FINE 2000 Lecture Notes - Lecture 1: Market Research, Capital Budgeting, Working Capital

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15 Sep 2016

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Week 8 chapter 9 (chapter 9 is also week 7) + 10. To calculate net present value you need to discount cash flows not accounting profits. Income statements do not show cash flows, rather, how well a firm performs. Forecast the cash flows from the project if you proceed with it. Then forecast the cash flows if you don"t accept the project: the difference is the extra (or incremental) cash flows produced by the project. Incremental cash flow = cash flow with project cash flow without project. Ex: microsoft"s new operating system: new products often damage sales of an existing project. To forecast incremental cash flow, you must trace out all indirect effects of accepting the project. Initial amount for a factory upfront to build. Working capital (in) ex: if that is an engine, the grease and oil (the money put into a project to keep a traction and moving forward)

Related Questions

The goal of the firm is to ____ because _____. Answer maximize shareholders' wealth; it considers all risks invest funds in real estate; the return is longer maximize shareholders' profit; it is a short term outlook closely matching management goals Mike is paying $8,000 a year on his mortgage at 6% nominal annual interest. He has 15 more years to make payments. He wants to sell his house today. The lowest [minimum] price he can sell the house without losing any money on the house would be about ___. Answer $120,000 $ 50,000 $77,698 $ 186,208 A firm's net income before tax, EBT [NIBT] (on the income statement) is affected by _____. Answer taxes interest dividends Common Stock as listed on the Balance Sheet could include which of the following? Answer A) retained earnings B) additional paid in capital over par value C) preferred capital Both A) and B) If an asset is sold for ___ than its basis, the tax effect would be ____. Answer A) more; capital gain and depreciation recapture B) less; depreciation recapture C) more; capital loss Both A) and B) The main reason for a firm to have assets is to _______. Answer generate revenue match the liabilities and equity both of the above be able to borrow money and pay its debts none of the above The only risk you would NOT have in loaning money to the United States Government (Uncle Sugar) is _____ risk. Answer liquidity maturity default A(n) ____ shows _____. Answer balance sheet; sources and uses of funds income statement; net income as of a specific date cash flow statement; how well the firm is doing relative to its competition You can compare dollars _____ because ______. Answer computed using equations; any math is always correct at any point in time; time is never a factor if they are at nominal value; that is when decisions are made only at the same point in time; dollars can be invested to earn interest There ___ a tax benefit to the company with paying preferred dividends because _______. Answer is; investors can write them off is not; investors declare them as income is; the company can use the payments as an expense is not; the company cannot use the payments as an expense XYZ issued a 6% coupon, $1,000 par, 30 year to maturity bond. It is now 6 years to maturity. What is the price of the bond if the yield to maturity [market interest rate] is 10%? Answer $1,000 $659.46 $825.79 $705.33 The valuation process can be described as ______. Answer calculating the present value of an expected future cash flow using the investor's required rate of return as the discount rate calculating the future value of an expected future cash flow using the investor's required rate of return as the discount rate amortizing the value of the asset over its holding period The ______ is the minimum required rate of return a firm must earn on its investments. Answer net present value opportunity cost of capital or weighted average cost of capital. internal rate of return gross profit margin The value of an asset is the _____ dollar price someone is willing to pay for it. Answer usual maximum minimum Companies use ____ in capital budgeting project analysis because ________. Answer accounting profit; that is the total net income after tax cash flow; that is what the owners would receive from the project and reinvest accounting profit; that is what the owners would receive from the project and reinvest after tax cash flow; that is the result of prudent accounting When borrowing money, you want to know the ____ interest rate because ____. Answer nominal; it is the easiest to find. effective; it is the true cost of borrowing risk free; that is what the government pays Fed funds; that is what you would pay the bank Cash available to pay out to the investors after the firm pays for new investments or additions to working capital is _____. Answer a statement of cash flows operating after tax cash flow free cash flow net income An organization that raises money from investors and provides financing for individuals and businesses is a ___. Answer factor federal government regulatory unit state government taxing authority financial intermediary Negatives/cons of the Net Present Value (NPV) technique include: Answer least conservative reinvestment assumption multiple rates of return for non-conventional cash flows all of the above none of the above A fixed exchange rate means a country _____. Answer can only use gold coins as money is limited in the amount of paper money it can print can print money as the economy demands Your company is considering an investment with the following expected cash flows: Initial Investment = $407,596 Operating Cash Flows = $73,428 per year Terminal Cash Flow = $11,872. The company's WACC is 11% for similar risk projects. The proposed project would have an expected life of 9 years. Your boss asks you to do the analysis. You would tell your boss this proposed project ___ because ____. Answer is acceptable; NPV is about $3,620 is acceptable; NPV is zero should be rejected; NPV is about -$5,660 [negative $5,660]. should be rejected; NPV is zero All ratios are ___ and a reason to analyze ratios is ____. Answer good; to continue to look productive good and bad; because seemingly good ratios can be masking something bad bad; to try to rework the numbers to have them look good basically irrelevant; there really is no need to analyze financial statements When analyzing financial statements, ratio analysis gives ____ and provides insight into ____. Answer very little useful information; practically nothing good practice in logical thinking; what has occurred and the logic behind it financiers something to do during slow periods; how the financier spends his time accountants a reason to provide financial statements; why accountants do what they do while at work Given: Economic State[i]: Good Average Expected Return[i]: 10% 8% Probability[i]: 30% 70% What is the Standard Deviation? Answer 3% 8.4% 0.92% 5.6% Chapter 9: XYZ has a projected project to install a new press. The expected cash revenue is $175,000 per year. Expected yearly expenses are: Operatinf costs of $50,000; Rental of $17,000; Utilities of $20,500; and Depreciation of $10,000. The tax rate is 35%. What is the expected After-Tax Operating Cash Flow for the first year? Answer $65,500 $60,375 $77,500 $97,500 A stock just paid a dividend of $1.60 per year. The dividend is expected to grow at 3% per year indefinately. Equally risky stocks offer expected rates of return of 8%. What should be the stock price? Answer 53.33 $16.00 $32.96 None of the above. A plot of the CAPM is the _____. Answer wrong thing to do Security Market Line a function showing how to calculate TVM All of the above. Derivatives are used to ___. Answer divide one number by another find old ways to do things hedge risk none of the above With the end of the Gold Standard in the 1970's, what new risk did business face in the international market? Answer Comjpetition Exchange rate Worker compensation Property taxes One of the positive aspects [pros] of a Floating Exchange Rate System is ____. Answer money can be printed as needed to support financial/economic growth no/reduced inflation economic growth is reduced as a result of reduced liquidity [lower money supply] business planning is more difficult A(n) ____ contract obligates the seller to execute the contract and the contract is executed. Answer backwards forward future option What policies did countries institute after the Great War that help lead to the Great Depression? Answer A. Mandatory military service B. Trade restrictions C. High tariffs D. Isolationism Only B., C. and D. All of the above

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1a- What are the direct costs and indirect costs of financial distress, from default that leads to bankruptcy? Explain in a well-stated description and discussion, not over a page in length.

1b- What are the impacts of the following on BECA Corporation's value, given the following information? SHOW ALL CALCULATIONS, and make a summary about the impact on equity owners between leveraged and unleveraged capital structures, and the impact on firm value from Financial Distress Costs.

BECA Corporation faces an uncertain future in a challenging business environment. Due to increased competition from foreign imports, its revenues have fallen dramatically in the past year. BECA's managers hope that a new product in the company's pipeline of new products will restore its fortunes. While the new product represents a significant advance over BECA's competition, whether that product will be a hit with consumers remains uncertain. If it is a hit, revenues and profits will grow, and BECA will be worth $200 million at the end of the year. If it fails, BECA will be worth only $130 million at the end of the year.

BECA Corporation may employ one of two alternative capital structures at the beginning of the year to provide the funding for this new project: (1) it can use all equity financing or (2) it can use debt that matures at the end of the year with a total of $150 million due.

Look first at the consequences of these capital structures when the new product succeeds, and when the new product fails, in a setting of perfect capital markets. Calculate what the debt and equity values will be for success and for failure, in both the unlevered and levered capital structures, at the end of the year. Show the totals to all investors (debt + equity) as well.

Now, since it has been assumed that BECA Corporation is operating in a perfect capital market, according to the M&M Proposition I, the investors (debt and equity total) will NOT be worse off because BECA may have some leverage at the beginning of the year. In other words, the value of BECA will be the same whether it has incurred the $150M of debt or not.

So, you are to show if that is indeed the case for BECA Corporation, under the following scenario.

Suppose the risk-free rate is 5%, and BECA's new product is equally likely to succeed or to fail. For simplicity, suppose that BECA's cash flows are unrelated to the state of the economy (i.e., the risk is diversifiable), so that the project has a Beta coefficient of 0 and the cost of capital is the risk-free rate. Compute the value of BECA's securities (that means both debt and equity, as applicable) at the beginning of the year with and without the $150M debt, and show whether or not the M&M Proposition I holds. That is, show if the value of the securities with or without leverage (the debt of $150M) have the same total value or not.

Now, to "get at" the value, VL or VU of the BECA Corporation, you have to discount the value of the cash flows to investors, per equation 9.23 in Chapter 9. But, what you need to know about the M&M Propositions is they assumed that the entire earnings (EBIT) in each year are paid out to the shareholders in the form of dividends or to the debtholders in the form of interest. So, regardless, the owners of the firm receive all the cash flows. So, for equation 9.23, you only have one year of FCFs, and the discount rate is 5%. What is the FCF? Since it is all of the cash flows with no taxes existing, and all of it is paid out to the equity and debt holders in a perfect capital market, what you find out is that the numerator is nothing more than the equity or debt values you calculated above. This is illustrated in Example 16.1 on page 554 of the texbook (I just provided an explanation of why the equity and debt values are used in the numerator instead of cash flows...in this case, they are the same).

2.Suppose you are a rational investor and looking at the following tax rates:

Year	Capital Gains Rate	Ordinary Income Rate	Dividend Rate
1997-2000	20%	40%	40%
2001-2002	20%	39%	39%
2003-2012	15%	35%	15%

(The 2012 tax rates were revised in 2013 by the U.S. Congress, and signed into law by the President, but that is for information only). The tax rates shown are for financial assets held for one year or more. For assets held less than one year, capital gains are taxed at the ordinary income tax rate (currently 35% for the highest bracket); the same is true for dividends if the assets are held for less than 61 days.

Your assignment: What is the effective dividend tax rate for a buy and hold individual investor in 2006 ?

Show all of your calculations.

You are the General Manager at the Bicker, Slaughter, and Lynch Law Firm. There is an opportunity to buy out a small law firm that was just started by a young MBA/JD, and you believe the firm can be grown and become a lucrative part of your Firm. With help from your finance leader, you have estimated the following benefit streams for this new division:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Before Tax $(149,000) $0 $51,380 $88,760 $114,100 $129,780 $143,640 $167,300

Cash Flow

From Operations

After Tax Net Income

From Operations $(103,500) $(50,500) $36,700 $63,400 $81,500 $92,700 $102,600 $119,500

After Tax Cash Flow

From Operations $(85,600) $15,000 $48,600 $72,200 $95,550 $101,300 $125,200 $140,200

You estimate that the purchase price for this firm would be $200,000 and that additional net working capital would be needed in the amount of $60,000 in year 0, an additional $20,000 in year 2 and then $20,000 in year 5. BSL usually spend about $275,000 per year in advertising. If you make this acquisition, you would ask that advertising spending be increased by an incremental one-time amount of $50,000 in year 0 to publicize the firmâs expansion. Your finance leader has indicated that the firm has access to a credit line and could borrow the funds at a rate of 6%. He also mentions that when he runs project economics for capital budgeting (such as a new copier or a company car), he recommends a standard 10% rate discount, but the one other time they looked at an acquisition of a smaller firm, he used a 12% rate discount. Obviously you will want to select the most appropriate discount rate for this type of project.

At the end of 8 years, the plan will be to sell this division. The estimated terminal value (the sale and the return of working capital) is conservatively estimated to be $300,000 of after-tax cash flow help. Using the data that you need (and ignoring the extraneous information),

calculate the Nominal Payback, the Discounted Payback, the Net Present Value, and the IRR for this potential acquisition.

Discussion â in a Word Document in paragraph form, respond to the following:

1) From a purely financial (numbers) perspective, would you recommend this purchase to management? Why?

2) What are some of the non-financial elements that need to be considered for this proposal?

3) Assumptions in project economics can have a huge impact on the result. Identify 3 financial elements/assumptions in your analysis that would make this project not be financially attractive (e.g., answer this question: what would have to be true for this to be a bad investment?).

4) If you were the CEO, would you approve this proposal? Why or why not?

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FINE 2000 Lecture Notes - Lecture 1: Market Research, Capital Budgeting, Working Capital

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