating investment opportunities; the measure of value a project adds to the firm. NPV = PV{cash inflows} - PV{cash outflows} ,, CF, NPV : Elm—Fl”), or, ,, CF NPV = Z ‘ so (1+ WACC)‘ CE = forecasted after-tax Operating 035“ Flow (CF) at the end Of yea” r = the required risk-adjusted rate of return 0 = the economic life of the project WACC = the appropriate weighted average cost of capital for the proiect 9 - Richard T. Bliss, Robson University and Tmy D. Nixon, Miami University FIN 301A,B—F 02011 2 151 a The decision rules associated with NPV analysis: NPV > $0 :> accept project NPV < $0 :> reject project NPV = $0 :> indifferent to project Example: Gamma Industries is analyzing a new project with the following information: Initial investment = $306,000 Annual after—tax operating cash flows: In addition, the equipment being purch $25,000 at the end of the project. If th should Gamma undertake the project? Timeline: NPV Ii FM 301 AB ~ Fall 2011 ’=° (1 + WACC)’ m 1-3 46 E $80,000 $90,000 ased will have an after-tax salvage value of 152 e firm‘s weighted average cost of capital is 15%. Lecture 17 a “135' Note that we used Gamma's existing weighted average cost of capital (WACC) as the appropriate discount rate. What does this assume about the project and its financing? How can we compute the NPV of risk-changing investments? - arbitrary adjustment, i_e_, “fudging” - CAPM approach rproject : rRF 1' ( {M — rRF) Biamiect Important: The CAPM approach gives us the cost of common stock for a company. If ‘ ’ I! equity financed firm. It the we use r - as the firm 5 WACC, we are assuming an a I I I firm has its capital structure, you will need to recalculate the firm 5 WACC using 1' m- in place of the company's usual rs. Question: Where could we obtain a Bproiect? 6 - Richard T. Bliss, Babsnn University and Terry D. Nixon, Miami University FIN 301 AB - Falt 2011 153 h" I” E154 Example: The CFO of Henderson-Cincinnati Corp. is evaluating the foilowing projects: flgjefl 991g Forecast Return A 1.9 17.5% B 1.2 14.0% C 0.8 12.0% The risk—free rate is 5% and the market return is 12%. if the firm’s overall WACC is 13% (asijan which projects should be accepted? rproject = rRF + (I'M " I.RF) Bproject 7 i751 401201 <1 i1. 01. QUEStion: What part does the company’s‘oyerell of té‘qi‘foiplay in this problem? We 3 (assume 12% WACC), Example 4 (assume CUBE Problems from the previous Lecture. FIN 301 AB — Fall 2011 1%! Internal Rate of Return jIRRj - the'annualize&rate of return a project generates on the funds invested in it. -e-——- The IRR is the interest rate that equates the PV of cash inflows with the PV of cash outflows for any project or investment. RF? is conceptually the same as YTM. What is the NPV if PV{inflows} = PV{outflows}? Thus, ,. CF NPV = z m—’—.=o _ so (1+IRR) or, ,1 CF! Initial Investment Outlay =Zr=lm How can we solve for IRR? ’ll use it in a delivery business Exam le: You can bu a truck today for $5.200. You WI for one;3 year and earn 3'" after-tax Cash Flow (CF) of $3,800. At the end of the year, the after-tax cash flow from the sale of the truck is $2.000. What is the lRR 0‘ this investment? TIMELINE: e - mama T. Bliss. Babson University and Terry D. NM Miami University FlNSD‘t B-Fafl201't 155 A1 _ 155 NM 29921531] 5:133:53 MaChine TUOIS i5 COHSiderinQ a new Stamping mBChine- The maChine Example: Sallinger’s Inc. is considering a new refrigerated truck that costs $25,000. It next 6 ea; W :dtay 3;” generates efier-tax 0:8 of $65,000 at the end of each of the increases the firm's after—tax cash flow by $4,000 in years 1-3, and by $10,000 in years y s. a IS t e R of this Investment. 4-6. What the NPV of buying the truck if the appropriate discount rate (WACC) is 9%? - I - ‘i rrer-—r~A—-l—~-—Aer A l Imtzal Investment Outlay = "_ —~’— « q— 4 a ,0 '0 10 "‘(1+IRR)’ N! [I . 1 -Ihfitfi ' I 1 " J I 4- IUGKV‘ \ ] = R WW . 00 _t W l - 051 i ‘0‘} 3 “‘ 1 ‘ What is the investment's IRR? I } 43H 5 ____l__,_ "' I "+1 1 N ‘v’ : 430:) P It“)? ] + Io.mo[Ti El Practice: You are an I ‘ ' - - ‘ ILL prOject's RR? 3 yang a pm'ect “"1 the fol'owmg cash flows. What is the U003 M m ,, —- : iatr‘sil 0 - " r ' ~ - $550,000 g? L h___ g _ JC m 330 1 $200,000 .0 L I “j i3 ‘l. 2 $400,000 . I ' T ' m NV»! : %03 9% [Egg/[=1RR 3 $250,000 ‘ __M_ _ g 4 $ 50,000 w; ' j = ~ 2 a, 5 $ 10,000 -;_ ERR Decision Rule: NWW “h med . . : - - _ 4 , acce e What ‘5 the PFOject’s IRR? ‘ ’ ' if the project's IRR > WACC, the requ1red risk adjusted return p p I - if the project’s IRR < WACC. reject the W019“ “N < O . . - ‘ he ro'ect N v : Initial Investment Outlay :2»: CF’ . ifthe project’s IRR _—_ WAcc, we are Indifferent tot D J . F (z! + 0 I ‘ g- Q ~ Richard T. Bliss, Babsori University . and Tary Dt Nixon, Miami University w e - Richard T. aim, W “M i, Fiat 301 AB —' Fall 2011 " ' mm“ 0' "WWW 157. Ft” 391 M3 - Fa" 20“ I 156 .. __n__..___.__.___.___ . _ 158 _ Calculate the MIRR for the previous problem (Sallinger’s). W’CL '- q l 3: Mariam (WV Joeslfi‘ 5m Hag pubic-eras. L133. '"”'“°'9 '33: Li"‘°"“%f‘*‘é“‘3 01:75 W “U” timid W 3 i it Lfiig‘liom, W ll \ mum): ‘E 0‘3": 70-: 9:6 4.129 EGG?) i . mince? - assumes reinvestment at the IRR q qu )u l ? - Calculate the IRR for Example 3, Example 4. and the 44 j to Practice problems from the previous Lecture. E , I l s ‘ (_ m ‘9 m r; W 4 : 1: [In — i v————_———-—— “f—hH—F—F—n4 { L10“ 5 06 SW Em LKR l 38L f: ! (‘4 n I _‘_‘_,———¢—1___J ? - Calculate the MIRR for Example 3, Example 4, and the Practice problems from the previous Lecture. Nimitz: I’l-lslal MlRRs main advantage over IRR is that it-fitfilonger assume reinvestment at the Eli Funds are now assumed to be reinvested at the firm’s WACC (this is generally a more __ Z‘Faflt l elimitzm‘m“ reasonable assumption) CIFt 1+ N" ZN 2; ( r) _. W r:O(l+r)f — where, ‘ LA! .4 COF = Cash outflows L 5 .yfii‘xic CIF = Cash inflows " TV = terminal value (the co " e . Richtd r. Bliss. Babson Un'tversity \‘ md‘fcrry D. Nixon, Miami Unwasrly 9 - Rim T. Bliss, : FiN 301. AB - Fati 2011 and Teny D. Nixon. mm 159 J FIN 301 AB - Fai12011 158 I Im— - A 5' 151] Lecture 1? as #5 .6 .07 “W; Practice: You are the financial manager for a large and highly profitable letaptt‘ug [W L 4000 manufacturing company. You are currently evaluating a project proposal involving the x to a — LI - t ’ construction of a new product line. The proposed project will have a 5—year life and will [3‘ TC k W HER - require the purchase of new capital equipment with a total purchase price of $175,000. q 3. 2C . EU. In addition, the project will require an initial $15,000 investment in supplies and spare I L 3 parts for the equipment, with of this amount financed with accounts payable. The {W new product line is expected to increase annual cash sales by $80,000 and increase r {3300:} annual cash operating expenses by $10,000. The new equipment will have a 3-year ‘ ‘ ‘ _ 1 , _ m |_MACR3,_.class life. At the end of five years, you expect to terminate the project, liquidate 42553? 7 1‘7 75 C5 ‘1’; 907% Cf m” the supplies and parts, and seli the equipment for $10,000. Assume the marginal tax rate is 34 percent. Calculate the IRR and MIRR (assume a WACC of 10%) for this bit-3’“? project. in t- .t 7 NW; weeczlo‘l- _ 1 . a _ a true {09* 0t asset (Heme) 9383:; (Hoff t 771175 Llalcf’ + astutmol 60350“) i INDUCE-I) DEM} c :snfrzt . So ’5°,Gofi—-.Lt['§000) t ‘— l‘m Ctiter) 9 .4 \J O ‘ffl—A -— -u «j ‘ ,.,, 4. ,5 TA UN’OU‘Q 7)? (LP . 95*: _ 5 _ HE firton CH men) : 377LtZl-50 “WC-Co) :H MLKRf : 377m s/Wr-‘O L 3 3’ t" 9 mm: ’S-Ltgll W0: lie“) U51) 523% €3,393 S2300 fill-WU 9m ‘icoi— K" A“ "1 £3 r-P'c'isflifi (a: ‘ costs “7”” £606 elm L) I. DOCI 14:11:. _ ‘ ,7 ’ j... ‘ ‘1 ' 5m?" HS no ‘7 , t t at .- Ste H? K2,.) _, u ‘fil .Lt; y ll: XII: / .3 six“ t at t ,w O I“@3053 -~ “h— -' .Bl' ,BbsonUni i h E %5) US Lt j 5; ' 9.3933,“; we: islianiUniEig diet) _ “' _ r ©-RichudT.BliSs.wm I; “’65 8’53 "‘m—mé” ’* a ,. and Terry 1). Nixon. Mum FIN 301 AB - Fali 201 1 FIN 301 A,B ‘ Felt 2011 7241 1‘; “~15- 16.1- N FIN 301 As — Fall 2011 mm arin N nd IRR Causes of potential disagreement between NPV and IRR: Under the following assumptions, NPV and IRR will accept and reject the same projects: - proiect size (scale) differences '—‘-_-__ {i l _ _ _ A . WWW—Witt TPlEztm‘l 1. independent proiects km 2' h’i [Ll-FL - P3 = 'Kl Wdfll‘fi {iommg w: {equfid‘ J l l EICEC'UD’C ERR: 73“ I. 2. no capital rationing lgt-i’, a ‘ ' . . . I" “is; _l - timing differences 0 s l L‘“‘ -—¢——_+—!~—*—-—*—‘* my“! \/ ‘t‘r- " this» - . low A I goo l0“ ‘ grgjlgtgne followmg assumptions, NPV and IRR may disagree regarding the ordering of ) {a LA W & WM" " gl'w “'7” - 0 es} __h______+_.__——-———-t-————"-"—l L ' l W 1:13: iii} 1. mutually exclusive projects l timings HM) m 3% {MW @57- 9 30h? \/ : up» ' 1] manila 2. capitairationing NPV yields similar conclusions to IRRs comparison relative to NPV.) (Note: A comparison of MIRR with o - Richard T. Bliss, Bataan University ' ' warm D. Him. Miami umva © - Richard T. Bliss, Babsm "W I . - ’u and‘reny D. eron. Miami FIN 301 AB — Fall 2011 152 i: 153 Lecture-w LEVERAGE - Operating versus Financial Leverage - DOL, DFL, and DTL - EBlT EPS Analysis QUESTION: What is leverage? ANSWER: > This defimfion Can appty both to a firm's operations and its choice of financing. Operating leverage is: Financial leverage is: o — Richard r. Bliss. Began} :M and Teny D. Nixon. Mm' U” FIN 301 AB - Fall 201'? 164 Lemma —nm AH- Measurement of Leverage: > Degree of Operating Leverage (DOL) percentage change in E31?" 0 safes — variable cos (3 DOI. = r percentage change in sales sales — variable costs — fixed cos 1:; > Degree of Financial Leverage (DFL) or EB” l EBIT — I - [Pfd Divx ] (lflT) DFL = percentage change in EBIT *The use of EPS and EAT only result in the same DFL for firms preferred stock. Different textbooks provide different definitions, but the use of EPS IS likely more technically correct from the common stockholder paint of vrew. ' ' ' ting leverage (I.e., degrees of o eratm leverage white other firms have little opera ' operating costs). Lifiewise, some firms operate with high degrees of financral leverggre1 e (i-en det or preferred stock) while others have low degrees of financral leverage. o Of these decisions are influenced by a tinn’s industry. Before a firm's managers set their financial leverage, they should consider its operating J risk as set by Its lfldUStW- ,, > Degree of Total Leverage (DTL) DTL : Percentage change in EPS(ar EAT) : DOL I DFL percentage change in sales e - Richard 11355, Baboon University “Terry D. Nixon, Minot Univers'Ey FIN 301 AB - Fail 201 ‘t - . ' '2 ' ‘ ‘ 7 Example: Question. How can we interpret these results. What Is their meaning. l common stockholders Common ‘Shares 70,000 7 outstanding 0.000 I EBIT EPS Analysis Earnings per share (EPS) $10 $5235 5 Sales ’ $0,000,000 $16,000,000 — variable operating costs 3,000,000 6,000,000 " - Ixed operating costs 1,000,000 1,000,000 _ _ _ g _ E'ng $4 000 000 $9 000 000 These calculations depict the concepts of business versus financial nsk discussed earlier in the semester. - interest expense 2,000,000 2,000,000 EBT $2,000,000 $7,000,000 . _ taxes (@4006) 800,000 2,300,000 E Managers of firms with high degrees of operating leverage shouid think ca;efully f before taking on high degrees of financial leverage. Firms wrth high degrees 0 PP973 "‘9 EAT $1,200,000 $4,200.000 |everage shou|d generally have relatively lower degrees of finanCial leveragethrznl: that ‘ preferred StOCk diVidendS 500.000 500,000 Operate with low levels of operating leverage are in a much better position to an Earnings available to $700300 $3.700'000 higher degrees of tinancral leverage. > How can we heip determine when it is safe for a firm to use more financral leverage (i.e., fixed cost sources of financing)? DOL = ‘ um tion that we DFL = BE CAREFUL!!! The analysis about to be presented mireeinfgfigizfionpof EPS is the Cannot always make. EBIT EPS anatysis assumes that are ahead», aware. this is not 3time as the maximization of shareholder wealth. A5 You necessarily the case. DTL = e - Ridnrd T. Bliss. Baboon University - h and I'm D. Nixon, Miami 15mm © - Richard T. Btiss, Babsolt Unites!" ; WTMDNW’MMW E Fm 301 A,B — Faii 2011 FIN 301 AB - Fatl 2011 E 166 163' ' _.__...__._...i Lecture 13 RECALL: Earnings per share (EPS) = w # of shares outstanding > in EBlT EPS analysis, the practitioner solves for an indifference EBIT. This is a speCial" EBIT at which a finn's EPS will be equivalent irregardless of the choice of financing (debt or equity}. 1‘» Let’s look at this graphically. EPS FIN 30‘! AB ~ Felt 201‘! EBIT © - Richard T. Bliss, Babsolf Um:qu anchtry D. Nixon, Miam- UM 168 E Example: The management of WCW has completed its capital budget and discovers that $6,000,000 are needed to finance a proposed project. The company faces the following capital structure choices: (1) WOW can net $30 a share from selling common stock, which wouid require issuing 200,000 shares. WCW currently has 800,000 shares of common stock outstanding and no debt. (2) WOW can borrow $6,000,000 through a bond issue at 10 percent per year. The financial manager wants to know the impact of each alternative financing source on earnings per share if earnings before interest and taxes reach $2,000,000 and $4,000,000. Financing Choice ___________________._.._ Common stock Corporate Bonds _—_____________________ Assuming EBIT = $2,000,000 EBIT $2,000,000 $2,000,000 - interest expense 0 500.000 ______‘_________._____...——-— EBT $2,000,000 $1,400,000 -taxes (40%) 300,000 500,000 ______~_____———— EAT $1,200,000 5840.000 00,000 # of shares outstanding 1.000.000 3 EP8 $1.20 51.05 Assuming EBIT = $4,000,000 000 EBIT 1543001000 $4,000. ‘ eras expense / EBT $4,000,000 $3,400,000 - 1 000,000 1360-90" taxes (40%) ' 040 000 EAT $2,400,000 52' 1 # f - 1 000,000 800.000 0 shares outstanding ' $2 55 EPs $2.40 ' 9 . gm 1'. 813531350" “Rim?” FIN301 ALB-Fall 2011 FIN 30? A.B - Fa1l2011 - 171 _ ' Lecture 18 .r 7—— £- [ Lecture 18* r Should WCW use equity or debt to finance this $6,000,000? EPS > Solve for level of EBIT at which WCW is indifferent. # of shares uutstamjingomml # of shares outstandingopm 2 EBIT“ denotes the indifference EBIT. Solve for it as an unknown. * — $0) (1 7'40) : (EBIT * - $600,000) (1 - .40) 800,000+ 200,000 800,000 EBIT Solve for EBlT‘: Choose? Question: Which type of financing should this firm be careful. This 355“ Recall: You must hareho'd maflmization. The firm’s true 908' is 5 e — Richard T. Bliss, Bahsorg WW" and Tim D. Nixon. Min“ 0""“5'” _‘_-# 1?0 .-u Derivatives Definition: Option premium — Derivatives are: 0 controversial C 1'10 “on - have led to some huge losses and failures (e.g., Procter & Gamble, Orange County, etc.) p ' D Rith to b_uy: an asset ' atan“exercise price” known today Motivation: Although we will focus on options as financial securities, the concept of options . I on a future matunty date applies all over the place: Example: ' Intel stock is $59 ' call with exercise price = X= $55 - exercise the call now = $59 - $55 = $4 0 a student has the option to drop a class if you don’t like the instructor or you think it’s a lousy class a Iand-owuer has the option to develop a piece of land if the demand for housing goes up a factory—owner has the option to close a factory if demand for the product goes down a salesperson ofien has an option in his contract to get a bonus if his sales are high a consumer has a option to return a product for a full refund if the quality is too low - you have the Option to many (entry option) or to divorce (exit optiOn) I took to g0 “P Q: Suppose you own this call and maturity date is three monthS, do you want lnte s ordown? 23‘ Call is bet the stock price will go uP :2" our immediate focus is a financial security :> what we learn applies to options found in all types of economic arrangements Q: mum rises to $62’ What is the payoff? 3’) $62-35 5:37 Q: lflntel drops to 352, what is the payoff? Options =>Ifexercised, $52-$55 = 5-3 If not exercised, $0 Definition: Therefore, best to not exercise. Let T = maturity date 3? = stock price at maturity T “c—v—’ If STSX. if STJX. mannaqu . . . than exercise Exercrse (strike) pnce ~ i 1 Important terms: i can P3303: M ST —X , 0 i : MfldAl - A2,U) is the format for a spreadshw l l i _ . were!!! 1 ‘ o — Richard T. Bliss, Babsm WW!" and Terry D. Nixon, Miami Unwm - - 2011 nusomfl Fa” , FIN 301 AB - Fan 2011 1 _ _, .n_._._....u p 72 - ...
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lecture 17&amp;amp;18 - THE BASICS or CAPITAL BUDGETING -...

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