FI3300 Corporate FinanceLearning objectivesTextbook example – problem 11.6Textbook Example: Fixed Assets and DepreciationCorrect accounting distortions (1): Fixed Assets and DepreciationTextbook Example: Net Working Capital (NWC)Correct accounting distortions (2): Net Working Capital (NWC)Ignore CFs related to financing decisions: Interest expense and dividendsTextbook Example: Consider only relevant incremental CFs (1)Consider only relevant incremental CFs (1)Textbook Example: Consider only relevant incremental CFs (2)Slide 12Calculate the initial CF (investment)Calculate the annual incremental CF (1)Calculate the annual incremental CF (2)Calculate the annual incremental CF (3)End of project’s life: liquidation / residual valueSummarize all CFs: the time lineSlide 19CF calculation check listThe Cost of CapitalSlide 22Another example (Based on Spring 2001 Final Exam)Project information 1Project information 2Project information 3QuestionsQ1: initial investmentQ2: 3rd incremental operating cash flowSlide 30Q3: 5th year incremental non-operating cash flowSlide 32Slide 33Slide 34FI3300Corporate FinanceSpring Semester 2010Dr. Isabel TkatchAssistant Professor of Finance12Learning objectives☺Fined the project’s CFs☺Correct accounting distortions:☺Long term investments: fixed assets and depreciation☺Short term investments: the Net Working Capital (NWC)☺Eliminate the effect of financing decisions and payouts:☺Interest (creditors) compared with dividends (equity holders)☺Use only relevant incremental CFs:☺Account for negative or positive effects on other projects☺Avoid arbitrarily allocated costs☺Avoid sunk costs☺Account for opportunity costs☺CF type and the appropriate cost of capital☺The cost of equity – for dividends☺The (after tax) cost of debt – for interest payments☺The Weighted Average Cost of Capital (WACC) – for project’s CF3Textbook example – problem 11.6You are responsible for the firm’s capital budgeting decisions: use the following data to calculate the project’s CFs and the NPV rule to decide whether to accept / reject the project.☺The appropriate (annual) risk adjusted cost of capital is 12%☺The firm is in the 30% tax bracket4Textbook Example:Fixed Assets and Depreciationb. If the project is undertaken, prior to construction, an amount of $100,000 would have to be spend to make the land usable for construction purposese. The project will require an initial outlay of $20 million for plan and machineryh. The company uses straight-line depreciation. The project has an economic life of ten years and will have a salvage value of $3 million at the end (date t=10)5Correct accounting distortions (1):Fixed Assets and Depreciation1a. Increasing the investment in Fixed Assetsis a cash outflow1b. Decreasing the investment in Fixed Assetsis a cash outflow2. Depreciation expenseis not a cash outflow3. Depreciation tax shieldis a cash inflowDepreciation tax shield = Depreciation-expense x tax-rate6Textbook Example:Net Working Capital (NWC)i. Because of the project, the company will need additional working capital of $1 million, which can be liquidated at the end of ten years7Correct accounting distortions (2): Net Working Capital (NWC)NWC = Current Assets – Current Liabilities1a. Increasing the investment in NWC is a cash outflow1b. Decreasing the investment in NWC is a cash inflowNote: Investment in NWC↑ if (i) CA↑ (ii) CL↓Simplifying assumption: we invest in NWC in the beginning of the project and liquidate at the end8Ignore CFs related to financing decisions: Interest expense and dividends1. Ignore interest payments to creditorsInterest payments are ignored even though they are considered an expense (accounting) and they constitute a cash outflow (finance)We account for the interest tax shield when calculating the (after tax) cost of capital2. Ignore dividend payments to shareholdersDividend payout is ignored. It is not considered an expense (accounting) but dividends are a cash outflow (finance)9Textbook Example: Consider only relevant incremental CFs (1)f. The sales from this project will be $15 million per year, of which 20% will be from lost sales of existing productsg. The variable costs of manufacturing for this level of sales will be $9 million per yearj. The project will require additional supervisory and managerial manpower that will cost $200,000 per yeark. The accounting department has allocated $350,000 as overhead cost for supervisory and managerial salaries10Consider only relevant incremental CFs (1)1. If the project affects the CFs from other projects consider only the net contribution:- If the project increases the CFs of other projects adjust for cash inflow - If the project decreases the CFs of other projects adjust for the cash outflow2. Allocated expenses:- don’t affect the project’s CF is they exist with or without the project- affect the project’s CF if they exist only if the it is accepted (i.e., don’t exist if the project is rejected)11Textbook Example: Consider only relevant incremental CFs (2)c. To come up with the project concept, the company had hired a marketing research firm for $200,000d. The firm has spent another $250,000 on R&D for this projecta. The project will be built on a piece of land that the firm already owns. The market value of the land is $1 million.12Consider only relevant incremental CFs (1)3. Sunk costs :- If a cost (or any other relevant CF) is in the future it should be taken into account - If a cost is in the past (sunk cost) it does not affect the project’s CFs and value4. Opportunity cost:- The cost of an asset that you buy for the project is the price you paid- The cost of an asset that you own and allocated for the project is the highest price you could have gotten for it – opportunity cost (usually not zero)13Calculate the initial CF (investment)Market value of land: $ 1,000,000Investment in land improvement: $ 100,000Investment in plant & machinery: $ 20,000,000Investment in working capital: $ 1,000,000 __________Initial CF (investment) = $ 22,100,00014Calculate the annual incremental CF (1)Calculate incremental sales:Incremental sales = 0.8 x 15,000,000 = $12,000,000Calculate the depreciation expense and tax shield:Investment in fixed assets = $20MLiquidation value of fixed assets = $3M Straight line depreciation, 10 years Depreciation expense = =(20,000,000 – 3,000,000)/10=