Professional Documents
Culture Documents
Semester 1, 2015
Section II:
Capital Budgeting
School of Banking and Finance
Australian School of Business
UNSW
Robert Tumarkin
r.tumarkin@unsw.edu.au
Introduction to
financial statements
Financial Statements
Accounting reports a firm issues to provide a
snapshot of financial health...
Balance sheet
Income statement
Cash flows statement
Balance sheet
Balance sheet
A snapshot of a firms financial assets and liabilities at a
single point in time.
Liabilities
Assets
Current assets
Cash
Accounts receivable
Inventories
Current liabilities
Accounts payable
Short-term debt
Long-term assets
Property, plant, equipment
Long-term liabilities
Long-term debt
Total liabilities
Shareholders equity
Total liabilities & shareholders
equity
Total assets
6
Balance sheet
Liabilities
Assets
Current assets
Current assets
Cash
Accounts receivable
Inventories
Current liabilities
Accounts
Cashpayable
or assets that can be
Short-term
debt to cash within a
converted
year
Long-term assets
Property, plant, and equipment
Total liabilities
goods, work
Shareholders
equityin
Total liabilities &
shareholders equity
Total assets
Balance sheet
Long-termLiabilities
assets
Assets
Current
liabilitiesthat produce
Assets
Accounts
payable
more
than one year
Short-term debt
Current assets
Cash
Accounts receivable
Inventories
benefits for
Long-term assets
Property, plant, and equipment
Long-term debt
Totaldecreased
liabilities each year to match
assets useful
Shareholders
equitylife. Equal to
Totaldepreciation.
liabilities &
shareholders equity
Total assets
Balance sheet
Current liabilitiesAssets
Liabilities
Current liabilities
Accounts payable
Short-term debt
Inventories
Long-term liabilities
Long-term liabilities
Long-term debt
Total liabilities
Shareholders equity
Total liabilities &
shareholders equity
10
Liquidation
Definition
The process of closing a firm by selling its assets and paying its
liabilities.
11
Liquidation example
What is an estimate of the liquidation value of the firm as of 2009?
Why is this only an estimate?
12
Balance sheet
Shareholders equity
Liabilities
Assets
Represents
the net worth of
Current
assets
the firm from an accounting
Cash
Accounts
receivable
perspective.
Inventories
Current liabilities
Accounts payable
Short-term debt
Long-term
assets
value of
the firm.
Property, plant, equipment
Long-term liabilities
Long-term debt
Total liabilities
Shareholders equity
Total liabilities &
shareholders equity
13
14
Income statement
15
Income statement
Lists the firms revenues and expenses over a period of time
Net profit is a measure of firm profitability over the period. Net
profit may also be referred to as:
16
Income statement
17
18
19
20
21
Scenario
Year 0
At the start of the project, the firm expects to buy manufacturing equipment for $5,000. The
manufacturing equipment has a useful life of 5-years and will be depreciated at prime cost.
Year 1
The firm expects to sell 600 finished products at a price of $8.00 each. The raw materials
required are expected to cost $2.50 each. The firm will depreciate the manufacturing
equipment and pay taxes.
Year 2
The firm expects to manufacture 400 products, with raw materials costing $3.00 each. It
expects to sell 300 finished products at $7.00 each. The firm will depreciate the manufacturing
equipment and pay taxes.
22
Scenario (continued)
Year 3
The firm expects to sell 400 finished products at $6.00 each. 300 items will be sold in cash
and the remaining 100 on credit. It also expects to manufacture 400 products, with raw
materials costing $3.00 each. It will pay 70% of the costs to the supplier in cash and will
receive credit on the remainder. The firm depreciates the manufacturing equipment and pay
taxes.
Year 4
The firm will manufacture 200 items at $4.00 per each. It will sell these items and any
remaining inventory. It will close out all outstanding debt accounts. It will depreciate the
manufacturing equipment and pay taxes. Finally, it will sell the manufacturing equipment for
$2,000 and end the project.
23
Income statement
Determined using rules of accrual basis accounting
24
Revenues
Costs
Depreciation
Earnings before interest
and taxes (EBIT)
Income tax (30%)
Earnings
25
Depreciation
Definition
The systematic allocation of the acquisition cost of long-lived or fixed
assets to the expense accounts of particular periods that benefit from
the use of the assets. Required by accrual basis accounting.
26
27
Year
Depreciation
Book Value
$2,000
$500
$1,500
$500
$1,000
$500
$500
$500
28
29
Investment activities
Capital expenditures
After-tax salvage
Cash from investing activities
Total cash flow
30
After-tax salvage
Definition
The cash received for selling an asset adjusted for taxes overor under-paid because the selling price differs from the book
value.
31
After-tax salvage
Example
A laptop purchased for $2,000 has a 4 year useful life. It will be
depreciated using prime cost (straight-line) depreciation.You
expected to sell the computer after 3 years for $750.
What is the after-tax salvage value?
32
After-tax salvage
Sale Price
Sale Price
$750
500
Taxes
250
After-tax salvage
Taxes (30%)
75
33
$750
75
675
Capital budgeting
34
Capital budgeting
The project life cycle
35
Capital budgeting
A capital budget lists the projects and investments that
a company plans to undertake during future years.
To create this list, firms analyse alternate projects and
decide which ones to accept through a process called
capital budgeting.
Pro-forma statements consist of financial projections
under a set of hypothetical assumptions
36
Capital budgeting
A few questions need to be answered:
What measure of performance matters for project
valuation?
How can we value a project independent of the rest of
the firm?
What is an effective way to derive our performance
estimates?
37
38
Example
Original firm cash flows
$10
Cash
flows
$10
t=1
t=0
$10
t=2
t=3
Time
$15
Cash
flows
t=0
$6
t=1
t=2
$5
39
t=3
Time
Example
Values at 10% discount rate
Scenario
Firm NPV
Original
$24.87
28.02
Difference
3.15
40
Example
Imagine doing this in a large company
Requires gathering information on EVERY
expected cash flow the company will ever
receive
Is there a better way?
41
Example
Difference in cash flows
$8
$5
Cash
flows
t=0
t=1
t=2
$5
t=3
$4
42
Time
Stand-alone principle
Definition
A project can be evaluated by finding the incremental cash
flows from undertaking the project and discounting at the rate
appropriate for the project.
44
Sunk costs
Definition
A cost that has already been incurred and
cannot be recouped, and therefore should not
be considered in an investment decision.
Why?
Our interest is in expected outcomes. We value
the future, not the past.
45
Side Effects
Definition
Cash flows gained or lost in the firms existing
projects due to taking a new project are
considered incremental cash flows.
Why?
Changes in other projects that are a direct
consequence of a new project impact overall
firm value.
46
Opportunity costs
Definition
The most valuable alternative that is given up if a
particular investment is undertaken.
Why?
Eliminating a future cash flow is equivalent to
losing money on the investment.
47
Opportunity costs
48
49
A difference in perspectives
Accrual
basis
Cash flow
basis
Income
Statement
Cash Flow
Statement
Philosophy
Revenues
Expenses
50
A difference in perspectives
51
A difference in perspectives
Accrual
basis
Cash flow
basis
Income
Statement
Cash Flow
Statement
Incremental
Cash Flows
52
53
Indirect method
Incremental earnings + Adjustments =
Incremental
Cash Flows
54
Incremental earnings
55
Incremental earnings
Definition
For incremental earnings (and when valuing firms in general),
we use incremental net operating profit, the change in net
operating profit from undertaking a project or investment. It is
the incremental operating income less taxes directly related to
the project. Incremental earnings does not include financing
costs, such as interest payments to bond holders.
tax rate)
56
3
200
Incremental revenues
500
800
Incremental costs
-150
-300
-50
Incremental depreciation
-204
-204
-204
146
296
-54
-43.8
-88.8
16.2
Incremental earnings
102.2
207.2
-37.8
58
Taxes
59
60
organizations.
3. Dividends (other than capital gain
distributions) received from a REIT that,
for the tax year of the trust in which the
dividends are paid, qualifies under
sections 856 through 860.
4. Dividends not eligible for a
dividends-received deduction, which
include the following.
a. Dividends received on any share of
stock held for less than 46 days during
the 91-day period beginning 45 days
before the ex-dividend date. When
counting the number of days the
corporation held the stock, you cannot
count certain days during which the
corporations risk of loss was diminished.
See section 246(c)(4) and Regulations
section 1.246-5 for more details.
b. Dividends attributable to periods
totaling more than 366 days that the
corporation received on any share of
Example:preferred stock held for less than 91 days
during the 181-day period that began 90
U.S. IRS
1120
days Form
before the
ex-dividend date. When
counting the number of days the
A firm
has a potential project
corporation held the stock, you cannot
generating
4 million
in which the
count certain
days during
corporations
risk of loss was diminished.
incremental
income.
See section 246(c)(4) and Regulations
1.246-5
more details.
The section
firm has
totalfortaxable
Preferred dividends attributable to periods
income
of less
10.5than
million
totaling
367 days are subject to
the 46-day holding period rule, above.
What tax
rate should be used
c. Dividends on any share of stock to
to evaluate
project? is under an
the extentthe
the corporation
obligation (including a short sale) to make
related payments with respect to positions
in substantially similar or related property.
5. Any other taxable dividend income
not properly reported elsewhere on
Schedule C.
61
Line 2
If the corporation is a member of a
controlled group and is filing Schedule O
(Form 1120), enter the corporations tax
from Part III of Schedule O. Most
corporations that are not members of a
controlled group and not filing a
consolidated return figure their tax by
using the Tax Rate Schedule below.
Qualified personal service corporations
should see instructions below.
Tax Rate Schedule
If taxable income (line 30, Form 1120) on page 1
is:
Over
But not
over
$0
$50,000
15%
$0
50,000
75,000
$ 7,500 + 25%
50,000
75,000
100,000
13,750 + 34%
75,000
100,000
335,000
22,250 + 39% 100,000
335,000 10,000,000
113,900 + 34% 335,000
10,000,000 15,000,000 3,400,000 + 35% 10,000,000
15,000,000 18,333,333 5,150,000 + 38% 15,000,000
18,333,333
----35%
0
Of the
amount
over
Year
Tax is:
Project
incremental
-16-
Firm
+ project
5000
300
5300
Costs
-1500
-100
-1600
-500
-500
3500
-300
3200
-1050
90
-960
Earnings
2450
-210
2240
62
63
Line 3
A corporation that is not a small
corporation exempt from the AMT
may be required to file Form 4626,
Alternative Minimum Tax Corporations,
if it claims certain credits, even though it
does not owe any AMT. See Instructions
for Form 4626 for details.
Unless the corporation is treated as a
small corporation exempt from the AMT, it
CAUTION
Revenues
Depreciation
Capital expenditures,
depreciation, and salvage
64
Depreciation
The systematic allocation of the acquisition
cost of long-lived or fixed assets to the
expense accounts of particular periods that
benefit from the use of the assets. Required
by accrual basis accounting.
Salvage
65
Capital expenditures
Adjustments under the indirect method
How: Subtract capital expenditures from incremental earnings
Why: Under accrual accounting,
66
Depreciation
Adjustments under the indirect method
67
After-tax salvage
Adjustments under the indirect method
How: Add after-tax salvage value to incremental earnings
Why: Under accrual accounting,
68
69
Increase added to
incremental earnings to
find operating cash flows.
70
71
72
Examples:
74
75
Depreciation
Capital expenditures
After-tax salvage
76
= (Revenues
Costs
+ Depreciation
= (Revenues
CapEx
CapEx
T ax rate)
Change in N W C
Depreciation) (1
CapEx
Costs) (1
T ax rate)
Change in N W C
T ax rate)
Evaluating projects
78
Evaluating projects
First create Pro Forma:
Incremental earnings
Capital expenditures and after-tax salvage
Net working capital requirements
Incremental project cash flows
79
Evaluating projects
Then determine the NPV per the following general
framework:
1. Determine expected cash flows for period until project
stabilizes
2. Determine stable, long-term project cash flows
3. Compute value of long-term cash flows using perpetuity or
annuity formula, this is called the terminal value
4. Compute NPV using all cash flows and terminal value
80