Acknowledgment of Country

The University of Wollongong would like to pay

respect and acknowledge the traditional custodians
of the Land on which we meet, and pay my respect
to Elders past, present and future. I would also like
to extend my respect to Aboriginal and Torres Strait
Islander people present here today.
 FIN322 Advanced Corporate Finance

• Emergency Procedures
• When an alarm sounds:
– The priority is to leave the building immediately and orderly via the
nearest exit

– Do not re-enter the building until advised by building warden (will be

wearing orange vests) or security that it is safe to do so

– The nearest emergency assembly area for 40-153 is: Area G

• House-keeping
• Coordinator/lecturer/tutor: Liangbo (Jack) Ma
– Office: 40.204
– Email: liangbo@uow.edu.au
– Tel: 4221 5793
– Consultation: Thursday 13:30-14:30 (from week 4) &
Friday 12:30-13:30
» Other times by appointment
• Assessments:
– Tutorials (5%)
• Attendance is compulsory and recorded.
• Tutorial question preparation: attempt all questions; marked for both the
number of questions attempted and the quality of preparation
– In-session test (20%)
• In Week 8 during lecture time
• May consist of both multiple-choice & short-answer questions
– Major assignment (15%)
• Due on Oct. 11, Thursday in Week 11
• Group assignment, with each group consisting of 2 to 3 students
• List of groups submitted to your tutor in week 3 tutorial
• Deemed equal contribution by each group member
• Detailed instruction available on Moodle after Week 4
– Final exam (60%)
• Consisting of both calculations & short-answer questions
• You must pass the final exam to pass this subject; otherwise “TF”
 Lecture 1 Capital budgeting
Ch5, 6, & 7 (part)
• Capital budgeting is a process used by a business to analyze,
evaluate and determine whether long-term investments are
worth pursuing.
• the primary goal is to identify investments that add value to
the business  decision rules (criterion)
• capital budget is a list of investment projects under
consideration by a firm.
• cash flow estimates for projects are uncertain
• to handle uncertainty, a common practice is to generate
more than one cash-flow estimate using risk analysis
 Decision rules

• Net Present Value (NPV)

• Payback period
– Discounted payback period

• Internal Rate of Return (IRR)

– Issues with IRR

• Profitability Index (PI)

• Some practical issues

– A comparison of different rules
– Case study
NPV

• NPV= - Initial investment + PV (all future CFs)

• NPV rule:
– Accept a project/investment if NPV > 0
– Choose the project with the highest NPV
• A simple example
• Alpha Co. is considering a project with initial cash outlay of
$100 and expected cash inflow of $107 at year-end.
– Scenario A: Assume discount rate 3% (low-risk)
• NPV= - 100+107/1.03= $3.88 (accept)
– Scenario B: Now assume discount rate of 10% (high-risk)
• NPV= -100+107/1.10= -$2.73 (reject)

What does the discount rate represent?

• Why use the NPV rule?
• Looking from an alternative perspective:
– For scenario A, if the firm does not take the project, the firm’s value
today would be $V+$100 (with V being the value of the firm’s all other
assets). By investing in this project, the firm’s value becomes
$V+$107/1.03=$V+$103.88(i.e., an increase of $3.88). That is,
shareholders are better off by $3.88. (Accept)
– For scenario B, if the firm distribute the $100 cash to shareholders and
they invest in the other investments with the same risk, the rate of
return would be 10%, meaning the year-end value would be $110. In
other words, investing in this particular project makes shareholders
worse off by $3 in one year. (Reject)
• Conclusion:
• Accepting positive NPV projects benefits shareholders

• The value of the firm (today) increases by the NPV of the

project

• The NPV rule considers and uses the correct discount rate
 Payback period

• The payback period (PB) measures how long it takes the

project to “pay back” its initial investment

• Payback Period = number of years to recover initial costs

• Payback period rule:

– Accept a project if the payback is shorter than the pre-set cutoff date
– Choose the project with the shortest payback
• Problems with the payback period rule:
• While the payback period rule is easy to understand, there are
several issues:
• Ignores cash flows after the payback period (biased against long-term projects)

• The pre-set cutoff date is arbitrary (no good guide for choosing the payback
cutoff date)

• Ignores the timing of cash flows within the payback period (ignores the time
value of money)
• An example:

– Projects A, B, and C are same attractive based on the payback rule

– However, based on NPV, project C adds more value to the firm (and
shareholders) than A and B
– Compare A & B:
• Cash flows prior to the cutoff are implicitly discounted at a rate of zero; In
contrast, the NPV rule discount CFs at the correct rate
– Compare B & C:
• Discounted payback period (DPB)
• Example: (-$100, $50, $50, $20), discount rate 10%
– Discounted CFs over the 3 years:
– $101.8= $50/1.1+ $50/(1.1)2+ $20/(1.1)3
– Therefore, the DPB is slightly less than 3 years; the standard PB is 2
years.
• The DPB is an improvement from the standard PB, but issues
are:
– Requires an arbitrary cutoff date
– Ignores CFs after the cutoff date
 Internal Rate of Return (IRR)

• IRR is the single discount rate that sets the NPV=0

• Example:

$50 $100 $150

NPV  0  200   2  3
(1 IRR) (1 IRR) (1 IRR)

• The IRR for this project is 19.44%

• The IRR rule:
• Accept a project if the IRR exceeds the required return
• Choose the project with the highest IRR
• Why?
• Alternative views of IRR:
– The minimum acceptable rate of return on the project

– The maximum cost of capital that the project can survive (generating
positive NPV)
• If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept
0% $100.00
4% $73.88
8% $51.11
12% $31.13
16% $13.52
20% ($2.08)
24% ($15.97)
28% ($28.38)
32% ($39.51)
36% ($49.54)
40% ($58.60)
44% ($66.82)
• Problems with IRR
• To understand the potential problems with IRR, we need to
first separate mutually exclusive projects from independent
projects
• Mutually Exclusive projects: only ONE of several potential
projects can be chosen, e.g., acquiring an accounting system
– Rank all alternatives, and select the best one.
• Independent projects: accepting or rejecting one project does
not affect the decision of the other projects
– Must exceed a minimum acceptance criterion
• Problems of IRR associated with both mutually exclusive and
independent projects
• Multiple IRR $200 $800

0 1 2 3
-$200 - $800
NPV

$100.00
IRR2=100%
$50.00

$0.00
-50% 0% 50% 100% 150% 200%
($50.00) Discount rate

($100.00)

IRR1=0
• Solution to multiple IRR  Modified IRR
• Approach 1: (example in the textbook)
– Discount cash flows over a single period (or subset of time), then
combine them as necessary to eliminate any sign differences

• Approach 2:
– Calculate the NPV of all cash outflows using the borrowing rate;
– Calculate the NPV of all cash inflows using the investing rate;
– Find the rate of return that equates these values;
– Benefits: single answer and allows specific rates for borrowing and
reinvestment; more generalized than approach 1
• Investing or financing?
Recall that the IRR
rule says the higher
the IRR the better.
But you can’t use
this rule for both
project A & B
• Problems of IRR associated with mutually exclusive projects
• The scale problem
Higher IRR

• Solution: Incremental IRR Larger NPV

– Incremental IRR is the IRR on the incremental investment from

choosing the large project instead of the small project

– Incremental IRR=66.67% > 25%

– Go with the large budget
• The timing problem

NPVA=NPVB (indifferent)
• Finding out the crossover rate
Compute the IRR for either (hypothetical) project “A-B” or “B-A”
0 ($10,000) ($10,000) $0 $0
11 $10,000 $1,000 $9,000 ($9,000.00)

2 $1,000 $1,000 $0 $0

3 $1,000 $12,000 ($11,000.00) $11,000

If the relevant discount rate is below 10.55 percent, Project B is preferred

to Project A. If the relevant discount rate is above 10.55 percent,
Project A is preferred to Project B
• Another problem with IRR (not mentioned in the textbook)
• Reinvestment assumption
– All future cash flows are assumed to be reinvested at the IRR
– Why is it a problem?
 Profitability index (PI)

Total PV of Future Cash Flows

PI 
Initial Investent

• The PI rule:
• Accept a project if PI > 1
• Select the project with the highest PI
• Problem with the PI index
– The scale problem with mutually exclusive projects

• Advantages:
• May be useful when available investment funds are limited
• Easy to understand and communicate
• Correct decision when evaluating independent projects
 Summary of decision rules

• Net present value

– Difference between market value and cost
– Accept the project if the NPV is positive
– Has no serious problems
– Preferred decision criterion (go the the NPV rule if conflicts arise)
• Internal rate of return
– Discount rate that makes NPV = 0
– Take the project if the IRR is greater than the required return
– Same decision as NPV with conventional cash flows
– IRR is unreliable with non-conventional cash flows or mutually exclusive
projects
• Profitability Index
– Benefit-cost ratio
– Take investment if PI > 1
– Cannot be used to rank mutually exclusive projects
– May be used to rank projects in the presence of capital rationing
• Payback period
– Length of time until initial investment is recovered
– Take the project if it pays back in some specified period
– Does not account for time value of money, and there is an arbitrary
cutoff period
• Discounted payback period
– Length of time until initial investment is recovered on a discounted
basis
– Take the project if it pays back in some specified period
– There is an arbitrary cutoff period
• Capital budgeting in practice:
• Case study: Woolworths to shut down Masters
• So far we have seen the importance of cash flow estimates in
the NPV analysis, it’s now logical to examine how we obtain
the CF figures

• We then proceed with the task of analysing NPV by

considering some complex situations

• Finally, as CF estimates are by nature uncertain (i.e, with

risks), we will learn how we handle such risks
 Incremental cash flows

• Cash flows, not accounting earnings, matter

• Incremental CFs are the key to capital budgeting
– The changes in a firm’s CFs as a direct result of taking a particular project,
i.e., the difference between CFs with the project and the CFs without the
project
• Sunk costs are not relevant
– Just because “we have come this far” does not mean that we should
continue to throw good money after bad
– You can’t cry over spilt milk
• Opportunity costs do matter
– By taking a project, the firm forgoes other opportunities for using the assets
– Just because a project has a positive NPV, that does not mean that it should
also have automatic acceptance. Specifically, if another project with a
higher NPV would have to be passed up, then we should not proceed
• Side effects matter: erosion & synergy
– Erosion is a “bad” thing. If our new product causes existing customers
to demand less of our current products, we need to recognize that.
– If, however, synergies result that create increased demand of existing
products, we also need to recognize that

• Taxes matter
– we care about after-tax incremental cash flows

• Inflation (or deflation) matter

– Can affect both CFs and discount rates used in calculating the NPV
 Estimating cash flows

• Cash flow to the firm (or cash flow from assets) include:
– Cash Flow from Operations (OCF)
• OCF = EBIT – Taxes + Depreciation/Amortization
– Net capital spending
• = ending fixed assets – beginning fixed assets + depreciation
• Do not forget salvage value (after tax, of course).
– Changes in NWC
• = ending NWC – beginning NWC
• CFFA = operating cash flow – net capital spending – changes
in net working capital
• Interest expense
• Note that interest expense is not included in the calculation of
operating cash flows
– The amount of debt that a firm has (in other words, its capital structure)
will have an impact on firm value, which will be dealt with in later
chapters
– OCF concerns the operating (investment) cycle, while capital structure
and hence interest expense is part of financing cycle. They are separate
activities
– Alternative, you can view that the discount rate in the calculation of
NPV captures interest related issues
 Example: the Baldwin Company

• Background information:
• Costs of test marketing (already spent): $250,000
• Current market value of proposed factory site (which we own):
$150,000
• Cost of bowling ball machine: $100,000 to be depreciated
according to modified accelerated cost recovery system
(MACRS) over a 5-year period, with a salvage value of
$30,000
• Initial increase in net working capital: $10,000
• Production (in units) by year during 5-year life of the machine:
5,000, 8,000, 12,000, 10,000, 6,000
• Price during first year is $20; price increases 2% per year
thereafter
• Production costs during first year are $10 per unit and increase
10% per year thereafter
• Annual inflation rate: 5%
• Working Capital: initial $10,000 changes with sales. Net
working capital at the end of each year will be equal to 10
percent of sales for that year
• The investment in working capital is to be completely
recovered by the end of the project’s life
• Incremental corporate tax rate is 34%
 • ($ thousands) (All cash flows occur at the end of the year.)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine –100.00 21.76
(2) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76
machine after
depreciation (end of year)
(4) Opportunity cost –150.00 150.00 (?)
(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0 (?)
(end of year)
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98
investment
[(1) + (4) + (6)]
 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs -50.00 -88.00 -145.20 -133.10 -87.85
(10) Depreciation -20.00 -32.00 -19.20 -11.52 -11.52
(11) Income before taxes 30.00 43.20 85.30 67.62 30.53
[(8) – (9) - (10)]
(12) Tax at 34 percent -10.20 -14.69 -29.00 -22.99 -10.38
(13) Net Income 19.80 28.51 56.30 44.63 20.15
 Some notes:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine –100.00 21.76
(2) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76
machine after
depreciation (end of year)

The capital gain is $24,240 (= $30,000 – $5,760)

The capital gains tax due is $8,242 = [0.34 * ($30,000 – $5,760)]
The after-tax salvage value is $30,000 – 8,242 = $21,758
 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89

Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 2 = 8,000×[$20×(1.02)1] = 8,000×$20.40 = $163,200.
 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85

Again, production (in units) by year during 5-year life of the machine is given
by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000
 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs -50.00 -88.00 -145.20 -133.10 -87.85
(10) Depreciation -20.00 -32.00 -19.20 -11.52 -11.52

Depreciation is calculated using the Modified Year ACRS %

Accelerated Cost Recovery System (shown at 1 20.00%
right). 2 32.00%
Our cost basis is $100,000. 3 19.20%
4 11.52%
Depreciation charge in year 4
5 11.52%
= $100,000×(.1152) = $11,520. 6 5.76%
Total 100.00%
 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.52 11.52
(11) Income before taxes 30.00 43.20 85.30 67.62 30.53
[(8) – (9) - (10)]
(12) Tax at 34 percent 10.20 14.69 29.00 22.99 10.38
(13) Net Income 19.80 28.51 56.30 44.63 20.15
(14) OCF
[13+10] 39.80 60.51 75.50 56.15 31.67
(7) –260.00 –6.32 –8.65 3.75 192.98
(15) CFFA
[7+14] -260.00 39.80 54.19 66.85 59.90 224.65

$39.80 $54.19 $66.85 $59.90 $224.65

NPV  $260   2  3  4 
(1.10) (1.10) (1.10) (1.10) (1.10) 5
NPV  $51.59
• Alternative Definitions of OCF
• All these approaches are consistent if done correctly. Practice
them!
• Top-Down Approach
• OCF = Sales – Cash Costs – Taxes
• Do not subtract non-cash deductions
• Bottom-Up Approach
• Works only when there is no interest expense
• OCF = NI + depreciation
• Tax Shield Approach
• OCF = (Sales – Costs)(1 – T) + Depreciation*T
 Investments of Unequal Lives

• There are times when the simple application of the NPV rule
can lead to the wrong decision.
• Example: The Downtown Athletic Club must choose between
two mechanical tennis ball throwers. Machine A costs less than
Machine B but will not last as long. The cash outflows from
the two machines are shown here:
• Assuming a discount rate of 10 percent, the PV of cash outflows are:

• This overlooks the fact that Machine B lasts one year longer than
Machine A. In other words, Machine A needs to be replaced one
year earlier than Machine B.
• To incorporate the different lives of Machine A & B, we look at
Equivalent Annual Cost.
– The EAC is the value of the level payment annuity that has the same PV as our
original set of cash flows
• For Machine A, $798.42 = C × PVIFA (.10, 3);
C = $321.05
• For Machine B, $916.99 = C × PVIFA (.10, 4);
C = $289.28
• Therefore, Machine B is the preferred choice.
 Inflation

• Inflation is an important fact of economic life and must be

considered in capital budgeting
• Consider the relationship between interest rates and inflation,
often referred to as the Fisher equation:
(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)
• In capital budgeting, one must compare real cash flows
discounted at real rates or nominal cash flows discounted at
nominal rates
• Please refer to Section 6.5 of the textbook for a detailed
example
 Risk analysis in capital budgeting

• Cash flow estimates are, by nature, uncertain. We conduct risk

analysis to handle/mitigate such risks

• Types of Analysis
• Sensitivity
– Analyzes effects of changes in sales, costs, etc., on project
– Only 1 variable is changed at a time
• Scenario
• Project analysis given particular combination of assumptions
• Break Even
• Level of sales (or other variable) at which project breaks even
Example: A motor scooter project

Estimates for the underlying variables

Estimates
Variable Pessimistic Expected Optimistic
Market size .9 mil 1.0 mil 1.1 mil
Market share .04 .1 .16
Unit price 350,000 375,000 380,000
Unit var cost 360,000 300,000 275,000
Fixed cost 4 bil 3 bil 2 bil
 10
3
𝑁𝑃𝑉 = −15 + ෍ = +3.43
1.10𝑡
𝑡=1
 • NPV calculations — Optimistic market size
Year 0 Years 1 - 10
Investment - 15
Sales 41.25  1.1* 37.5 (no change in unit price)
Variable costs 33  1.1* 30 (no change in variable cost)
Fixed costs 3(no change)
Depreciati on 1.5
Pretax profit 3.75
Taxes @ 50% 1.88
Profit after tax 1.88
Operating cash flow 3.38
Net Cash Flow - 15  3.38
 Possibilit ies( Billions ¥)
Variable Pessimisti c Expected Optimistic
Market size 1.1 3.4 5.7
Market share - 10.4 3.4 17.3
Unit price - 4.2 3.4 5.0
Unit var cost - 15.0 3.4 11.1
Fixed cost 0.4 3.4 6.5
• Scenario analysis:
• Assumptions (more than 1 variable are changed at one time)
Scenario analysis is useful when a limited number of scenarios and combinations
of variables are considered
• Break-even analysis
– A common tool for analyzing the relationship between sales volume
and profitability
• There are three common break-even measures
• Accounting break-even: sales volume at which net income = 0

• Cash break-even: sales volume at which operating cash flow = 0

• Financial break-even: sales volume at which net present value = 0

• Let’s assume Q is the accounting break-even point
• Net profit=Q*(0.375 mil - 0.3 mil) - 3000 mil -1500 mil = 0
Q=60,000 units
• Now let’s assume N is the financial break-even point
• OCF=[N*(unit price-unit variable cost)-Fixed cost-Dep’n]
*(1-t) + Dep’n
𝑂𝐶𝐹
𝑁𝑃𝑉 = −15 + σ10
𝑡=1 1.10𝑡 = 0, therefore N=85,000 units

• It’s obvious that N > Q (Why?)

• Accounting break-even ignores the opportunity cost and the
time value of money