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Chapter 8, 9, 10 Notes, Questions, and Answers

Things to Remember
1. Dierence between independent and mutually exclusive. 2. Dierence between ordinary payback and discounted payback 3. If project is replacement or expansion. 4. If replacing old machinery with new take into account the incremental cash ows.

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2.1

Chapter 8 Notes
Capital Budgeting categories:

1. Replacement projects. 2. Expansion projects. 3. New products and services. 4. Regulatory, safety, and environmental projects.

2.2

Principals of Capital Budgeting.

1. Timing of cash ows is crucial. Time Value of Money 2. Incremental Cash Flows. 3. Cash ows are analysed on an after-tax basis. 4. Financing costs are ignored. 5. Cash ows are not net income.

2.3

Capital budgeting concepts.

1. A sunk cost is one that has already been incurred. 2. An opportunity cost is what a resource is worth in its next-best use. 3. Independent versus mutually exclusive.

2.4

Capital budget procedures

NPV IRR Payback Period Protability Index

2.4.1

Drawbacks of Payback

Does not take into account time value of money ignores cash ows after payback. Projects with shorter paybacks may have lowest NPV

2.4.2

Pitfalls of IRR

Borrowing or Lending Multiple Rates of Return Mutually Exclusive. Diering Cash ow patterns and Scale.

2.5 2.6

NPV and Stock Prices Investment Timing

You may purchase a computer anytime within the next ve years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer?

Chapter 9 Notes

1. Initial Outlay: Outlay = F CInv + N W CInv where FCINV=investment in new xed capital. NWINV=investment in net working capital. 2. Annual after-tax operating cash ow: CF = (S C D)(1 T ) + D or CF = (S C)(1 T ) + T D where S=Sales C=cash operating expenses D=depreciation charge T=taxes (3) (2) (1)

3. Terminal year after-tax nonoperating cash ow: T N OCF = SALT + N W InvT (SalT BT ) where SALT=cash proceeds from sale of xed capital BT=Book value of xed capital on termination date. (4)

Chapter 10 notes

Risk is the measure of the dispersion of outcomes. In this case we measure the riskiness of a project by the dispersion of NPVs or IRRs. 1. Sensitivity Analysis - Analysis of the eects on project protability of changes in sales, costs, etc. 2. Scenario Analysis - Project analysis given a particular combination of assumptions. 3. Simulation Analysis - Estimation of the probabilities of dierent possible outcomes. 4. Break Even Analysis - Analysis of the level of sales at which the company breaks even.

4.1

Real Options

Timing options: A company can delay investing. Sizing or Abandon: If the cash ow from abandoning a project exceeds the PV of cash ows from continuing than abandon. Flexibility: Fundamental option: The payos from the investment are contingent on an underlying asset. Ex. the value of an oil well is contingent on the price of oil.

Chapter 8 Questions

Use Table 1 to answer questions 1-6. The required rate of return is 8%. Table 1: Capital Budgeting Year Cash ow 0 -50,000 1 15,000 2 15,000 3 20,000 4 10,000 5 5,000

1. Calculate the NPV. 2. Calculate the IRR. 3. Should you invest? 4. Calculate the payback period. 5. Calculate the discounted payback period. 6. Calculate the protability index. Use Table 2 to answer questions 7-8. The required rate of return is 12%. Table 2: Independent and Mutually Exclusive Project A 15,000 5 years 5,000/year Project B 20,000 4 years 7,500/year

Initial Cost Life Cash inows

7. If the projects are independent the company should accept both, reject both, accept A and not B, or accpet B and not A? 8. If the projects are mutually exclusive the company should accept both, reject both, accept A and not B, or accpet B and not A?

Use Table 3 to answer question 9. Table 3: Mutually Exclusive: Magnitude year A B 0 -100 -400 1 50 170 2 50 170 3 50 170 4 50 170

9. If the two projects in Table 3 are mutually exclusive which one would you choose if the discount rate is 10%? 10. You are interested in investing in a new computer. The cost today is 950. The cost next year is 900. The present value of the savings is 1150. The discount rate is 10%. Should you buy today or next year?

CHAPTER 9 QUESTIONS

Questions 1 to 5 refer to the following information. You are an analyst with Smith Securities. One of the companies that you follow is Mac Company. Mac Company is considering the purchase of a new 400-ton stamping press. The press costs $400,000. The press will depreciate straight line to 0 over a ve-year life. The press will generate $200,000 in revenues and $60,000 in operating expenses. The press will be sold for $120,000 after ve years. An inventory investment of $60,000 is required during the life of the investment. Mac is in the 40 percent tax bracket. The cost of capital is 10%. 1. What is Macs net investment outlay? 2. What is Macs annual after-tax operating cash ow? 3. What is the terminal years after-tax nonoperating cash ow at the end of year 5? 4. What is the NPV? 5. Invest or Not?

6. Your supervisor tells you that you are relying too heavily on the NPV approach in order to value the investment decision. She thinks that you should use an IRR approach because of the mutually exclusive problem. How should you respond to your supervisor? 7. Quick computing installed equipment 3 years ago. This equipment becomes obsolete in 5 years. It originally cost 40 million and they use straight-line depreciation. It can be sold now for 18 million. The tax rate is 35%. What is the after-tax cash ow from the sale? 8. Your boss tells you they want to replace old equipment with new equipment. She gives you the following numbers to calculate the initial outlay and operating cash ows. The tax rate is 40%. Table 4: Replacement
Variable BV MV Sales Expenses Depreciation Old 400 500 200 100 30 New 1000 300 130 50

Chapter 10 Questions
1. A project generates sales of $10 million, variable costs equal to 50% of sales, and xed costs of $2 million. The rms tax rate is 35%. What are the eects of the following changes on after-tax prots and cash ow? A. Sales increase from 10 to 11 million. B. Variable costs increase to 65% of sales. 2. The project in the review question 1 will last for 10 years and the discount rate is 12%. What is the eect on project NPV of each of the changes considered in the problem?

3. Explain why options to expand or contract production are most valuable when forecasts about future business conditions are uncertain? 4. The initial outlay is $200,000. Project Life is 5 years. Cash ow is $60,000. Salvage value is zero. The required rate of return is 10 percent. In one year, after realizing rst-year cash ow, the company has the option to abandon the project and receive the salvage value of $200,000. Should the Company Abandon? 5. A farm estimates the NPV for a new plant to be -2 million. The farm is evaluating an incremental investment of 6 million that would give management the exibility to switch between coal, natural gas, and oil as an energy source. The original plant relied only on coal. The switch has an estimated value of 10 million. What is the value of the new plant?

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1.

Chapter 8 Answers

N P V = 50, 000 + 13, 889 + 12, 860 + 15, 876 + 7350 + 3, 402 = 3, 378.83 2. The IRR is 10.88% With the TI calculator the IRR can be calculated with: 50,000 +/- Enter 13, 889 12, 860 15, 876 7, 350 3, 402 IRR CPT 3. NPV is positive and IRR is greater than the cost of capital so invest. 4. You break even in the third year. So the payback is 3 years. Table 5: Payback
Year Discounted Cash ow Cumulative 0 -50,000 -50,000 1 15,000 -35,000 2 15,000 -20,000 3 20,000 0 4 10,000 10,000 5 5,000 15,000

(5)

Enter

Enter Enter Enter Enter

5. The discounted payback uses discounted cash ows. Table 6: Discounted Payback
Year Discounted Cash ow Cumulative 0 -50,000 -50,000 1 13,889 -36,111 2 12,860 -23,251 3 15,876 -7,374 4 7350 -24 5 3,402 3,378

The discounted payback is 4 years plus 24.09/3402=.007 or 4.01 years. 6. PI = PV 53, 378 = = 1.067 InitialInvestment 50, 000 9 (6)

7. Independent projects accept all with positive NPV or IRR greater than cost of capital. Project A NPV is 3,024 and Project B NPV is 2,780. So accept both. 8. Accept the project with highest NPV which is Project A. 9. Calculate NPV and choose one with the highest NPV. Project A has a NPV of 58.49 and project B has a NPV of 139. Project B is the better of the two. 10. The NPV today is 1150-950=$200 The NPV next year is Wait until next year.
1150900 =$227 1.1

Chapter 9 Answers
1. The investment outlay is

Outlay = F CInv + N W CInv Sal0 + T (SAL0 B0 ) (400, 000) + 60, 000 0 + 0 = $460, 000 2. Depreciation is $400,000/5=$80,000 per year. The after-tax operating cash ow: CF = (S C D)(1 T ) + D = [200, 000 60, 000 80, 000](1 .40) + 80, 000 = $116, 000 3. The terminal year nonoperating cash ow is T N OCF = Sal5 + N W CInv T (Sal5 B5 ) = 120, 000 + 60, 000 .4(120, 000 0) = $132, 000 4. The NPV N P V = 460, 000 + 116, 000[ 1 1 132, 000 ]+ = $61, 700 5 .1 .1(1.1) 1.105

(7) (8)

(9) (10)

(11) (12)

(13)

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5. Yes, invest. NPV is positive. 6. I would tell my supervisor that there is only one project and therefore IRR and NPV will give us the same answer. 7. Depreciation expense per year = $40/5 = $8 million Book value of old equipment = $40 (3 x $8) = $16 million After-tax cash ow = $18 [0.35 x ($18 $16)] = $17.3 million 8. Initial Outlay = 1000-500 + .4(500-400)=540 Operating Cash Flow = [(300-200) - (130-100) - (50-30)](1-.40) + (50-30)=50

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Chapter 10 Answers

1. a. (Revenue expenses) changes by: $1 million $0.5 million = $0.5 million After-tax prots increase by: $0.5 million x (1 0.35) = $0.325 million b. Expenses increase from $5 million to $6.5 million. After-tax income and cash ow decrease by: $1.5 million x (1 0.35) = $0.975 million 2. The 12%, 10-year annuity factor is=5.65022 The eect on NPV equals the change in CF x 5.65022 a. $0.325 million x 5.65022 = $1.836 million b. $0.975 million x 5.65022 = $5.509 million 3. Options give one the ability to change your actions is most important when the ultimate best course of action is most dicult to forecast. 4. Four years of $60,000 cash ow has a PV of $190,191. This is lower than the $200,00. Do Abandon 5. The NPV includes the real option. NPV = NPV(original)-cost of option-value of option = -2-6+10 =$2 million

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