Fundamentals of Finance Tom C. Nelson, PhD CUBIC 2012 Section 4 Fundamentals of Finance Tom C. Nelson, PhD

Clicker Question (4.0) Consider two business ventures with the following cash flows. Which should you invest in? Guess.. Note: cost of capital (discount rate) is 15% Cash Flows Venture “A” Venture “B” Cash Flow Now -10,000 -30,000 Cash Flow Year 1 6,000 9,000 Cash Flow Year 2 5,000 15,000 Cash Flow Year 3 4,000 21,000 Cash Flow Year 4 3,000 32,000 Venture “A” Venture “B”

4-0 Capital Budgeting Topics 4-1 Introduction to Capital Budgeting 4-2 Capital Budgeting Tools 4-3 Determining Relevant Cash Flows 4-4 Developing Cash Flow Projections 4-5 Determining Cost of Capital 4-6 Case #2: Business Start-up Decision: Naturally Wrapped Food Stand

Capital Budgeting 4-1 Introduction to Capital Budgeting Allocating scarce company resources to the highest use Types of projects Replacement projects Efficiency projects New business Expand existing business Go into a new business Research and development Independent versus mutually exclusive projects

Capital Budgeting 4-1 Introduction to Capital Budgeting Decision tools: Payback (breakeven) Net Present Value (NPV) Internal Rate of Return (IRR) Comment on direction of cash flows: Positive (+) is a cash inflow Negative (-) is a cash outflow

Capital Budgeting 4-2 Capital Budgeting Decision Tools Payback Definition: period of time it takes to recover the initial cost of a project—then compare to company standard Example Cash Flow $ Cash Flow Year 0 (start) -10,000 Cash Flow Year 1 +6,000 Cash Flow Year 2 +5,000 Cash Flow Year 3 +4,000 Cash Flow Year 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Payback Decision criteria Independent projects: Fund all projects with payback less than company standard. Mutually exclusive projects: Fund project with fastest payback less than company standard.

Capital Budgeting 4-2 Capital Budgeting Decision Tools Payback Advantages Simple Focus on liquidity (when initial investment is returned) Good for low cost, short term projects Disadvantages Ignores cash flows after payback period Company payback standard is arbitrary Ignores time value of money Poor for high cost, long term projects

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Definition NPV = PV Cash Inflows – PV Cash Outflows Example, where discount rate is 15% Cash Flow $ Cash Flow Year 0 (start) -10,000 Cash Flow Year 1 +6,000 Cash Flow Year 2 +5,000 Cash Flow Year 3 +4,000 Cash Flow Year 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Working with a calculator Cash Flow $ CF 0 -10,000 CF 1 +6,000 CF 2 +5,000 CF 3 +4,000 CF 4 +3,000 Discount rate = 15%

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Working with a spreadsheet Cash Flow $ CF 0 -10,000 CF 1 +6,000 CF 2 +5,000 CF 3 +4,000 CF 4 +3,000 Discount rate = 15%

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Cash Flow $ CF 0 -10,000 CF 1 +6,000 CF 2 +5,000 CF 3 +4,000 CF 4 +3,000 Discount rate = 15%

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Decision Criteria Independent projects: Fund all positive projects. Mutually exclusive: Fund highest positive NPV project.

Capital Budgeting 4-2 Capital Budgeting Decision Tools Net Present Value (NPV) Advantages Considers all cash flows Considers time value of money, taking risk into account Disadvantages Can be hard to understand the meaning of “present values”

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return Definition The average return associated with given cash flows; The return (discount rate) that makes the NPV = 0 Example Cash Flow $ Cash Flow Year 0 (start) -10,000 Cash Flow Year 1 +6,000 Cash Flow Year 2 +5,000 Cash Flow Year 3 +4,000 Cash Flow Year 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return (IRR) Working with a calculator Cash Flow $ CF 0 -10,000 CF 1 +6,000 CF 2 +5,000 CF 3 +4,000 CF 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return (IRR) Working with a spreadsheet Cash Flow $ CF 0 -10,000 CF 1 +6,000 CF 2 +5,000 CF 3 +4,000 CF 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return Decision Criteria: Independent projects: Fund all projects with IRR greater than company hurdle rate. Mutually exclusive projects: Fund project with highest IRR greater than company hurdle rate.

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return Advantages Usually similar results to NPV Considers all cash flows IRR rate can be compared to risk, cost of capital (“hurdle rate”) Disadvantages Can give multiple solutions (rare) Can be unrealistic with reinvestment assumption Can conflict with NPV when projects are different sized and mutually exclusive (if so, use NPV)

Capital Budgeting 4-2 Capital Budgeting Decision Tools Comparing 2 projects: Apply each decision tool and decide which project is best. Required return = 15% for both projects. Cash Flows Venture “A” Venture “B” Cash Flow Now -10,000 -40,000 Cash Flow Year 1 6,000 10,000 Cash Flow Year 2 5,000 11,000 Cash Flow Year 3 4,000 12,000 Cash Flow Year 4 3,000 35,000

3 years 3.2 years 4 years More than 4 years Clicker Question (4.2.1) What is the payback period for the following cash flows? Cash Flows Venture “B” Cash Flow Now -40,000 Cash Flow Year 1 10,000 Cash Flow Year 2 11,000 Cash Flow Year 3 12,000 Cash Flow Year 4 35,000 3 years 3.2 years 4 years More than 4 years

Clicker Question (4.2.2) What is the NPV for the following cash flows (discount rate is 15%)? Cash Flows Venture “B” Cash Flow Now -40,000 Cash Flow Year 1 10,000 Cash Flow Year 2 11,000 Cash Flow Year 3 12,000 Cash Flow Year 4 35,000 $ -3,678 $ 2,875 $ 4,915 $ 14,587

Clicker Question (4.2.3) What is the IRR for the following cash flows? Venture “B” Cash Flow Now -40,000 Cash Flow Year 1 10,000 Cash Flow Year 2 11,000 Cash Flow Year 3 12,000 Cash Flow Year 4 35,000 -14.1% +11.2% +19.8% +29.4%

Capital Budgeting 4-2 Capital Budgeting Decision Tools Comparing 2 projects: Apply each decision tool and decide which project is best. Criteria Venture “A” Venture “B” Decision? Best? Payback < 2 years A, B NPV $3,343 IRR 32.98%

Capital Budgeting 4-3 Determining Relevant Cash Flows Basic Principle: include all incremental (marginal) cash flows associated with the project The stand alone principle Sunk costs Opportunity costs Erosion, cannibalization Net working capital changes

Capital Budgeting 4-4 Developing Cash Flow Projections Cash flows measured over time and divided into 3 categories: Initial investment expenses Project cost Net working capital needed Annual operating cash flows OCF = EBIT + Dep – Tax Terminal year cash flows (if given a fixed project life) Salvage value recovery (after tax) Recovery of working capital

Capital Budgeting 4-5 Determining Cost of Capital Concept of Cost of Capital Definition and approach; weighted average cost of capital (WACC) Purposes of cost of capital Valuing divisions of companies Valuing companies, both public and private Valuing capital projects Setting rates and returns for regulating utilities

Capital Budgeting 4-5 Determining Cost of Capital Concept of Cost of Capital Calculating WACC 1) Determine amount of debt and equity 2) Determine proportion of debt and equity 3) Determine cost of equity and after tax cost of debt 4) Calculate weighted average cost of capital

Capital Budgeting 4-5 Determining Cost of Capital Calculating WACC Example Determine amount of debt and equity Amount of debt = $100 million Market value of equity = $ 200 million Determine proportion of debt and equity Percent of debt = 100 / (100 + 200) = .333 = 33% Percent of equity = 200 / (200 + 200) = .667 = 67%

Capital Budgeting 4-5 Determining Cost of Capital Calculating WACC Example Determine cost of equity and after tax cost of debt Cost of debt = 8%, tax rate = 35% Cost of debt = 8 x (1 - .35) = 5% Beta = 2.0; risk-free rate = 3%; market return = 10% Cost of equity (CAPM) = 3 + (10 – 3)(2) = 17%

Capital Budgeting 4-5 Determining Cost of Capital Calculating WACC Example: Conch Republic 4) Calculate weighted average cost of capital WACC = (weight of debt x cost of debt) + (weight of equity x cost of equity) = (.33 x 5) + (.67 x 17) = 13%

Capital Budgeting 4-6 Business Start-up Case Evaluation of proposals to fund new businesses by venture capitalists (“sharks”) on ABC show “Shark Tank”. http://www.youtube.com/watch?v=DZ8vt9LpYDw&feature=related http://www.youtube.com/watch?v=LkF9txWtesk http://www.youtube.com/watch?v=3UuFR4Y4uw8

Capital Budgeting 4-6 Business Start-up Case Tasks for Case Preparation Case Review case information case spreadsheet case questions Teams prepare and discuss case numbers Teams address case questions Class discussion Link to Case Information Link to Case Spreadsheet

Module Wrap Up: Fundamentals of Finance Course Objectives • a working knowledge of the terminology of finance and fundamental concepts and tools used in the business world; • an understanding of the interrelationships between accounting and finance; • an understanding of the interrelationships between business management and a firm's financial statements; • an introduction to financial markets, the time value of money, risk and return, and the valuation of assets and business projects.

Module Wrap Up: Fundamentals of Finance Resources Textbooks “Essentials of Corporate Finance”, 7th edition, by Ross, Westerfield, Jordan, McGraw Hill, 2011. “Corporate Finance Demystified”, by Adair, McGraw Hill, 2006. “Finance and Accounting for Non-financial Managers, by Droms, Persius Publishing, 2003

Module Wrap Up: Fundamentals of Finance Resources On-line Yahoo Finance http://finance.yahoo.com/ MSN MoneyCentral http://moneycentral.msn.com/home.asp Wall Street Journal On-line http://online.wsj.com/home-page

How useful were clickers to you in this module? Clicker Question How useful were clickers to you in this module? A. Very useful B. OK C. Not very useful

Clicker Question Pick the statement most true for you about the clickers as used in this module: Helps break up the class routine Helps me with topics/concepts Too easy Not helpful, shouldn’t be used