Master in Management of International Projects

CORPORATE FINANCE
Alexandra Horobe , PhD
Professor – ASE Bucharest

Course topics
Introduction to Corporate finance Fundamental principles of finance Time value of money Investment criteria Cash flow principles

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Corporate Finance / MPI / Alexandra Horobet, PhD

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Topic #1

Introduction to Corporate finance
Finance is the study of managing funds it involves where to raise them and how to use (invest) them Basic areas of finance
Corporate Finance Investments Financial institutions and markets International finance

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Corporate Finance / MPI / Alexandra Horobet, PhD

What is corporate finance?
Corporate finance is finance applied in a business setting Corporations face two main financial questions questions:
1. What investments should

the firm make? 2. How should it pay for those investments?

SPENDING MONEY RAISING MONEY

The secret of success in financial management is TO INCREASE COMPANY’S VALUE
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Some statements about Corporate finance
Corporate finance has an internal consistency
Objective function maximizing firm value Fundamental principles on which it is based

Corporate finance must be viewed as an integrated whole, rather than as a collection of decisions The best way to learn managerial finance is by applying its models and theories Corporate finance is fun ☺

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Corporate Finance / MPI / Alexandra Horobet, PhD

Finance and Economics
Finance is closely related to economics Financial managers must:
understand the economic framework and be alert to consequences of varying levels of economic activity and changes in economic policy be able to use economic theories as guidelines for efficient business operations:
supply and demand analysis profit-maximizing strategies price theory

The most important economic principles used in managerial finance are marginal analysis and opportunity cost
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PhD 4 .Finance and Accounting The firm’s treasurer and controller activities are closely related and generally overlap Managerial finance and accounting are not easily distinguishable There are two basic differences between finance and accounting: Finance Revenues and expenses are considered on: Decision making A cash basis Financial managers evaluate the data and make decisions Accounting An accrual basis Accountants collect and present financial data 7 Financial reporting and statements Financial reporting provides information about: The economic resources of an enterprise and the claims to those resources The effects of transactions and events that change resources and claims to those resources An enterprise’s financial performance during a period Interested parties in financial reporting and statements: Current and potential investors and creditors Managers of the company Any interested parties that have a reasonable understanding of the business and economic activities 8 Corporate Finance / MPI / Alexandra Horobet.

with the change in retained earnings between the start and the end of that year Statement of cash flows a summary of the cash flows over the period of concern 9 Corporate Finance / MPI / Alexandra Horobet. PhD 5 .Basic financial statements Balance sheet presents a summary statement of the firm’s financial position at a given point in time Income statement provides a financial summary of the firm’s operating results during a specified period Statement of retained earnings reconciles the net income earned during a given year. PhD Balance sheet The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity Assets are economic resources which are owned by a business and are expected to benefit future operations Liabilities are obligations of the entity to outside parties who have furnished resources Equity are net assets or net liabilities 10 Corporate Finance / MPI / Alexandra Horobet. and any cash dividends paid.

liabilities or equity can actually be bought or sold Market value and book value are often very different equity and asset “market values” are usually higher than their “book values” Which is more important to the decision-making process? 12 Corporate Finance / MPI / Alexandra Horobet.The main balance sheet items Current Assets Cash Marketable securities Receivables Inventories Current Liabilities Payables Accruals Short-term debt + Fixed Assets Tangible Assets Intangible Assets 11 = + Long-term Liabilities + Shareholders’ Equity Corporate Finance / MPI / Alexandra Horobet. PhD Market value versus Book value The balance sheet provides the book value of the assets. liabilities and equity Market value is the price at which the assets. PhD 6 .

assets worth $10 billion. and the debt’s market value is $4 billion. Equity = $7. debt worth $4 billion. Debt = $4 bill. PhD Market Value vs.5 bill. Book Value Example (continued) Book Value Balance Sheet Assets = $10 bill. Debt = $4 bill.Market Value vs. PhD 7 . The market value of your firm’s equity is $7. Book Value Example Your firm has equity worth $6 billion. 14 Corporate Finance / MPI / Alexandra Horobet.5 bill. Q:What is the market value of your assets? A: Since (Assets = Liabilities + Equity). 13 Corporate Finance / MPI / Alexandra Horobet. Market Value Balance Sheet Assets = $11. Equity = $6 bill. your assets must have a market value of $11.5 billion.5 billion.

PhD 8 .669 2.Bartlett Co.244 Paid-in capital in excess of par on common stock Retained earnings Total stockholders' equity 200 191 428 1.072 1.374 3. in 2002: 76.223 2.50 par.866 358 275 98 4.693 316 314 96 4.270 0 1 10 123 134 327 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY 16 Corporate Finance / MPI / Alexandra Horobet.$ in thousands 2003 2002 Changes 363 68 503 289 1.023 1.322 2.000 shares authorized.012 1.450 112 -20 45 137 56 193 Long-term debt TOTAL LIABILITIES Stockholders' equity Preferred stock .954 3.597 Corporate Finance / MPI / Alexandra Horobet.$ in thousands 2003 2002 Changes LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Accounts payable Notes payable Accruals Total current liabilities 382 79 159 620 1. $100 at par. Balance Sheet As of December 31 .004 1.056 2. 100.262.135 1.820 3. 2.270 75 17 138 -11 219 169 173 42 -39 2 347 239 108 327 Gross fixed assets (at cost) Land and buildings Machinery and equipment Furniture and fixtures Vehicles Other (includes financial leases) Total gross fixed assets (at cost) Less: Accumulated depreciation Net fixed assets TOTAL ASSETS 15 Bartlett Co. Balance Sheet ASSETS Current assets Cash Marketable securities Accounts receivable Inventories Total current assets As of December 31 . PhD 288 51 365 300 1.643 270 99 114 483 967 1.$2.000 shares authorized and issued Common stock .597 200 190 418 1.295 2.903 1. shares issued and outstanding in 2003: 76.cumulative 5%.266 3.

Income Statement Sales revenue Less: Cost of goods sold Gross profit Less: Operating expenses Selling expenss General and administrative expenses Lease expense Depreciation expense Total operating expenses Operating profits (EBIT) Less: Interest expense Net profits before taxes (EBT) Less: Taxes Net profits after taxes (EAT) Less: Preferred stock dividends Earnings available to common stockholders 18 As of December 31 .$ in thousands 2003 3. PhD Bartlett Co.711 863 108 187 35 223 553 310 91 219 64 155 10 145 Change 500 377 123 0 -8 7 0 16 15 108 2 106 31 75 0 75 Corporate Finance / MPI / Alexandra Horobet.088 986 100 194 35 239 568 418 93 325 94 231 10 221 2002 2.Income Statement The income statement is more like a video of the firm’s operations for a specified period of time You generally report revenues first and then deduct any expenses for the period Matching principle – accounting rules (GAAP.574 1. IAS) say to show revenue when it accrues and match the expenses required to generate the revenue 17 Corporate Finance / MPI / Alexandra Horobet.074 2. PhD 9 .

012 Total liabilities and owners’ equity $3.270 $1. PhD Liabilities and Owners’ Equity Liabilities $1.004 2. not when the cash exchanges actually occur Profits do not consider changes in working capital 19 Corporate Finance / MPI / Alexandra Horobet. PhD Statement of retained earnings Condensed Balance Sheet As of December 31.088 Gross profit 986 Less operating exp. 2002 Assets Current assets Net fixed assets Total assets $1. 568 EBIT 418 Interest & taxes 187 EAT. 2003 $231 Statement of Retained Earnings Retained earnings Add net income Less dividends paid Retained earnings 20 Corporate Finance / MPI / Alexandra Horobet.266 $3. Cash Flows Differences Profits subtract depreciation (a non-cash expense) Profits ignore cash expenditures on new capital Profits record income and expenses at the time of sales.450 Owners’ Equity Paid-in capital 808 Retained earnings 1.074 Less COGS 2.135 10 .Profits vs.012 231 1.270 Income Statement For the Year 2003 Sales revenue $3.243 108 $1.

597 21 Corporate Finance / MPI / Alexandra Horobet.135 Current assets Net fixed assets Total assets $1.643 Owners’ Equity Paid-in capital 819 Retained earnings 1.243 108 $1.374 $3. 2003 Assets Statement of Retained Earnings Retained earnings Add net income Less dividends paid Retained earnings $1. PhD Bartlett Co.223 2. PhD 92 11 .012 231 1.597 Liabilities and Owners’ Equity Liabilities $1.135 Total liabilities and owners’ equity $3.Statement of retained earnings Condensed Balance Sheet As of December 31. – Statement of cash flows Cash Flow from Operating Activities Net profits after taxes Depreciation expense Change in accounts receivable Change in inventories Change in accounts payable Change in accruals Cash provided by operating activities 231 239 -138 11 112 45 500 Cash Flow from Investment Activities Change in gross fixed assets Change in business interests Cash provided by investment activities -347 0 -347 Cash Flow from Financing Activities Changes in notes payable Changes in long-term debt Changes in stockholders' equity Dividends paid Cash provided by financing activities -20 56 11 -108 -61 Net increase in cash and marketable securities 22 Corporate Finance / MPI / Alexandra Horobet.

a firm will be compared to a key competitor in industry benchmarking Time-series analysis evaluates performance over time and enables assessing the firm’s progress Combined analysis to ratio analysis 24 the most informative approach Corporate Finance / MPI / Alexandra Horobet. PhD Financial ratios comparisons Cross-sectional analysis involves comparison of different firms’ financial ratios at the same point in time It is important to understand how the firm has performed in relation to other firms in its industry Frequently. PhD 12 .Financial analysis/ratios objectives Ratio analysis involves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance Basic inputs: income statement and balance sheet Interested parties: Shareholders risk and return characteristics of the firm Creditors short-term liquidity & company ability to make interest and principal payments Management all aspects of firm’s financial situation 23 Corporate Finance / MPI / Alexandra Horobet.

51 620 For Bartlett ⇒ Quick ratio = Cash ratio = Cash + Marketable securities Current liabilities 363 + 68 = 0.289 = 1.223 . PhD 13 .Financial ratios Liquidity ratios – measure the firm’s ability to satisfy shortterm obligations as they come due Leverage (financing) ratios – measure the firm’s ability to pay its long-term debt Efficiency (activity) ratios – measure the speed with which various accounts are converted into sales or cash Profitability ratios – shows the firm’s ability to generate income from its assets Market ratios – give insight into how well investors in the market value the firm 25 Corporate Finance / MPI / Alexandra Horobet.97 620 For Bartlett ⇒ Current ratio = Quick ratio = Current assets . PhD Liquidity ratios Current ratio = Current assets Current liabilities 1.69 620 For Bartlett ⇒ Cash ratio = 26 Corporate Finance / MPI / Alexandra Horobet.223 = 1.Inventory Current liabilities 1.

06 93 Corporate Finance / MPI / Alexandra Horobet.52 1.954 EBIT + Depreciati on Interest 418 + 239 For Bartlett ⇒ TIE = = 7.074 = 0.954 Long .term debt + Value of leases Equity For Bartlett ⇒ Debt equity ratio = Times interest earned(TIE ) = 1.34 1.term debt + Value of leases + Equity For Bartlett ⇒ Debt ratio = Debt equity ratio = 1.597 Total assets turnover = For Bartlett ⇒ Total assets turnover = 28 Corporate Finance / MPI / Alexandra Horobet.85 3. PhD 27 Efficiency ratios and operating cycle Efficiency of total assets Sales Total assets 3.023 + 1.term debt + Value of leases Long . PhD 14 .023 = 0.023 = 0.Leverage ratios Debt ratio = Long .

55 days 7.Operating cycle 29 Corporate Finance / MPI / Alexandra Horobet.22 For Bartlett ⇒ Inventory period = 30 Corporate Finance / MPI / Alexandra Horobet. PhD Operating cycle Efficiency of current assets – OPERATING CYCLE Finding the inventory period Inventory turnover = Cost of goods sold Inventory 2.22 289 For Bartlett ⇒ Inventory turnover = Inventory period = 365 Inventory turnover 365 = 50.088 = 7. PhD 15 .

PhD Operating cycle Finding the payables period Cost of goods sold A/P 2.11 503 365 Receivable s period = A/R turnover A/R turnover = For Bartlett ⇒ Receivable s period = 365 = 59.74 = 110.56 days 32 Corporate Finance / MPI / Alexandra Horobet.074 For Bartlett ⇒ A/R turnover = = 6.29 days 31 Corporate Finance / MPI / Alexandra Horobet.Operating cycle Finding the accounts receivable (collection) period Sales A/R 3.47 382 365 Payables period = A/P turnover A/P turnover = For Bartlett ⇒ Payables period = 365 = 66.11 Operating cycle = Inventory period + Receivable s period For Bartlett ⇒ Operating cycle = 50.73 days 5.47 Cash cycle = Operating cycle .29 − 66.55 + 59.74 days 6.088 For Bartlett ⇒ A/P turnover = = 5.Payables period For Bartlett ⇒ Cash cycle = 110. PhD 16 .73 = 43.

PhD 17 .074 .074 Corporate Finance / MPI / Alexandra Horobet.60% 3. the longer the inventory period The longer it takes customers to pay their bills.3208 or 32.19% 3.2.074 Net profit margin = Earnings available to common shareholders Sales For Bartlett ⇒ Net profit margin = 34 221 = 0.08% 3.074 Operating profits Sales For Bartlett ⇒ Operating profit margin = 418 = 0.1360 or 13. PhD Profitability ratios Gross profit margin = Sales .0719 or 7. the shorter the cash cycle the cash conversion cycle is not given it is under management’s control to a large extent balance between the costs and benefits of maintaining high current assets 33 Corporate Finance / MPI / Alexandra Horobet.A few considerations on operating cycle The longer the production process.088 = 0.COGS Sales For Bartlett ⇒ Gross profit margin = Operating profit margin = 3. the longer the accounts receivable period The longer the accounts payable period.

1260 or 12.Profitability ratios ROA = Earnings available to common shareholde rs Total assets 221 = 0.597 For Bartlett ⇒ ROA = ROE = Earnings available for common shareholde rs Common shareholde rs' equity 221 = 0.4434 or 44.754 For Bartlett ⇒ ROE = 35 Corporate Finance / MPI / Alexandra Horobet.262 Payout ratio = Dividends to common shareholders Earnings available to common shareholders 98 = 0.34% 221 For Bartlett ⇒ Payout ratio = 36 Corporate Finance / MPI / Alexandra Horobet. PhD Market ratios Earnings per share (EPS) = Earnings available to common shareholders Number of shares outsanding For Bartlett ⇒ EPS = 221.0614 or 6. PhD 18 .000 = $2.14% 3.60% 1.90 76.

754.18% = 6.40 23 (1.25 32.14% 38 Corporate Finance / MPI / Alexandra Horobet.to .Market ratios P/E ratio (PER) = Price per share of common stock Earnings per share 32.90 For Bartlett ⇒ PER = Market .25 = = 1.85 × 7. PhD 19 .13 2.000/76. PhD The DuPont system ROA = Earnings available to common stockholders Total assets = Sales Earnings available to common stockholders x Total assets Sales Assets turnover ratio Net profit margin For Bartlett ⇒ ROA = 0.25 = 11.262) For Bartlett ⇒ Market − to − book ratio = 37 Corporate Finance / MPI / Alexandra Horobet.book ratio = Price per share of common stock Book value per share 32.

000 = 7.85 × 2. PER 2.00 51.86 32.26 0.97 1. Earnings per share 5.46 0.36% 34.70% 52.000 3.50 1.79 6.60 55.25 30.000 3.75 32.73 0.53% 13. Quick ratio 3. Net profit margin 4.597. Total assets turnover 1.41 4.20% 2.30 2.08 2. Current ratio 2.44 0. Efficiency 3. Market 1.71 5.14% 4.76 0. Days in inventory 3.05 1.91 0. PhD 20 .52 59.43 0.22 50.13% 7.45% 12.00% 6.89 1.85 2002 Industry average 2003 2.46 1.074. Leverage 34.60% 39 Corporate Finance / MPI / Alexandra Horobet. Liquidity 1.06% 6.50% 12. Market to book ratio 40 Corporate Finance / MPI / Alexandra Horobet. Operating profit margin 3. Cash ratio 1.000 3.75 0. Average collection period 4.59% 8.14 1.70 64.42 6.60% 8.60% 12.597.05 = 12. Times interest earned 1.754.08% 33. Debt ratio 2.04% 7. Gross profit margin 2.18% × 0.35% 53.18% 5. Debt-to-equity ratio 3.The DuPont system ROE = Earnings available to common stockholders Shareholders' equity Earnings available to common stockholders = Net profit margin Sales Sales × Assets turnover ratio Total assets Total assets Leverage ratio × Shareholders' equity For Bartlett ⇒ ROE = 221. Profitablity 1.70 0.65% 2.98% 11. Inventory turnover 2.70 7. ROA 7.074.06 5. ROE 5.00% 11.85 4. PhD Time-series and cross-sectional analysis for Bartlett 2003 1.51 0.000 × × 3.000 1.30 42. Payout ratio 6.46% 48.40 9.

PhD Topic #2 Fundamental principles of finance Role of financial manager Working with cash flows Goals of the corporation Financial institutions and markets Basic principles and rules in finance 42 Corporate Finance / MPI / Alexandra Horobet. PhD 21 .Problems of financial statements analysis The need for theory There is no compelling rationale for use of financial statement to make judgment about value and risk Which ratios matter most? What is the “right” value for the ratio? Conglomerates Not identified in a single industry or sector Hard to find comparables Global reach Comparability of financial statements between countries is problematic 41 Corporate Finance / MPI / Alexandra Horobet.

finance is about people WHY? PEOPLE ARE THE ONES THAT MAKE DECISIONS THE FINANCIAL MANAGER MUST DEAL WITH THE CONFLICTING OBJECTIVES ENCOUNTERED IN FINANCIAL MANAGEMENT 44 Corporate Finance / MPI / Alexandra Horobet. 3. PhD 22 . In what long-lived assets should the firm invest? CAPITAL BUDGETING How can the firm raise cash for required capital CAPITAL STRUCTURE expenditures? How should short-term operating cash-flows be managed? NET WORKING CAPITAL 43 Corporate Finance / MPI / Alexandra Horobet. PhD The financial manager Finance is about money and markets (most people think that way and they are right!!) Also.Three fundamental questions Corporate Finance is the study of 3 questions: 1. 2.

PhD What is the job of the financial manager? Separation of ownership and management for corporations shareholders delegate decision making for managers delegation works only if all shareholders have the same objective This objective is TO MAXIMIZE THE CURRENT VALUE OF THEIR INVESTMENT An effective financial manager makes decisions which increase the current value of the company and the wealth of its shareholders 46 Corporate Finance / MPI / Alexandra Horobet.Who is the financial manager? Chief Financial Officer (CFO) Responsible for: • Financial policy • Corporate planning Treasurer Responsible for: • Cash management • Raising capital • Banking relationships Controller Responsible for: • Preparation of financial statements • Accounting • Taxes 45 Corporate Finance / MPI / Alexandra Horobet. PhD 23 .

Finding the right financial instruments for financing the company.What is the job of the financial manager? The most important job of the financial manager is to create value from the firm’s capital budgeting. including the innovative tools available in the market 1. financing and liquidity activities How do financial managers create value? Buying assets that generate more cash than they cost 2. PhD 24 . 47 Corporate Finance / MPI / Alexandra Horobet. PhD Interplay: firm’s finance and financial markets 48 Corporate Finance / MPI / Alexandra Horobet.

49 Corporate Finance / MPI / Alexandra Horobet. PhD Agency costs 25 . PhD Do managers really maximize firm value? In most large corporations the managers are not the owners and they might be tempted to act in ways that are not in the best interests of the owners Conflicts between managers and shareholders Agency problems How are they solved? • Compensation plans for managers • Involvement of board of directors • Takeover threat • Specialist monitoring 50 Corporate Finance / MPI / Alexandra Horobet.Why maximizing short-term profits is a wrong goal? 1. Which year’s profits? Future profits can be increased by cutting current year’s dividend and investing the freed-up cash Profits can be calculated in different ways 3. 2.

000 –900. on February 8. PhD Timing and risk of cash flows The value of an investment made by the firm depends on the timing of cash flows Basic assumption in finance: individuals prefer to receive cash flows earlier rather than later ONE DOLLAR RECEIVED TODAY IS WORTH MORE THAN ONE DOLLAR RECEIVED TOMORROW The amount and timing of cash flows are not usually known with certainty Another basic assumption in finance: investors have aversion to risk 52 Corporate Finance / MPI / Alexandra Horobet.000 – 900.000 100. The raw materials and salaries required for the production of goods have been paid on December 3. had sold on December 7 goods of 1 mil. PhD 26 .Identifying cash flows Assume ABC Co.000.31 THE ABC COMPANY Corporate finance view Income statement – Dec. THE ABC COMPANY Accounting view Income statement – Dec.31 0 –900. which are to be paid next year..000 Sales Costs Profit 51 1.000 Cash inflows Cash outflows Net cash flow Corporate Finance / MPI / Alexandra Horobet.

PhD 27 .Financial institutions and markets Financial institutions act as intermediaries between investors and firms Rationale of financial institutions: promoting efficient allocation of resources Two types of relations between funds suppliers and funds demanders Deposits Funds suppliers INDIRECT FINANCE Loans Financial intermediaries Funds demanders DIRECT FINANCE 53 Corporate Finance / MPI / Alexandra Horobet. PhD Types of financial markets FINANCIAL MARKETS Maturity Type of sale Money markets Capital markets Primary markets Secondary markets 54 Corporate Finance / MPI / Alexandra Horobet.

PhD 28 .The financial market economy Individuals have different preferences for consuming and investing Financial markets develop to facilitate borrowing and lending between individuals so as they reach their consumption and investment preferences Financial markets trade financial instruments The interest rate on financial instruments is set so as the total demand for loans equals the total supply of loans 55 Corporate Finance / MPI / Alexandra Horobet. ARBITRAGE 56 Corporate Finance / MPI / Alexandra Horobet. PhD Competitive financial markets Conditions for a competitive financial market: Trading is costless Information about lending and borrowing is readily available There are many traders and no single trader can have a significant impact on market prices Only one interest rate can be quoted in the market at any one time if not.

PhD A lending and a borrowing example Consider a person concerned only about this year and the next one Income of $100. PhD 29 .000 this year and $100.000 next year? Problem 2: should she invest in the same piece of land that costs $70.000 and brings a certain $75.000 next year? 58 Corporate Finance / MPI / Alexandra Horobet.The basic principle in finance Financial markets provide a benchmark against which proposed investments can be compared The interest rate is the basis for a test that any proposed investment must pass An investment project is worth undertaking only if it increases the range of choices in the financial markets the project must be as desirable as what is available in the financial market 57 Corporate Finance / MPI / Alexandra Horobet.000 next year Interest rate is 10% Problem 1: should she invest in a piece of land that costs $70.000 and brings a certain $80.

727.000 Net present value = -$70. and not about meeting the consumption preferences of the shareholders 59 Corporate Finance / MPI / Alexandra Horobet.1) = -$70.Fisher’s separation theorem The value of an investment to an individual is not dependent on his consumption preferences However. these preferences dictate whether the person will borrow or lend As a consequence.000×(1/1. PhD 30 . PhD Evaluating an investment opportunity Cash inflows r = 10% $80.000 Time 0 1 Cash outflows -$70.000 + $80.727 60 Corporate Finance / MPI / Alexandra Horobet. the managers of the firm may worry only about maximizing the value of the company.27 = +$2.000 + $72.

727.727.000.000 + $72.Evaluating an investment opportunity Net present value (NPV) rule how much cash an investor would need to have today as a substitute for making the investment NPV > 0 investment is worth taking doing so is essentially the same as receiving a cash payment equal to the NPV NPV < 0 investment should be rejected taking it on today is equivalent to giving up some cash today 61 Corporate Finance / MPI / Alexandra Horobet.27 62 Corporate Finance / MPI / Alexandra Horobet.000 ×(1/1. PhD Present value and net present value The present value of a future cash flow is the value of that cash flow after considering the appropriate market interest rate Example: PV($80. 1 y. PhD 31 .727.27 The net present value of an investment is the PV of the investment’s future cash flows minus the initial cost of the investment Example: NPV= -$70. 10%) = = $80.1) = 72.27 = $2.

28% 70.000 − 70.000 Return > 10% project should be accepted !!! Equivalent to NPV > 0 IMPORTANT CONCLUSION: CONCLUSION: The NPV rule and the Rate of return rule are two equivalent decision rules for capital investment 64 Corporate Finance / MPI / Alexandra Horobet.000 = 0.NPV rule and rate of return rule Another way of stating the NPV rule is through the rate of return rule Only investments that offer rates of return in excess of their opportunity costs of capital should be accepted Rate of return > Opportunity cost of capital accept project Rate of return < Opportunity cost of capital reject project 63 Corporate Finance / MPI / Alexandra Horobet.1428 or 14. PhD Rate of return rule – an example Rate of return = Return = Profit Investment 80. PhD 32 .

PhD 33 .The opportunity cost of capital The opportunity cost of capital is the return foregone by investing in the project rather than investing in the financial market securities with the same risk as the project Also referred to as discount rate. hurdle rate Opportunity cost of capital is 10% (= r = the interest rate available in the financial market) We have obtained the present value of the investment by multiplying the cash flow in year 1 with a factor 1 DISCOUNT FACTOR 1+r 65 Corporate Finance / MPI / Alexandra Horobet. PhD Risk and present value The cash flows generated in the future by any investment cannot be certain We have to think in terms of expected payoffs and expected returns on investments Not all investments are equally risky The opportunity cost of capital for an investment has to take into account the risk of the project The appropriate discount rate for a project is the return obtained (and foregone) from an investment in the financial market of similar risk 66 Corporate Finance / MPI / Alexandra Horobet.

PhD Topic #3 Time value of money What is time value of money? Compounding and discounting Shortcuts: perpetuities and annuities Frequent compounding and interest rates Working with inflation 68 Corporate Finance / MPI / Alexandra Horobet.Corporate investment decision-making View firms as ways in which many investors can pool their resources to make large-scale business decisions Shareholders of the firm will be unanimous in wanting the firm to increase its value by taking on positive NPV projects Managers can all be given one simple instruction: MAXIMIZE NET PRESENT VALUE 67 Corporate Finance / MPI / Alexandra Horobet. PhD 34 .

PhD 35 .000 in one year.What is time value of money? Most financial decisions involve costs and benefits that are spread out over time Time value of money allows comparison of cash flows from different periods Using TVM we can offer answers to questions such as: “Would it be better for a company to invest $100.000 after two years?” 69 Corporate Finance / MPI / Alexandra Horobet.000 in a product that would return a total of $200. PhD What is time value of money? TVM concept: A dollar today is worth more than a concept: dollar tomorrow WHY? Real interest rate Time Inflation Risk 70 Corporate Finance / MPI / Alexandra Horobet. or one that would return $500.

that is. FV future value.r = PV x (1+r)t Future value factor (FVF) 72 Corporate Finance / MPI / Alexandra Horobet.Time value terminology 0 1 2 3 t PV FV PV present value. the value today. t the number of time periods between PV and FV r the discount rate all time value questions involve the four values above: PV. or the value at a future date. it is always possible to calculate the fourth 71 Corporate Finance / MPI / Alexandra Horobet. r. 5y) = $100 × (1. FV. 10%. How much will you have in 5 years? you are interested in finding the FV for five years of the $100 today (=PV) FV($100. PhD Future values You deposit $100 today at 10% interest.05 FVt. PhD 36 .1)5 = $161. and t given three of them.

PhD Simple interest vs. 74 Corporate Finance / MPI / Alexandra Horobet.10 = $100 × FVF(5y. compound interest Growth of $100 original amount at 10% per year Darker shaded area represents the portion of the total that results from compounding of interest.05 73 Corporate Finance / MPI / Alexandra Horobet.Future values using tables What is the future value of $100 today in 5 years at a 10% interest rate? FV5.6105 = $161. 10%) = $100 × 1. PhD 37 .

r = FV × 1/(1+r)t Discount factor or Present value factor (PVF) 76 Corporate Finance / MPI / Alexandra Horobet. If you can earn 8% on your money. PhD Present values The process of obtaining the PV is the inverse of the one which gives the FV Suppose you need $20. PhD 38 .876. how much do you need today? PV = $20.08)3 = $15.000 in three years to pay your college tuition.64 PVt.000 × 1/(1.The power of compounding 75 Corporate Finance / MPI / Alexandra Horobet.

15 = $1. PhD 39 .000 × 0. PhD The power of discounting 78 Corporate Finance / MPI / Alexandra Horobet.5 77 Corporate Finance / MPI / Alexandra Horobet.Present values using tables What is the present value of $1000 to be received in 3 years at a 15% interest rate? PV3. 15%) = $1.000 × PVF(3y.6575 = $657.

The case of multiple cash flows FV of a set of cash flows is the sum of FVs for the individual cash flows 79 Corporate Finance / MPI / Alexandra Horobet. PhD 40 . PhD The case of multiple cash flows PV of a set of cash flows is the sum of PVs for the individual cash flows 80 Corporate Finance / MPI / Alexandra Horobet.

What is the value today of this set of cash flows? PV(perpetu ity) = 81 $1.000 0.000.000 = $16. and the discount rate is 10%.000 = 2. PhD 41 . Your opportunity rate is 6%.0. If this continues indefinitely growing perpetuity PV(growing perpetuity ) = C r -g PV(growing perpetuity ) = 82 100.06 Corporate Finance / MPI / Alexandra Horobet.a.66 0.Perpetuities Perpetuity = financial concept in which a cash flow is received forever PV(perpetu ity) = Cash flow C = r r Example: Example Suppose you receive $1.1. These cash flows are expected to rise at 5% p. PhD Growing perpetuities Imagine an apartment building where cash flows to the landlord after expenses will be $100.000 next year.000 per year forever.666.05 Corporate Finance / MPI / Alexandra Horobet.

PhD Annuities Annuity = a stream of regular payments that lasts for a fixed number of periods The payments are assumed to be received at the end of each period A good example of an annuity is a lottery. 3. where the winner is paid over a number of years 84 Corporate Finance / MPI / Alexandra Horobet. PhD 42 . The numerator (C) is the cash flow one period hence. not at date 0 The discount rate (r) must be greater than the growth rate for the formula to work Timing assumption formula assumes cash flows are received and disbursed at regular and discrete points in time 83 Corporate Finance / MPI / Alexandra Horobet. 2.Few points concerning growing perpetuities 1.

PhD Calculating PV of an annuity Suppose you need $5. You can place money in a savings account yielding 5% compounded annually. PhD 43 .000 each year for the next three years to make your tuition payments. How much do you need to have in the account today? 86 Corporate Finance / MPI / Alexandra Horobet.000 in one year. You need the first $5.PV and FV of an annuity 1 1  PV(annuity) = C ×  − t   r r(1 + r)  PV ANNUITY FACTOR ⇒ in tables  (1 + r)t 1  FV(annuity) = C ×  −  r r  FV ANNUITY FACTOR ⇒ in tables 85 Corporate Finance / MPI / Alexandra Horobet.

PhD 44 .7232 = $13.05(1.000 × 2. How much money will you have in the account after 5 years? 88 Corporate Finance / MPI / Alexandra Horobet.000 per year in a savings account at 4% p.a.5%) = 5.000.05)  = 5.. compounded annually for 5 years. The first payment is made one year from now. 3y.05 0. PhD Calculating FV of an annuity Assume you deposit $2.000 ×  − 3  0.616 87 Corporate Finance / MPI / Alexandra Horobet.Calculating PV of an annuity  1  1 PV(5.

0075  0.04   0.5075 = 239. how much should you deposit at the end of each month to reach your goal?  (1. 5y.000 ×  −  0.04 = 2.000 = C ×  −  0.4%) = 2. If the account pays 9.000.0% annual interest compounded monthly.6 89 Corporate Finance / MPI / Alexandra Horobet.0075)12 1  3.832.000 in your savings account 12 months from now.85 90 Corporate Finance / MPI / Alexandra Horobet.4163 = $10. PhD 45 .0075 ⇒ C = 3. PhD Finding C in an annuity calculation You would like to have $3.04)5 1  FV(5.000 × 5.Calculating FV of an annuity  (1.000 ÷ 12.

12/12)5×12 = $181. (c) quarterly.12/2)5×2 = $179. (b) semiannually. PhD Compounding more frequently than annually What would be the difference in future value if you deposit $100 for 5 years and earn 12% annual interest compounded (a) annually.67 92 Corporate Finance / MPI / Alexandra Horobet.23 × 100 x (1 + 0. the effective interest rate is greater than then the nominal (annual) interest rate The effective rate of interest will increase the more frequently interest is compounded 91 Corporate Finance / MPI / Alexandra Horobet. and (d) monthly? Annually Semiannually Quarterly Monthly × 100 x (1 + 0.61 × 100 x (1 + 0.09 × 100 x (1 + 0. PhD 46 .Compounding more frequently than annually Compounding more frequently than annually results in a higher effective interest rate because you are earning interest on interest more frequently As a result.12/4)5×4 = $180.12/1)5×1 = $176.

PhD Nominal and effective rates What is the EAR on your credit card if the nominal rate is 18% p.18/4)4 – 1 = 19.. PhD 47 .a.1 EAR > APR whenever compounding occurs more than once per year 93 Corporate Finance / MPI / Alexandra Horobet.56% What if compounded quarterly? Answer: EAR = (1+ 0. compounded monthly? Answer: EAR = (1 + 0.25% 94 Corporate Finance / MPI / Alexandra Horobet.Nominal and effective rates The nominal interest rate (sometimes denoted APR – from annual percentage rate) is the stated or contractual rate rate of interest charged by a lender or promised by a borrower The effective annual rate (EAR) is the rate you actually pay or earn EAR = [1 + (r/m)]m .18/12)12 – 1 = 19.

38129 10.12 = $100 × e0.51709 95 Corporate Finance / MPI / Alexandra Horobet.51558 10.600 Effective annual rate (%) 10.22 96 Corporate Finance / MPI / Alexandra Horobet.760 525.47131 10.r = PV × ert 2.50648 10.12×5 = $182. PhD 48 .51703 10.Compounding periods.7183 What is the future value of a $100 deposit after 5 years if interest of 12% is compounded continuously? FV5. APRs and EARs Compounding period Year Quarter Month Week Day Hour Minute Number of times compounded 1 4 12 52 365 8. PhD Continuous compounding The number of compounding approaches infinity The FV equation becomes: periods per year FVt.00000 10.

What will be your real rate of interest if the inflation rate is zero? Real interest rate = 1.0 What if inflation rate is 5%? Real interest rate = 1. PhD 49 . PhD Nominal and real interest rates Suppose you invest your funds at an interest rat of 8%.08 − 1 = 2.A word on inflation Rate of inflation = rate at which prices as a whole are increasing Nominal interest rate = rate at which money invested grows Real interest rate = rate at which the purchasing power of an investment increases 1 + real interest rate = 1 + nominal interest rate 1 + inflation rate OR using an approximation Real interest rate ≈ Nominal interest rate – Inflation rate 97 Corporate Finance / MPI / Alexandra Horobet.08 − 1 = 8% 1.85% 1.05 98 Corporate Finance / MPI / Alexandra Horobet.

Valuing cash flows Nominal (current) cash flows must be discounted by the nominal interest rate Real cash flows must be discounted by the real interest rate If there is no error in the calculation. the two methods should always give the same result 99 Corporate Finance / MPI / Alexandra Horobet. PhD Topic #4 Investment criteria What is capital budgeting? Using net present value Payback period Internal rate of return and incremental IRR Profitability index and capital rationing 100 Corporate Finance / MPI / Alexandra Horobet. PhD 50 .

PhD Types of projects Independent projects Mutually exclusive projects Expansion projects Existing products / markets New products / markets Replacement projects Maintenance of business Cost reduction Research & development projects Other projects (safety / environmental projects) 102 Corporate Finance / MPI / Alexandra Horobet.What is capital budgeting? Capital budgeting deals with the analysis of potential additions to firm’s fixed assets These are long-term decisions that generally involve large expenditures Any of the following decisions would qualify as projects: Major strategic decisions to enter a new area of business or new markets Acquisitions of other firms Decisions on new ventures with existing business or markets Decisions that may change the way existing ventures and projects are run 101 Corporate Finance / MPI / Alexandra Horobet. PhD 51 .

000 Expenses 500 Cash flow – $1.00 $500 x +454.000 Expenses $500 1.000 Cash flow $1.NPV rule illustrated Assume you have the following information on Project X: Initial outlay: -$1.102 52 .100.000 x 1 1. PhD 2 Revenues $2.000 $500 1 1. PhD NPV rule concluded 0 Initial outlay ($1.55 +826.00 NPV 104 Corporate Finance / MPI / Alexandra Horobet.10 $1.100) 1 Revenues $1.000 Draw a time line and compute the NPV of project X 103 Corporate Finance / MPI / Alexandra Horobet.000 2.45 +$181.000 Expenses 1.100 Required return = 10% Annual cash revenues and expenses are as follows: Year 1 2 Revenues $1.

Foundations of the NPV rule Why does NPV work? And what does “work” mean? A “firm” is created when security holders supply the funds to acquire assets that will be used to produce and sell goods and services The market value of the firm is based on the free cash flows it is expected to generate 105 Corporate Finance / MPI / Alexandra Horobet. PhD Foundations of the NPV rule (cont’d) Thus. “good” projects are those which increase firm value “Good” projects are those projects that have positive NPVs Moral: Moral: INVEST ONLY IN PROJECTS WITH POSITIVE NPVs 106 Corporate Finance / MPI / Alexandra Horobet. PhD 53 .

PhD Payback period The payback period of a project (PB) is the number of years it takes before the cumulative forecasted cash flows equal the initial outlay Payback period rule accept projects that “payback” in the desired time frame 108 Corporate Finance / MPI / Alexandra Horobet. PhD 54 . since it takes into account TVM 107 Corporate Finance / MPI / Alexandra Horobet.Why do we like NPV that much? NPV uses cash flows. and not other accounting artificial constructs NPV uses all the cash flows generated by the project during its life NPV discounts the cash flows properly.

000 -2.000 -2.000 C1 500 500 1800 C2 500 1800 500 C3 5000 0 0 Payback period 3 2 2 109 Corporate Finance / MPI / Alexandra Horobet.000 C1 500 500 1800 C2 500 1800 500 C3 5000 0 0 Payback period 3 2 2 NPV @ 10% +2. PhD 55 .624 -58 +50 110 Corporate Finance / MPI / Alexandra Horobet.000 -2. PhD Pitfalls in using the payback period Which project to choose from the followings? Project A B C C0 -2.000 -2.Pitfalls in using the payback period Which project to choose from the followings? Project A B C C0 -2.

PhD Use of payback period PB is often used when making relatively small decisions PB has some desirable features for managerial control PB ensures liquidity Nevertheless.Pitfalls in using the payback period Payback period may select projects that are not acceptable under NPV rule Timing of cash flows within the payback period compare project B and project C Payments after the payback period project A and project C Arbitrary standard for payback period compare 111 Corporate Finance / MPI / Alexandra Horobet. as a decision grows in importance. the NPV becomes the order of the day 112 Corporate Finance / MPI / Alexandra Horobet. PhD 56 .

PhD 57 .44% ⇒ this r is IRR IRR rule: rule: • Accept the project if IRR > opportunity cost of capital • Reject the project if IRR < opportunity cost of capital 114 Corporate Finance / MPI / Alexandra Horobet. PhD Internal rate of return illustrated Year Cash flow 0 -200 1 50 2 100 3 150 Find r such that NPV = 0 0 = −200 + 50 100 150 + + 2 1 + r (1 + r) (1 + r )3 r = 19.Internal rate of return IRR tries to find a single number that summarizes the merits of a project This number does not depend on the interest rate that prevails in the capital market The number is intrinsic to the project and only depends on the cash flows of the project and their timing 113 Corporate Finance / MPI / Alexandra Horobet.

44% Approximation formula NPV + IRR = rmin + (rmax − rmin ) × NPV + + NPV − For our project : IRR = 15 + (20 − 15) × 116 18 = 19. PhD 58 .00 40.00 -40.00 -60.00 IRR = 19.00 1 -20.NPV profile 100.00 5 9 13 17 21 25 29 Discount rate (%) 115 Corporate Finance / MPI / Alexandra Horobet.44% NPV 20. PhD Trial and error for IRR Trial and error Discount rates 0% 5% 10% 15% 20% NPV $100 68 41 18 -2 IRR is just under 20% 19.00 80.00 0.5% 18 + 2 Corporate Finance / MPI / Alexandra Horobet.00 60.

00 -5.00 0 -15. PhD Investing or financing? With some cash flow patterns. PhD Corporate rate / MPI 59 .00 25. the NPV of the project increases as the discount rate increases 35.00 5.Pitfalls with the IRR approach Pitfall 1: IRR assumes funds can be invested each year at the same rate Pitfall 2: Investing or financing? Pitfall 3: Multiple rates of return Pitfall 4:The scale problem Pitfall 5:The timing problem 117 Corporate Finance / MPI / Alexandra Horobet.00 -25.00 118 Project A IRR(A) = IRR(B) Year A B 100 -130 0 -100 1 130 10 20 30 40 50 60 Project B DiscountFinance(%) / Alexandra Horobet.00 -35.00 Net present value 15.

IRR rule is reversed: Accept project if IRR < opportunity cost of capital Reject project if IRR > opportunity cost of capital 119 Corporate Finance / MPI / Alexandra Horobet.08 15 25 35 45 55 65 IRR2 = 33.035 3 2.8% -0.02 -0. PhD Multiple internal rates of return Year Cash flow 0 -252 1 1. PhD 60 .000 0.6% IRR1 = 25.04 0.0% IRR3 = 42.3% 120 Discount rate Corporate Finance / MPI / Alexandra Horobet.06 -0.431 2 -3.Investing or financing? Project A is a substitute for investing Project B is a substitute for financing In the case of financing-like projects.850 4 -1.04 -0.00 NPV IRR4 = 66.02 0.

The two projects look as follows: C0 Small budget Large budget -$10 mil. IRR 300% 160% Which one would you choose? 122 Corporate Finance / MPI / Alexandra Horobet. PhD 61 . NPV @ 25% $22 mil.Multiple rates of return When should we expect a project to have more than one IRR? Answer: whenever we have more than one sign change (+/. $65 mil. IRR rule cannot be applied the only criteria we can use 121 Corporate Finance / MPI / Alexandra Horobet. -$25 mil. $27 mil. PhD NPV is The scale problem Suppose you have purchased the rights to produce a motion picture and you have to decide on allocating either a small or a large budget for it. C1 $40 mil.or -/+) on the cash flows How many IRRs can a project have? Answer: as many as the number of sign changes (example: 4 changes maximum 4 IRRs) In all these cases.

000 @10% @15% 669 751 109 -484 1 10.000 -10.25 Large budget is better than small budget project 123 Corporate Finance / MPI / Alexandra Horobet.A Inv.67% > 25% 1 + IRR 25 NPV of incrementa l cash flows = −15 + =5>0 1.00 0.04% 5 10 15 20 IRRB=12.000 Intersection point @ 10. 94% Corporate Finance Discount rateHorobet.00 -2000.000 3 1. small budget large -25 – (-10) = -15 C1 65 – 40 = 25 0 = −15 + 25 ⇒ Incrementa l IRR = 66.00 124 NPV 2 1. PhD The timing problem Year 0 Inv.55% IRRA=16.00 0 -1000.000 1.00 NPV 1000.000 4. B -10. PhD / MPI / Alexandra 62 .00 3000.000 4000.000 1.The scale problem and incremental IRR Incremental IRR of large budget versus small budget C0 Incremental cash flows: budget vs.000 @0% 2.00 2000.000 12.

PhD 63 . PhD Profitability index Profitability index = PV(Cash flows subsequent to initial investment ) Initial investment PI Rule for independent projects: Accept project if PI > 1 Reject project if PI < 1 Look at this! NPV > 0 NPV < 0 PI > 1 PI < 1 IRR > discount rate IRR < discount rate ACCEPT PROJECT REJECT PROJECT 126 Corporate Finance / MPI / Alexandra Horobet.The timing problem In making the decision between projects like A and B one should not compare their IRRs Selecting the best project: Compare NPVs of the two projects Compare incremental IRR to the discount rate Calculate NPV on incremental cash flows 125 Corporate Finance / MPI / Alexandra Horobet.

but you have only $20 mil.4 Suppose the projects above are independent.34 NPV @ 12% 50. PhD Capital rationing Cash flows Project 1 2 3 C0 -20 -10 -10 C1 70 15 -5 C2 10 40 60 PV @ 12% 70.5 35. Which project(s) do you choose? USE PROFITABILITY INDEX 128 Corporate Finance / MPI / Alexandra Horobet.3 43.5 45.53 4.4 PI 3.3 Same problems as in the case of scale problem form IRR decide using NPV 127 Corporate Finance / MPI / Alexandra Horobet. to invest. PhD 64 .Which project(s) do you choose? Suppose now you have $25 million to invest.53 4.Problems with PI Making decisions with PI for mutually exclusive projects Cash flows Project 1 2 C0 -20 -10 C1 70 15 C2 10 40 PV @ 12% 70.5 45.3 33.53 NPV @ 12% 50.3 PI 3.5 35.53 4.

Capital rationing Profitability index does not work if funds are also limited beyond the initial time period use linear programming Two types of capital rationing: Soft rationing provisional limits adopted by management as an aid to financial control Hard rationing desires the firm is unable to raise the money she 129 Corporate Finance / MPI / Alexandra Horobet. PhD 65 . PhD Topic #5 Cash flow principles Relevant cash flows of a project Calculating cash flows Example: Blooper project 130 Corporate Finance / MPI / Alexandra Horobet.

PhD 66 . PhD Incremental cash flows Ask yourself this question: “Would the cash flow still exist if the project did not exist?” If answer is YES analysis If answer is NO Incremental cash flow 132 do not include the cash flow in the include the cash flow Cash flow WITH project = - Cash flow WITHOUT project Corporate Finance / MPI / Alexandra Horobet. not later when the work is undertaken or the liability is incurred Projects are financially attractive because of the cash they generate The focus of capital budgeting must be on cash flow.Cash flows versus accounting profits Recognize cash flows when they occur. not profits Cash flow Dollars coming in Dollars going out = - 131 Corporate Finance / MPI / Alexandra Horobet.

Sunk costs A company is evaluating the NPV of establishing a line of chocolate milk.000 to perform a test marketing analysis. PhD 67 . At the same time.000. the company is able to sell the warehouse to another company for $200. Is this cost relevant for the current decision? NO this is a SUNK COST Sunk costs are past and irreversible outflows Sunk costs are NOT RELEVANT cash flows 133 Corporate Finance / MPI / Alexandra Horobet. The company has paid last year a consulting firm $100. PhD Opportunity costs Suppose a company wants to use an empty warehouse that she has in Seattle to store a new line of products. Should the price of the warehouse be included in the costs associated with introducing a new line of products? Answer:YES this is an OPPORTUNITY COST Opportunity costs are relevant cash flows 134 Corporate Finance / MPI / Alexandra Horobet.

Are the cash flows for new store the only cash flows you should take into account? NO. PhD 68 . Are all sales and profits from the new sports car incremental? Answer: NO some of the cash flow represents transfers from other elements of the company’s product line This is an example of EROSION or CANNIBALIZATION included in the NPV calculation 135 Corporate Finance / MPI / Alexandra Horobet. a compact sedan. since the new store might increase the traffic into the adult store and increase profits at that store This is an example of PROJECT SYNERGY 136 Corporate Finance / MPI / Alexandra Horobet.Indirect effects Suppose a company is determining the NPV of a new sports car. PhD Indirect effects – project synergies Assume you are a clothing retailer considering whether to open an up-scale clothing store for children in the same shopping center where you already own a store which caters to adult consumers. Some of the customers who would purchase the car are potential owners of the company’s other product.

or may not We should be cautious about assuming that the accountant’s allocation of overhead costs is an incremental cash flow for the project 137 Corporate Finance / MPI / Alexandra Horobet. PhD Investment in working capital Net working capital = Short-term assets Accounts receivable - Short-term liabilities Payables Inventories Cash Accruals Investments in working capital result in cash outflows Investments in working capital are relevant cash flows for a project 138 Corporate Finance / MPI / Alexandra Horobet.Allocated overhead costs A project may generate extra overhead costs. PhD 69 .

PhD 70 . ignore how it is financed Following the logic from incremental analysis. you must separate financing and investment decisions 140 Corporate Finance / MPI / Alexandra Horobet. PhD Separating investment and financing decisions When valuing a project.Investments in working capital Most common mistakes regarding working capital: Forgetting about working capital entirely Forgetting that working capital may change during the life of the project Forgetting that working capital is recovered at the end of the project 139 Corporate Finance / MPI / Alexandra Horobet. ask yourself the following question: “Are the cash flows of the project dependent of the project’s financing?” If the answer is NO.

etc. PhD CASH FLOW Calculating cash flows The initial cash outflow • Cost of new assets • Investment in working capital • Set-up costs. 142 Corporate Finance / MPI / Alexandra Horobet.Calculating cash flows Cash flow from investment in plant and equipment Cash flow from investments in the working capital Cash flow from operations 141 Corporate Finance / MPI / Alexandra Horobet. etc. • After-tax proceeds from sale of old assets CASH FLOW Intermediate cash flows (operating cash flows) Terminal Cash Flow • The last year operating cash flow • Recovery of the project’s incremental working capital • After-tax resale value of the assets related to the project. PhD 71 .

PhD 72 .$10 = $40 mil. Slick. 7 $50 . At that point. until replaced by a more advanced technology. The blade factory will run for 7 years. PhD Cash flow from investment in working capital You have forecasted the components of working capital over the life of a project: Date Accounts receivable Inventory Accounts payable NWC Cash flow 144 0 0 75 35 +40 -40 1 100 130 25 +205 -165 2 200 30 120 +110 +95 Corporate Finance / MPI / Alexandra Horobet. Date Cash flow 0 -$800 mil. the machinery will be sold for scrap metal. Taxes of $10 million will be assessed on the sale.Cash flow from capital investment Gillette’s competitor. for a price of $50 million. 143 Corporate Finance / MPI / Alexandra Horobet. invests $800 million to develop the Mock4 razor blade.

Cash flows from operations
A project generates revenues of $1,000, cash expenses of $600, and depreciation charges of $200 in a particular year.The firm’s tax bracket is 35%. Revenues Cash expenses EBITDA Depreciation expense EBIT Tax @ 35% Net operating income
145 Corporate Finance / MPI / Alexandra Horobet, PhD

1,000 600 400 200 200 70 130

Cash flow from operations
Method 1
Cash flow from operations

=

EBIT × (1-T)

+

Depreciation

In our example: CF = 130 + 200 = $330

146

Corporate Finance / MPI / Alexandra Horobet, PhD

73

Cash flows from operations
Method 2
Cash flow from operations

=
(Revenues – Cash expenses) × (1 – Tax rate)

+
(Depreciation × Tax rate) EBITDA TAX SHIELD

In example: CF = (1,000 – 600) × (1 – 0.35) + (200 × 0.35) = $330
147 Corporate Finance / MPI / Alexandra Horobet, PhD

Blooper project
As the newly appointed financial manager of Blooper Industries, you are about to analyze a proposal for mining and selling a small deposit of high-grade iron ore The project requires an investment of $10 million in mining machinery. At the end of 5 years the machinery has no further value The working capital needs for the 5 years are estimated as follows: Wk. cap = 15% of the following year’s expenses Accounts receivable rise with sales and equal 1/6 times of the current year’s revenues
148 Corporate Finance / MPI / Alexandra Horobet, PhD

74

Blooper project
The company expects to be able to sell 750,000 pounds of iron a year at a price of $20 a pound in year 1 Inflation is running at 5% a year, and iron prices keep pace with inflation The sales forecasts are cut off after 5 years, since iron ore deposits will run out at that time Expenses are equal to $10,000 in the first year, and will also increase in line with inflation at 5% per year The company applies straight-line depreciation to the mining equipment over 5 years Company taxes are 35% of pretax profits

149

Corporate Finance / MPI / Alexandra Horobet, PhD

Profit projections for Blooper project
Year 1. Capital investment 2. Working capital 3. Change in working capital 4. Revenues 5. Expenses 6. EBITDA 7. Depreciation 8. EBIT 9. Tax 10. Profit after tax
150

0 1 10,000 1,500 4,075 1,500 2,575 15,000 10,000 5,000 2,000 3,000 1,050 1,950

2 4,279 204 15,750 10,500 5,250 2,000 3,250 1,138 2,113

3 4,493 214 16,538 11,025 5,513 2,000 3,513 1,229 2,283

4 4,717 225 17,364 11,576 5,788 2,000 3,788 1,326 2,462

5

6

3,039 0 -1,679 -3,039 18,233 12,155 6,078 2,000 4,078 1,427 2,650

Corporate Finance / MPI / Alexandra Horobet, PhD

75

PhD 76 .950 4.(Figures in percent of depreciable investment).500 -2.039 3. Cash flow from operations Total cash flow -11.113 4.329 3.678 3. PhD Blooper project Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) .000 151 Corporate Finance / MPI / Alexandra Horobet.651 3.Cash flows for Blooper project Year 0 1 2 3 4 5 6 -10.237 6. Investment in working capital -1. Capital investment 2.462 4.069 4.575 -204 -214 -225 1.000 1.909 4.564.375 3.500 1.039 NPV @ 12% = 3. 152 Corporate Finance / MPI / Alexandra Horobet.283 4.

583 154 2.523 153 Corporate Finance / MPI / Alexandra Horobet.000 2.000 Tax shield 700 700 700 700 700 0 3.000 2.000 Tax shield 700 1.000 2.120 672 403 403 202 3.500 PV tax shield @ 12% 625 893 478 256 229 102 2.523 Corporate Finance / MPI / Alexandra Horobet.583 PV of tax shields under MACRS > PV of tax shields under straight-line 2.152 576 10. PhD Blooper project – a note on tax shields Tax shields under 5 years MACRS depreciation Year 1 2 3 4 5 6 Total Depreciation 2.000 0 10.Blooper project – a note on tax shields Tax shields under straight-line depreciation Year 1 2 3 4 5 6 Total Depreciation 2.500 PV tax shield @ 12% 625 558 498 445 397 0 2.920 1.000 2.000 3.152 1. PhD 77 .200 1.

30 million New NPV @ 12% = $4.A note on salvage value We assumed earlier that the mining equipment would be worthless when the iron ore closed Suppose now that the equipment can be sold for $2 million in year 6 SALVAGE VALUE Any difference between the sale price and the value of the tax books is treated as a taxable gain Extra cash flow in year 6 = $2 million × (1-0.222.9 155 Corporate Finance / MPI / Alexandra Horobet.985. PhD 78 .35) = $1.

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