FINS1613.Section III.capital Budgeting.12 Apr 2015.3 Per Page

Section II: Capital Budgeting

FINS1613: Business FinanceSemester 1, 2015

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School of Banking and FinanceAustralian School of Business

UNSW

Robert [email protected]

Introduction to financial statements

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Disclosure of financial information

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Accurate and reliable financial information is critical to financial market health

Accounting boards provide rules by which corporations prepare financial statements Australian Accounting Standards Board International Accounting Standards Board (IASB) Financial Accounting Standards Board (U.S.)

Auditors are neutral third parties that verify annual financial statements Attest that statement prepared according to rules Provide evidence that information is reliable

Financial Statements

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Accounting reports a firm issues to provide a snapshot of financial health...

Balance sheet... and describe past performance

Income statement Cash flows statement

Balance sheet

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Balance sheetA snapshot of a firms financial assets and liabilities at a single point in time.

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Assets LiabilitiesCurrent assets Current liabilitiesCash Accounts payableAccounts receivable Short-term debtInventories

Long-term assets Long-term liabilitiesProperty, plant, equipment Long-term debt

Total liabilitiesShareholders equity

Total assets Total liabilities & shareholders equity

Balance sheet terminology

Assets

The firms cash, inventory, property and any other investments

Liabilities

The firms obligations to creditors

Shareholders equity

The difference between the firms assets and liabilities. It is the book value of the firms equity.

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Long-term assets Long-term liabilitiesProperty, plant, and equipment Long-term debt



Balance sheet

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Current assets

Cash or assets that can be converted to cash within a year

Accounts receivable: amount owed to firm by customers who purchase on credit

Inventories: value of finished goods, work in progress, and raw materials


Long-term assets Long-term liabilitiesProperty, plant, and equipment Long-term debt



Long-term assets

Assets that produce benefits for more than one year

Property, plant, and equipment: includes real estate, machinery, etc...

Book value (balance sheet value) decreased each year to match assets useful life. Equal to acquisition cost less accumulated depreciation.

Balance sheet

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Balance sheet

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Current liabilities

Accounts payable: amount owed to suppliers for purchases by the firm on credit

Short-term debt: loans that must be repaid in the next year

Long-term liabilities

Long-term debt: loans and debt (bonds) that must be repaid after one year

Definition

Liquidation

The process of closing a firm by selling its assets and paying its liabilities.

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Liquidation example

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Copyright 2011 Pearson Australia (a division of Pearson Australia Group Ltd) 9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition

What is an estimate of the liquidation value of the firm as of 2009? Why is this only an estimate?

Balance sheet

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Shareholders equity

Represents the net worth of the firm from an accounting perspective.

An estimate of the liquidation value of the firm.

It is not the market value of the firm (the value to investors) because it is a snapshot in time and ignores potential future earnings.

DefinitionThe two sides of the balance sheet must balance.

The balance sheet identity

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Assets = Liabilities + Shareholders0 equity

Income statement

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Income statement

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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:

The bottom line due to its location on the income statement Net income EarningsDetermined using rules of accrual basis accounting

Revenues and expenses are matched and recognised when incurred, not when paid

Income statement

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Cash flow statement

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Lists the cash generate by a firm and how the cash has been allocated over a period of time

Operating activities: main activities of the firm Investing activities: capital expenditures, acquisitions Financing activities: dividend payments, net borrowingDetermined using rules of cash basis accounting

Revenues and expenses are recognised when paid

Cash flow statement

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Cash flow statement

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Preparing basic financial statements for project evaluation

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Scenario

Year 0At 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 1The 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 2The 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.

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Scenario (continued)

Year 3The 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 4The 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.

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Income statement

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Determined using rules of accrual basis accounting

Revenues and expenses are matched and recognised when incurred, not when paid

Property, plant, and equipment is depreciated over time. This matches the long-term life of these items to their period of use.

Taxes are based on Earnings before Interest and Taxes (EBIT). Debt payments are ignored when evaluating projects. The tax benefits of debt are addressed through an appropriate discount-rate.

Income statement example

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Year 0 1 2 3 4

Revenues

Costs

Depreciation

Earnings before interest and taxes (EBIT)

Income tax (30%)

Earnings

Definition

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.

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In order to calculate depreciation, we require:

1. Initial acquisition cost of the asset2. Useful life of the asset3. Depreciation method

Prime cost depreciation

Prime cost (straight-line)

1. Set initial book value to acquisition cost

2. Compute annual depreciation as: Initial book value / Depreciation Life

3. Depreciate the book value by the annual depreciation each year.

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Prime cost depreciation

Example

A laptop purchased for $2,000 has a 4 year useful life. Compute the annual depreciation and book value of the laptop for each year using prime cost (straight-line) depreciation

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Year Depreciation Book Value

0 - $2,000

1 $500 $1,500

2 $500 $1,000

3 $500 $500

4 $500 -

Cash flow statement

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Determined using rules of cash basis accounting

Revenues and expenses are recognised when paid, not matched to when they are incurred.

Property, plant, and equipment costs are recognized when paid.

Tax payments are based on the income statements Earnings before Interest and Taxes (EBIT). Debt payments are ignored when evaluating projects. The tax benefits of debt are addressed through an appropriate discount-rate..

Cash flow statement example

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Year 0 1 2 3 4Operating activitiesCash collected from revenues

Cash payments on expenses

Taxes (30% of EBIT)

Cash provided by operating activities

Investment activities

Capital expenditures

After-tax salvage

Cash from investing activities

Total cash flow

Definition

After-tax salvage

The cash received for selling an asset adjusted for taxes over- or under-paid because the selling price differs from the book value.

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After-tax salvage

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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?

After-tax salvage

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Sale Price $750

Book Value (Year 3) 500

Capital gain (loss) 250

Taxes (30%) 75

Sale Price $750

Taxes 75

After-tax salvage 675

After tax salvage = Salvage price Tax rate Capital gains

Capital budgeting

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The project life cycle

Capital budgeting

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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

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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?

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The stand-alone principal (Incremental earnings and cash flows)

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t=0 t=1 t=2 t=3Time

Cashflows

t=0 t=1 t=2 t=3Time

Cashflows

Original firm cash flows

Cash flows after adding new project investment

Example

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$10 $10 $10

$15 $18

$6

$5

Example

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Values at 10% discount rate

Scenario Firm NPV

Original $24.87

After new investment 28.02

Difference 3.15

Decision: Proceed with investment in new project as firm NPV increases.

Example

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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?

t=0 t=1 t=2 t=3Time

Cashflows

Example

The NPV is $3.15 when discounted at 10%.

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$5$8

$4$5

Difference in cash flows

Incremental Earnings and Cash Flows

Incremental Earnings

The incremental earnings for project evaluation consist of any and all changes in the firms future net operating profit that are a direct consequence of taking the project.

Incremental cash flows

The incremental cash flows for project evaluation consist of any and all changes in the firms future cash flows that are a direct consequence of taking the project.

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Definition

Stand-alone principle

A project can be evaluated by finding the incremental cash flows from undertaking the project and discounting at the rate appropriate for the project.

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Stand-Along Principle Decision Rule

An investment is acceptable if the NPV of the incremental cash flows is positive. It should be rejected otherwise.

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.

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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.

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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.

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Opportunity costs

Useful for addressing profits from assets already in place when projects are mutually exclusive.

Hard to generalise to many mutually exclusive projects.

Always possible to evaluate all options as separate projects without opportunity costs and pick the best alternative.

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Project Pro Forma cash flow analysis

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A difference in perspectives

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IncomeStatement

Cash Flow Statement

RevenuesRecognised when earned/realised and payment is expected

Recognised when cash flows received

Philosophy Describe average firm performance Money money money

Expenses Recognised in period where related revenue is recognisedRecognised when cash flows paid

Accrual basis

Cash flow basis

In finance, we are interested in cash flows. However, we cannot simply compute the cash flow statement because taxes are determined

from income statements.


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IncomeStatement

Cash Flow Statement

Incremental earnings Adjustments+ =Incremental Cash Flows

Accrual basis

Cash flow basis

Determined under cash flow basis accounting by one of two methods

Direct: compute gross cash received and paid, requires tax payment in incremental earnings

Indirect: adjust incremental earnings for missing cash-related activities

Incremental cash flows

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To understand adjustments for the indirect method, we will:

Analyse problem step-by-step.

Build a balance sheet, income statement, and cash flow statement.

Determine adjustments for indirect method

Indirect method

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Incremental earnings Adjustments+ =Incremental Cash Flows

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2

3

Incremental earnings

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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.

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Incremental Earnings = Incremental EBIT (1 tax rate)

Incremental earnings example

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Year 1 2 3

Incremental revenues 500 800 200

Incremental costs -150 -300 -50

Incremental depreciation -204 -204 -204

Incremental earnings before interest and taxes (EBIT)

146 296 -54

Incremental income tax (30%) -43.8 -88.8 16.2

Incremental earnings 102.2 207.2 -37.8

When analysing projects, incremental values are always implied. We may, on occassion, omit the term incremental for brevity.

Financing costs and incremental earnings

Why do we ignore financing costs in evaluating projects?

Borrowing and lending do not affect project value in competitive markets by the Law of One Price

If borrowing and lending do not affect project value, then financing costs do not factor in the investment decision

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Implication: The particular mixture of debt and equity a firm actually chooses to use in financing a project is analyzed separately.

Taxes

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In general, we envision projects as part of a large, profitable firm which affects how we

(i) determine the tax rate, and

(ii) handle negative taxes.

Definition

Marginal tax rate

The tax rate a company pays on an incremental dollar of pre-tax income. This should be used in capital budgeting decisions.

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Marginal tax rate

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Example:

U.S. IRS Form 1120 A firm has a potential project

generating 4 million in incremental income.

The firm has total taxable income of 10.5 million

What tax rate should be used to evaluate the project?

Page 16 of 24 Instructions for Form 1120 15:39 - 23-JAN-2012

The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.

c. Any estate of an employee orLine 17, Column (a)retiree described above, orSchedule J. Include the following. d. Any person who acquired the stock1. Dividends (other than capital gain Tax Computation and of the corporation as a result of the death

distributions reported on Schedule D of an employee or retiree (but only for thePayment(Form 1120) and exempt-interest 2-year period beginning on the date of thedividends) that are received from RICs employees or retirees death).Part ITax Computationand that are not subject to the 70%

Mutual savings bank conducting lifededuction. Line 1 insurance business. The tax under2. Dividends from tax-exempt If the corporation is a member of a section 594 consists of the sum of (a), aorganizations. controlled group, check the box on line 1. partial tax computed on Form 1120 on the

Complete and attach Schedule O (Form3. Dividends (other than capital gain taxable income of the bank, determined1120), Consent Plan and Apportionment without regard to income or deductionsdistributions) received from a REIT that,Schedule for a Controlled Group. allocable to the life insurance department,for the tax year of the trust in which the Component members of a controlled and (b), a partial tax on the taxabledividends are paid, qualifies under group must use Schedule O to report the income computed on Form 1120-L of thesections 856 through 860.apportionment of taxable income, income life insurance department. Enter the4. Dividends not eligible for a tax, and certain tax benefits between the combined tax on line 2. Attach Formdividends-received deduction, which members of the group. See Schedule O 1120-L as a schedule (and identify it as

include the following. and the Instructions for Schedule O for such), together with the annualmore information. statements and schedules required to bea. Dividends received on any share of

filed with Form 1120-L. See Regulationsstock held for less than 46 days during Line 2 section 1.6012-2(c)(1)(ii).the 91-day period beginning 45 daysIf the corporation is a member of abefore the ex-dividend date. When Exception for insurance companiescontrolled group and is filing Schedule O filing their Federal income tax returnscounting the number of days the (Form 1120), enter the corporations tax electronically. If an insurance companycorporation held the stock, you cannot from Part III of Schedule O. Most files its income tax return electronically, itcount certain days during which the corporations that are not members of a should not include the annual statementscorporations risk of loss was diminished. controlled group and not filing a and schedules required to be filed withSee section 246(c)(4) and Regulations consolidated return figure their tax by Form 1120-L. However, such statementssection 1.246-5 for more details. using the Tax Rate Schedule below. must be available at all times forQualified personal service corporationsb. Dividends attributable to periods inspection by the IRS and retained for soshould see instructions below.totaling more than 366 days that the long as such statements may be material

corporation received on any share of in the administration of any internalTax Rate Schedulepreferred stock held for less than 91 days revenue law.

If taxable income (line 30, Form 1120) on page 1during the 181-day period that began 90 Deferred tax under section 1291. If theis:days before the ex-dividend date. When corporation was a shareholder in a PFICcounting the number of days the and received an excess distribution orOf thecorporation held the stock, you cannot disposed of its investment in the PFICBut not amount

Over over Tax is: over during the year, it must include thecount certain days during which theincrease in taxes due under sectioncorporations risk of loss was diminished. $0 $50,000 15% $0 1291(c)(2) (from Form 8621, Part IV, lineSee section 246(c)(4) and Regulations 50,000 75,000 $ 7,500 + 25% 50,000 11e) in the total for line 2. On the dottedsection 1.246-5 for more details. 75,000 100,000 13,750 + 34% 75,000 line next to line 2, enter Section 1291Preferred dividends attributable to periods 100,000 335,000 22,250 + 39% 100,000and the amount.335,000 10,000,000 113,900 + 34% 335,000totaling less than 367 days are subject to

10,000,000 15,000,000 3,400,000 + 35% 10,000,000 Do not include on line 2 any interestthe 46-day holding period rule, above.15,000,000 18,333,333 5,150,000 + 38% 15,000,000 due under section 1291(c)(3). Instead,c. Dividends on any share of stock to 18,333,333 - - - - - 35% 0 show the amount of interest owed in thethe extent the corporation is under an bottom margin of page 1, Form 1120, and

obligation (including a short sale) to make label it as Section 1291 interest.Qualified personal service corporation.related payments with respect to positions See the instructions for Form 8621,A qualified personal service corporationin substantially similar or related property. Part IV, lines 11e and 11f.is taxed at a flat rate of 35% on taxable5. Any other taxable dividend income income. If the corporation is a qualified Additional tax under section 197(f). Anot properly reported elsewhere on personal service corporation, check the corporation that elects to pay tax on theSchedule C. box on line 2 even if the corporation has gain from the sale of an intangible underno tax liability. the related person exception to the

anti-churning rules should include anyIf patronage dividends or per-unit A corporation is a qualified personal additional tax due under sectionretain allocations are included on line 17, service corporation if it meets both of the 197(f)(9)(B) in the total for line 2. On theidentify the total of these amounts in a following tests. dotted line next to line 2, enter Sectionstatement attached to Form 1120. 1. Substantially all of the corporations 197 and the amount.activities involve the performance of

Line 3services in the fields of health, law,Line 18, Column (c)engineering, architecture, accounting,Section 247 allows public utilities a A corporation that is not a smallactuarial science, performing arts, ordeduction of 40% of the smaller of corporation exempt from the AMTconsulting.(a) dividends paid on their preferred stock may be required to file Form 4626,CAUTION!2. At least 95% of the corporationsduring the tax year, or (b) taxable income Alternative Minimum TaxCorporations,stock, by value, is directly or indirectly

computed without regard to this if it claims certain credits, even though itowned bydoes not owe any AMT. See Instructionsdeduction. In a year in which an NOL a. Employees performing thefor Form 4626 for details.occurs, compute the deduction without services,

regard to section 247(a)(1)(B). See b. Retired employees who had Unless the corporation is treated as asection 172(d). performed the services listed above, small corporation exempt from the AMT, it

-16- Instructions for Form 1120Negative tax payments

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YearFirm

originalProject

incrementalFirm

+ project

Revenues 5000 300 5300

Costs -1500 -100 -1600

Depreciation 0 -500 -500

Earnings before interest and taxes (EBIT)

3500 -300 3200

Income tax (30%) -1050 90 -960

Earnings 2450 -210 2240?

+ =

Taxes and negative earnings creates tax savings that must be considered in cash flow estimates.

Negative tax payments

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Capital expenditures, depreciation, and salvage

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Property, plant, and equipment during project life

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Does not appear as part of incremental earnings, but is a cash investment. Must

be subtracted from incremental earnings to find cash flows

Appears in incremental earnings, but is not a cash expense. Must be added back

to incremental earnings to find cash flows.

Does not appear as part of incremental earnings, but is a cash recovery of

equipment. Must be added to incremental earnings to find cash flows.


Purchases of new property, plant and equipment.

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

The sale of used property, plant, and equipment.


Adjustments under the indirect method

How: Subtract capital expenditures from incremental earnings

Why: Under accrual accounting,

Capital expenditures entered as Property, Plant, and Equipment on the balance sheet

Cost depreciated over time reducing balance sheet book value

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Depreciation

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How: Add back depreciation to incremental earnings Why: Under accrual accounting,

Depreciation arises from matching principle, matching costs to period of use

Subtracted from gross profit, reducing income statement incremental earnings

Not a cash flow

After-tax salvage


How: Add after-tax salvage value to incremental earnings

Why: Under accrual accounting,

Salvage eliminates Property, Plant, and Equipment and appears as cash on the balance sheet

Salvage is not considered operating income, instead it is considered part of the firms investment activities

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Net working capital

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Indirect method for working capital

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Increase subtracted from incremental earnings to find

operating cash flows.

Increase subtracted from incremental earnings to find

operating cash flows.

Increase added to incremental earnings to

find operating cash flows.

Inventories

Items needed for the continued operation of the business.

Accounts receivable

Sales that have been recognised in incremental earnings, but have not yet been received.

Accounts payable

Expenses that have been recognised in incremental earnings, but have not yet been paid.

DefinitionThe difference between current assets and current liabilities is the firms net working capital. It is the capital available in the short term to run the business.

Net working capital

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Net working capital is an asset!

Net Working Capital =Working Capital Assets

Working Capital Liabilities

Net working capital

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For most of our problems:

As net working capital is an asset, an increase in NWC should be subtracted from incremental earnings when computing operating cash flows.

Net Working Capital = Accounts Receivable + Inventories Accounts Payable

Net working capital

A note about cash:

Cash held for some purposes may be included as in net working capital

Examples: Cash required for firm operations (e.g. cash held to

purchase inventories or pay suppliers) is counted as net working capital

Cash held from profits before distribution to share holders is not net working capital

In this class, we will not concern ourselves with a cash component of net working capital to simplify analysis.

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Net working capital


How: Subtract changes in book value of net working capital from incremental earnings

Why: Under accrual accounting, Net working capital is an asset Expenses are recognised only when related sales are made

under the matching principle

Timing of cash receipt or payment does not matter

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The indirect method

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The indirect method

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+ Depreciation

- Capital expenditures

+ After-tax salvage

- Change in net working capital

Incremental free cash flows

Analysing the indirect method

It can be useful to separately analyse the tax benefits of depreciation

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Depreciation tax shield = Depreciation Tax rate

FCF = Incremental EBIT (1 Tax rate)+Depreciation CapEx Change in NWC

= (Revenues CostsDepreciation) (1 Tax rate)+Depreciation CapEx Change in NWC

= (Revenues Costs) (1 Tax rate) CapEx Change in NWC +Depreciation Tax rate

Evaluating projects

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Evaluating projects

First create Pro Forma:


Capital expenditures and after-tax salvage

Net working capital requirements

Incremental project cash flows

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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

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FINS1613.Section III.capital Budgeting.12 Apr 2015.3 Per Page

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Transcript of FINS1613.Section III.capital Budgeting.12 Apr 2015.3 Per Page