CORPORATE FINANCE II

FUNDAMENTALS OF CAPITAL BUDGETING AND

FINANCIAL INVESTMENT

Chapter 1: Capital Budgeting Cash Flows

Chapter 2: Capital Budgeting Techniques

Chapter 3: Capital Budgeting in Practice

Chapter 4: Financial investment of companies

 SYLLABUS
Discussion
Chapter Duration Theories
& Exercises

1-Capital Budgeting Cash Flows 9 hours 5 hours 4 hours

2-Capital Budgeting Techniques 7.5 hours 4.5 hours 3 hours

3-Capital Budgeting in Practice 8.5 hours 5 hours 3.5 hours

4-Financial Investment of companies 5 hours 3 hours 2 hours

Midterm test & Revision 3 hours

TOTAL 33 hours
 LEARNING MATERIALS

• Course materials:
– PhD. Pham Thi Van Anh & PhD. Ngo Thi Kim
Hoa (2022). Fundamentals of Capital Budgeting
and Financial Investment. Upcoming
– PhD. Pham Thi Van Anh (2018). Corporate
Finance – Questions & Exercises. Finance
Publisher.
– Department of Corporate Finance, Slides for
Corporate Finance II for AEP in Customs &
Logistics.
 LEARNING MATERIALS
• References:
– PhD. Pham Thi Van Anh & PhD. Diem Thi Thanh Hai (2018).
Basic Corporate Finance. Finance Publisher.
– Assoc.PhD.Bui Van Van & Assoc.PhD.Vu Van Ninh (2015).
Corporate Finance University Textbook. Finance Publisher.
– PhD. Vu Van Ninh (2014). Corporate Finance. Finance
Publisher.
– PhD. Doan Huong Quynh & PhD. Pham Thi Van Anh (2015).
Corporate Finance – Questions & Exercises. Finance Publisher.
– Financial Management, Study Manual, ACCA 2021.
– Richard Brealey, Stewart Myers, Alan Macus (2018).
Fundamentals of Corporate Finance, McGraw-Hill Irwin.
 Faculty of Corporate Finance
Department of Corporate Finance

CHAPTER 1
CAPTAL BUDGETING CASH FLOWS

Thu TRAN, PhD

 Faculty of Corporate Finance
Department of Corporate Finance

Learning Objectives:
o To understand definition, features and content of capital budgeting

o To understand the fundamentals of long-term investment projects

o To identify and examine factors affecting capital budgeting

o To understand the principles in estimating cash flows in capital budgeting

o To be able to determine the relevant cash flows of a project

o To understand the impact of depreciation on the project’s cash flows

 Faculty of Corporate Finance
Department of Corporate Finance

Content:
1.1. Capital Budgeting

1.2. Long-term Investment & Investment Projects

1.3. Principles of Capital Budgeting

1.4. Capital Budgeting cash flows

1.5. The impacts of depreciation on a project’s cash flows

 1.1. Capital Budgeting

1.1.1. Definition and Features

v Definition:
Capital Budgeting (investment appraisal) refers to the planning
process used to analyze and determine which long-lived projects are
worthy to invest in.
v Features:

12/4/22 8
 1.1. Capital Budgeting

1.1.2. Contents
v Motives for capital budgeting:

v Procedure:
v Identify available investment opportunities and make proposals
v Review and analysis
v Decision making
v Implementation
v Control, evaluation and make adjustments (if any)

12/4/22 9
 1.2. Long-term Investment & Investment Projects

Long-term Investment of a company

Financial Investments
Investments in physical assets:
- Initial Investments - Bonds
- Additional Investments - Stocks

To achieve future benefits

12/4/22 10
 1.2. Long-term Investment & Investment Projects

1.2.1. Long-term Investments

v Definition:
The process of using capital to form necessary assets in order to have
benefits in the long-term future.
v Features:
- Various forms of investments
- Require a significant amount of money
- Take a long period of time
- Involve uncertainties and high risk
v Classification:
v Based on the structure of investment:
- Investment in fixed assets: PP&E; tangible & intangible
- Investment in permanent working capital: minimum requirements
- Investment in joint venture and financial assets: joint ventures, stocks

12/4/22 11
 1.2. Long-term Investment & Investment Projects

1.2.1. Long-term Investments

v Classification:
v Based on the target of investment:

v Based on the scope of investment:

v Based on the size of investment:

12/4/22 12
 1.2. Long-term Investment & Investment Projects

1.2.2. Investment Projects

v Definition:
A set of coordinated and interrelated activities that are planned to fulfill a
specific purpose via the uses of particular resources.
v Features:
- Specific objectives: financial purpose or socio-economic benefits.
- Results: products & services to fulfill the projects’ objectives.
- Activities: many activities will be implemented to get the target.
- Resources: require for conducting the project’s activities
v Classification:
v Based on the final objectives:

12/4/22 13
 1.2. Long-term Investment & Investment Projects

1.2.2. Investment Projects

v Classification:
v Based on the nature of the projects:
Independent projects

• An independent project is the project, which the acceptance

or rejection of this project does not affect the acceptance/rejection
of other projects of a firm.
Projects • The independent projects satisfying capital budgeting criteria are accepted

Mutually exclusive projects

• Mutually exclusive projects is a set of projects
with more than one project satisfying the capital budgeting criteria
• However, only one project can be accepted

12/4/22 14
 1.2. Long-term investment and investment projects

1.2.3. Long-term investment decision

v The importance of the long-term investment decision

12/4/22 15
 1.2. Long-term investment decision

1.2.3. Long-term investment decision

v Factors affecting the long-term investment decision
v Government’s policies
v Market and competition
v Interest rate and taxation
v Advancement of science and technology
v Level of investment risk
v Financial capacity of a company
v Process to make Long-term investment decision
v Making project proposals
v Planning, analyzing, evaluating and reviewing the proposal
v Making decision and implementing the project activities
v Monitoring the project activities
12/4/22 16
 1.3. Principles of Capital Budgeting

v A company must determine which includes in and excludes from the cash
flows => Identify the relevant costs.
v After-tax incremental cash flows, not accounting income
v Sunk costs
v Opportunity costs
v Financing expense
v A company must evaluate comprehensively the interaction between
investment and current operating activities
v The side effects
v A company must identify the effect of external factors on cash flows of a
project
v The impact of inflation
v A company must apply relevant techniques to determine the potential of
investments

12/4/22 17
 Faculty of Corporate Finance
Department of Corporate Finance

Incremental cash flows reflects the difference in the firm future cash flows

between two cases, with or without the investment. Accounting profits (EBIT;

EBITDA; NI) do not concern the cash flows’ variation.

Year 1 Year 2 Year 3 Total Year 0 Year 1 Year Year Total

2 3
Revenue 1,000 1,000 1,000 3,000
Revenue 1,000 1,000 1,000 3,000
Cost 500 500 500 1,500
Cost 500 500 500 1,500
Depreciation 300 300 300 900
Asset -900 -900
Pre-taxed profit 200 200 200 600
Pre-taxed CFs -900 500 500 500 1,500
Tax@30% 60 60 60
Tax@30% 60 60 60
NI 140 140 140 420
After tax CFs -900 440 440 440 420
 Faculty of Corporate Finance
Department of Corporate Finance

Sunk costs include all expenditures already incurred. Firms have to pay these costs

whether or not the projects are accepted or rejected. Thus, they are excluded from

the incremental cash flows of the project.

Example: Vinamilk intends to launch a new formula powder milk to the market.

It paid the Nisel corporation 100 m. VND for the pilot marketing study last year.

Whether or not 100 m. VND is relevant to the capital budgeting today?

 Faculty of Corporate Finance
Department of Corporate Finance

Opportunity costs reflects the most valuable alternative that is given up

if a particular project is conducted.

Example: Company X has an empty warehouse at North Tu Liem district.

The current market value of this asset is VND 800 million.

Company X intends to use the warehouse for a projected new line of electronic fans.

Should the warehouse be considered a cost in the decision to sell the fans?
 Faculty of Corporate Finance
Department of Corporate Finance

o The side effects (externalities) concerns to the positive/negative impacts of

the projects on the other parts of a firm. It includes:

* Erosion: a loss in sales of current products

*Synergy : an increase in cash flow of current products

o The financing expenses include interest payment, dividend payment, loan payments

They refers to financing decision; not reflect the incremental value of a project.

o The impacts of inflation partly indicates the time and risk in evaluating a project.

Please keep the consistency when discounting the cash flow of the project.
 1.4. Capital Budgeting Cash Flows
1.4.1. Overview of capital budgeting cash flows

Initial investments
The cash outflows (Fixed assets and WC)
(1) Additional capital expenditures
Changes in WC

Taxes
The project
cash flows
Operating cash flows (OCF)
The cash inflows
(2) Depreciation/Amortization

WC recovery
Salvage value
Deductible tax expenses

The net cash flows

 1.4. Capital Budgeting Cash Flows

1.4.2. Estimating a project’s cash flows

v Step 1: Identify the cash flows at the start of the project
v Step 2: Identify the project cash inflows and outflows over each
year of the project life
v Step 3: Identify the cash flows when terminating the project
v Step 4: Calculate the net cash flows for each year of the project

12/4/22 23
 Faculty of Corporate Finance
Department of Corporate Finance

1.4.2. Estimating project cash flows – A detail approach

Step 1: Estimating the cash flows at the beginning of the project

… … The project life

0 1 2 T- n T- 1 T

Initial investments Opt. Costs o Sales from old assets Sunk Costs
(in the replacement projects)
o Tax implication of asset selling

Fixed assets Working capital

 Faculty of Corporate Finance
Department of Corporate Finance
1.4.2. Estimating project cash flows – A detail approach
Step 2: Estimating cash flows during the project’s life
(1)
The bottom-up: NI + Depreciation / Amortization
(2)
The top-down : Sales – Cash expenses - Taxes
OCF
(3)
The tax shield : (S – C)*(1-T) + Deprecation/Amortization*T

OCF OCF OCF OCF OCF

… … The project life
0 1 2 T- n T- 1 T

o Additional investment
o Side effects (Externalities)

Note: T is the income tax rate

 Faculty of Corporate Finance
Department of Corporate Finance

1.4.3. Estimating project cash flows – A detail approach

Step 3: Estimating the cash flows when terminating the project

WC recovery

Salvage value

Tax implication relating

to assets disposal

… … The project life

0 1 2 T- n T

Step 4: Estimating the net cash flows in a whole life of the project
 Faculty of Corporate Finance
Department of Corporate Finance
Estimating project cash flows – An Illustration
o Company X considers to launch a new product line. This project occurs in 5 years.
o The market research last in 6 month and cost 450 m. VND
o Initial investment in fixed asset : 12,000 m. VND. The effective life is 6 years.
o Company X applies the straight-line depreciation method. The estimated salvage value
at the end of the project is 900 m. VND.
o At the end of the first year, company X buys a new machine to improve its productivity.
o The new machine costs 1,000 m. VND, depreciates in the effective life of 4 years,
and has estimated salvage value of 100 m. VND at the end of the project.
o The sales will be: 8,000 m. VND for 1st year; 9,000 m. VND for 2nd year;
10,000 m. VND for 3rd year; 11,000 for two remaining years.
o The total operating fixed costs (excluding depreciation) is 600m. VND
o The annual variable costs accounts for 50% of sales
o The required working capital is 4,000 m. VND
o This project also impacts on the sales of the current product lines. The estimated loss in sales
of the existing products is 200m. VND
o The company’s required return on this project is 10%
o The corporate income tax rate is 20%
 Faculty of Corporate Finance
Department of Corporate Finance
Estimating project cash flows – The Solution

Step 1: Cash Flows at the beginning of the project (year 0)

Initial investments:

Fixed asset = -12,000 m. VND

+
WC = - 4,000 m. VND

Total investment = -16,000 m. VND

??? How about the market research cost?

??? How about the sale reduction?

 Faculty of Corporate Finance
Department of Corporate Finance
Estimating project cash flows – The Solution

Step 2: Cash flows over the project life

Additional investment at the year 1: Fixed asset = 1,000 m. VND
How to calculate annual OCF ?
- Depreciation: Fixed asset at the year 0 = 12,000/6 =2,000 m. VND/year
Fixed asset at the year 1 = 1,000/4 = 250 m. VND/year
Depreciation at the year 1 = 2,000 m. VND
Depreciation at the year 2~5 = 2,000 +250 =2,250 m. VND/year

(1) = {8,000-200 -8,000*50% - 600-2,000}*(1-20%) + 2,000 = 2,960 m.

(2) ={8,000-200-8,000*50% - 600}–{8,000-200-8,000*50% - 600-2,000}*20% = 2,960

(3) ={8,000-200-8,000*50% - 600}*(1-20%)+2,000*20% = 2,960 m.

 Faculty of Corporate Finance
Department of Corporate Finance
Estimating project cash flows – The Solution
Step 2: Cash flows over the project life
Unit of measure : m. VND
Description Year 1 Year 2 Year 3 Year 4 Year 5

1. Additional investment in machine -1,000

2. Sales 8,000 9,000 10,000 11,000 11,000

3. Loss of sales on current products -200 -200 -200 -200 -200

4. Fixed costs (excluding D) 600 600 600 600 600

5. Variable costs (50% sales) 4,000 4,500 5,000 5,500 5,500

6. Pre-taxed OFC 3,200 3,700 4,200 4,700 4,700

7. Tax (20%) -640 -740 -840 -940 -940

8. Depreciation tax savings 400 450 450 450 450

9. OCF 2,960 3,410 3,810 4,210 4,210

 Faculty of Corporate Finance
Department of Corporate Finance
Estimating project cash flows – The Solution
Step 3: Cash flows when terminating the project

Investment Collection

Fixed assets Salvage value

Tax gain/loss

Working capital WC recovery

How to calculate tax gain/loss in fixed asset selling/disposal???

The Written Down Value (WDV) for tax purpose = Historic Cost – Accumulated Depreciation

o If WDV = Salvage value; tax = 0; No gain no loss in asset disposal

o If WDV > Salvage value; loss = - (WDV – Salvage); tax gain = (WDV – Salvage)*T
o If WDV < Salvage value; gain = (Salvage – WDV); tax loss = (Salvage – WDV)*T
 Faculty of Corporate Finance
Department of Corporate Finance
Estimating project cash flows – The Solution
Step 3: Cash flows when terminating the project
In the above example
o The first fixed asset:

o The machine at the year 1:

o The recovery of WC:

o The cash flow at the year 5:

 Faculty of Corporate Finance
Department of Corporate Finance
Estimating project cash flows – The Solution
Step 4: The net cash flows of the project
Unit of measure : m. VND

Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

1. Initial investment -16,000

2.Additional investment -1,000

3. OCF 2,960 3,410 3,810 4,210 4,210

4. Collection at the end of the project 5,200

5. Net cash flows -16,000 1,960 3,410 3,810 4,210 9,410

 1.5. The impacts of depreciation on a project’s cash flows

v Depreciation methods affect the depreciation expenses =>

operating costs => operating income => operating cash flows =>
Cash inflows => Net cash flows.
v The impacts of depreciation on cash flows of a project as
follows:
Net OCFt = Pre-tax OCFt x (1-t%) + Depreciationt x t%
Net OCFt = (Salest – Cash costst) x (1-t%) + Depreciationt x t%
Where:
Net OCFt : Net operating cash flows at year t
Pre-tax OCFt: Pre-tax operating cash flows (excluding depreciation)
at year t
t%: corporate income tax rate
Depreciation x t%: tax savings due to depreciation at year t

12/4/22 34
 KEY TERMS
Capital Budgeting
Investment
Long-term Investment decision
Independent projects
Dependent projects
Mutually exclusive projects
Initial investment
Cash flows
Cash inflows
Cash outflows
12/4/22
Operating Cash Flows
Incremental cash flows
Net cash flows
Project life span
Opportunity costs
Sunk costs
Relevant costs
Side effects
Financial expenses
Depreciation Impact
35