U8-1 UNIT 8 Project Valuation

U8-2 What is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future.

U8-3 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.

U8-4 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.

U8-5 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.

U8-6 Net Present Value (NPV) Sum of the PVs of all cash inflows and outflows of a project:

U8-7 Internal Rate of Return (IRR) IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

U8-8 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.

U8-9 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.

U8-10 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: Cash flows: -$2,000 $600 $500 $700 $600

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U8-12 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: Cash flows: -$2,000 $600 $500 $700 $600

U8-13 Tapley Dental Associates is considering a project that has the following cash flow data. What is the project's payback? Year: Cash flows: -$1,000 $400 $420 $440 $460 $480

U8-14 Tapley Dental Associates is considering a project that has the following cash flow data. What is the project's payback? Year: Cash flows: -$1,500 $400 $420 $440 $460 $480

U8-15 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: Cash flows:-$1,500 $450 $440 $430 $420

U8-16 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%

U8-17 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 $40,000 Operating costs(x-depr) $18,000 Depreciation expense $15,000 ____________________________________________ Operating income (EBIT) $7,000 -Taxes -$2,450 ____________________________________________ After-tax EBIT $4,550 + Depreciation $15,000 ____________________________________________ Operating cash flow $19,550

U8-18 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%

U8-19 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%

U8-20 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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