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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

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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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