...Learning Team Reflection The net present value (NPV) is the total present value of a time series of cash flows. NPV is used to determine what an investment is worth (present value of all cash flows) and how much it costs. The NPV of an investment is found when cash flows are discounted at the projects required return rate, otherwise known as a discount rate (Emery, Finnerty & Stowe, 2007). Discount rates reflect the riskiness of the expected future cash flows of a project. However, NPV should be calculated using a project specific discount rate due to the wide range of non-diversifiable risks specific to each project. If a firm uses a single discount rate to compute NPV of a portfolio of projects, it will assume more risk over time. This is because different projects may actually have lower risks or diversifiable risks (that can be eliminated through diversification) or higher risks. In that case, using one discount rate will apply higher risk to otherwise lower risk projects or lower risk to high risk projects masking the actual riskiness of the project. Any decisions made purely using NPV as the criteria may end up being incorrect or inaccurate, which will add more risk to a firm over time. Net present value is the total present value of a time series of cash flows. The net present value (NPV) method discounts all cash flows at the projects require return (Emery, Finnerty & Stowe, 2007). If a company uses this method it is because the projects are independent of each...
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...TO CAPITAL BUDGETING 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 Overview 159 The NPV Rule for Judging Investments and Projects 159 The IRR Rule for Judging Investments 161 NPV or IRR, Which to Use? 162 The “Yes–No” Criterion: When Do IRR and NPV Give the Same Answer? 163 Do NPV and IRR Produce the Same Project Rankings? 164 Capital Budgeting Principle: Ignore Sunk Costs and Consider Only Marginal Cash Flows 168 Capital Budgeting Principle: Don’t Forget the Effects of Taxes—Sally and Dave’s Condo Investment 169 Capital Budgeting and Salvage Values 176 Capital Budgeting Principle: Don’t Forget the Cost of Foregone Opportunities 180 In-House Copying or Outsourcing? A Mini-case Illustrating Foregone Opportunity Costs 181 Accelerated Depreciation 184 Conclusion 185 Exercises 186 158 0195301501_158-192_ch7.qxd 11/3/05 12:47 PM Page 159 CHAPTER 7 Introduction to Capital Budgeting 159 OVERVIEW Capital budgeting is finance terminology for the process of deciding whether or not to undertake an investment project. There are two standard concepts used in capital budgeting: net present value (NPV) and internal rate of return (IRR). Both of these concepts were introduced in Chapter 5; in this chapter we discuss their application to capital budgeting. Here are some of the topics covered: • Should you undertake a specific project? We call this the “yes–no” decision, and we show how both NPV and IRR answer this question. • Ranking projects: If you have several alternative investments...
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...Chapter 13 ------------------------------------------------- Capital Budgeting: Estimating Cash Flow ------------------------------------------------- and Analyzing Risk ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 13-1 The firm’s FCFs reflect both its past and current investments. Past investments produce current FCFs, but current investments are expected to add to FCF at some future point. Conceptually, a project’s projected cash flows and are expected to contribute that same amount to the firm’s future free cash flows. In practice, project cash flows are analyzed to determine what projects the firm will invest in, and then the sum of those investments, and the cash flows they produce, will in the future be reflected in the firm’s FCFs. If a firm identifies and then invests in positive NPV projects, this will increase the value of its operations as determined by the FCF model. The central issue is analyzing individual projects, and here the key factor is assessing the cash flows. See the BOC spreadsheet model. We go through the model to show how capital budgeting projects are analyzed. In this case, the initial NPV, IRR, and MIRR, all evaluated at the 12% average cost of capital and using the expected input values, indicate that the firm should accept the project. However, the risk analysis as done in the scenario analysis indicates that the project is riskier than average, hence the evaluation should be done with a somewhat higher WACC...
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...influence the size and risk of a project’s cash flows by taking different actions during the project’s life. They are referred to as real options because they deal with real as opposed to financial assets. They are also called managerial options because they give opportunities to managers to respond to changing market conditions. Sometimes they are called strategic options because they often deal with strategic issues. Finally, they are also called embedded options because they are a part of another project. b. Investment timing options give companies the option to delay a project rather than implement it immediately. This option to wait allows a company to reduce the uncertainty of market conditions before it decides to implement the project. Growth options allow a company to expand if market demand is higher than expected. This includes the opportunity to expand into different geographic markets and the opportunity to introduce complementary or second-generation products. It also includes the option (an abandonment option) to abandon a project if market conditions deteriorate too much. Flexibility options allow a company to have flexibility in their operations, such as the flexibility to use different fuels or different types of machinery. c. Decision trees are a form of scenario analysis in which different actions are taken in different scenarios. 20-2 Postponing the project means that cash flows come later rather than sooner; however...
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...a. -$22,180 b. -$30,000 c. -$33,600 d. -$36,000 e. -$40,000 Risk-adjusted discount rate Answer: c Diff: E [ii]. Dandy Product's overall weighted average required rate of return is 10 percent. Its yogurt division is riskier than average, its fresh produce division has average risk, and its institutional foods division has below-average risk. Dandy adjusts for both divisional and project risk by adding or subtracting 2 percentage points. Thus, the maximum adjustment is 4 percentage points. What is the risk-adjusted required rate of return for a low-risk project in the yogurt division? a. 6% b. 8% c. 10% d. 12% e. 14% Medium: [MACRS table required] New project NPV Answer: d Diff: M [iii]. Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for $10,000. The firm expects to be able to reduce net operating working capital by $15,000 when...
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...TEAM 5 AYSEL NAZIROVA BANU ALIZADA KHAVAR GULIYEVA KONUL AHMADOVA SHAFIGA MAMMADZADA SADRADDIN RZAYEV- CAPTAIN 1. RAINBOW PRODUCTS A. Rainbow should not purchase this equipment by looking at NPV as the purchase criteria because it seems that although IRR may give the false impression of 14.15% return on investment, when those cash flows get discounted at the rate of cost of capital, the total payback comes to $34,054 which means we are actually paying $946 more today compared to sum of the benefits we will get through labor costs reduction for 15 years. Machine Savings per year | $5,000 | Machine cost | $35,000 | Machine lifetime (yrs) | 15 | Cost of Capital ( r ) | 12.00% | | | Payback period | 7.00 | Total Present Value | $34,054 | Net Present Value | ($946) | Internal rate of return | 14.15% | Payback period | 7.00 | Total Present Value | $34,054 | Net Present Value | ($946) | Internal rate of return | 14.15% | B. Yes because with this new payment of $500 we will gain $2,500. Total savings ($4500 in perpetuity will be able to cover the total cost of the machine: which is initial investment ($35,000) + give us $2,500 extra return. Cost of "Good as New" Additinoal Expenditure per year | $500 | | | | | Machine savings per year | $4,500 | Machine cost | $35,000.00 | Total Present Value | $37,500 | Net Present Value | $2,500 | C. Actually this is even better than option B indeed this way the...
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...University of Nottingham Ningbo China Business School Academic Year 2015/16 Autumn Semester CORPORATE FINANCE Prof. Michele Geraci Analysis of Boeing Investment Plan Yuliana Tan Student ID: 6519982 Word Count: 2,220 (exc. Table of Contents, Tables, Charts & References) Executive Summary This paper discusses whether The Boeing Company should build a plant specializing in producing aircraft 787 in China. Having analyzed the project from a purely financial view, through the calculation of NPV, IRR, Profitability Index (PI) and Payback Period for 30 years, it is recommended that The Boeing Company do so. The project is assumed to start in 2016, with 2 years construction and sales beginning in 2018. The calculations are made on the assumption that all 787planes will be solely produced in China's plant with other plants ceasing the production of this model once China plant has been set up and sales start in 2018. With an initial investment of USD 6.5 Billion, The Boeing Company will be financing the project with 80% debts and 20% equities. Further assumption is made on the source of the capital. Equity will be gained by issuing stocks on the NYSE, hence, the calculation of the project is in USD; the cost of debt, in this case, follows the US lending rate (3.5%) assuming Boeing borrows from the American Bank with a constant rate. The plant will be located in Chong Qing province, specifically Jiangbei district. The reason for this is that Chong Qing is the fourth major municipal...
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...of sales 22% of sales Repair and maintenance cost 10, 000 (THB) / year Case Overview Beach Karaoke Pub Capital structure (75% equity & 25% debt) Debt – loan from Siam Commercial Bank – interest rate 10% Hotel owners’ cost of equity - 12% Corporate tax rate – 30% Future profits – discounted 5% Risk factor – 25% Conservatism- risk factor (consideration due to the negative factor for pub) Question 1 Assess the economic benefits associated with each of the capital projects. What is the initial outlay? What are the incremental cash flows over the life of the project? What is an appropriate discount rate to use for discounting the cash flows of the projects? Initial Outlay Planet Karaoke Pub To invest THB 770,000 or THB1,000,000? Beach Karaoke Pub To invest THB1,700,000 or THB2,100,000? Incremental Cash Flows Planet Karaoke Pub Year Annual Cash Flow (THB) -Lower Annual Cash Flow (THB) - Upper 0 -770,000.00 -1,000,000.00 1...
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...Contents 1:0 TO IDENTIFY THE RELEVANT CASH FLOWS TO EVALUATE THE PRODUCTION OF THE NEW SECURITY RIGHT 1 1.1 OPORTUMNITY COST 1 1.2 CASH FLOWS VS PROFIT 2 1.3 WORKING CAPITAL 2 1.3 OVERHEARDS 2 1.4 SUNK COST 2 2.0 A REPORT ON THE RECOMMENDATION IF THE PROJECT IS ACCEPTED OR REJECTED 3 3.0 TO CALCULATE THE NET PRESENT VALUE OF THE NEW PRODUCT USING GLOW PLC 3 4.0 TO CALCULATE THE INTERNAL RATE OF RETURN 4 5.0 TO WRITE A REPORT ON THE ADVISABILITY OF ACCEPTING THE CONTRACT AND ANY ADDITIONAL FACTORS TO BE CONSIDERED 5 1:0 TO IDENTIFY THE RELEVANT CASH FLOWS TO EVALUATE THE PRODUCTION OF THE NEW SECURITY RIGHT For the financial managers to evaluate investment opportunities, they must first determine the relevant cash flows which are the incremental investment and resulting subsequent inflows associated with the proposed capital expenditure. Incremental cash flows are the additional operating cash flow that an organization receives from taking on a new a project, and this incremental cash flow is divided into scenarios and namely; the positive incremental cash flow and the negative cash flow. The positive incremental cash flow means that the company’s cash flow will increase with the acceptance of the project and vice versa. The following are the relevant cash flows that have been identified in the production of the new security right in Glow Plc. of an Irish manufacturer. 1.1 OPORTUMNITY COST Opportunity cost refers to what you have to give up buying what...
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...500 | 65.000 | 32.500.000 | | | | | | | | | 2 | 500 | 82.000 | 41.000.000 | | | | | | | | | 3 | 500 | 108.000 | 54.000.000 | | | | | | | | | 4 | 500 | 94.000 | 47.000.000 | | | | | | | | | 5 | 500 | 57.000 | 28.500.000 | | | | | | | | | | | | | | | | | | | | | Annual Depreciation | | | | | | | | | Year | MACRS % | Depreciation | Ending Book Value | | | | | | | | | 1 | 14,29% | 4.644.250 | 27.855.750 | | | | | | | | | 2 | 24,49% | 7.959.250 | 19.896.500 | | | | | | | | | 3 | 17,49% | 5.684.250 | 14.212.250 | | | | | | | | | 4 | 12,49% | 4.059.250 | 10.153.000 | | | Total Cash Flow = OCF - Change in NWC - Capital Spending (Initial Investment) | 5 | 8,93% | 2.902.250 | 7.250.750 | | | | | | | | | 6 | 8,92% | 2.899.000 | 4.351.750 | | | | | | | | | 7 | 8,93% | 2.902.250 | 1.449.500 | | | | | | | | | 8 | 4,46% | 1.449.500 | - | | | | | | | | | | 100,00% | | | | | | | | | | | | | | Income Statement | | | | | | | | Year | | | | Year | 0 | 1 | 2 | 3 | 4 | 5 | | | | | | Revenue | | 32.500.000 | 41.000.000 | 54.000.000 | 47.000.000 | 28.500.000 | | | | | | Variable costs | | 13.975.000 | 17.630.000 | 23.220.000 | 20.210.000 | 12.255.000 | | | | | | Fixed costs | | 4.300.000 | 4.300.000 ...
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...save for a rainy day. Businesses are no different. But what we call mad money, they call free cash flow. Free cash flow is the remaining cash flows that are available for use by a company to bring added wealth and value to the shareholders after all the bills have been paid. It represents real cash. The presence of free cash flow indicates that a company has cash to expand, develop new products, buy back stock, pay dividends, or reduce its debt. High or rising free cash flow is often a sign of a healthy company that is thriving in its current environment (investinganswers.com). There is an extensive selection of criteria for selecting projects. Some may want to select projects that show instantaneous increases in cash inflow, while others may want to concentrate on long-term growth. Examples of projects include investments in property, plant and equipment, and research and development projects. Bauer Industries, an automobile manufacturer, was presented with a proposal to build a plant that will manufacture lightweight trucks. The plan utilized a cost of capital of 12% to evaluate the project over a ten year period. Based on extensive research, an incremental free cash flow projection (in millions of dollars) was prepared. The net present value of the estimate free cash flow to manufacture the lightweight trucks was determined using the following formula: NPV = -150 + 36 x 1/(.12) (1- 1/〖1.12〗^9 ) + 48/〖1.12〗^10 = -150 + 36 x 8.33333(1- 1/2.77308) + 48/3...
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...FNBK 3250 Review Sheet for 3rd exam CHAPTER 10 COST OF CAPITAL Calculate cost of each capital source: After-tax (AT) cost of debt = rd(1 - T), where rd is the before-tax cost of debt and T = tax rate. Likewise, rd = AT/(1 – T). (rd = YTM on bonds) Cost of preferred stock= rp =Dp/Pp; where Dp is annual dividend payment per share and Pp is the preferred stock price per share. Cost of Retained Earnings= rs Constant growth model: rs = D1/Po + g; D1 = Do(1 + g) CAPM model rs = rrf + (rm – rrf)b Cost of New Common Stock (re): D1 re = --------- + g where Pn = net price = Po(1 – F%) or $Po - $F Pn F% or $F= flotation cost per share re typically higher than rs because of flotation costs. Weighted Average Cost of Capital (WACC) = wdrd(1 - T) + wprp + wc(rs or re) calculate WACC with retained earnings calculate WACC with new common stock Capital structure weights (wd, wp, wc) based on book values. The weight is the dollar amount of the capital type divided by total assets. The sum of the weights must equal 100%. Calculate the breakpoint: the amount of new capital a firm can raise before it uses up its level of retained earnings and has to issue new common stock to finance its investments. $retained earnings $net income x (1 – dividend payout ratio) Breakpoint = --------------------------------...
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...It’s been two months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation, but also to respond to a number of questions aimed at judging your understanding of the capital budgeting process. The memorandum you received outlining your assignment follows: TO: The Assistant Financial Analyst FROM: Mr. V. Morrison, CEO, Caledonia Products RE: Cash Flow Analysis and Capital Rationing We are considering the introduction of a new product. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last five years and then, because this is somewhat of a fad project, to be terminated. The following information describes the new project: Cost of new plant and equipment: $7,900,000 Shipping and installation costs: $ 100,000 Unit sales: Year Units Sold 1 70,000 2 120,000 3 140,000 4 80,000 5 60,000 Sales price per unit: $300/unit in years 1–4, $260/unit in year 5 Variable cost per unit: $180/unit Annual fixed costs: $200,000 Working-capital requirements: There will...
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...net cash flow. We have used three options such as a. Timing option, b. Decision Tree Analysis, and c. Option to Wait (Black Scholes Model). |1. Timing Option | We have used Timing Option to calculate the NPV if the stocks were issued immediately. Here we consider FCF in the three methods. Here, we assume 30% probability for high demand, 40% for average and 30% for low demand. We calculated the net annual cash flow for each scenario and then calculated the expected NPV for the issuance. |Demand |Probability |Annual FCF |E(NPV) | |High |30% |142400.97 |686590.51 | |Average |40% |109539.20 |526734.24 | |Low |30% |76677.44 |366877.96 | If Spiegel issued the stocks immediately the Expected net present value gained by the company would be $526734.24 thousand. |2. Decision Tree Analysis | Here we consider three types of demand a. high, b. average, and c. low. Then we calculated the average cash flow for each scenario, then we got net present value. Then we calculated expected NPV. Then we compare this NPV with the expected NPV if there was immediate issue. |0 |Probability |Cost |Future Cash...
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...NPV We can compute a net present value for each project to decide which project creates more value. First, we need to figure out the initial cash outflow of each project. Table 1 and table 2 illustrate the initial cash outflows of MMDCL and DYOD separately. As the upfront R&D and marketing are tax deductible and the tax rate is 40%, the initial expenditures are $3.02 million and $5.331 millions. Next step is to calculate the unlevered cash flows of each year. As the result 9.2 (p.310) illustrates, unlevered cash flow = profit before interest and taxes + depreciation and amortization – change in working capital – capital expenditures + sales of capital assets – realized capital gains + realized capital losses – profit before interest and taxed * tax rate.The process of computing the working capital from year 2010 to 2020 was explained in Table 3 and Table 4. The computation of the unlevered cash flows for each project was illustrated in Table 5. As the case pointed out, project MMDCL entailed moderate risk, which is 8.4%, while project DYOD revealed a relatively high risk, which is 9%. In addition, both projects can create indefinitely value if it is given continuing investment. As a consequence, when calculate the net present value; we have to regard it as a growing perpetuity. The U.S. retail sales of dolls were planed to grow at a constant rate by 3% per year. To persuade a conservative projection, we used a relatively low perpetual growth rate, which is 2% in this case. Therefore...
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