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FIN320 - Fundamental Capital Budgeting

by: Kimberly Hong

FIN320 - Fundamental Capital Budgeting FIN 320

Marketplace > California State University - Fullerton > Finance > FIN 320 > FIN320 Fundamental Capital Budgeting
Kimberly Hong
Cal State Fullerton
GPA 3.42

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Important chapter for Exam 2.
Business Finance
Amadeu DaSilva
Class Notes
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This 3 page Class Notes was uploaded by Kimberly Hong on Saturday March 5, 2016. The Class Notes belongs to FIN 320 at California State University - Fullerton taught by Amadeu DaSilva in Spring 2016. Since its upload, it has received 12 views. For similar materials see Business Finance in Finance at California State University - Fullerton.

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Date Created: 03/05/16
Capital Budgeting - 4/11/16 Steps: 1. Estimate CFs (Cash flows) (chap. 9) 2. Estimate cost of financing: r (chap. 13) 3. Evaluate CFs using r (NPV, IRR, MIRR) (chap. 18) Rules for Step#1 (Estimate CFs) 1. We are interested in CFs and not accounting income (profit) 2. We are interested in incremental CFs of the project a. CFs with the project vs. CFs without (only the cash that changes with the project) 1. Sunk cost: expense that you cannot get back: not incremental; therefore, not relevant. 2. Opportunity costs: relevant 3. Externalities: Some costs or benefits that you do not really take into account when making decision. Are there any negative or positive impact on other people/products?  Cannibalization: the cost of losing to competitor (-)  Synergies: positive effect of externalities. 4. Financing costs: not relevant. Examples: interest payment and dividend. 3 types of CFs CF behavior of each type - 1. CFs from operations CF 0 CF1 CF2 CF3 2. CFs due to investment in fixed assets (PPE) Type 1 (+)Type 1 (+) Type 1 (+) 3. CFs due to investment in net operating working capital Type 2 (-) Type 2 (-) Type 3 (-) Type 3 (+) Type 1: CFs from operations: Formula: EBIT – taxes + depreciation expense = EBIT – (1-Taxes) + depreciation exp. AKA (Revenue – cost) x (1-T) + dep. Expense x Tax (this formula emphasizes the value of depreciation expense) Income Statement Sales Less: Cost (COGS, MKTG, Admin…) Less: Depreciation expense EBIT (operating expense) Less: Interest expense EBT Less: Taxes Net Income (NI)  Depreciation Expenses x Tax = depreciation tax shield o Depreciation tax shield: how much we save every time we purchase a machine. Example: Fixed Asset (FA) cost: $100, 10 years, straight line (SL) depreciation, tax rate (T): 40%  Depreciation expense: $100 / 10 = $10/year  Tax shield: $10 x 40% = $4 Accelerated depreciation: depreciate FA more in the beginning and less at the end. One common accelerated depreciation method is MACRS. Example of MACRS: Period 1 2 3 4 5 Depreciate $20 $20 $7.5 $7.3 $6 Type 2: CFs due to investment in fixed asset (PPE) Example: At period (t): 0, we will need property, machine, and/or equipment for a bike store. Assume: PPE cost $2 m, at t = 1, we sell 100 bikes, at t = 2, we sell 200 bikes CF 0 CF 1 CF2 CF3 Type 2 (-) Type 2 (-) - CF 0s negative because we need money to purchase the fixed asset. - CF 1s negative because we need additional investment in fixed asset for the increase in # of bikes for t = 2. If at t = 2, we sell 70 bikes instead of 200, then we have extra fixed asset. So we are going to sell some of the fixed asset back. CF 0 CF 1 CF2 CF3 Type 2 (-) Type 2 (+) - CF 2s positive because we are selling existing fixed assets; cash inflow. If at t = 3, at the end of the project, we sell fixed asset. - CF 0 CF 1 CF2 CF3 Type 2 (-) Type 2 (-) Type 2 (+) - CF 3s positive because we sell fixed asset. Salvage value net of taxes: salvage value – taxes on gain on selling of fixed assets. If fixed asset sold at a loss, we will assume a negative tax. Type 3: CFs due to investment in net operating working capital (NowC) Assets (inventory, cash, AR) – Liabilities (AP, Accrued expense) = NowC Note: The bigger the liabilities, the less borrowing of cash you have to do. - CF 0 CF 1 CF 2 CF3 Type 3 (-) Type 3 (+) -> Recover NowC investment - If we collect all Accounts Receivable (on account $$) then we will have cash inflows for working capital. Example: Four (4) year project, FA cost = $200,000 with shipping cost of $10,000, and installation fee of $30,000. Fixed asset has zero salvage value and 4 useful life. Use straight line depreciation method. It’s predicted that the annual sales is 1,250 units at the price of $200 per unit. The product cost is $100 per unit. NowC is 12% for next year sales, tax rate is 40%, and interest rate is 10%. A. Find cash flows for period zero to period 4. B. Is this a good project? Solutions: Calculate CFs operations: EBIT (1 – T) + Depreciation Expense Income Statement Revenue $250,000 Less Cost $125,000 (1,250 units x $100) Less Dep. Exp. $60,000 ((*$240,000 - 0) / 4) EBIT $435,000 CFs operations: 65,000 x (1-40%) + 60,000 = $99,000 Total fixed asset cost: FA cost + Shipping + installation = $200000 + $10,000 + $30,000 = $240,000 t = 0 t = 1 t = 2 t = 3 t = 4 CFs Operation + $99,000 + $99,000 + $99,000 + $99,000 CFs Fixed Asset - $240,000 0 CFs NowC - $30,000 $30,000 r = 10% Total - $270,000 + $99,000 + $99,000 + $99,000 + $129,000 Calculate NVP and IRR. Use financial calculator. NVP = $64,307.08 > 0 IRR = 20.14% > r = 10% This project is a good project.


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