1. CGA Finance 1

2. Learning objectives ( lesson 6) Describe the general administrative structure that exists in most firms for the capital budgeting decision process, and the reasons for such a structure. Define the relevant cash flows to evaluate in capital budgeting. calculate the present value of tax shields arising from depreciation / amortization. Perform the additional analysis necessary when cash flows are uncertain. Identify the additional complications that are introduced by cash flows involving international operations.

3. CGA Finance 1 Learning objectives (Lesson 7) Explain why net present value (NPV) is the correct capital budgeting criterion, and demonstrate how it is implemented. Select the correct discount rate to be applied to an investment project Analyze and explain the relationship between NPV and other frequently employed capital budgeting criteria. Calculate the internal rate of return of an investment. Outline the general methods used to select projects when there is a constraint on the amount of capital the firm can spend on new projects.

4. CGA Finance 1 Key terms (1) Key terms (1) Chapter 9  Capital budgeting 资本预算  Discounted payback period 动态回收期  Internal rate of return 内部收益率 ( 内含报酬率 )  Modified internal rate of return 修正后的内含报酬率  Net present value 净现值  Net present value profile 净现值曲线  Payback period 回收期  Profitability index ( PI) (or benefit /cost ratio) 现值指数法 ( 或盈利指数法 )

5. CGA Finance 1 Key terms (2) Key terms (2) Chapter 10  Capital rationing 资金限额  Equivalent annuity 等效年金  Initial outlay ( 项目 ) 初始现金流出  Mutually exclusive projects 互斥项目

6. CGA Finance 1 1 Estimating project cash flows Determine the economic value of the project by:  categorizing the risk profile of the project.  Assigning a discount rate to be used in evaluating the project ( CAPM and RAD rate method can be used to determine the required rate of return as discount rate)  Calculating the NPV of the project, or applying an alternative criterion ( Such as IRR, Payback period, etc) 1. Typical Capital budgeting analysis

7. CGA Finance 1 1 Important rules in estimating cash flows:  Use actual cash flows ( or free cash flows), not accounting income.  Use incremental cash flows Ignore sunk costs Include opportunity cost.  Use nominal cash flows  Use after-tax cash flows 2. Estimating cash flows

8. CGA Finance 1 1 Free cash flow: Amount of cash available from operations after paying for investments in net operating working capital and fixed assets. This cash is available to distribute to the firm ’ s creditors and owners. Free cash flow are what matter to shareholders. The capital budgeting and project evaluation must be based on the free cash flow, rather than the accounting profit. 2.1 Free cash flow

9. CGA Finance 1 1 Project ’ s free cash flow = Project ’ s change in operating cash flow +/- change in net working capital +/- change in capital spending Formula: free cash flow

10. CGA Finance 1 1 Incremental cash flow: the changes in the cash flow caused by the implementation of the project. It is only the incremental cash flow that be relevant to the decision.  Ignore sunk costs  Include opportunity costs 2.2 Incremental Cash flows

11. CGA Finance 1 1 Opportunity cost: Net cash flows that would have been received if the project under consideration were rejected. Typical opportunity cost:  Opportunity cost arising from the fact that there is an alternative use of the resources.  Side effect and synergistic( 协同作用 ) effect. Example 6-4 (LN 6) Opportunity costs

12. CGA Finance 1 1 Basic Principle: The cash flow measurement and decision criteria or discount rate should be consistent. The project ’ s estimated cash flows must have inflation inputted in them because the market discount rate reflect expected inflation. 2.3 Use nominal cash flows

13. CGA Finance 1 1 Interest payments and other financing cash flows that might result from raising funds to finance a project should not be considered incremental cash flows. (Why?) Note

14. CGA Finance 1 1 When we discount the incremental cash flows back to the present at the required rate of return, we are implicitly accounting for the cost of raising funds to finance the new project. In evaluating new projects and determine cash flows, we must separate the investment decision from the financing decision.  Manager first determine the desirability of the project and then determine how best to finance it. Separation of the investment decision and financing decision

15. CGA Finance 1 1 The reasons why the corporate-after-tax cash flows should be used?  Shareholders can only benefit from after-tax cash flows.  Different projects have different tax exposures. 2.4 After-tax cash flows

16. CGA Finance 1 1 Basic way to determine the after-tax cash flows Top down approach (LN6.6) CF t = REV t ( cash ) – EXP t (cash) – TAX t (Actually Payment) = EBIT t + DEP t – TAX t = NI t + DEP t Note: Cash flow is affected by the tax depreciation and amortization, rather than the accounting depreciation and amortization.

17. CGA Finance 1 1 Comprehensive Example Comprehensive Example: Calculating free cash flow (Textbook P341 – 344) Questions:  What are the initial outlay, Annual free cash flow and terminal cash flow?  Describe the treatment of net working capital in project evaluation?  Why is the salvage value not taken into account when calculating the terminal cash flow? What if the equipment has salvage value of 10,000?

18. CGA Finance 1 1 Tax Shield approach to determine the after-tax cash flows : 3. The value of depreciation tax shield CFt = REVt ( cash ) – EXPt (cash) – TAXt (Actually Payment) = (REV t – EXP t )(1-T) + DEP t T After tax operating cash flow Tax shield of depreciation

19. CGA Finance 1 1 Determination of depreciation and tax shield The major depreciation method:  Straight-line method Note: 1.For the simplified straight-line method ( Assuming zero salvage value: d (depreciation rate) = 1 / life 2. DEP. = Cd Tax shield = CdT  Accelerated depreciation methods Double-declining balance method USA Tax Law: MACR ( 修正后的加速成本回收制 ) Canadian Tax Law: CAA ( 资本成本备抵制 ) Note: DEP. = Cd Tax shield = CdT ( where d is different from the depreciation rate under straight line method)

20. CGA Finance 1 1 Example See the table in LN6.9 Question:  Why six years for five-year depreciable asset?  How to determine the value of tax shield?

21. CGA Finance 1 1 Major Capital Budgeting evaluation criteria: 4. Capital budgeting evaluation criteria 1)Payback period Method ( Ignore the time value) 2) Discounted Payback Period 3) Net- Present-Value ( NPV) Methods 4) Profitability Index (Benefit/Cost Ratio) 5) Internal Rate of Return (IRR & MIRR)

22. CGA Finance 1 1 NPV rule is the overwhelming capital budgeting rule, because accepting new capital projects with positive NPV is consistent with making decisions to raise shareholder wealth. See Example 7-1 (LN 7.2) Question: What conclusion can you get from the Example 7-1? 4.1 NPV

23. CGA Finance 1 1 Conclusion from the Example 7-1 V 1 = V 0 + NPV (New projects’) Irrespective of the financing of project, positive NPV can increase the firm’s value and the shareholder’s wealth. NPV rule is the overwhelming capital budgeting rule. When the other capital budgeting criterion is in conflict with NPV rule, PLS following NPV rule.

24. CGA Finance 1 1 Comprehensive Example 7-2 (LN 7.3 – 7.6) Note :  the categories of cash flows in determining the NPV (See LN7.6) Question: What else cash categories should be considered?  How come $3750 ( the book value of machinery at the end of 6 years)? Is it correct? How to Use NPV rule

25. CGA Finance 1 1 Discount rate should reflect the opportunity cost to the firm considering the project. Opportunity Cost: the required rate of return on an equivalent-risk alternative investment opportunity.  Risk-free rate: If the project is risk-free ( cash flows are certain)  WACC: If the project is in the same risk as the firm itself  CAPM: If the project is in a different risk class than the firm How to determine the correct discount rate

26. CGA Finance 1 1 The discount rate used in NPV analysis must reflect the risk of the project being analyzed. Note

27. CGA Finance 1 1 4.2 IRR The return on the firm’s invested capital. IRR is simply the effective rate of return that the firm earns on its capital budgeting projects. n t=1  IRR: = IO FCF t (1 + IRR) t

28. CGA Finance 1 1 Rule for IRR Criterion Acceptable: if IRR > The required rate of return Unacceptable: If IRR < The required rate of return

29. CGA Finance 1 1 Problem with IRR Multiple IRRS Crossing NPV Profiles: When the mutually exclusive projects has crossing NPV profiles, IRR criterion is likely be inconsistent with NPV criterion.

30. CGA Finance 1

33. 1 Note From the NPV profile of the investment with 4 times change of cash flows, we can see that there are 4 IRRs from 25% to 66.67%. Multiple IRR is meaningless, the analysis should turn to the NPV

34. CGA Finance 1

36. 1 Note Two Basic conditions can cause NPV profiles to cross, and thus conflicts to arise between NPV and IRR ?  Size or scale difference  Timing difference of cash flow What cause the conflicts between NPV and IRR?  The NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital ( or the required rate of return),  whereas the IRR method assumes that the firm can reinvest at the IRR. ( irrational assumption)

37. CGA Finance 1 1 Questions What conditions should be met to ensure that NPV and IRR lead to the same investment decisions? –Conventional cash flow – Independent project rather than mutually exclusive projects.

38. CGA Finance 1 Modified Internal Rate of Return (MIRR) IRR assumes that all cash flows are reinvested at the IRR. MIRR provides a rate of return measure that assumes cash flows are reinvested at the required rate of return.

39. CGA Finance 1 MIRR Steps Calculate the PV of the cash outflows. –Using the required rate of return. Calculate the FV of the cash inflows at the last year of the project’s time line. This is called the terminal value (TV). –Using the required rate of return. MIRR: the discount rate that equates the PV of the cash outflows with the PV of the terminal value, ie, that makes: PV outflows = PV inflows

40. CGA Finance 1 MIRR Example Using our time line and a 15% rate: PV outflows = (900) FV inflows (at the end of year 5) = 524.71 + 608.35 + 529 +575 +600 MIRR: FV = 2837, PV = (900), N = 5. 0 1 2 3 4 5 (900) 300 400 400 500 600

41. CGA Finance 1 MIRR Solve: I = 25.81% 900 = 2837 ÷ (1 + MIRR) 5 (1 + MIRR) 5 = 2837 ÷ 900 (1 +MIRR) 5 = 3.1522 MIRR = 1.2581 - 1 MIRR = 25.81 %.

42. CGA Finance 1 Note The project’s IRR of 34.37% assumes that cash flows are reinvested at 34.37%. Assuming a reinvestment rate of 15%, the project’s MIRR is 25.81%.

43. CGA Finance 1 1 4.3 Capital Rationing Ranking projects by IRR is not always the best way to deal with a limited capital budget. It’s better to pick the largest NPVs.

44. CGA Finance 1 1 Capital Rationing decision ( LN7.14-16) PI method Brute force method ( 一揽子决策法 ) Note: PI method may not correctly solve the capital budgeting problem under capital rationing. For a reasonable number of projects, the brute force can be more appropriate.

45. CGA Finance 1 1 EAA ( applicable to mutually exclusive project with unequal life) *Project risk Analysis ( Chapter 11, Textbook) *Options in capital budgeting ( P351 in Textbook) Other Issues in capital budgeting

46. CGA Finance 1Assignments

47. End of Lesson Notes 6 & 7 This is real value-added time!