1. Managerial Finance Session 5/6
Nicole Hruban

2. Cost of Capital
MGM Manufacturing is considering a major capital expenditure to begin production of a major new product. Key facts and assumptions about this new product appear below. Using this information, answer the questions following.
Data
Sales Data:
Estimate MGM's equity beta
b. Estimate MGM's cost of equity capital
c. Estimate MGM's weighted-average cost of capital
d. Estimate the after-tax cash flows relevant to the investment. Assume the salvage value is realized in year 8 and working capital is liquidated in year 9.

3. Cost of Capital Facts and Assumptions
Yield to maturity on long-term government bonds
5.00%
Yield to maturity on company long-term bonds
7.00%
Market price of risk
6.90%
Estimated company and project asset beta
0.70
Stock price per share
$60
Number of shares outstanding
2 million
Market value of interest-bearing debt outstanding
$80,000,000
Tax rate
35%
Inflation rate 3%
Initial cost of investment
$200,000,000
Year 1 selling price per unit
$80
Year 1 variable manufacturing cost per unit
$55
Year 1 general selling & administrative expenses
Expected project life 8
Salvage value
$40,000,000
Depreciation schedule
Straight-line
Working capital
20% of Sales
Year
Number of Units Sold 1
2,000,000 2
10,000,000 3
20,000,000 4
23,000,000 5
24,000,000 6 7
22,000,000 8
15,000,000

4. Cost of Capital a) Estimate MGM's equity beta 𝛽 𝐸 = 𝛽 𝐴 [1+ 1−𝑇 𝐷 𝐸 ]
Recall: Levered beta = Equity beta and Unlevered beta = Asset beta
Therefore:
𝛽 𝐸 = 𝛽 𝐴 [1+ 1−𝑇 𝐷 𝐸 ]
We know:
𝛽 𝐴 𝐴𝑠𝑠𝑒𝑡 𝑏𝑒𝑡𝑎 = 0.7
T (tax rate) = 0.35
D (market value of debt) = $80,000,000
E (market value of equity) = Stock price per share * # shares outstanding =
= $60 * 2,000,000 = $120,000,000
𝛽 𝐸 =0.7[1+ 1− ,000, ,000,000 ] = 0.7* [ *0.6667]=

5. Cost of Capital b. Estimate MGM's cost of equity capital
Re = Rf + Risk premium or
Re = Rf + be (Rm - Rf)
(risk free rate + equity beta * equity market risk premium)
We know:
𝛽 𝐸 𝑒𝑞𝑢𝑖𝑡𝑦 𝑏𝑒𝑡𝑎 =1.0033
Rm - Rf (equity market risk premium) = 0.069
Rm (government bond yield) = 0.05
Re = * 0.069= = or 11.92%

6. Cost of Capital c. Estimate MGM's weighted-average cost of capital
kWACC = 𝐷 𝐸+𝐷 kd (1-T) + 𝐸 𝐸+𝐷 ke
or proportion of debt in capital structure * cost of debt * tax shield + proportion of equity in capital structure * cost of equity
We know:
ke = (calculated)
T = 0.35
E = $120,000,000 (# shares outstanding * price per share)
D = $80,000,000
kd (company bond yield) = 0.07
kWACC = 80,000, ,000,000+80,000, * (1-T) , ,000,000 * =
= 0.4*0.07* * = = or 8.97%

7. Capital Budgeting
d. Estimate the after-tax cash flows relevant to the investment. Assume the salvage value is realized in year 8 and working capital is liquidated in year 9.
Step 1) Calculate Revenue and Gross profit
3% increase per year b/c of inflation
given
given
Price per unit * Units sold
3% increase per year b/c of inflation
Variable costs per unit * Units sold

8. Capital Budgeting
Step 2) Calculate Cash flow form operations (after tax) and Total after tax cash flow
[Initial investment (200) – Salvage value (40)] / project life 8 = 20
3% increase per year b/c of inflation
Tax rate * EBIT
given
Free Cash Flow (FCF) = EBIT + Depreciation – Tax– WCR – Net Fixed Asset Investments
After tax CF from Ops – Change in WC (-investment + salvage value )
Working capital is 20% of sales (here: 0.2 * 824)
WC current year – WC previous year (here: )

9. Capital Budgeting
SUMMARY

10. Estimate the investment's net present value
Capital Budgeting
Estimate the investment's net present value
FOR NPV you would discount all the cash flows at WACC and add (negative) initial investment

11. Estimate the investment's net present value
Cost of Capital
Estimate the investment's net present value
Ct = Cash flow during period t
r = discount rate
C0 = initial investment
t = number of time periods
NVP = -123/( ) – 92/( )^2 + 39/( )^3 + … + 295/( )^9
Calculate with Rate, Range of Cash flows) – initial investment
NPV = $ ~ $590 (Million USD)

12. Calculate the Internal Rate of Return
Capital Budgeting
Calculate the Internal Rate of Return
Recall: IRR is the discount rate the makes the NVP = 0
= 0
Solve with Excel:
Calculate with of Cash flows)
IRR = 29.13%

13. Capital Budgeting
In market value terms, MGM's debt to capital ratio is 40%. Assume the company will finance the investment in the same proportions and estimate the economic value added. (Assume the company will use an 8-year, 7% loan to be repaid in equal annual installments.)

14. EVA = NOPAT – kWACC * (Economic) Capital Employed
Capital Budgeting
In market value terms, MGM's debt to capital ratio is 40%. Assume the company will finance the investment in the same proportions and estimate the economic value added. (Assume the company will use an 8-year, 7% loan to be repaid in equal annual installments.)
STEP 1) Calculate EVA
Economic Value Added: profit earned by the firm less the cost of financing the firm’s capital
The value that is created when the firm’s capital is employed is greater than the cost of that capital
EVA = NOPAT – kWACC * (Economic) Capital Employed
Economic Value Added = Net Operating Profit After Tax – Cost of Capital * Capital Employed
Capital Employed: amount of cash/capital invested net of depreciation

15. Capital Budgeting
In market value terms, MGM's debt to capital ratio is 40%. Assume the company will finance the investment in the same proportions and estimate the economic value added. (Assume the company will use an 8-year, 7% loan to be repaid in equal annual installments.)
Capital employed - depreciation
kWACC (b/c investment is financed at 40/60 ratio)

16. STEP 2) Estimate Economic Value Added
Capital Budgeting
In market value terms, MGM's debt to capital ratio is 40%. Assume the company will finance the investment in the same proportions and estimate economic value added. (Assume the company will use an 8-year, 7% loan to be repaid in equal annual installments.)
STEP 2) Estimate Economic Value Added
STEP 3) Discount Cash Flows at WACC
@NPV(Discount Rate, Range of Cash flows)
NVP = $590

17. STEP 1) Calculate the equity investment
Capital Budgeting
Estimate the net present value of the equity cash flows. (That is, analyze the investment from the equity perspective.)
STEP 1) Calculate the equity investment
given
Debt ratio * Initial Investment: 0.4*80

18. STEP 2) Calculate the principal payments / Interest Pymt
Capital Budgeting
Estimate the net present value of the equity cash flows. (That is, analyze the investment from the equity perspective.)
STEP 2) Calculate the principal payments / Interest Pymt
Yr1
Yr2
Yr8
7% of $80MM
Amount financed by debt
Annuity payment – Interest = 13.4 – 5.6
Annuity Payment:
@PMT(0.07,8,-80,0,0)

19. STEP 3) Calculate the Cash Flow to Equity
Capital Budgeting
Estimate the net present value of the equity cash flows. (That is, analyze the investment from the equity perspective.)
STEP 3) Calculate the Cash Flow to Equity
Yr1
Yr2
Yr8
Cash Flow to Equity =EBIT – Capital Expenditure – Tax + Depreciation + (Net Borrowing – Debt Repayment ) – Change NWCR
Previously calculated
Tax: 0.35*175.6
CFE Yr1 = EBIT – CAP.Ex. – Tax + Dep. – Repayment – Change NWCR
CFE Yr 1= (-61.5)

20. Capital Budgeting STEP 4) Calculate NPV
Estimate the net present value of the equity cash flows. (That is, analyze the investment from the equity perspective.)
STEP 4) Calculate NPV
Yr1
Yr2
Yr8
Calculate with Rate, Range of Cash flows) – initial investment
NPV = $ ~ $466 (Million USD)
Cash Flow to Equity =EBIT – Capital Expenditure – Tax + Depreciation + (Net Borrowing – Debt Repayment ) – Change NWCR

21. Capital Budgeting Estimate the internal rate of return to equity Yr8
Calculate with of Cash flows)
IRR = 32.88%
Cash Flow to Equity =EBIT – Capital Expenditure – Tax + Depreciation + (Net Borrowing – Debt Repayment ) – Change NWCR

22. Capital Budgeting
Atlantic Drydock is considering replacing an existing hoist with on of two newer more efficient pieces of equipment. The existing hoist is 3 years old, cost $32,000, and is being depreciated under MACRS using a 5 year recovery period. Although the existing hoist has only 3 years (4,5, and 6) of depreciation remaining under MACRS, it has a remaining usable life of 5 years.
Hoist A, one of the two possible replacement hoists, costs $40,000 to purchase and $8,000 to install. It has a 5 years usable life and will be depreciated under MARCS using a 5 year recovery period
Hoist B costs $54,000 to purchase and $6,000 to install and will be depreciated under MACRS using a 5 years recovery period.
Increased investment in the NWC will accompany the decision to acquire Hoist A or Hoist B. Purchase of hoist A will result in a $4,000 increase in NWC, and B in a $6,000 increase

23. Capital Budgeting
The projected earnings before depreciation, interest , and taxes with each alternative hoist are given below:
The exisiting hoist can currently be sold for $18,000 and will not incur any removal or cleanup costs. At the end of 5years, the existing hoist can be sold to net $1,000 before taxes. Hoist A and B can be sold net $12,000 and $20,000 before taxes respectively at the end of the 5 year period. The firm is subject to a 40% tax rate.
YEAR 1
HOIST A
HOIST B
Exist. HOIST 1
21,000
22,000
14,000 2
24,000 3
26,000 4 5

24. Capital Budgeting
Calculate the initial investment associated with each alternative
Calculate the incremental operating cash inflows associated with each alternative (be sure to consider the depreciation in year 6)

25. Capital Budgeting
Calculate the initial investment associated with each alternative
Initial Investment A B
Cost of New Asset
40,000
54,000
+Installation Cost
8,000
6,000
=Installed Cost of New Asset
48,000
60,000
-Proceeds from sale of old assets
(18,000)
+ Tax
3,488
After Tax proceeds
(14,512)
+Change in Working Capital
4,000
Total Initial investment
37,488
51,488
Book value of old asset: [1- (0.20* 0.32* 0.19)]* ($32,000) =$9,280
Difference BV – Sale Proceeds = 18,000 – 9,280 = 8,720 = > 40% of 8,720 = 3,488

26. Capital Budgeting
Calculate the initial investment associated with each alternative
Calculate the incremental operating cash inflows associated with each alternative (be sure to consider the depreciation in year 6)

27. Capital Budgeting
Calculate the incremental operating cash inflows associated with each alternative (be sure to consider the depreciation in year 6)
Step 1) Calculate Operating Cash Flows for Hoists
Assuming instant refund
Depreciation Yr1: Initial Investment * 0.2 = [$40,000 (hoist A) + $8,000 (installation)] * 0.2 = $9,600
Taxes: Profit bef. Taxes * 0.4 = $11,400 * 0.4 = $4,560
Operating CF: Net profit after Taxes + Depreciation = $6,840 + $9,600 = $16,440

28. Capital Budgeting
Calculate the incremental operating cash inflows associated with each alternative (be sure to consider the depreciation in year 6)
Step 1) Calculate Operating Cash Flows for Hoists

29. Capital Budgeting
Calculate the incremental operating cash inflows associated with each alternative (be sure to consider the depreciation in year 6)
Step 1) Calculate Operating Cash Flows for Hoists
Note depr. percentages, hoist is already in third year of depreciation

30. Capital Budgeting
Calculate the incremental operating cash inflows associated with each alternative (be sure to consider the depreciation in year 6)
Step 2) Calculate Incremental Cash Flows
Operating Cash Flow A – Operating Cash Flow Existing

31. Capital Budgeting
Calculated the terminal cash flow at the end of year 5 associated with each alternative
Proceeds sale of asset
-/+Tax
=After tax proceeds
Proceeds from sale of old assets
-/+ Tax
-After Tax proceeds (old)
+Change in Working Capital (Div)
=Terminal CF
At end of firm’s life, firm will dispose of the new asset, so after tax proceeds represent a cash inflow.
HOWEVER: If firm had not replaced the old asset, the firm would have received proceeds from the disposal of the old asset at the end of the project (rather than counting upfront as part of the initial investment). Therefore we must count as a cash outflow the tax proceeds that the firm would have received from disposal of the old asset.

32. Capital Budgeting
Calculated the terminal cash flow at the end of year 5 associated with each alternative
Initial Investment A B
Proceeds sale of asset
12,000
20,000
-Tax
(3,840)
(6,800)
=After tax proceeds
8,160
13,200
Proceeds from sale of old assets
1,000
- Tax
(400)
After Tax proceeds (old)
600
+Change in Working Capital (Div)
4,000
6,000
Terminal CF
12,760
19,800

33. Capital Budgeting
Calculated the terminal cash flow at the end of year 5 associated with each alternative
Book value of Hoist A at end of year 5: $2,400 *
$12, $2,400 = $9,600 recaptured depreciation
$9,600 * 0.40 = $3,840 tax
Book value of Hoist B at end of year 5: $3,000
$20, $3,000 = $17,000 recaptured depreciation
$17,000 * 0.40 = $6,800 tax
*Initial Investment - Sum of all depreciations yr1 through yr5 (or yr6 depreciation value)

34. Capital Budgeting
XYZ Corp is considering the purchase of a new piece of equipment. The total installed cost is $2.2 million. This outlay would be partially offset by the existing equipment. The old piece of equipment has a BV = 0, cost 1 million and can be sold for 1.2 million today (before taxes). As a result of the acquisition of the new equipment, sales are expected to be $1.6 million higher than before. Product costs will represent 50% of the sales.
The new equipment will not affect NWC requirements,
The equipment will be depreciated under MACRS, using a 5-year period.
The firm has a 40% tax rate and its Cost of Capital is 11%
(Assume that the old and the new press will each have a terminal value of $0 at the end of year 6.

35. Capital Budgeting
Determine the initial investment required (assume old press is sold)
Determine the operating cash inflows (consider depreciation in year 6)
Determine the pay-back period
Determine the NPV and IRR

36. Capital Budgeting
Determine the initial investment required (assume old press is sold)

37. Capital Budgeting Determine the initial investment required Tax:
NOTE: Assumed that old machine is sold, when new one is purchased
Tax:
Book value: $0
$1,200,000 - $0 = $1,200,000 income from sale of existing press
$1,200,000 income from sale * (0.40) = $480,000

38. Capital Budgeting
Determine the operating cash inflows (consider depreciation in year 6)

39. Capital Budgeting
Determine the operating cash inflows (consider depreciation in year 6)

40. Capital Budgeting Determine the pay-back period Payback Period = A + B
A is the last period with a negative cumulative cash flow; B is the absolute value of cumulative cash flow at the end of the period A; C is the total cash flow during the period after A

41. Capital Budgeting
Determine the pay-back period

42. Capital Budgeting
Determine the NPV and IRR

43. Capital Budgeting
Determine NPV and IRR
NPV:

44. Capital Budgeting
Determine NPV and IRR
IRR:
WHAT WOULD YOU DO???