CF Winter 2014

Questions 1. What cash flows should I consider? 2. How does the market set r ? 3. How should I set r ?

CF 1 at time 0 at CF 1 n 1 = 0

CF 1 at time 0  at the very beginning of the project when decision to go ahead made  any costs incurred to make decision ignored  when added all together almost always < $0

CF 1 at time 0  includes capital cost  usually equipment shipping, installation, training, etc.  everything needed to get it up & running working capital  cash flotation costs start-up costs

CF 1 at time 0  also includes present value of Capital Cost Allowance  minus the CCA of salvage revenue  PV CCA tax shield PV of getting working capital back  PV working capital

CF 1

start-up costs weighted average flotation cost fafa

Flotation Costs issuing new stocks or bonds isn’t free  weighted average flotation cost f d =2% debt f e =5% equity 1/21/2.5 1/11/1 1 2/12/1 2 w d =.50 w d =.33 w d =.67 w e =.50 w e =.67 w e =.33

Flotation Costs issuing new stocks or bonds isn’t free  weighted average flotation cost use target weights  over the long term, firm will issue securities in these percentages

Flotation Costs project  firm’s target D/E ratio is.6  flotation costs 5% equity 3% debt

Flotation Costs

you get the cash (working capital) back at end of project what’s that refund worth to you today?

CCA tax shield t CCA CCA tax shield rate t c corporate tax rate r discount rate s salvage value n number of periods in the project

Equipment cost c $100,000 Installation & delivery cost c $10,000 Salvage s $17,000 when? n 6 Marginal tax rate tctc 40% CCA tax rate t CCA 20% discount rate r 10% “hurdle rate”

CF 1

Productivity considering  new production system initial cost $1 million save $300,000/yr  in inventory & receivables management costs last for 5 years CCA tax shield rate of 20% salvage value of $50,000 no impact on Net Working Capital marginal tax rate is 40% required return is 8%.

Productivity Equipment cost c equipment $1,000,000 Installation & delivery cost c installation $0 Working capital c working $0 Benefit CF 2 …CF n+1 $300,000 Salvage s $50,000 when? n 5 Flotation cost fafa 0% Marginal tax rate tctc 40% CCA tax rate t CCA 20% discount rate r 8%

Applications  cost-cutting proposals  replacing an asset  setting a bid price  comparing equipment with different lifespans

Cost-Cutting Proposal  equip $80,000  to buy & install  save $35,000  pretax  lifespan 5 years  NWC $0  CCA tax rate 20%  salvage $0  tax rate 40%  discount rate 10%

Cost-Cutting Proposal Equipment cost c equipment $80,000 Installation & delivery cost c installation $0 Working capital c working $0 Benefit CF 2 …CF n+1 $35,000·(1- t C ) Salvage s $0 Lifespan n 5 Flotation cost fafa 0% Marginal tax rate tctc 40% CCA tax rate t CCA 20% discount rate r 10%

Cost-Cutting Proposal

annuity

Replacement? original machine  initial cost $150,000  purchased 4 yrs ago  salvage today $50,000  salvage in 6 yrs $10,000 new machine  initial cost $200,000  6-year life  salvage in 6 yrs $30,000  cost savings $75,000/year  net working capital $0 CCA rate = 20% required return = 15% marginal tax rate = 44% $150,000 -PV PV only question: What will be different if we do project?

Replacement?

Equipment cost net c equipment $150,000 Installation & delivery cost c installation $0 Working capital c working $0 Benefit CF 2 …CF n+1 $75,000·(1- T C ) Salvage net s $30,000 Lifespan n 6 Flotation cost fafa 0% Marginal tax rate tctc 44% CCA tax rate t CCA 20% discount rate r 15%

Replacement?

Setting a Bid Price  required return 20%  5 trucks/year for 4 years  truck platforms $10,000 ea  facilities lease $24,000/year  labor & material $4,000/truck  new equipment $60,000  salvage $5,000  NWC $40,000  CCA 20%  tax 43.5%

Setting a Bid Price Equipment cost c equipment $60, Installation & delivery cost c installation $0 Working capital c working $40, Benefit CF 2 …CF n+1 $94,000.00·(1- t c ) Salvage s $5, Lifespan n 4 Flotation cost fafa 0% Marginal tax rate tctc 43.5% CCA tax rate t CCA 20% discount rate r 20%