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Lecture 1
Introduction
Course Overview
Prerequisites Bus635 and/or EMB 510 Requirements and Grading Two Midterm Examinations (30%)
Mid1 examination in the computer lab
Web-page: http://fkk.weebly.com
Exams
Paper
Paper
Make-up Policy
There will be only one make-up for all examinations (mid-terms, final etc.) towards the end of the course to accommodate force majeure. All examination dates are pre-announced. Please make necessary arrangements with your office. Historically, the performance of students taking make-up examinations were always poorer compared to students taking examinations on schedule. I hope you will appreciate that it is not practical to offer a customized course for any or group of individual student(s).
Firms maximize shareholders wealth Government, NGOs, and multilateral institutions maximize net social benefits.
Capital budgeting Concerned with sizeable investment in long-term assets by firms Various investment criteria Choice between projects with different life span, Tax and depreciation issues. Cost benefit analysis Shadow prices To correct for distortions in the market prices or put a price on non-marketed goods The problem of aggregation of benefits and costs of different groups of individuals in the society. Social discount rate Financial appraisal Economic appraisal Financial modeling with Excel spreadsheet
Project Appraisal
Nature of project appraisal Given the limitation of resources, choices must be made among the competing uses, and project appraisal is one method of evaluating alternatives in a convenient and comprehensive fashion Project appraisal assesses the benefits and cost of a project and reduces them to a common yardstick. If benefits exceed costs, the project is acceptable; if not the project should be rejected Societys objective
Growth:
to increase total national income Equity: to improve the distribution of national income
Projects should be assessed in relation to their net contribution to both of these objectives
Program:
Analysis by whom?
Private
Investor Lender
Government Donor
agency
Public-private partnership
8 Principles of Finance
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2. 3. 4.
5. 6. 7. 8.
Buy assets that add value, avoid buying assets that dont add value Cash is king The time dimension of financial decisions is important Know how to compute the cost of financial alternatives Minimize the cost of financing Take risk into account Markets are efficient and deal well with information Diversification is important
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Capital Budgeting
Capital budgeting is primarily concerned with sizeable investments in long-term assets.
Projects are significantly large Long-lived projects with their benefits or cash flows spreading over many years.
Capital budgeting decisions have significant impact on firms performance and they are critical to the firms success or failure
Capital Budgeting
Capital budgeting is one of the most significant financial activity of the firm. Capital budgeting determines the core activities of the firm over a long term future. Capital budgeting decisions must be made carefully and rationally.
Financing Decision
Debt/Equity Mix
Dividend Decision
Dividend Payout Ratio
Capital Budgeting
Emphasizes the firms goal of wealth maximization, which is expressed as maximizing an investments Net Present Value Requires calculation of a projects relevant cash flows
Time series analysis by the application of simple and multiple regression, and moving averages Qualitative forecasting by the application of various techniques, such as the Delphi method
requires that management should endeavor to maximize net present value (NPV) of expected future cash flows to the shareholders of the firm. NPV represents discounted sum of the expected net cash flows.
Cash outflows: capital outlays Cash inflows: proceeds from sales
Net cash flows are determined by subtracting a given periods cash outflows from that periods cash inflows.
Class Exercise
Project Alpha requires an initial capital outlay of Tk. 45,000 and will have net cash inflows of Tk. 15,000, Tk. 20,000 and Tk. 30,000 at the end of years 1,2, and 3 respectively. The discount rate is 8% per annum. How much project Alpha will add to the firms value?
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Complementary projects, pharmacy and doctors clinic Substitute projects, Thai or Fast-food restaurant
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They measure actual economic wealth. They occur at identifiable time points. They have identifiable directional flow: inflow and outflow. They are free of accounting definitional problems.
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cash flows. Incremental cash flows. Changing cash flows. Project cash flows.
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Additional middle-way investments such as upgrades and increases in working capital investments Terminal cash flows
Inflows, proceeds from sale, salvage value of the asset net of tax, recovery of remaining working capital Outflows, cost of asset disposal, environmental rehabilitation, redundancy payment to employees
Operating cash flows: cash inflows from sales, cash outflows for marketing and advertising, payments for wages, utilities, raw materials
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Evaluation of the proposed project purely on its own merits, in isolation from any other activities or the projects of the firm Negative effects, new model of car, lower sales of existing model, must be deducted from future cash flows Positive effects, pharmacy adjacent to doctors clinic, favorable impact on clinics cash flows to be added to pharmacy projects cash flows
Opportunity cost principle: the most valuable alternative that is given up if the proposed investment project is undertaken
Past consulting expenses Utilities, executive salaries With or without the project, incremental costs to be included Current assets (inventories, accounts receivables) minus current liabilities (accounts, wages payable) Increases in working capital is treated as cash outflows even though there is no actual cash outflow, opportunity cost Capital flows, not operational flows, it is a fund
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Overhead costs
Must be accounted for as a cash outflow, not based on net cash flow but on taxable income Is not a cash flow In project appraisal, what is relevant is not the accounting depreciation but tax allowable depreciation to measure the tax effect
Treatment of depreciation
Investment allowance, enhances NPV Financing flows, excluded. double counting, included in the discount rate
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Occurs at various points of time in a year Standard practice is to assume that capital expenditure occur at the beginning of the year and all other cash flows occur at the end of the year Points in cash flow timing is are set at the end of each year. An initial outlay of Tk. 50,000 at the start of year 1will be timed as occurring at the end of year zero.
Nominal returns, incorporating the inflationary effect is preferred over cash flow forecasts in real terms, excluding the inflationary effects Fisher effect Consistency, cash flow in nominal terms- use nominal discount rate; cash flow in real terms- use real discount rate
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Initial investment in plants and working capital Add back depreciation Exclude depreciation from costs Add tax shield of depreciation (tax rate x depreciation) Proceeds from sale of assets minus taxes on sale of an assets plus recovery of working capital
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Initial investment in plants and working capital minus proceeds from sale of old asset plus taxes on sale of old assets Operating cash flow of new assets minus operating cash flow of old assets Proceeds from sale of new asset- proceeds from sale of old asset - taxes on sale of old assets- taxes on sale of an assets-taxes on sale of old assets plus recovery of working capital
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Project Cash Flows: Summary There are generally three kinds of cash flows that can be affected by a capital budgeting project:
1) Initial period cash flow 2) Operating cash flow 3) Terminal year cash flow
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Treatment of Taxes
Since taxes are cash flows, we must include taxes in our cash flow estimates. All estimated cash flows should be aftertax cash flow estimates!
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Operating cash flow will be affected whenever a revenue or expense is changed on the income statement.
For example, operating cash flow is increased/decreased if a project results in increased/decreased sales revenues. Operating cash flow is decreased/increased if a project results in increased/decreased expense of some kind.
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Class Exercise
Assume that accepting the new investment project would increase the business sales by $10 million, and increase the operating costs by $4 million, plus increase depreciation expense by $2 million. What is the incremental operating cash flow for the project?
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Answer
Operating cash flow with the new project = ($105 - $69 - $17) x (1.3) + $17 = $30.3 million.
The incremental operating cash flow for the project equals the change in cash flows from before accepting the project to after accepting it = $30.3 $25.5 = $4.8 million per year. (Assume these benefits continue the same each year for 10 years.)
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An Alternative Way It is usually easiest to compute this incremental cash flow by just using the incremental numbers themselves. Thus,
The relevant incremental operating cash flow for the example project =
+ Inc. in sales revenue $10 million - Inc. in op. costs (expenses) .. 4 million - Inc. in depreciation expense 2 million = Inc. in EBT . 4 million - Inc. in taxes (@ 30%) ..... 1.2 million = Inc. in EAT ... 2.8 million + Inc. in depreciation expense 2 million = Inc. in operating cash flow .. $ 4.8 million
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Notice that this method of calculating the incremental operating cash flow requires you to simply identify every item in the companys income statement that changes, and then to calculate the change in net income that results. Finally, the operating cash flow equals the change in net income plus the change in depreciation.
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What to Do with the Project? Since the NPV > 0 we know the project is a good one.
We could alternatively have made the decision using the IRR method. IRR of the project can be calculated to be 17%. Since this is > the 10% cost of capital, the project should be accepted. We could also have (alternatively) made the decision using the PI method. PI = 1.33, which is > 1.00.
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Class Exercise 2
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The total initial period (period 0) incremental cash flows for the replacement project are:
-$100,000 + $25,000 - $3,000 = $78,000.
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Calculation of Taxes
Assume that both the old machine and the new one would be fully depreciated after 8 years.
With the new machine, sale in year 8 for $5,000 => taxable gain on the sale equal to the salvage value minus the book value = ($5,000 0) = $5,000. Tax on this gain = $5,000 x .3 = $1,500. With the old machine, sale in year 8 for $500 => taxable gain on the sale equal to the salvage value minus the book value = ($500 0) = $500.Tax on this gain = $500 x .3 = $150.
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Important:
While in general, any cash flow affected by a project is relevant, we do not include any cash flows that are financing costs. For example, we do not include interest expense or lease payments. The reason for this is that all financial cash flows are implicitly included in the cost of capital used to find NPV (or used to compare to IRR). To include the financial cash flows and then discount them to PV would be to double count their impact.
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