FINC3240 International Finance Capital Budgeting 2 1 The Value of a Project Determined by the present value of its expected investment cost and future cash flows Rule NPV 0 2 NPV N CIFt NPV B C t t 0 1 r N COFt t t 0 1 r 3 Computing NPV using BA II Plus Press CF press 1200 and then press ENTER for CF0 Next press and enter 500 for C01 Press ENTER and enter 1 for F01 then ENTER Similarly enter C02 600 F02 1 C03 700 and F03 1 Make sure that all the cash flows later than C03 are zero Press NPV Enter the discount rate of 10 percent by pressing 10 and then ENTER The display will show that I 10 Next press the and press CPT The calculator will display the NPV of 276 33 Decision Accept project 4 Last Homework 1 Your division is considering a projects with the following net cash flows in millions The initial investment cost is 25 the cash flows at the end of year 1 2 3 are 5 10 17 respectively What are the projects NPV assuming the cost of capital is 5 10 15 2 Your division is considering a projects with the following net cash flows in millions The initial investment cost is 20 the cash flows at the end of year 1 2 3 are 10 9 6 respectively What are the projects NPV assuming the cost of capital is 5 10 15 3 A firm with a 14 capital cost is evaluating a project The project needs 6000 as the initial investment and has 2 000 cash inflows for the following 5 years Calculate NPV 5 Estimating Project Cash Flows To apply NPV rule we need the project s cash flows and the appropriate discount rate In this session you will learn how to estimate a project s cash flows The discount rate cost of capital WACC will be given to you 6 Income Statement Overview 1 Also called earnings statement profit loss statement Matches revenues expenses over a period of time e g past quarter or year Flow measure statement Each value on an income statement represents cumulative amount of that item through the accounting period 7 Income Statement Overview 2 Income Statement Company Name For the time period ending date Earnings before taxes EBT Net Sales Cost of Goods Sold Operating Expenses Depreciation Operating Profit Interest Expense Profit Before Taxes Taxes Net Income Operating income Earnings before interest taxes EBIT Earnings Net profit 8 Income Statement Items 1 Net sales Gross sales returns allowances Cost of Goods Sold COGS include raw material and labor costs 9 Income Statement Items 2 Operating expenses Include management salaries advertising expenditures repairs maintenance R D general administrative expenses lease payments Interest expense Taxes Federal state and or local levels Net income bottom line of income statement profit earned during accounting period NI Retained Earnings Dividend Payout 10 Example Prepare a multi step income statement for the ABC company for the year ending Dec 31 2006 given the information below Advertising expenditures Cost of goods sold Depreciation Gross sales Interest expenses Lease payment Management salary Material purchase R D expenditures Repair and maintenance costs Returns and allowances Taxes 68 000 2 433 000 78 000 3 210 000 64 000 52 000 240 000 2 425 000 35 000 22 000 48 000 51 000 11 Solution Gross Sales Return and Allowance 3 210 000 48 000 Net Sales 3 162 000 Cost of Goods Sold 2 433 000 Gross Profit 729 000 Operating Expenses 417 000 Depreciation EBIT Interest Expense 78 000 234 000 64 000 EBT Tax 170 000 Net Income 119 000 51 000 12 Estimating cash flows guidelines Add back depreciation to net income Ignore interest expense All project cash flows must be incremental Ignore allocated costs and sunk costs Include opportunity costs Include changes in net working capital 13 Why add back depreciation Depreciation is a non cash charge and must be added to net income to estimate cash flow 14 Ignore interest expense WACC weighted average cost of capital includes the interest expenses In determining a domestic project s cash flows we ignore it s financing cost i e the interest expense 15 All project cash flows must be incremental To evaluate a project we look at the cash flows which it contributes towards the firm s existing cash flows In other words we look at project s incremental cash flows How to determine incremental cash flows Look at the firm s cash flows without the project Look at the firm s cash flows with the project The difference is the incremental cash flows 16 Ignore allocated costs and sunk costs Allocated costs rent supervisory salaries administrative costs and various overhead expenses These costs are not incremental They don t change if the project is undertaken Thus they should not be considered in estimating the project s incremental cash flows Sunk irrecoverable costs costs which cannot be recovered regardless of whether the firm undertakes the project Examples R D expenses and consultant fees occurred already 17 Include opportunity costs Suppose the project requires the use of some asset owned by the firm If the asset is not used by the project the firm can sell the asset for X This X is the opportunity cost of the asset Such a cost should be included in the project s cost An asset s opportunity cost is the money that the firm can receive if the asset is put to the next best use The next best use may be to sell the asset 18 Changes in net working capital Net working capital current asset current liability Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short term debt and upcoming operational expenses The management of working capital involves managing inventories accounts receivable account payables accruals and cash Very often a project will require an initial increase in net working capital This increase in net working capital must be added to the project s costs Assume that this additional working capital is liquidated sold for cash at the end of the project s life So this liquidation is a cash inflow in the last period 19 Balance Sheet Overview Assets Liquidity Cash Marketable securities Accounts Receivable Inventories Total Current Assets Gross Fixed Assets less Accum Depreciation Net Fixed Assets Total Assets Assets Liabilities and Owners Equity Notes Payable Accounts Payable Accrued Expenses Current Portion of LTD Total Current Liabilities Long term L T Debt Total Liabilities Preferred Stock Common Stock Retained Earnings Total Liabilities and equity Claims on Assets S T Funds L T Capital 20 Question Thompson Company has to decide