Corporate Finance

Dr. Rania Salem Department of Finance Office: B3.209

Winter Term 2011 Lecture notes 1 Capital Budgeting Cash Flows

Dr. Rania Salem/Corporate Finance Winter 2011

General Information
Lecturer: Dr. Rania Salem Email: Rania.salem@guc.edu.eg Lecturer Office Hour: Sunday 2nd slot (B3.209) Course Lecture: Saturday 1st & 2nd slot, hall H5

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Course Agenda
Long term Investment Decisions - Capital Budgeting Cash Flows - Capital Budgeting Techniques - Risk & Refinements in Capital Budgeting Long Term Financial Decisions - The Cost of Capital - Leverage & Capital Structure - Dividend Policy Short Term Financial Decisions - Working Capital & Current Assets Management

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Course schedule
Week 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Date 10-Sep 17-Sep 24-Sep 1-Oct** 8-Oct 15-Oct 22-Oct 29-Oct** 5-Nov** 12-Nov 19-Nov 26-Nov** 3-Dec 10-Dec 17-Dec 24-Dec** 31-Dec Topic Introduction Ch. 8: Capital Budgeting Cash Flows Ch. 9: Capital Budgeting Techniques Graduation Ceremony (no teaching activity) Ch. 9: Capital Budgeting Techniques Ch. 10: Risk & Refinements in Capital Budgeting Midterm Exams Activity Week 3rd year Eid El Adha (H) Ch. 11: Cost of Capital Ch. 11: Cost of Capital Islamic New year(1st Moharam) (H) Ch. 12: Leverage & Capital Structure Ch. 13: Dividend Policy Ch. 14:Working Capital & Current Assets Management Western Christmas (H) Revision week

*Subject t to change based on changes in the GUC calendar **No lecture

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Course Agenda
Long term Investment Decisions - Capital Budgeting Cash Flows - Capital Budgeting Techniques - Risk & Refinements in Capital Budgeting Long Term Financial Decisions - The Cost of Capital - Leverage & Capital Structure - Dividend Policy Short Term Financial Decisions - Working Capital & Current Assets Management

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What is Capital Budgeting?

Capital Budgeting is the process of identifying, evaluating, and implementing a firms investment opportunities. It seeks to identify investments that will enhance a firms competitive advantage and increase shareholder wealth. The typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. Poor capital budgeting decisions can ultimately result in company bankruptcy.

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Capital Expenditures versus Operating Expenditures

Capital expenditures: - An outlay of funds by the firm that is expected to
produce benefits over a period of time greater than 1 year - Key Motives for Capital Expenditures: Expansion replacement renewal

Operating expenditures:
An outlay of funds by the firm resulting in benefits received within 1 year
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Capital Budgeting Process

1. 2. 3. 4. 5. Proposal Generation Review and Analysis Decision Making Implementation Follow-up

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Basic Terminology: Independent versus Mutually Exclusive Projects

Independent Projects
- Investments (Projects) with independent cash flows. Such projects do not compete with one another, where the acceptance of one does not eliminate the others from further consideration. - A company can select one, or the other, or bothso long as they meet minimum profitability thresholds.

Mutually Exclusive Projects

- Are investments that compete in some way for a companys resourcesa firm can select one or another but not both. - The acceptance of one investment eliminates further consideration of all other investments
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Basic Terminology: Unlimited Funds versus Capital Rationing

If the firm has unlimited funds for making investments, then all independent projects that provide returns greater than some specified level can be accepted and implemented. However, in most cases firms face capital rationing restrictions since they only have a given amount of funds to invest in potential investment projects at any given time.

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Basic Terminology: Accept-Reject versus Ranking Approaches

The accept-reject approach involves the evaluation of capital expenditure proposals to determine whether they meet the firms minimum acceptance criteria. The ranking approach involves the ranking of capital expenditures on the basis of some predetermined measure, such as the rate of return.

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Cash Flow Patterns: Conventional versus Nonconventional Cash Flows

Figure 8.1 Conventional Cash Flow

Figure 8.2 Nonconventional Cash Flow

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Cash Flow Components

Figure 8.3
CFs resulting from implementation of a project Non-operating CF at the final year of the project

Cash outflow for a proposed investment/project at time zero

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Sunk Costs Versus Opportunity Costs

Cash outlays already made (sunk costs) are irrelevant to the decision process. However, opportunity costs, which are cash flows that could be realized from the best alternative use of the asset, are relevant.

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Finding the Initial Investment

Installed Cost of New Asset (Cost of New Asset + Installation Cost) - After Tax Proceeds from the Sale of Old Asset (Proceeds from Sale -/+ Tax on Sale of Asset) There are 3 + Changes in Net Working Capital possible tax situations based (Current Assets Current Liabilities) on the relationship Initial Investment NWC is the amount by between the
which a firms Current Assets exceeds its Current Liabilities asset sale price & its Book Value (BV)

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Tax Treatment of Sale of Assets

Relation between Sale (SP) Price & Purchase Price/BV* SP > BV Gain/Loss Tax Treatment

Gain in the form of Capital gain/recaptured depreciation No gain/loss Loss asset used in the business Loss asset not used in the business

Taxed @ the firms marginal tax rate 1 No tax implications 2 Used to offset ordinary income 3 Used to offset Capital gains

SP = BV SP < BV

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*To Calculate the BV

BV = Installed Cost of Asset Accumulated depreciation

e.g: Hudson Industries, a small electronics company, 2 years ago acquired a machine tool with an installed cost of $100,000. The asset was being depreciated under MACRS using a 5-year recovery period*. Thus 52% of the cost (20% + 32%) would represent accumulated depreciation at the end of year two. BV = $100,000 - $52,000 = $48,000
*Note that based on MACRS dep., the dep. % for 5 years is 20%, 32%, 19%, 12%, 12%, 5%

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Tax Treatment of Sale of Assets SP > BV

If Hudson sells the old assets for $110,000, it realizes a gain of $62,000 ($110,000 - $48,000). Technically this gain consist of both a Recaptured depreciation and a Capital gain Recaptured depreciation is the difference between the cost of the asset and book value ($100,000 $48,000 = $52,000) While, the Capital Gain is the difference between the sale price and the purchase price ($110,000 - $100,000 = $10,000)
1

Both Taxed @ the firms marginal tax rate

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Tax Treatment of Sale of Assets

SP = BV If Hudson sells the old assets for $48,000, it realizes no gain or loss ($48,000 - $48,000).
2

No tax implications

SP < BV If Hudson sells the old assets for $30,000, it realizes a loss of -$18,000 ($30,000 - $48,000). 3 Used to offset Capital gains or ordinary Income
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Finding the Initial Investment (Cont.)

Installed Cost of New Asset (Cost of New Asset + Installation Cost) - After Tax Proceeds from the Sale of Old Asset (Proceeds from Sale -/+ Tax on Sale of Asset) There are 3 + Changes in Net Working Capital possible tax situations based (Current Assets Current Liabilities) on the relationship Initial Investment NWC is the amount by between the
which a firms Current Assets exceeds its Current Liabilities asset sale price & its Book Value (BV)

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Powell Corporation, a large diversified manufacturer of aircraft components, is trying to determine the initial investment required to replace an old machine with a new, more sophisticated model. The machines purchase price is $380,000 and an additional $20,000 will be necessary to install it. It will be depreciated under MACRS using a 5-year recovery period. The firm has found a buyer willing to pay $280,000 for the present machine (Purchased 3 years ago @ $240,000) and remove it at the buyers expense. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement. Both ordinary income and capital gains are taxed at 40%.
Note that based on MACRs dep., the dep. % for 5 years is 20%, 32%, 19%, 12%, 12%, 5%
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Finding the Initial Investment Example

Finding the Initial Investment Example (Cont.)

Installed Cost of New Asset $400,000 (Cost of New Asset + Installation Cost) ($380,000 + $20,000 ) - After Tax Proceeds from the Sale of Old Asset $195,840 (Proceeds from Sale -/+ Tax on Sale of Asset) ($280,000 (40%*gain on sale)) = (280,000 84,160) Gain on sale = SP BV = 280,000 (240,000 71%*240,000) = 280,000 (240,000 170,400) = 210,400 + Changes in Net Working Capital $17,000 (Current Assets Current Liabilities) = (35,000 18, 000) Initial Investment $221,160
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Calculating the Terminal CF

After Tax Proceeds from Sale of New Asset (Proceeds from Sale -/+ Tax on Sale of Asset) - After Tax Proceeds from Sale of Old Asset (Proceeds from Sale -/+ Tax on Sale of Asset) + Changes in Net Working Capital (Current Assets Current Liabilities) Terminal Cash Flow

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Calculating the Terminal CF Example

Continuing with the Powell Corporation example, assume that the firm expects to be able to liquidate the new machine at the end of its 5-year useable life to net $50,000 after paying removal and cleanup costs. The old machine can be liquidated at the end of the 5 years to net $10,000. The firm expects to recover its $17,000 net working capital investment upon termination of the project. Again, the tax rate is 40%.
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Calculating the Terminal CF Example (Cont.)

After Tax Proceeds from Sale of New Asset $38,000 (Proceeds from Sale -/+ Tax on Sale of Asset) (50,000 (0.4*(SP-BV)) , BV=400,000 (400,000*95%)= $20,000 (50,000 0.4*30,000) = (50,000 12,000) - After Tax Proceeds from Sale of Old Asset $6,000 (Proceeds from Sale -/+ Tax on Sale of Asset) (10,000 0.4*10,000) = (10,000 - 4,000) + Changes in Net Working Capital $17,000 Terminal Cash Flow $49,000

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Finding Operating Cash Flows

Table 8.5 Powell Corporations Revenue and Expenses (Excluding Depreciation and Interest) for Proposed and Present Machines

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Finding Operating Cash Flows (Cont.)

Table 8.6 Depreciation Expense for Proposed and Present Machines for Powell Corporation

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Finding Operating Cash Flows (Cont.)

Table 8.7 Calculation of Operating Cash Inflows Using the Income Statement Format

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Finding Operating Cash Flows (Cont.)

Table 8.8 Calculation of Operating Cash Inflows for Powell Corporations Proposed and Present Machines

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Finding Operating Cash Flows (Cont.)

Table 8.9 Relevant Operating Cash Inflows for Powell Corporation

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Summarizing the Relevant Cash Flows

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