Tuck Bridge Finance Module 3

8/4/2019 Tuck Bridge Finance Module 3

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CLASS 3

CAPITAL BUDGETING

Bridge Program 2005

Finance module

Finance, Bridge Program 2005 1


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Contents

1 Investment criteria 4

2 Financial statement analysis 8

2.1 Income Statement . . . . . . . . . . . . . . . . . . 9

2.2 Balance-sheet items . . . . . . . . . . . . . . . . . 14

2.3 A recipe . . . . . . . . . . . . . . . . . . . . . . . . 17

3 Assignment 3 18

4 More capital budgeting applications 23



3/27

Recap

The NPV rule.

Annuities and perpetuities.

Mortgage calculations and after-tax effects.

Examples of applications of NPV rule.

In this class we will further apply the NPV rule

through several examples and the assignment, as

well as discuss other investment criteria (IRR), and

review a bit of accounting.



4/27

1 Investment criteria

Basic idea of DCF analysis (NPV rule):

Forecast incremental cash flows from a project (firm) in the

future.

In particular, forecast cash flows from operations and cash

flows from investing, i.e. ignore cash flows from financing

(class 7 will deal with why we ignore financing cash flows).

This is mostly Accounting.

Discount these cash flows at appropriate discount rate.

First 3 lectures are about the mechanics of discounting.

Next 4 lectures are about where the discount rate comes from.



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The NPV rule

States that we should undertake a project if and only if its NPV

is positive.

Why is this optimal, i.e. why should we not invest in negativeNPV projects?

If NPV < 0, then you could put your money in alternative

investment (with same risk) and earn higher cash flows.

No other alternative investment criteria is optimal (unless itreduces to NPV).



6/27

Alternative investment criteria

What is the Internal Rate of Return of a project?

It is the discount rate y such that its NPV, when using y as a

discount rate, is equal to zero.

Namely it is the rate y for which

NPV = CF0 +T

t=1

CFt

(1 + y)t= 0

IRR rule: undertake projects if IRR is greater than cost of

capital (expected return on assets of similar risk).

What is the payback period?

The time it takes to get back the initial investment (in dollar

terms - with or without discounting the actual cash flows).



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Pitfalls with other investment criteriaRelying solely on IRR can cause problems, which are avoided

with the NPV rule:

It does not account for scale of project.

This can be dangerous when considering mutually-exclusiveprojects.

If the term-structure is not flat, what rate do we compare

the IRR to?

Nevertheless it is the only other alternative criteria that is worthlooking at (its a nice statistic).

The payback rule suffers from these and many other problems.



8/27

2 Financial statement analysis

Financial accounting is the language of business.

Finance uses Accounting statements (and forecasts) in order to

compute the cash flows that a given firm/project will generate.

Important note: we will make no distinction between projects

and firms. View firms simply as a collection of projects, or a

project as a very small firm.

The following slides are a rough summary of relevant accountingissues for Finance (more on the book in chapters 9 and 30).



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2.1 Income Statement

Calculates profits.Examples of items in an income statement:

Sales (revenues).

Cost of goods sold.

SG&A expenses. Depreciation expenses.

Interest expenses.

Taxes.

Net income (profits). EBITDA, EBIT.

Are profits the same as cash flows?

No! Depreciation and timing issues throw things off.



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Depreciation

Depreciation creates a gap between profits and cashflows as a result of different conventions.

In Finance we care about cash flows, so we should

always ignore depreciation charges (per se).

In Accounting they care about measuring the

profitability of a business, therefore they use the

convention of expensing large capital investments

over their useful life.

Should we then ignore depreciation altogether?

No! Depreciation matters since it affects the taxes that a

firm pays (since it reduces paper profits).



11/27

Example 1 (basic cash flow estimation)

Consider a project that yields increased sales of

$3m per year for 10 years, with COGS being 70%

of sales.

It requires an initial investment of $3m. The initialinvestment is depreciated to zero using the

straight-line method over 10 years.

Assume a tax rate of 50%, and a discount rate of

10%.

What are the cash flows from this project?

What is its NPV?



12/27

Basic cash flow estimation

Sales 3.0

COGS -2.1

Depreciation -0.3

EBIT =0.6

Profits (after tax) =0.3

Depreciation +0.3

CF =0.6

The NPV is then

NPV = 3 +0.6

0.1

1

1

1.110

= 0.68 > 0



13/27

Basic cash flow estimation

Useful shortcut:

CF = EBITDA(1 ) + (Depreciation)

where denotes the firms tax rate. The last term

in the above equation is usually referred to as

depreciation tax shield.

In our example:

CF = 0.9(1 0.5) + 0.5(0.3) = 0.45 + 0.15 = 0.6



14/27

2.2 Balance-sheet items

My own name for things such as deferred taxes and

working capital items.

What are working capital items?

Current assets: inventory, accounts receivable.

Current liabilities: accounts payable.

These items will affect cash flows: recording a sale

in income statement will increase our estimate ofcash flows, but if we dont get paid for it until next

year (accounts receivable increase) we should

adjust our cash flow projections!



15/27

Illustration

Firm makes sale of $1m to be paid in equal installments overthe next 4 quarters.

In this case accountants book sale and increase the account

receivables balance. This balance is reduced through the

next 4 quarters to zero.

From a Finance perspective we only want to account forpositive cash flows of $0.25m every quarter.

Quarter 0 1 2 3 4

Balance in AR 1 0.75 0.50 0.25 0

CF 0 0.25 0.25 0.25 0.25

Note: we can compute the cash flow by looking at the net

change in the working capital item (accounts receivable in

the example).



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Net working capital items

An increase in the balance in accounts receivable in a given

period t should be accounted for as a negative cash flow

(think about it as a bad thing since you get paid later on

some new sales). An increase in inventory has a similar effect as an increase in

accounts receivable - it creates a negative cash flow (you

pay for the inventory but do not get sales).

An increase in the balance in accounts payable in a given

period should be accounted for as a positive cash flow (goodsince you get to pay for things later).



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2.3 A recipe

Cash Flows can be estimated from financial statements

as follows:

EBIT

Income tax= Net Operating Profit

+ Depreciation

= Gross Cash Flow

Increase in Working Capital

Capital Expenditure

= Cash Flow from Operations



18/27

3 Assignment 3

Data for problem 1:

Investment on information systems of $3000 (000s).

Savings on operating costs of $500.

Five-year life, no salvage value, straight-line depreciation.

Cut inventory from 50% to 45% of sales (currently at

$10000).

Marginal tax rate 40%, discount rate 10%.

How good is this investment?



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The incremental cash flows

Operating costs are reduced by 500 (all numbers 1000s). Inafter tax terms this is an increase in cash flow of

0.6(500) = +300.

Depreciation generates a cash flow (which we refer as tax

shield) of (Depreciation) = 0.4(600) = +240.

The initial investment of $3m is just that - a negative cash

flow of $3m (note the tax effect on this cost come

through depreciation).

The reduction of inventory, from 50 to 45% of sales, will

cause an increase in cash, namely equal to 5% of sales, i.e.+500.

Therefore cash flows are 300 + 240 = 540 in years 1-5, and 2500

in year 0.



20/27

Assessing profitability

Discounting the cash flows back to time 0:

NPV = 2500 +540

0.10

1

1

1.15

= 453.

The IRR can be computed by solving

2500 +540

IRR

1

1

(1 + IRR)5

= 0.

which yields IRR = 2.62% < 10%.

So according to both NPV and IRR criteria this is not a goodproject.

The calculations in assign3sol.xls suggest that cost savings of

$699.16 would make NPV = 0.



21/27

Problem 2

Relevant data:

Investment (transfer fee) of $25m, depreciated over next 5

years.

10 year contract with Mr. Behham.

Increase in sales of apparel of $5m.

Ticket sales increase of $1m.

TV contract will be $2m higher per year for the duration of

Mr. Behhams contract (starting in year 3).

Behhams salary $3m.

Other costs increase by $0.5m.

Marginal tax rate 35%, and 10% discount rate.



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Incremental cash flows and NPV

Year 1 3 6

Increase in revenue 6.00 8.00 8.00

Increase in operating costs 3.50 3.50 3.50

Depreciation 5.00 5.00 -

Increase in EBIT (2.50) (0.50) 4.50

Tax (0.88) (0.18) 1.58

Income (1.63) (0.33) 2.93

Depreciation addback 5.00 5.00 -

Free cash flow 3.38 4.68 2.93

Discounting at 10% we get a negative NPV around 2.65

million.

With sales of apparel of 5.66m a year (barely 10% more of the

previous estimate) the NPV of the project is zero.



23/27

4 More capital budgeting applications

Example 2

A firm knows (i.e. there is no risk) that the sales of a

new product will grow over the next 2 years by 15% (in

nominal terms), and from then on have a real growth

rate of zero.

Next years sales are expected to be $20m. Yearly costs

are 50% of sales. Assume the firm pays no taxes.

You estimate inflation to be around 5%, and you knowthe term structure is flat at 15%.

If the initial investment of this project is $120m, should

we undertake it?



24/27

Example 2

How can we estimate cash flows?

Use growth rate of sales of 15% over first two-years,

then sales grow at the inflation rate of 5%.

1 2 3 4 5

Sales 20.00 23.00 24.15 25.36 26.63

CF 10.00 11.50 12.08 12.68 13.31



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Note that starting in year 3 the cash flows are a

perpetuity with constant growth rate.

How much are those cash flows worth today?

PV3 =

12.08

0.15 0.05

1

1.152= 91.3

The value of the cash flows in years 1 and 2 is

PV12 =10

1.15+

11.5

1.15= 17.39

The total value of the project is then

V= 17.4 + 91.3 108.7

Therefore the firm should not undertake the project

(108 < 120).



26/27

Recap

The NPV rule.

How to apply it using tools we have learned thus far(dealing with inflation, shortcuts for computing

NPVs using perpetuities and annuities).

Estimating cash flows.

How to decide what projects to take.



27/27

Thursday

Topics:

Statistics (fun, fun, fun).

Intro to Investments (almost as much fun).

Optimal investment decisions in a mean-variance

framework.Suggestions:

Start on the reading tonight (you have a light load

for tomorrow).

Work through assignment 4, and give your best at

assignment 5 (the last question is on the hard side).

Try to enjoy the readings and assignments - they are

as good as Finance gets!


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Tuck Bridge Finance Module 3

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