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1 Capital Budgeting Project Analysis Cash Flows 1) investment outlay equipment cost, working capital 2) after tax operating cash flows net income + depreciation 3) terminal year non-operating cash flows after tax salvage value, return of working capital Example 1: Kramerica Corp. is considering the purchase of a new machine. The machine s basic price is $50,000, and it will cost another $10,000 to modify it for special use to fit in the small, but comfortable Kramerica Corp. head office. Assume that the machine falls into the MACRS 3-year class. It will be sold after 3 years for $20,000, and it will require an increase in net working capital of $2,000. The machine purchase will have no effect on revenues, but it is expected to save Kramerica Corp. $20,000 per year in before-tax operating costs. Kramerica Corp. faces a marginal tax rate of 40%. MACRS percentage allowances are 0.33, 0.45, 0.15 in years 1, 2 and 3 respectively. 1. Kramerica Corp. s net investment, initial cash flow, if it acquires the machine is closest to: A ($50,000) B ($62,000) C $62,000 D $50, The operating cash flows for years 1, 2 and 3 are respectively: A $20,000, $20,000, $20,000 B $19, 800, $27,000, $9,000 C $7,920, $10,800, $3,600 D $19,920, $22,800, $15, The terminal year cash flow is closest to: A $20,000 B $22,000 C $15,680 D ($6,320) 4. If the project s cost of capital is 10%, which of the following statements is correct? A It should be purchased because the machine has a positive NPV B It should not be purchased Because the NPV is equal to negative $60,453 C The NPV is equal to -$1,547 D The NPV is equal to -$263 Exam Preparation & Investment Sales Training 1 info@examsuccess.ca

2 Solutions: 1. X 2. X 3. X 4. X Solutions to this Item Set can be found on our Level 2 Test Bank. The Level 2 Test Bank contains 60 full Item Sets. The cost of the Test Bank is only $99 (+tax) To gain access, simply click on the Buy Now below and you will be taken to our ecommerce/paypal site where you can complete the transaction. Thank you. Best of luck with your studies! Exam Success Buy Now Exam Preparation & Investment Sales Training 2 info@examsuccess.ca

3 Effects of Inflation Inflation reduces the value of depreciation tax savings Inflation reduces the value of fixed payments to bondholders Inflation does not affect all revenues and expenses in the same way Bottom line: Nominal cash flows/nominal discount rate or Real cash flows/real discount rate, just be consistent Mutually Exclusive Projects with Unequal Lives Not one shot investments replaced over time replacement chain 1) Least Common Multiple of Lives Approach Extend the time horizon of each project until they result in the same number of years Select the investment that has the highest NPV Example 2: John Jawonski is an analyst at BQC. BQC is planning to modernize its distribution center, and it is considering either a conveyor system (Project C) or some forklift trucks (Project F) for moving goods. Figure 1 shows both the expected net cash flows for these two mutually exclusive alternatives. Figure 1 Year Project C -40,000 8,000 14,000 13,000 12,000 11,000 10,000 Project F -20,000 7,000 13,000 12,000 Assuming the appropriate discounting rate is 12%, and the analyst can only consider the information given above, which project should be selected based on the least common lives approach? Exam Preparation & Investment Sales Training 3 info@examsuccess.ca

4 2) Equivalent Annual Annuity Approach EAA is the annuity payment that equivalent in value to the NPV Select the investment that has the highest EAA Example 3: John Jawonski is an analyst at BQC and he is at it again. BQC is planning to modernize its distribution center, and it is considering either a conveyor system (Project C) or some forklift trucks (Project F) for moving goods. Figure 1 shows both the expected net cash flows for these two mutually exclusive alternatives. Figure 1 Year Project C -40,000 8,000 14,000 13,000 12,000 11,000 10,000 Project F -20,000 7,000 13,000 12,000 Assuming the appropriate discounting rate is 12%, and the analyst can only consider the information given above, which project should be selected based on the equivalent annual annuity approach? Exam Preparation & Investment Sales Training 4 info@examsuccess.ca

5 Solutions: Solutions to these examples can be found on our Level 2 Test Bank. The Level 2 Test Bank contains 60 full Item Sets. The cost of the Test Bank is only $99 (+tax) To gain access, simply click on the Buy Now below and you will be taken to our ecommerce/paypal site where you can complete the transaction. Thank you. Best of luck with your studies! Exam Success Buy Now Exam Preparation & Investment Sales Training 5 info@examsuccess.ca

6 3) Capital Rationing Select the projects that have the highest NPV or highest Profitability Index (PI) first, until your budget is exhausted Use NPV and Profitability Index, NOT IRR! Sensitivity analysis calculates the effect on the NPV of changes in one input variable at a time Scenario analysis calculates the effect on the NPV of changes in several input variable at one time Monte Carlo simulation assign probabilities to thousands of possible outcomes Discount Rates and Project Required Return CAPM: Required Return = Discount Rate = R F + B (R M - R F ) Real Options are options that allow mangers to make decisions in the future that alter the value of capital budgeting investment decisions made today Types of Real Options 1) timing options delay investing until some future date when more information is available 2) sizing options abandonment options permit discontinuation of poor performing projects, growth options permit increase investment in well performing projects 3) flexibility options price setting options or production flexibility options 4) fundamental options the whole investment can be viewed like an option Capital Budgeting Pitfalls 1) mistreatment of sunk costs and opportunity costs 2) using IRR only 3) incorrect discount rate used 4) poor accounting techniques Accounting Income = revenue - expenses Economic Income = cash flow + change in the market value Economic Profit = NOPAT (WACC)(Capital) NOPAT = EBIT x (1 tax rate) Residual Income = Net Income t (Re)(BV t-1 ) Claims Valuation cash flows are divided between various suppliers of capital, such as interest and principal payments to bondholders and equity distributions to shareholders Exam Preparation & Investment Sales Training 6 info@examsuccess.ca

7 Franka Hvelk is reviewing cash flow projections for a $300,000 capital investment for adaptable equipment to service her company s manufacturing efforts. After careful study, analysts have determined that when put to the best use over the next five years, the incremental contribution of the equipment produces a positive net present value assuming a 15% annual discount rate (see Exhibit 1). Exhibit 1: Forecasted Cash Flow (in $) Year Sales 370, , , , ,024 VC 185, , , , ,512 FC 30,000 50,000 50,000 50,000 50,000 Depreciation 60,000 60,000 60,000 60,000 60,000 EBT 95, , , , ,512 Tax 38,000 41,100 58,120 88,756 62,205 EAT 57,000 61,650 87, ,134 93,307 After tax OCF 117, , , , ,307 Salvage Value (SV) 20,000 After tax SV 12,000 Total After tax Cash Flow 117, , , , ,307 Depreciation is calculated using the straight line method over 5 years 15% is $183,109 Hvelk receives a request from her manager, Sarah Dornchester, to change the cash flows from nominal to real. She decides to remove inflation effects from the sales, variable cost, and salvage value figures, but not to adjust either fixed costs or depreciation The remainder of this Item Set can be found on our Level 2 Test Bank. The Level 2 Test Bank contains 60 full Item Sets. The cost of the Test Bank is only $99 (+tax) To gain access, simply click on the Buy Now below and you will be taken to our ecommerce/paypal site where you can complete the transaction. Thank you. Best of luck with your studies! Exam Success Buy Now Exam Preparation & Investment Sales Training 7 info@examsuccess.ca

8 Capital Structure Modigliani-Miller Propositions Proposition I: without taxes (and no bankruptcy) Says that the capital structure is irrelevant: Vu = V L Vu = EBIT/reu Proposition II: without taxes (with bankruptcy) Says the cost of equity rises proportionally as the leverage increases: re = reu + (reu rd)(d/e) World with taxes (no bankruptcy) Optimal capital structure is 100% debt: V L = Vu + (t)(d) World with taxes and bankruptcy (trade-off theory) Optimal capital structure is the point where WACC is minimized and firm value is maximized VL = Vu + (t)(d) PV(bankruptcy costs) WACC = (D/V)(rd)(1-t) + (E/V)(re) Exam Preparation & Investment Sales Training 8 info@examsuccess.ca

9 Dividends and Share Repurchases: Analysis Dividend Policy Theories 1) Irrelevance 2) Bird in the hand 3) Clientele Information Signals Initiating a dividend or increasing a dividend sends a positive signal, while decreasing a dividend or omitting a dividend payment sends a negative signal Clientele Effect different classes of investors prefer different dividend payout levels and will seek investment in companies that satisfy their needs (think about tax exempt institutional investors) Other Issues Affecting Dividend Payouts taxation methods, floatation costs on new issues and informal and formal legal restrictions, investment opportunities Taxation Methods 1) Double taxation- dividends are taxed at the corporate and shareholder level DT Example: Xerex, a U.S. corporation had pre-tax earnings of $1,000,000. Xerex pays out all of its earnings as dividends. Assume the corporate tax rate is 35%, the cost of equity id 12% and the risk free rate is 5%. Bill Pennyworth is a wealthy inverstor who holds 1,000 Xerex common shares. If Pennyworth is taxed at 40% on all income sources, what is the effective double taxation rate applied to dividends? 2) Split Rate System - retained earnings and dividends, are taxed at different rates, shareholders in lower tax brackets prefer higher payouts SR Example: MFR is a Canadian corporation that had net income before tax of $2,000,000. The corporate tax rate on retained earnings is 35% and 20% tax on earnings allocated to dividends. If MFR retains 50% of its net income before tax and shareholders face a tax rate of 35%, what is the effective tax rate on the dividend? Exam Preparation & Investment Sales Training 9 info@examsuccess.ca

10 3) Tax Imputation System - shareholders receive a credit on dividends for the tax paid on corporate profits, effectively making it a system that places a tax only at the shareholder level TI Example: Assume Reading Corp. has pre tax income of $1,000,000 and faces a 30% corporate tax rate. Reading pays out all of its after tax income as dividends. If shareholders are taxed at 15%, what is the effective tax rate on the dividends? Residual Dividend Policy Payment of dividends resulting from earnings less funds required to finance the equity portion of a company's capital budget Various capital spending plans result in different dividend payments - may be interpreted as higher risk! RD Example: Xerex Inc. follows a strict residual dividend policy. The firm will have profits of $500,000 this year. After screening all available investment projects, Xerex has decided to take three out of the ten projects and those three will cost $410,000. What dividends will Xerex pay to its shareholders this year? Its current equity market value is $5,000,500 and the current market price of its shares is $ What is the shortcoming of this policy? Exam Preparation & Investment Sales Training 10 info@examsuccess.ca

11 Stable Dividend Approach Stability in the rate of increase in dividends Target Payout Approach Payout ratio = D/EPS Increase in dividends = increase in EPS x target payout ratio x adjustment factor TP Example: Target Payout Approach Last year Luna Inc. had earnings of $2.00 per share and paid a regular dividend of $0.40. For the current year, the company anticisarahes earnings of $2.80. It has a 30 percent target payout ratio and uses a 5-year period to adjust the dividend. Compute the expected dividend for the current year. Cash Dividend vs. Share Repurchase Same effect on shareholder wealth (ignoring taxes) Question of tax rate applied Management may want to send a positive signal to investors Could be done simply for cash flow reasons CD vs. SR Example: What is the change in share price if a firm spends its extra $600,000 to buy back stocks at $31 per share instead of paying $600,000 in cash dividends? The next period market value of equity is $2,500,000 and there are currently 100,000 shares outstanding, with k = 15%. Exam Preparation & Investment Sales Training 11 info@examsuccess.ca

12 Solutions: Solutions to these examples can be found on our Level 2 Test Bank. The Level 2 Test Bank contains 60 full Item Sets. The cost of the Test Bank is only $99 (+tax) To gain access, simply click on the Buy Now below and you will be taken to our ecommerce/paypal site where you can complete the transaction. Thank you. Best of luck with your studies! Exam Success Buy Now Exam Preparation & Investment Sales Training 12 info@examsuccess.ca

Table of Contents. Chapter 1 Introduction to Financial Management Chapter 2 Financial Statements, Cash Flows and Taxes...

Table of Contents. Chapter 1 Introduction to Financial Management Chapter 2 Financial Statements, Cash Flows and Taxes... Table of Contents Chapter 1 Introduction to Financial Management... 1 22 Importance of Financial Management 2 Finance in the Organizational Structure of the Firm 3 Nature and Functions of Financial Management: