Fundamentals of Managing Finance Chap 12

Of capital is 10 solution steps 1 since the outflow

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Unformatted text preview: ,000) $ 6,500 Question: What is the net present value of this decision if the firm’s cost of capital is 10%? Solution steps: 1. Since the outflow takes place at year 0, its present value is its face value of $50,000. 3 Cross-reference: The model for the present value of a perpetuity first appears on pages 78–79. Chapter 12 Investing in Permanent Working Capital Assets 291 2. Use the perpetuity model to calculate the present value of the ongoing cash flows: PV PMT/r $6,500/.10 $65,000 3. NPV present value of benefits present value of costs $65,000 50,000 $15,000 Answer: The proposed investment has a net present value of $15,000. Question: What is the internal rate of return of this decision? Solution steps: Use the perpetuity model to calculate the rate of return in the cash flows, letting the year 0 outlay be the value of the variable PV: r PMT/PV $6,500/$50,000 13.00% Answer: The proposed investment has an internal rate of return of 13.00%. Question: Should this proposed investment be pursued? Answer: Yes! Its NPV is greater than zero and its IRR exceeds the firm’s cost of capital. 2. Net Annual Benefit The assumption that the ongoing cash flow change will continue indefinitely at a constant level is troubling to many people—it is, after all, difficult to predict next year’s cash flows much less flows many years into the future. As a result, some analysts prefer to use a third rearrangement of the perpetuity model: PMT net annual benefit (NAB)— the amount by which the annual benefit from an investment exceeds the amount required to cover the firm’s cost of capital r PV and calculate net annual benefit (NAB). With this technique, we calculate the cash flow required each year to support the money invested and test this number against the actual benefit provided. If net annual benefit is positive, we accept the proposed project; we reject the proposal if net annual benefit is negative.4 Example Net Annual Benefit A proposed change to permanent working capital promises the following cash flows: Year 0 Net cash flows ($50,000) Years 1– $6,500 Question: What is the net annual benefit of this decision if the firm’s cost of capital is 10%? 4 Elaboration: In investments with an initial cash flow followed by a perpetuity, such as those in this chapter, net annual benefit will always agree with net present value. When one is positive, the other will also be positive, etc. Therefore, they are perfect substitutes for each other. See Web Appendix 12A for a demonstration of why this must be true. 292 Part IV Adding Value Solution steps: 1. Use the perpetuity model to calculate the annual benefit required given the amount of the initial investment: PMT 2. NAB r PV actual annual benefit $6,500 5,000 .10 $50,000 $5,000 required annual benefit $1,500 Answer: The net annual benefit is $1,500. Each year, this investment returns the $5,000 required to support the $50,000 capital investment plus an additional $1,500 which adds to the value of the firm. Permanent Cash The line “cash” on a firm’s balance sheet refers to money held in any of several forms. These include coins and currency, demand (checking) deposits, and time (savings) deposits. Some companies also include marketable securities with their cash balance. Because there are so many varieties of “cash,” this balance sheet line is often labeled “cash and cash equivalents.” Business organizations hold cash for several reasons. Perhaps the most obvious is to pay for the operating and capital resources required to run the business. Like individuals, firms hold cash for their transactions needs and also hold extra cash as a precaution in case their spending needs unexpectedly increase.5 There are also other, less obvious reasons why firms hold cash. Large deposit balances often reduce the fees and other charges levied by banks for services such as processing of checks, credit checking, currency conversion, and letters of credit. A high cash balance raises a firm’s current and quick ratios,6 making it appear more solvent to potential creditors. Holding (or electing not to hold) cash in a particular location or currency can also minimize currency movements, thereby reducing costs and risks: the cost of excessive foreign exchange transactions, the cost of taxes on money transfers, the risk of limitations on cash movement, and the risk of expropriation due to adverse political events. 1. Cash Allocation A company’s treasury function allocates its cash (1) among the various possible types and (2) among different currencies. Types of cash Coins and bills are kept for retail transactions and petty cash, although this amount is usually held to a minimum since it earns no interest and is exposed to theft. The appropriate local balance differs among each business location due to the nature and volume of business conducted. It also differs among 5 Cross-reference and elaboration: The transactions, precautionary, and speculative motives for holding cash were first described by John Maynard Keynes. Unlike i...
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