Course: Capital Budgeting The problem is labeled "current" and the two other attached files are previous questions leading up to this one with the solution to get an example of how things need to be done and what we are discussing The problem requires you to go through the Bal sheet and P&L to make sure everything is intact and remove/fix whatever isnt as well as whatever else is stated to be done

4a 5 base points + 2 = 7 total The CEO of social media company FacePlant is unhappy with the resulting analysis. She comments, 'This project is so big, effectively it will represent our entire compan The FacePlant CFO then says, 'I'm glad the Harvard guy is gone. It appears to me he made a mistake on the depreciation. It should be 10X the amounts shown on the s Initially, FacePlant has essentially no long term assets, but it does have some current account activity due to other operations. All the other numbers are attributable to The Chairman of the Board looks at you and says, "I need a new cash flow analysis reflecting the changes. I also need an understanding of all the various terminal value Where appropriate assume the following, but be aware the statements were assembled by a newby and may or may not be correct and his data may not be relevant. 300 million shares outstanding 12 P/E of competitors 2.5 Price-to-EBITDA for this industry, from Yahoo! Finance 40% tax rate 250,000 project CAPEX 1.2 competitor price-to-book (an MVA metric) 10% typical write-down of asset liquidations in this industry 11% cost of capital 2% horizon cash flow growth BALANCE SHEET ASSETS Cash Accounts Receivable Inventory 0 5,000 15,000 20,000 1 54,850 15,450 20,600 2 104,700 15,900 21,200 3 154,550 16,350 21,800 4 204,400 16,800 22,400 Fixed assets (OAC) less Acc. Depr. NBV 250,000 0 250,000 250,000 -100,000 150,000 250,000 -180,000 70,000 250,000 -230,000 20,000 250,000 -250,000 0 TOTAL ASSETS 290,000 240,900 211,800 212,700 243,600 LIABILITIES Current Liabilities Debt TOT Liabilities 30,000 15,000 45,000 30,900 14,250 45,150 31,800 13,538 45,338 32,700 12,861 45,561 33,600 12,218 45,818 Equity 245,000 195,750 166,463 167,139 197,782 TOTAL LIABILITIES AND EQUITY 290,000 240,900 211,800 212,700 243,600 Sales COS Gross Margin 0 0 0 0 1 200,000 80,000 120,000 2 200,000 80,000 120,000 3 200,000 80,000 120,000 4 200,000 80,000 strictly variable cost 120,000 + allocations "Decrease in Contribution of Other Products" Adjusted Gross Margin 0 0 0 3,000 -15,000 108,000 3,000 -15,000 108,000 3,000 -15,000 108,000 3,000 newby added these back. They are -15,000 newby believed this adjustment wa 108,000 SG&A "Interest on bonds expected to be used" PBT - tax PAT 0 18,000 -18,000 -7,200 -10,800 40,000 18,000 50,000 20,000 30,000 40,000 18,000 50,000 20,000 30,000 40,000 18,000 50,000 20,000 30,000 40,000 strictly variable cost 18,000 50,000 20,000 30,000 CASH FLOW STATEMENT PAT + Depreciation Cash Flow from Operations -10,800 ?? 30,000 ?? 30,000 ?? 30,000 ?? 30,000 ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? ?? CASH FLOW ?? ?? ?? ?? ?? P&L Cash Flow balance sheet items ?? Notes Copy and paste Bal sheet & P&L below and repopulate what should be there and find what is appropriate. Also formate dynamically*** Depreciate is obtained from accum dep Find balloon animal spreadsheet re company by the end of the 4th year.'. (The numbers are stated in thousands of dollars). She continues: 'This effectively means everything rests on the terminal value. If we are wn on the statements. I corrected the error and here's how I see the Balance Sheet trend. I basically ignored our other operations because for this analysis they are insignificant.'. T ibutable to the project. minal values you can generate. Have that for me ASAP." Completely out of the blue he then says, "Forget about the ones in Bierman & Smidt Ch.2 ADV, however. There could be a relevant. . They are known to be direct allocations stment was appropriate y*** e. If we are completely wrong, the company is bankrupt. If we are partly wrong, we become a buy-out target. But if we get it right, we have a major exit event in the form of an IPO gnificant.'. Then he hands you a document, shown below. could be a 'balloon animal' spreadsheet out there somewhere that might be valuable.". rm of an IPO or a merger where we set the terms. I want a better understanding of the terminal value.'. G.J. Feigel, 2013 et seq REVIEW OF KEY CONCEPTS, LAST LECTURE TIME LINES (again) - NPV using " " - IRR using " " MIRR - What it is - How to calculate it - The benefit is an "~IRR" constistent with NPV - To derive, the true cash flow pattern is damaged - The "new" IRR of the asset bears a weaker relationship to the underlying asset Payback makes some intuitive sense, discounted payback does not. - Payback values 'nearer' cash & likelier realization vs. NPV NPVI and PVI are inconsistent w/ NPV and IRR - Since NPV is the base rule, NPVI and PVI are useless for decisions - While IRR has some info value, NPVI and PVI add no useful information Spring 2016 problem 3 series Q3a - 5 points HAL Co. is considering investment in a new product. The information for the typical year is shown in the following table. These results are expected to continue for 4 years. Accounting Profit Sales 200,000 FOR THE SAKE OF THE TAX CALC, DEPR MUST BE Gross Margin 50,000 (*) manufacturing cost, including $112500 of depreciation. Also included here is a $15000 allocation from corporate HQ THE ALLO - The company uses straight line depreciation and the asset will last 4 years THE ACTUAL DEPR METHOD IS THE METHOD IN US SG&A ** 40,000 (**) sales, general and administrative expenses directly associated with the new product COS * 150,000 CAPEX *** Working Capital 450,000 IN OTHER WORDS, NO ALLOCATIONS (***) Capital Expenditures related to this product ASSUME THROUGHOUT THE FIRST YEAR, ONLY, THEN IS CONSTANT Incr. / Decr. * - AR -35,000 Negative means asset build or liability reduction Incr. / Decr. * - Inventory -1,000 Negative means asset build or liability reduction Incr. / Decr. * - Curr. Lia. Negative means asset build or liability reduction 30,000 USE THE SIMPLEST POSSIBLE EXAMPLE TO DETERMINE DIRECTION Liabilities of this type often termed "SPONTANEOUS LIABILITIES" It's expected that the P&L and Balance Sheet lines are representative of the near term and future time periods. The company also knows the following: Decrease in Contribution of Other Products, per year Interest on bonds expected to be used, per year. Corporate tax rate Cost of Capital -15,000 aka cannibalization BY DEFINITION A DEDUCTION 18,000 BY DEFINITION IRRELEVANT 40% AGAIN, THE ONLY ACCURATE WAY TO CALCULATE TAX IMPACT IS ON A PROPERLY STRUCTURED ACCOUNTING P& 11% BASED ON DISCUSSIONS AND ALL YOU'VE LEARNED IN OTHER COURSES, THIS WOULD BE IN THE FORM OF A "W 1.) For the purposes of present value computations, construct a timeline with all relevant values included. What is the value of the business? SOLUTIONS 15,000 allocation to COS from HQ THE TYPICAL YEAR Accounting Profit Sales (1) FOLLOW THE NORMAL P&L FORMAT --> 200,000 COS - adj for allocation 150,000 DEPR is already included so no need to worry about 'tax shield' 15,000 Gross Margin "Decrease in Contribution of Other Products"* Adjusted Gross Margin SG&A 65,000 -15,000 Here we have to assume this is true 'contribution', i.e., (P-V) x Q, and all before tax * 50,000 40,000 Note: SG&A "...directly associated with the product...", NO ALLOCATIONS! Interest * - that way taxes are easy and always correct (2) NO FINANCING ELEMENTS PBT - tax PAT (*) "Interest on bonds expected to be used" See below 10,000 = 50000 - 40000 4,000 Here, we assume that this is purely incremental to this product, = 40% tax rate 6,000 I.E., THE MARGINAL RATE, NOT THE AVER 0 This would normally fall on a P&L before PBT, but is never used in a project cash flow like this. (our hope is that the tax line above is not polluted with this) This is why the P&L format is always best - no need to make assumptions, or guess PAT 6,000 + Depreciation (3) THEN FOLLOW THE STANDARD CASH FLOW FORMAT ---> 112,500 non-cash: always added back - what about accruals??, amortization??, depletion?? Cash Flow from Operations 118,500 CAPEX Working Capital Incr. - AR Incr. - Inventory Incr. - Curr. Lia. CASH FLOW (450,000) T0 in this case -35,000 -1,000 Wherever the net change occurs, see below. Note: change in cash account is not included 30,000 ???? Will depend, as indicated above. SEE BELOW (*) Opportunity Cost - "...decrease in contribution of other products..." - implies cannabalization - the term "contribution" - equals Price - Variable Cost = direct costing, = fixed-variable cost analysis 'ALGEBRAIC' FORMULAE ARE SURE TO FAIL HERE - THE ACCOUNTING FORMAT IS FOOL-PROOFED...THIS IS HOW YOU ACTUALLY CALCULATE TAXES, SO HOW CAN YOU GO WRONG ON THAT? ALSO, THE CASH FLOW STATEMENT FORMAT IS ALSO SOLID: AGAIN ERRORS ARE REDUCED IF YOU FOLLOW PROVEN TECHNIQUES! (eliminates all 'tax shield' calculations, algebra, etc.). EVEN GOOD ACCOUNTING T-ACCOUNTS ARE INFERIOR TO ABOVE BECAUSE THEY "ASSUME" A CERTAIN TAX POSITION, MARGINAL TAX RATE, ETC. WHICH IS ACTUALLY A DYNAMIC EVENT, NOT STATIC (changes year-to-year), AND DEPENDS UPON NOL CARRYFORWARD / BACK SO THE TIME LINE LOOKS LIKE THIS P&L Sales COS adj for alloc Gross Margin 0 1 200,000 150,000 15,000 65,000 2 200,000 150,000 15,000 65,000 3 200,000 150,000 15,000 65,000 4 200,000 150,000 DEPR MUST BE INCLUDED HERE or taxes will be wrong 15,000 irrelevant 65,000 Note calc "Decrease in Contribution of Other Products"* Adjusted Gross Margin -15,000 50,000 -15,000 50,000 -15,000 50,000 -15,000 WHAT IS "CONTRIBUTION"? 50,000 SG&A (*) "Interest on bonds expected to be used" PBT - tax PAT 40,000 0 10,000 4,000 6,000 40,000 0 10,000 4,000 6,000 40,000 0 10,000 4,000 6,000 6,000 112,500 118,500 6,000 112,500 118,500 6,000 112,500 118,500 6,000 112,500 118,500 0 0 0 0 -35,000 -1,000 30,000 -35,000 -1,000 30,000 -35,000 -1,000 30,000 -35,000 -1,000 30,000 112,500 112,500 112,500 112,500 1 112,500 0.900901 101,351.35 2 112,500 0.811622 91,307.52 CASH FLOW STATEMENT PAT + Depreciation Cash Flow from Operations CAPEX Working Capital Incr. - AR Incr. - Inventory Incr. - Curr. Lia. -450,000 CASH FLOW -450,000 40,000 WHAT IS "DIRECT COST"? 0 10,000 dynamic, as is all that follows 4,000 6,000 This section of a Cash Flow statement captures RELEVANT Balance Sheet changes ANSWER, QUESTION 1 VALUE W/O TERMINAL VALUE 11% cost of capital TIME 0 CASH FLOW -450,000 DISCOUNTING FACTOR 1.000000 PV -450,000.00 NPV -100,974.86 3 4 112,500 112,500 FALLS RIGHT OUT OF A PROPERLY POPULATED FINANCIAL STATEMENT FORMAT. 0.731191 0.658731 82,259.03 74,107.23 RECOMMENDATION: THE INVESTMENT DOES NOT INCREASE BUSINESS VALUE (aka NPV) E INCLUDED OCATION IS NOT A RELEVANT COST SE AS A PRIOR TAX ELECTION &L WACC" ERAGE RATE G.J. Feigel, 2013 et seq REVIEW OF KEY CONCEPTS, LAST LECTURE FINANCIAL STATEMENTS - deviation from the accounting model = disaster F/V (contribution) models - "direct costing" Relevant cost Working Capital cash flows - Spontaneous liabilities Irrelevance of financing in Enterprise valuation - WACC Q3b - 6 points 3b Assume the same assumptions of the previous problem, HAL Co., except as noted below. 1.) Assume the company has an outstanding offer to sell this product line at the terminal year, based on cash flow. What will be the value of the business at that time (aka the 'terminal value'), and the value of the busine 2.) If 1% growth is expected, and what would be the total business value of the project? 3.) After the change suggested in Q2, above, what would happen if the WACC dropped by 2%? 4.) Assume management is unconvinced by the previous valuations. Your are directed to return to the original WACC assumptions, but assume a terminal value = liquidation value. With that, what is the value of the bus 5.) Upon seeing the results from Q4, the VP of Manufacturing says, 'I know we can get a value for the equipment at the end of the project equal to $112500.'. With that, what is the value of the business? 1.000% growth ANSWER, QUESTION 1 NO GROWTH TERMINAL VALUE 11.00% cost of capital TIME 0 CASH FLOW -450,000 TERMINAL VALUE TOTAL CASH FLOW -450,000 DISCOUNTING FACTOR 1.000000 PV -450,000.00 NPV 572,727.27 ANSWER, QUESTION 2 GROWTH PERPETUITY TERMINAL VALUE 11.00% cost of capital TIME 0 CASH FLOW -450,000 TERMINAL VALUE TOTAL CASH FLOW -450,000 DISCOUNTING FACTOR 1.000000 PV -450,000.00 NPV 647,508.21 1 112,500 112,500 0.900901 101,351.35 11% original assumption 2 3 112,500 112,500 112,500 0.811622 91,307.52 112,500 0.731191 82,259.03 4 112,500 1,022,727 = 112500 / 0.11, 1,135,227 0.658731 747,809.37 NO GROWTH PERPETUITY 1.000% growth 1 112,500 2 112,500 3 112,500 112,500 0.900901 101,351.35 112,500 0.811622 91,307.52 112,500 0.731191 82,259.03 4 112,500 1,136,250 = (112500 X (1 + 0.01)) / (0.11 - 0.01), 1,248,750 0.658731 822,590.30 PERPETUITY WITH GROWTH Note the limitations of perpetuity-based valuations (beyond the obvious) - try growth = 12%, growth = 10.999% ... ANSWER, QUESTION 3 WITH 9% INSERTED ABOVE, 4 112,500 1,420,313 = (112500 X (1 + 0.01)) / (0.09 - 0.01), 1,532,813 0.708425 1,085,883.02 NPV 920,653.67 ...Or, if the discounting rate changes, comparable wide value swings ANSWER, QUESTION 4 WHAT ARE THE ASSETS TO BE LIQUIDATED AND THE LIABILITIES TO BE PAID OFF? 450,000 CAPEX SIMPLE 'ROLL-UP' TIME CAPEX Beg. Bal.: Depr.: Ending Bal. (NPV): OR, BALANCE SHEET VIEW TIME CAPEX Beg. Bal.: Acc. Dep.: Ending Bal. (NPV): 0 1 2 3 4 450,000.00 337,500.00 225,000.00 112,500.00 450,000.00 112,500.00 337,500.00 112,500.00 225,000.00 112,500.00 112,500.00 112,500.00 expense 0.00 NBV = 0 0 1 2 3 4 450,000.00 450,000.00 450,000.00 450,000.00 450,000.00 0.00 450,000.00 112,500.00 337,500.00 225,000.00 225,000.00 337,500.00 112,500.00 450,000.00 0.00 NBV = 0 In other words, no value at terminal year due to fixed assets. Incr. / Decr. * - AR Incr. / Decr. * - Inventory Incr. / Decr. * - Curr. Lia. ACTUAL VALUE IN ACCOUNTS -35,000 -1,000 30,000 Negative means asset build or liability reduction Negative means asset build or liability reduction Negative means asset build or liability reduction PERPETUITY WITH GROWTH TIME AR Inventory curr. Lia. 0 0.00 0.00 0.00 1 35,000.00 1,000.00 30,000.00 2 70,000.00 2,000.00 60,000.00 3 105,000.00 3,000.00 90,000.00 4 140,000.00 4,000.00 120,000.00 CASH VALUE 140,000.00 4,000.00 (120,000.00) 24,000.00 LIQUIDATION VALUE NPV IS ADDITIVE -100,974.86 NPV OF ORIGINAL PROBLEM, NO TERMINAL VALUE 15,809.54 = 24000 / (1 + 0.11)^4 -85,165.32 TOTAL NPV W/ liquidation value ANSWER, QUESTION 4 ADDITIONAL LIQUIDATION VALUE IF FIXED ASSETS HAVE POSITIVE SALVAGE VALUE 40% TAX RATE ACCOUNTING 112,500.00 0.00 112,500.00 (45,000.00) 67,500.00 CASH 112,500.00 SELL THE OLD ASSET NBV GAIN (45,000.00) TAX ON GAIN =- 112500 x 0.4 67,500.00 NET IN THIS CASH, CASH AFTER TAX = ACCOUNTING GAIN AFTER TAX - NOT ALWAYS THE CASE, (particularly when a capital loss occurs) NPV IS ADDITIVE -100,974.86 NPV OF ORIGINAL PROBLEM, NO TERMINAL VALUE 15,809.54 = 24000 / (1 + 0.11)^4 44,464.34 = 67500 / (1 + 0.11)^4 -40,700.98 TOTAL NPV W/ liquidation value STILL A LOSER > TERMINAL VALUE ASSUMPTIONS CAN SWING OVERALL VALUE IN ALL DIRECTIONS...ABOVE SHOWS BOTH 'ACCEPT' AND 'REJECT' WORKING CAPITAL A MORE 'TYPICAL' ANALYSIS REGARDING WORKING CAPITAL IS AS FOLLOWS... "A project will require $10K of working capital in the first year, which will increase 10% per year. The project will be abandoned in the 4th year and all assets sold." On a time line, this means... 0 1 10,000.00 (10,000.00) "working capital"* Cash Flow Sometimes immediate 2 11,000.00 (1,000.00) 3 12,100.00 (1,100.00) 4 13,310.00 13,310.00 Typically, the net asset is liquidated for cash, or assumed so for the purposes of term (*) EXCLUDING THE CASH ACCOUNT Here, all of the working capital is dumped assuming the business ends, or liquidatio Net current account change less spontaneous liability change Here, 11000 - 12100 = net balance sheet delta MORE NUANCES DRIVEN BY TAXES SALVAGE AND DISPOSAL VALUE TIME 0 1 2 Sometimes here 3 n lll Typically here But can also happen here THE PROBLEM > Occurs with fixed assets or other long term assets subject to amortization or depletion. > The same is true of disposition of liabilities, or, Merger, Acquisition and Divestiture ("MAD") transactions...consult a tax expert. > A cash event occurs upon disposition...that is clearly cash flow. > The disposition may result in a tax gain or loss...that is also cash flow. > The above ignores other, more complex tax events (recapture, AMT, capital gains, etc.). > Whatever the cash flow, it is part of the valuation. EXAMPLE 10,000.00 sale price of the asset 5,000.00 book value of the asset 40% tax rate CASH RECEIVED less BOOK VALUE GAIN TAX ON GAIN TOTAL CASH FLOW CASH FLOW? 10,000.00 Y -5,000.00 N 5,000.00 N -2,000.00 Y 8,000.00 AGAIN, THE FUNDAMENTAL RULE IS "WOULD THE CASH FLOW OCCUR ABSENT THE DECISION? OR, DOES THE DECISION RESULT IN THE CASH FLOW" A REAL RISK HERE IS CARE REGARDING ABSOLUTE VS. RELATIVE DECISIONS...MANY MAINSTREAM TEXTBOOKS MAKE THIS ERROR...EXPANSIVE THINKING IS THE ONLY REMEDY. - see p. 115, Bierman and Smidt, 8e INVESTMENT TAX CREDIT IT ISN'T IN EFFECT NOW, BUT THE SCAMMERS IN WASHINGTON PERIODICALLY BRING IT BACK. > (Explanation: it is a way to grant a temporary tax 'gift' that is invariably short-lived.) TWO FLAVORS > THE INTERNATIONAL VERSION SIMPLY REDUCES CASH FLOW IN T 0, e.g., $10,000 investment, 10% ITC, net $9,000 investment...but the full Original Acquisition cost ("OAC") is depreciated > THE US VERSION REDUCES CASH FLOW IN T0, e.g., $10,000 investment, 10% ITC, net $9,000 investment, BUT IT NETS IT OUT OF BOOK VALUE FOR DEPRECIATION. 10,000.00 purchase price 10% ITC 1,000.00 " " 9,000.00 Cash flow, T0 5 year life 9,000.00 basis for depreciation 1,800.00 depreciation per year, straight line ness today if no further cash flow growth is expected? siness? minal value on value is assumed most 'realistic