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UNIT 8Project Valuation
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What is capital budgeting?
• Analysis of potential additions to fixed assets.
• Long-term decisions; involve large expenditures.
• Very important to firm’s future.
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Steps to capital budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
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What is the difference between independent and mutually exclusive
projects?
• Independent projects – if the cash flows of one are unaffected by the acceptance of the other.
• Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.
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What is the difference between normal and nonnormal cash flow streams?
• Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs.
• Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.
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Net Present Value (NPV)
• Sum of the PVs of all cash inflows and outflows of a project:
N
0tt
t
)r 1 (CF
NPV
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Internal Rate of Return (IRR)
• IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:
N
0tt
t
) IRR 1 (CF
0
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Reinvestment rate assumptions
• NPV method assumes CFs are reinvested at the WACC.
• IRR method assumes CFs are reinvested at IRR.
• Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects.
• Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.
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What is the payback period?
• The number of years required to recover a project’s cost, or “How long does it take to get our money back?”
• Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.
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Blanchford Enterprises is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected.WACC = 10%Year: 0 1 2 3 4 Cash flows: -$2,000 $600 $500 $700 $600
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Blanchford Enterprises is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected. WACC = 10% Year: 0 1 2 3 4 Cash flows: -$2,000 $600 $500 $700 $600
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Tapley Dental Associates is considering a project that has the following cash flow data. What is the project's payback? Year: 0 1 2 3 4 5 Cash flows: -$1,000 $400 $420 $440 $460 $480
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Tapley Dental Associates is considering a project that has the following cash flow data. What is the project's payback? Year: 0 1 2 3 4 5 Cash flows: -$1,500 $400 $420 $440 $460 $480
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Rockmont Recreation Inc. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected.Year: 0 1 2 3 4 Cash flows:-$1,500 $450 $440 $430 $420
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As a member of Gamma Corporation's financial staff, you must estimate the Year 1 operating net cash flow for a proposed project with the following data. What is the Year 1 operating cash flow? Sales $40,000 Depreciation $15,000 Other operating costs $18,000 Interest expense $5,000 Tax rate 35%
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As a member of Gamma Corporation's financial staff, you must estimate the Year 1 operating net cash flow for a proposed project with the following data. What is the Year 1 operating cash flow? Sales $40,000 Depreciation $15,000 Other operating costs $18,000 Interest expense $5,000 Tax rate 35%
Sales Revenue $40,000Operating costs(x-depr) $18,000Depreciation expense $15,000____________________________________________Operating income (EBIT) $7,000-Taxes -$2,450____________________________________________After-tax EBIT $4,550+ Depreciation $15,000____________________________________________Operating cash flow $19,550
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Delta Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's operating cash flow during Year 1? Equipment cost (depreciable basis) $85,000 Straight line depreciation rate 40% Sales $80,000 Operating costs excl. depr’n $35,000 Tax rate 35%
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Sales Revenues $80,000-Operating costs (x-depr) -$35,000-Basis x rate = depreciation = -$28,331
Operating income (EBIT) $16,669
-Taxes -$5,834
After-tax EBIT $10,835+Depreciation $28,331
Operating cash flow, Year 1 $39,166
Delta Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's operating cash flow during Year 1? Equipment cost (depreciable basis) $85,000 Straight line depreciation rate 33% Sales $80,000 Operating costs excl. depr’n $35,000 Tax rate 35%
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Swannee Resorts is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight line method over the project's 3 year life, and would have zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)
WACC 10% Net investment cost (depreciable basis) $75,000 Straight line depr’n rate 33.33% Sales revenues $80,000 Operating costs excl. depr’n $30,000 Tax rate 35%
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