FINC3240 International Finance. Capital Budgeting (2). The Value of a Project. Determined by the present value of its expected investment cost and future cash flows. Rule: NPV > 0. NPV. NPV = B – C =. Computing NPV using BA II Plus. Press CF, press -1200 and then press ‘ENTER’ for CF0.
Capital Budgeting (2)
Rule: NPV > 0
NPV = B – C =
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.
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.
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
For the time period ending date
= Gross sales – (returns & allowances)
Cost of Goods Sold (COGS)
include raw material and labor costs
Include management salaries, advertising expenditures, repairs & maintenance, R&D, general & administrative expenses, lease payments.
Federal, state and/or local levels
‘bottom line’ of income statement
profit earned during accounting period
NI = Retained Earnings + Dividend Payout
Prepare a multi-step income statement for the ABC company for the year ending Dec 31, 2006, given the information below:
Advertising expenditures 68,000
Cost of goods sold 2,433,000
Gross sales 3,210,000
Interest expenses 64,000
Lease payment 52,000
Management salary 240,000
Material purchase 2,425,000
R&D expenditures 35,000
Repair and maintenance costs 22,000
Returns and allowances 48,000
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.
Depreciation is a non-cash charge and must be added to net income to estimate cash flow.
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.
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.
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.
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.
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.
Liabilities and Owners Equity
Total Current Assets
Gross Fixed Assets
(less Accum. Depreciation)
Net Fixed Assets
Current Portion of LTD
Total Current Liabilities
Long term (L.T.) Debt
Total Liabilities and equity
Claims on Assets
Thompson Company has to decide whether to build a new factory. Management has collected various cost data to use to make the decision. Some of the items collected are listed below. Which of the following should Thompson consider as being relevant for computing cash flows for the new factory project?
$500,000 was spent last year to upgrade a piece of property on which the company is planning to build the new factory.
It will cost $10,000,000 to construct the factory and new equipment costing $3,250,000 will need to be purchased and installed to begin production of the product to be sold.
The factory construction costs of $10,000,000 will be financed entirely with new long-term debt (specifically a new bond issue). The company estimates that the interest costs of this new debt will be $850,000 per year.
The variable cost of production is estimated to be 65% of annual sales.
The accounting department plans to allocate supervisory and management costs of $25,000 per year to the project. No new supervisory or management personnel will be required.
You are given the responsibility of conducting the project selection analysis in your firm. You have to calculate the NPV of a given project. The appropriate cost of capital is 12 percent and the firm is in the 30 percent tax bracket. You are provided the following pieces of information regarding the project:
The project is going to be built on a piece of land that the firm already owns. The market value of the land is $1 million.
If the project is undertaken, prior to construction, an amount of $100,000 would have to be spent to make the land usable for construction purposes.
In order to come up with the project concept, the company had hired a marketing research firm for $200,000.
The firm has spent another $250,000 on R&D for this project.
The project will require an initial outlay of $20 million for plant and machinery.
The sales from this project will be $15 million per year of which 20 percent will be from lost sales of existing products.
The variable costs of manufacturing for this level of sales will be $9 million per year.
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.
Because of the project the company will need additional working capital of $1 million which can be liquidated at the end of ten years.
The project will require additional supervisory and managerial manpower that will cost $200,000 per year.
The accounting department has allocated $350,000 as allocated overhead cost for supervisory and managerial salaries.
Initial cost is the sum of:
Market value of land: $1 mil (opportunity cost)
Land improvement $100 k
Plant & machinery: $20 mil
Incremental working capital: $1 mil
= 1,000,000 + 100,000 + 20,000,000 + 1,000,000
Calculate the annual depreciation expense
For this project, fixed assets refer to $20mil plant & machinery. Therefore,
= (20,000,000 – 3,000,000)/10
Calculate incremental sales
Incremental sales = 0.8 x 15,000,000 = $12,000,000
the incremental income statement
At the end of project’s life (t=10), company
Recovers $1 mil additional working capital (item 9)
Receives $3 mil salvage value from plant & machinery (item 8)
Additional cash flows at end of project
= 1,000,000 + 3,000,000
CF0 (initial cost) = $22,100,000
Annual incremental after-tax cash flow (Year 1 through Year 10) = $2,470,000
Additional cash flow in Year 10 = $4,000,000
So in year 10, the company receives a total of = 2,470,000 + 4,000,000 = $6,470,000
To compute NPV, enter cash flows in this way:
CF0 = -22,100,000
C01 = 2,470,000, F01=9
C02 = 6,470,000, F02=1
Then press NPV, enter I = 12, press CPT and NPV.
NPV = -$6,856,056.17
Decision: reject the project.
ABC Corp. manufactures television sets and computer monitors. The company is considering introducing a new 40” flat screen television/monitor. The company’s CFO has collected the following information about the proposed product.
1) The project has an anticipated economic life of 5 years.
2) The company will have to purchase a new machine to produce the screens. The machine has an up front cost (t = 0) of $4,000,000. The machine will be depreciated on a straight-line basis over 5 years. The company anticipates that the machine will last for five years and then have no salvage value (that is, it will be worthless).
3) If the company goes ahead with the proposed product, it will have to increase net working capital by $200,000. At t = 5, the net working capital will be recovered after the project is completed.
4) The screen is expected to generate sales revenue of $2,000,000 the first year; $4,500,000 the second through fourth years and $3,000,000 in the fifth year. Each year the operating costs (excluding depreciation) are expected to equal 50% of sales revenue.
5) The company’s interest expense each year will be $350,000.
6) The new screens are expected to reduce the sales of the company’s large screen TV’s by $500,000 per year.
7) The company’s cost of capital is 12%.
8) The company’s tax rate is 30%.
What is the initial investment for the project?
What is the 3rd year expected incremental operating cash flow? (i.e., the incremental after tax cash flow)
What is the 5th year incremental non-operating cash flow?
To answer Q1, you need points 2 & 3.
= machine cost + change in net working capital
= 4,000,000 + 200,000
To answer Q2, you need points 2,4,6,8.
1) Incremental sales
= 4,500,000 – 500,000 = 4,000,000
2) Annual depreciation = (4,000,000)/5 = 800,000
3) Incremental operating cost for 3rd year
= 0.5 x 4,500,000 = 2,250,000
Next, draw up the incremental income statement
Very simple. The only incremental non-operating cash flow is the cash flow from liquidating the increase in net working capital (point 3).
5th year incremental non-operating cash flow = $200,000