fundamentals of corporate finance/3e,ch08
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![Page 1: Fundamentals of Corporate Finance/3e,ch08](https://reader033.vdocuments.site/reader033/viewer/2022061219/54b905bb4a795986028b457c/html5/thumbnails/1.jpg)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-1
Chapter Eight
Making Capital Investment Decisions
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-2
Chapter Organisation
8.1 Project Cash Flows: A First Look
8.2 Incremental Cash Flows
8.3 Project Cash Flows
8.4 More on Project Cash Flows
8.5 Some Special Cases of Discounted Cash Flow
Analysis
8.6 Summary and Conclusions
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-3
Chapter Objectives
• Identify incremental cash flows relevant to investment evaluation.
• Calculate depreciation expense for tax purposes.• Apply incremental analysis to project evaluation.• Determine how to set the bid price and how to
value options.• Compare mutually-exclusive projects using annual
equivalent costs.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-4
Incremental Cash Flows
• Any and all changes in the firm’s future cash flows that are a direct consequence of undertaking the project.
• The only relevant cash flows in capital project evaluation.
• Stand-alone principle: we can evaluate the project on its own.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-5
Types of Cash Flows
• Sunk costs a cost that has already been incurred and cannot be removed incremental cash flow
• Opportunity costs the most valuable alternative that is given up by the investment = incremental cash flow
• Side effects erosion = incremental cash flow
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-6
Types of Cash Flows (continued)
• Financing costs incorporated in discount rate incremental cash flow
• Always use after-tax incremental cash flow
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-7
Investment Evaluation
• Step 1 Calculate the taxable income.
• Step 2 Calculate the cash flows.
• Step 3 Discount the cash flows.
• Step 4 Decision.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-8
Example—Investment Evaluation
• Purchase price $42 000• Salvage value $1000 at end of Year 3• Net cash flows Year 1 $31 000
Year 2 $25 000
Year 3 $20 000• Tax rate is 30%• Depreciation 20% reducing balance• Required rate of return 12%
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-9
Solution—Depreciation Schedule
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-10
Solution—Taxable Income
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-11
Solution—Cash Flows
Year 0 Year 1 Year 2 Year 3
Tax paid (6 780) (5 484) 1 764
Net cash flow 31 000 25 000 20 000
Salvage value 1 000
Outlay (42 000)
Cash flow (42 000) 24 220 19 516 22 764
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-12
Solution—NPV and Decision
Decision: NPV > 0, therefore ACCEPT.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-13
Interest
• As the project’s NPV is positive, the cash flows from the investment will cover interest costs (as long as the interest cost is less than the required rate of return).
• Interest costs should not therefore be included as an explicit cash flow.
• Interest costs are included in the required rate of return (discount rate) used to evaluate the project.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-14
Depreciation
• The depreciation expense used for capital budgeting should be the depreciation schedule required for tax purposes.
• Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes.
• Prime cost vs diminishing value methods• Depreciation tax shield = DT
-D = depreciation expense-T = marginal tax rate
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-15
Disposal of Assets
• If the salvage value > book value, a profit/gain is made on disposal. This profit/gain is subject to tax (excess depreciation in previous periods).
• If the salvage value < book value, the ensuing loss on disposal is a tax deduction (insufficient depreciation in previous periods).
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-16
Capital Gains
• Capital gains made on the sale of assets such as rental property are subject to taxation.
• Capital losses are not a tax deduction but can be offset against future capital gains.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-17
Example—Incremental Cash Flows
A firm is currently considering replacing a machine purchased two years ago with an original estimated useful life of five years. The replacement machine has an economic life of three years. Other relevant data is summarised below:
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-18
Solution—Taxable Income
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-19
Solution—Cash Flows
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-20
Solution—NPV and Decision
Decision: NPV < 0, therefore REJECT.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-21
Setting the Bid Price
• How to set the lowest price that can be profitably charged.
• Cash outflows are given.
• Determine cash inflows that result in zero NPV at the required rate of return.
• From cash inflows, calculate sales revenue and price per unit.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-22
Setting the Option Value
• Option value =
Asset value × Probability of the Value
–
Present value of the exercise price × Probability the exercise price will be paid.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-23
Annual Equivalent Cost (AEC)
• When comparing two mutually-exclusive projects with different lives, it is necessary to make comparisons over the same time period.
• AEC is the present value of each project’s costs to infinity calculated on an annual basis.
• Select the project with the lowest AEC.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-24
Example—AEC
• Project A costs $3000 and then $1000 per annum for the next four years.
• Project B costs $6000 and then $1200 for the next eight years.
• Required rate of return for both projects is 10 per cent.
• Which is the better project?
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-25
Solution—Project A
946 $13.1699
170 $6
0.10 4,PVIFA
costs of PVAEC
$6170
$3000$3170
$30003.1699$1000
0.10 4,PVIFANPV 0
C C
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-26
Solution—Project B
$23255.3349
402 $12
0.10 8,PVIFA
costs of PVAEC
402 $12
$6000$6402
$60005.3349200 $1
0.10 8,PVIFANPV 0
C C
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
8-27
Solution—Interpretation
Project A is better because it costs $1946 per year compared to Project B’s $2325 per year.