Part 4.
Capital Budgeting
Chap 9. Net present value and other investment criteria
- NET PRESENT VALUE: The difference between an investment’s market value and
its cost
- PAYBACK RULE: how long it takes to recover the initial investment of a project or
investment, an investment is acceptable if its calculated payback period is less than some
prespecified number of years
After two years, you've recovered $300 of the initial $500 investment.
Remaining amount to recover: $500 - $300 = $200
In the third year, the cash flow is $500
=> You need to recover the remaining $200
Fraction of the year needed to recover: $200 ÷ $500 = 0.4 years
Total Payback Period: 2 + 0.4 = 2.4 years
- DISCOUNTED PAYBACK PERIOD: the length of time until the sum of the discounted
cash flows is equal to the initial investment
● Initial Cost: $400
● Annual Cash Flow: $100 per year (perpetuity)
● Discount Rate: 20%
- Ordinary Payback Period:
- Annual Cash Flow: $100
- Initial Investment: $400
- Ordinary Payback = $400 ÷ $100 = 4 years
- This is the simple calculation where you divide the initial investment by the annual
cash flow
- Net Present Value (NPV) Calculation:
- Present Value of Perpetuity = Annual Cash Flow ÷ Discount Rate
- PV = $100 ÷ 0.2 = $500
- NPV = Present Value of Cash Flows - Initial Investment
- NPV = $500 - $400 = $100
- Discounted Payback Period:
- Method: Find how many years it takes for the discounted cash flows to equal the
initial investment
- Present Value Annuity Factor = Initial Investment ÷ Annual Cash Flow
- PVAF = $400 ÷ $100 = 4
- This means we're looking for the number of periods where the present value of the
annuity equals 4 at a 20% discount rate
- The calculation shows this takes a little less than 9 years
- AVERAGE ACCOUNTING RETURN: a project is acceptable if its average
accounting return exceeds a target average accounting return
we note that we started out with a book value of $500,000 (the initial cost) and ended up at $0. The
average book value during the life of the investment is ($500,000 + 0)/2 = $250,000. As long as we
use straight-line depreciation, the average investment will always be one-half of the initial investment.
- Internal Rate of Return: the required return that results in a zero NPV when
it is used as the discount rate
Chap 10. Making capital investment decisions
- A sunk cost, by definition, is a cost we have already paid or have already incurred the
liability to pay
- opportunity cost The most valuable alternative that is given up if a particular investment is
undertaken.
-
ex1: Your small remodeling business has two work vehicles. One is a small passenger car used for job
site visits and for other general business purposes. The other is a heavy truck used to haul equipment.
The car gets 25 miles per gallon (mpg). The truck gets 10 mpg. You want to improve gas mileage to
save money, and you have enough money to upgrade one vehicle. The upgrade cost will be the same
for both vehicles. An upgraded car will get 40 mpg; an upgraded truck will get 12.5 mpg. The cost of
gasoline is $2.65 per gallon. Assuming an upgrade is a good idea in the first place, which one should
you upgrade? Both vehicles are driven 12,000 miles per year
Current Situation:
1. Car
● Current mileage: 25 mpg
● Miles driven per year: 12,000
● Current fuel consumption: 12,000 ÷ 25 = 480 gallons/year
● Current fuel cost: 480 × $2.65 = $1,272/year
2. Truck
● Current mileage: 10 mpg
● Miles driven per year: 12,000
● Current fuel consumption: 12,000 ÷ 10 = 1,200 gallons/year
● Current fuel cost: 1,200 × $2.65 = $3,180/year
After Upgrade:
1. Car
● New mileage: 40 mpg
● Fuel consumption: 12,000 ÷ 40 = 300 gallons/year
● New fuel cost: 300 × $2.65 = $795/year
● Savings: $1,272 - $795 = $477/year
2. Truck
● New mileage: 12.5 mpg
● Fuel consumption: 12,000 ÷ 12.5 = 960 gallons/year
● New fuel cost: 960 × $2.65 = $2,544/year
● Savings: $3,180 - $2,544 = $636/year
Recommendation: Upgrade the truck, as it provides $636 in annual savings compared to $477 for the
car.
ex2: You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers
of fine zithers. The market for zithers is growing quickly. The company bought some land three years
ago for $1.9 million in anticipation of using it as a toxic waste dump site but has recently hired
another company to handle all toxic materials. Based on a recent appraisal, the company believes it
could sell the land for $2.1 million on an aftertax basis. In four years, the land could be sold for $2.3
million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost
of $175,000. An excerpt of the marketing report is as follows:
The zither industry will have a rapid expansion in the next four years. With the brand
name recognition that PUTZ brings to bear, we feel that the company will be able to
sell 5,100, 5,800, 6,400, and 4,700 units each year for the next four years, respectively
Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of
$425 can be charged for each zither. Because zithers appear to be a fad, we feel at the
end of the four-year period, sales should be discontinued.
PUTZ believes that fixed costs for the project will be $345,000 per year, and variable costs are 15
percent of sales. The equipment necessary for production will cost
$2.65 million and will be depreciated according to a three-year MACRS schedule. At the end of the
project, the equipment can be scrapped for $395,000. Net
working capital of $125,000 will be required immediately. PUTZ has a tax rate of
22 percent, and the required return on the project is 13 percent. What is the NPV of
the project?
1. Initial Cash Flows:
● Land purchase 3 years ago: -$1.9 million (sunk cost, not included in NPV)
● Marketing cost: -$175,000
● Equipment cost: -$2.65 million
● Net working capital: -$125,000
● Initial cash flow: -$2.95 million
2. Revenue Projection:
Year 1: 5,100 units × $425 = $2,167,500
Year 2: 5,800 units × $425 = $2,465,000
Year 3: 6,400 units × $425 = $2,720,000
Year 4: 4,700 units × $425 = $1,997,500
3. Cost Calculation: Fixed Costs: $345,000 per year Variable Costs: 15% of sales each year Tax
Rate: 22%
4. MACRS Depreciation Schedule (3-year): Year 1: 33.33% Year 2: 44.45% Year 3:
14.81% Year 4: 7.41%
Depreciation: Year 1: $2.65M × 33.33% = $883,245 Year 2: $2.65M × 44.45% = $1,177,925 Year 3:
$2.65M × 14.81% = $392,465 Year 4: $2.65M × 7.41% = $196,465
5. After-Tax Cash Flows Calculation: (I'll calculate each year's cash flow accounting for
revenues, costs, depreciation, and taxes)
6. Terminal Year Cash Flows:
● Land sale: $2.3 million
● Equipment salvage: $395,000
● Working capital recovery: $125,000
Chap 11. Project analysis and evaluation
Ex1: suppose the Wettway Sailboat Corporation is considering whether to launch its new Margo-class
sailboat. The selling price will be $40,000 per boat. The variable costs will be about half that, or
$20,000 per boat, and fixed costs will be $500,000 per year.
The total investment needed to undertake the project is $3,500,000.
This amount will be depreciated straight-line to zero over the five-year life of the equipment
The salvage value is zero = KHONG TRU SALVAGE VALUE, and there are no working capital
consequences. Wettway has a 20 percent required return on new projects.
Based on market surveys and historical experience, Wettway projects total sales for the five years at
425 boats, or about 85 boats per year. Ignoring taxes, should this project be launched?
To begin, ignoring taxes, the operating cash flow at 85 boats per year is:
Operating cash flow = EBIT + Depreciation - Taxes = (S - VC - FC - D) + D - 0
= 85 × ($40,000 - 20,000) - $500,000 = $1,200,000 per year
At 20 percent, the five-year annuity factor is 2.9906
, so the NPV is:
NPV = -$3,500,000 + $1,200,000 × 2.9906 = -$3,500,000 + 3,588,735 = $88,735
In the absence of additional information, the project should be launched
how many new boats does Wettway need to sell for the project to break even on an accounting
basis? If Wettway does break even, what will be the annual cash flow from the project? What
will be the return on the investment in this case?
Before fixed costs and depreciation are considered, Wettway generates
$40,000 - 20,000 = $20,000 per boat (this is revenue less variable cost)
Depreciation is $3,500,000/5 = $700,000 per year.
Fixed costs + depreciation = $1.2 million,
so Wettway needs to sell (FC + D)/(P - v) = $1.2 million/$20,000 = 60 boats per year to break even
on an accounting basis.
This is 25 boats less than projected sales; so, assuming that Wettway is confident its projection is
accurate to within, say, 15 boats, it appears unlikely that the new investment will fail to at least break
even on an accounting basis.
Accounting Break-Even and Cash Flow:
● When a project breaks even (makes no profit or loss), the cash it generates each year is the
same as the yearly depreciation.
● Example: If you spend $100,000 on a project that lasts 5 years and spreads the cost evenly
($20,000 per year), the project will give back $20,000 in cash each year if it breaks even.
Payback Period:
● If a project breaks even every year, the total cash it generates by the end of its life will equal
what you originally spent.
● This means the time it takes to "pay back" your investment is the same as the project's
lifespan.
Profitability and Returns:
A project doing better than breaking even has:
● A shorter payback period than its life.
● A positive return.
A project just breaking even has:
● A negative NPV.
● A zero rate of return.
Wettway requires a 20 percent return on its $3,500 (in thousands) investment. How many sailboats
does Wettway have to sell to break even once we account for the 20 percent per year opportunity cost?
The sailboat project has a five-year life. The project has a zero NPV when the present value of the
operating cash flows equals the $3,500 investment. Because the cash flow is the same each year, we
can solve for the unknown amount by viewing it as an ordinary annuity. The five-year annuity factor
at 20 percent is 2.9906, and the OCF can be determined as follows:
$3,500 = OCF × 2.9906
OCF = $3,500/2.9906 = $1,170
Wettway needs an operating cash flow of $1,170 each year to break even. We can now plug this OCF
into the equation for sales volume:
Q = ($500 + 1,170)/$20 = 83.5
So, Wettway needs to sell about 84 boats per ye
- OPERATING LEVERAGE: Operating leverage is the degree to which a project or firm is
committed to fixed production costs. A firm with low operating leverage will have low fixed
costs compared to a firm with high operating leverage. Generally speaking, projects with a
relatively heavy investment in plant and equipment will have a relatively high degree of
operating leverage. Such projects are said to be capital intensive.
Key Numbers:
● Selling price per can: $1.20
● Variable cost per can: $0.80
● Profit per can: $1.20 - $0.80 = $0.40
● Fixed costs: $360,000
● Depreciation: $60,000
Accounting Break-Even:
At the break-even point, total sales just cover fixed costs and depreciation.
● Total fixed costs (including depreciation): $360,000 + $60,000 = $420,000
EX1: You are considering a new product launch. The project will cost $1,950,000, have a four-year
life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 210 units
per year; price per unit will be $17,500, variable cost per unit will be $10,600, and fixed costs will be
$560,000 per year. The required return on the project is 12 percent, and the relevant tax rate is 21
percent.
a. Based on your experience, you think the unit sales, variable cost, and fixed cost
projections given here are probably accurate to within ±10 percent. What are the
upper and lower bounds for these projections? What is the base-case NPV? What
are the best-case and worst-case scenarios?
b. Evaluate the sensitivity of your base-case NPV to changes in fixed costs.
c. What is the cash break-even level of output for this project (ignoring taxes)?
Q = FC/P - v = $560,000/17500-10600 = 81.16
d. What is the accounting break-even level of output for this project? What is the
degree of operating leverage at the accounting break-even point? How do you
interpret this number?
accounting break-even level of output
Q = FC+D/P - v = $560,000 + 487500/17500-10600 = 151.8
DOL = 1 + FC/OCF = $560,000/87500 = 1.15
=> every 1% increase in sales, the Operating Cash Flow (OCF) will increase by 1.15%
Ex2: In an effort to capture the large jet market, Airbus invested $13 billion developing its A380,
which is capable of carrying 800 passengers.
The plane had a list price of $280 million. In discussing the plane, Airbus stated that
the company would break even when 249 A380s were sold.
a. Assuming the break-even sales figure given is the accounting break-even, what is
the cash flow per plane?
b. Airbus promised its shareholders a 20 percent rate of return on the investment. If
sales of the plane continue in perpetuity, how many planes must the company sell
per year to deliver on this promise?
c. Suppose instead that the sales of the A380 last for only 10 years. How many
planes must Airbus sell per year to deliver the same rate of return?
Part 5. Risk and return
Part 6. Cost of capital
Ex1: Titan Mining Corporation has 7.5 million shares of common stock outstanding, 250,000 shares
of 4.2 percent preferred stock outstanding, and 140,000 bonds with a semiannual coupon of 5.1
percent outstanding, par value $1,000 each. The common stock currently sells for $51 per share and
has a beta of 1.15, the preferred stock currently sells for $103 per share, and the bonds have 15 years
to maturity and sell for 107 percent of par. The market risk premium is 7.5 percent, T-bills are
yielding 2.4 percent, and the company’s tax rate is 22 percent.
a. What is the firm’s market value capital structure?
Market Value of Common Stock = 7,500,000×51=382,500,000
Market Value of Preferred Stock = 250,000×103=25,750,000
Market Value of Bonds = 140,000×1,070=149,800,000
Total Market Value = 382,500,000+25,750,000+149,800,000=558,050,000
b. If the company is evaluating a new investment project that has the same risk as
the firm’s typical project, what rate should the firm use to discount the project’s
cash flows
The firm is evaluating a new project that has the same risk as its typical project. This means the
project’s discount rate should be the Weighted Average Cost of Capital (WACC) of the firm, which
reflects the weighted costs of the three sources of capital: equity, preferred stock, and debt.
Ex2: Red Shoe Co. has concluded that additional equity financing will be
needed to expand operations and that the needed funds will be best obtained through
a rights offering. It has correctly determined that as a result of the rights offering,
the share price will fall from $49 to $47.60 ($49 is the rights-on price; $47.60 is
the ex-rights price, also known as the when-issued price). The company is seeking
$16.5 million in additional funds with a per-share subscription price equal to $34.
How many shares are there currently, before the offering? (Assume that the increment to the market
value of the equity equals the gross proceeds from the offering.)
The company is seeking $16.5 million in additional funds, and the subscription price (the price at
which new shares will be offered to current shareholders) is $34 per share. The total number of new
shares that will be issued is:
=>
Ex4: Prahm Corp. wants to raise $4.7 million via a rights offering.
The company currently has 530,000 shares of common stock outstanding that sell for
$55 per share. Its underwriter has set a subscription price of $30 per share and will
charge the company a spread of 6 percent. If you currently own 5,000 shares of stock
in the company and decide not to participate in the rights offering, how much money
can you get by selling your rights?
Ex5: Change Corporation expects an EBIT of $31,200 every year
forever. The company currently has no debt, and its cost of equity is 11 percent.
a. What is the current value of the company?
b. Suppose the company can borrow at 6 percent. If the corporate tax rate is 22 percent, what will the
value of the firm be if the company takes on debt equal to 50 percent of its unlevered value? What if it
takes on debt equal to 100 percent of its unlevered value?
c. What will the value of the firm be if the company takes on debt equal to 50 percent of its levered
value? What if the company takes on debt equal to 100 percent
of its levered value?
Ex6: Bellwood Corp. is comparing two different capital structures. Plan I would result in 12,700
shares of stock and $109,250 in debt. Plan II would result in 9,800 shares of stock and $247,000 in
debt. The interest rate on the debt is 10 percent.
a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that
EBIT will be $79,000. The all-equity plan would result in 15,000 shares of stock
outstanding. Which of the three plans has the highest EPS? The lowest?
=> Plan II has the highest EPS, and the All-Equity Plan has the lowest.
b. In part (a), what are the break-even levels of EBIT for each plan as compared to
that for an all-equity plan? Is one higher than the other? Why?
c. Ignoring taxes, when will EPS be identical for Plans I and II?
Ex7: FCOJ, Inc., a prominent consumer products firm, is debating whether to convert its all-equity
capital structure to one that is 30 percent debt. Currently, there are 5,800 shares outstanding, and the
price per share is $57. EBIT is expected to remain at $32,000 per year forever. The interest rate on
new debt
is 8 percent, and there are no taxes.
a. Allison, a shareholder of the firm, owns 100 shares of stock. What is her cash flow
under the current capital structure, assuming the firm has a dividend payout rate
of 100 percent?
b. What will Allison’s cash flow be under the proposed capital structure of the firm?
Assume she keeps all 100 of her shares.
=> we are considering a capital structure with 30 percent debt. The new capital structure will consist
of 30 percent debt and 70 percent equity.
Total value of the firm = 5,800×57 = 330,600
Debt=30%×330,600=99,180
Equity=330,600−99,180=231,420
The interest expense is 8 percent of the debt: Interest Expense=8%×99,180=7,934.40
EBIT after Interest=32,000−7,934.40=24,065.60
c. Suppose the company does convert, but Allison prefers the current all-equity capital structure.
Show how she could unlever her shares of stock to re-create the
original capital structure.
After this, she will have 57 shares of stock and a debt investment worth $2,439.60. This recreates her
original all-equity position.
d. Using your answer to part (c), explain why the company’s choice of capital structure is irrelevant.
The company's choice of capital structure is irrelevant because of the Modigliani-Miller Theorem
(under no taxes). The theorem states that, in a world with no taxes and other frictions, the value of the
firm is independent of its capital structure.
In this case:
● Allison can "unlever" her shares by selling some of her stock and buying debt, recreating the
original all-equity structure.
● No matter what capital structure the company chooses, Allison can always adjust her own
portfolio (through selling shares and buying debt) to achieve the same cash flow and risk as
she would have in an all-equity firm.
Thus, the choice of capital structure does not affect the value of the firm or the total cash flow to
shareholders, which is why it is irrelevant to Allison's overall financial position.
DIVIDENDS
Ex8: Ginger, Inc., has declared a $5.35 per share dividend.
Suppose capital gains are not taxed, but dividends are taxed at 15 percent. New IRS
regulations require that taxes be withheld at the time the dividend is paid. The company’s stock sells
for $74.20 per share, and the stock is about to go ex-dividend. What
do you think the ex-dividend price will be?
Ex9:
Common stock ($.50 par value) $ 25,000
Capital surplus
Retained earnings 215,000
Total owners’ equity 642,700
$882,700
a. If the company’s stock currently sells for $32 per share and a 10 percent stock
dividend is declared, how many new shares will be distributed? Show how the
equity accounts would change.
New shares=10%×Shares outstanding=0.1×50,000=5,000 shares.
For the company in Problem 2, show how the equity accounts
will change if:
a. The company declares a four-for-one stock split. How many shares are outstanding now? What is
the new par value per share?
b. The company declares a one-for-five reverse stock split. How many shares are
outstanding now? What is the new par value per share?
A four-for-one stock split increases the number of shares outstanding by a factor of 4:
New Shares Outstanding=4×50,000=200,000 shares.
Shares Outstanding After Reverse Split: A one-for-five reverse stock split decreases the number
of shares outstanding by a factor of 5:
Ex10: You own 1,000 shares of stock in Avondale Corporation. You will receive a $3.15 per share
dividend in one year. In two years, the company will pay a liquidating dividend of $57 per share. The
required return on the company’s stock is 15 percent. What is the current share price of your stock
(ignoring taxes)? If you would rather have equal dividends in each of the next two years, show how
you can accomplish this by creating homemade dividends
Create Homemade Dividends for Equal Payments
If you want equal dividends over the two years, the goal is to withdraw cash such that the present
value of the cash flows matches the stock price.
Step 1: Total Present Value of Dividends
The total present value of dividends for one share is $45.85. Over two years, this amount can be
evenly distributed into equal cash flows.
=> D= 28.21
Ex11:Stock Repurchase [LO4] Awake Corporation is evaluating an extra dividend versus a share
repurchase. In either case, $17,500 would be spent. Current earnings
are $1.89 per share, and the stock currently sells for $64 per share. There are 2,000
shares outstanding. Ignore taxes and other imperfections in answering the first two
questions.
a. Evaluate the two alternatives in terms of the effect on the price per share of the
stock and shareholder wealth.
b. What will be the effect on the company’s EPS and PE ratio under the two different
scenarios?
c. In the real world, which of these actions would you recommend? Why?
Extra Dividend:
● Provides immediate cash to shareholders, which may be favorable for investors seeking
income.
● Reduces retained earnings, potentially impacting the firm's ability to invest in future growth.
Share Repurchase:
● Increases EPS by reducing the number of shares outstanding.
● Signals confidence in the company's stock valuation, which could boost investor confidence
and support the stock price.
In the real world, the decision depends on the company's financial position and investor preferences.
If the company has strong growth opportunities, retaining cash for reinvestment (or share repurchases)
is preferable. If growth opportunities are limited, distributing cash as a dividend may be more suitable.
Share repurchases are generally recommended as they enhance EPS and can be a tax-efficient method
of returning cash to shareholders.
13. Costs of Borrowing [LO3] You’ve worked out a line of credit arrangement that allows you to
borrow up to $40 million at any time. The interest rate is .36 percent per month. In addition, 4
percent of the amount that you borrow must be deposited in a non-interest-bearing account. Assume
that your bank uses compound interest on its line of credit loans.
a. What is the effective annual interest rate on this lending arrangement?
b. Suppose you need $13 million today and you repay it in six months. How much
interest will you pay?
14. A stock has a beta of 1.15, the expected return on the market
is 10.3 percent, and the risk-free rate is 3.1 percent. What must the expected return
on this stock be
15. You have $100,000 to invest in a portfolio containing Stock X and Stock Y. Your goal is to create
a portfolio that has an expected return of 12.7 percent. If Stock X has an expected return of 11.4
percent and a beta of 1.25, and Stock Y has an expected return of 8.68 percent and a beta of .85, how
much money will you invest in Stock Y? How do you interpret your answer? What is the beta of your
portfolio?
Investment in Y=0.478⋅100,000=47,800
16. The Gecko Company and the Gordon Company are two firms that have the same business risk but
different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend
yield of 2.9 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 35
percent. Gecko has an expected earnings growth rate of 15 percent annually, and its stock price is
expected to grow at this same rate. If the aftertax expected returns on the two stocks are equal
(because they are in the same risk class),
what is the pretax required return on Gordon’s stock?
