Hi, please provide detailed solution for these two questions. Thank you.

RSM 333 Spring 2017 Assignment #2 Due Monday, February 6th @ 4pm in Commerce Office Problem #1: (20 marks) Project Analysis / Real Options (Consider using an Excel Spreadsheet to solve this problem.) Blueberry Farms Inc. is considering a four-year project to grow new and higher-quality blueberries. An initial investment of $20 million - depreciable straight-line to zero over the project's life - will buy the equipment necessary to get the project off the ground. The net working capital will also require an initial investment of $2.2 million to support the planting inventory; this cost is fully recoverable whenever the project ends. In the company's opinion, the project can generate pre-tax cash revenues of $19 million against the pre-tax cash operating costs of $6.2 million on an annual basis. The market value of the used equipment over the life of the project is as follows. At the End of Year 1 2 3 4 Market Value ($ million) $13.5 $11.7 $10.5 $0.0 Consider the following: An income tax rate of 35% An appropriate discount rate of 15% All types of income are taxed at the same tax rate Straight-Line depreciation is used for tax purposes (also assume the half-year rule does not apply) If applicable, consider terminal loss or recapture based on salvage (market) value (assume the asset class will close for tax purposes) a. If the company operates the project for four years, what is the NPV of the project? [6 marks] b. If the company operates the project for: [9 marks] a. the first year only, what is the NPV of the project? b. the first two years only, what is the NPV of the project? c. the first three years only, what is the NPV of the project? 1 c. What economic life of the project maximizes its value to the company? If it is not four years then relative to operating the project for four years, what is the value of the option to abandon it after the value-maximizing economic life? Would the company purchase an option to abandon the project for $100,000 today? [5 marks] Problem #2 (20 marks) Your boss has asked you to provide insight into the following options, all of which have the same underlying stock and time to maturity (1-year): Option Call Option A Call Option B Put Option A Put Option B Strike 20 30 15 25 Cost $5.85 $1.77 $0.75 $3.87 The underlying stock price is $23.22 a) Which options are ITM? ATM? OTM? (4 marks) b) What is the intrinsic and time value of each of the options? (4 marks) c) You boss wonders about the cost of another option, Call Option C, with a strike price of $25. Your boss thinks that the price in the market, $4.15, is incorrect. The discount rate is 7% per year with continuous compounding. What is the theoretical price of Call Option C and what course of action would you recommend to your boss? (6 marks) d) You believe that the stock will end the year near its current price. You want to generate a profit by creating an option position (called a Butterfly spread) by buying 1 Call Option A, selling 2 of Call Option C (at the theoretical price), and buying 1 Call Option B. What is the cost to enter the position today and what profit would you earn at a stock price of $23.22, 1-year from today? Include the profit chart for the option position in your answer. (6 marks) 2 Welcome! 2017 Class Corporate Finance (RSM 333) Contact: otto.yung@alumni.utoronto.ca 1 CORPORATE FINANCE RSM 333 - Session 1 AGENDA 1. 2. 3. 4. 5. Introductions Future (Beyond this course) Course/Format Survey/Break Project Evaluation (Chapters 13-14) Contact: otto.yung@utoronto.ca 2 CORPORATE FINANCE RSM 333 - Welcome to Session 1 Session 1 - Project Evaluation Session 2 - Special Cases in Capital Budgeting Session 3 - Project Evaluation under Uncertainty Session 4 - Options Session 5 - Working Capital Management Session 6 - Cost of Capital Session 7 - Midterm (Monday, February, 27th) (6:00pm - 8:00pm) Session 8- Capital Structure Session 9 - Dividend Policy Session 10 - Firm Valuation Session 11 - Mergers & Acquisitions Session 12 - Corporate Governance Contact: otto.yung@utoronto.ca 3 Office Rotman South Building - PhD House - 105 St. George Street - Room 3050: (Drop-In Office Hours) (Stair Access to Room 3050 by Event Hall) Thursdays (TBA) University of Toronto (Mississauga Campus) Kaneff Centre - Room 254 Contact: otto.yung@utoronto.ca 4 Corporate Finance: What is Going On? (5) (3) Firm's Financial Operations (4) (Financial Institutions, Decision Maker (2) Investors (1) Individuals, Other Firms) (1) (2) (3) (4) (5) Cash raised from investors by selling financial assets Cash invested in real assets (some are intangible) Cash generated by operations Cash reinvested in the firm (retained earnings) Cash repaid to investors (interest, dividends, etc.) Reference: Alex MacKay 5 RSM 333 Introduction to Corporate Finance Capital Budgeting, Risk Considerations, & Other Special Issues (Chapter 13) Cash Flow Estimation and Capital Budgeting Decisions (Chapter 14) Session 1 Project Evaluation (Chapter 13) Capital Expenditures and Capital Budgeting Evaluation of Investment Alternatives (DCF) NPV, Payback Period, IRR, PI Equivalent Annual NPV Approach (or Equivalent Annual Cost) International Considerations Project Evaluation (Chapter 14) Estimating Relevant Cash Flows Capital Budgeting (Project) Cash Flows: By Timing By Component Brennan Co - New Milling Machine CCA Tax Shield (Savings) Salvage Value UCC Salvage Value > Initial Cost 7 Capital Expenditures (Capex) Capital Expenditures: Definition: A firm's investments in long-lived assets Decisions are important and often determine the future direction: Significant outlay of money and managerial time Take many years to demonstrate their returns Often irrevocable Can significantly alter risk due to size and long-term nature Long-lived assets: Tangible (Property, Plant and Equipment - PPE) Intangible (R&D, Patents, Copyrights, Trademarks, Brand Names, and Franchise Agreements) Contact: otto.yung@alumni.utoronto.ca 8 Capital Expenditures (Capex) Capital Budgeting (process a firm goes through to make Capex decisions): 1. Identify investment alternatives 2. Evaluate these alternatives 3. Implement the chosen investment decisions 4. Monitor and evaluate the implemented decisions Decisions: Require a forecast of expected cash flows (i.e. consider timing, magnitude and riskiness) Difficult because projects often have a long time horizon Compared to security valuation decisions, one can change the underlying cash flows by changing the structure of the project (e.g. changing credit terms, delaying expansion, etc.) Contact: otto.yung@alumni.utoronto.ca 9 Evaluation of Investment Alternatives Discounted Cash Flow (DCF) Methodologies: 1. Net Present Value (NPV) 2. Simple Payback Period and Discounted Payback Period 3. Internal Rate of Return (IRR) 4. Profitability Index (PI) Contact: otto.yung@alumni.utoronto.ca 10 Evaluation of Investment Alternatives 1. Net Present Value (NPV) Equals to the Sum of PV of Benefits - Sum PV of Costs Equals to the Sum of PV of After-Tax Incremental Cash Flows - Sum PV of Investment Outlays Equals to the Sum of PV of Cash Inflows - Sum of PV of Cash Outflows If NPV > 0 (accept project) (create shareholder wealth) If NPV 2 years (Reject) Contact: otto.yung@alumni.utoronto.ca 15 NPV (10%) vs. Simple Payback Period (2 Years) Project 2: 0 $25,000 1 $25,001 2 3 Years $50k NPV = - $6,610.75 (Reject) Payback Discount Rate (accept project) If IRR IRR? Contact: otto.yung@alumni.utoronto.ca 21 NPV (15%) vs. IRR Example #2 (Mutually Exclusive Projects): Choose Project 1 or 2? Project 1: Invest $100 now (In 1 year receive $200) Project 2: Invest $500 now (In 1 year receive $750) Project 1: NPV = $73.91 IRR = 1.0 or 100% Project 2 NPV = $152.17 IRR = 0.50 or 50% Contact: otto.yung@alumni.utoronto.ca - NPV overrides the decision: the higher the better - maximizes shareholder's wealth Accept Project 2 even though it has a lower IRR 22 NPV vs. IRR Both methods use the same basic decision inputs For example: r = 0.15; NPV = $73.91 r = 1.00; NPV = $0 Contact: otto.yung@alumni.utoronto.ca 23 NPV vs. IRR For example: assume this is received to earn at the same rate NPV method assumes intermediate cash flows are reinvested at the cost of capital IRR method assumes intermediate cash flows are reinvested at IRR - when the level of risk rises, discount rate rises and NPV drops. - NPV=0 -> IRR Contact: otto.yung@alumni.utoronto.ca 24 Evaluation of Investment Alternatives 4. [ 13-3] Profitability Index (PI) Ratio of PV of benefits to PV of costs PI PV(cash inflows) PV (cash outflows) Contact: otto.yung@alumni.utoronto.ca Accept projects when PI > 1 25 Evaluation of Investment Alternatives 4. Profitability Index (PI) Useful tool to supplement NPV as it considers scale of benefits to costs Consider 2 Projects: Project 1: PV of Cash Outflows ($1,000) and PV of Cash Inflows ($1,010) NPV = $10; PI = 1.01 Project 2: PV of Cash Outflows ($10) and PV of Cash Inflows ($20) NPV = $10; PI = 2 Contact: otto.yung@alumni.utoronto.ca 26 Evaluating Investment Alternatives Contact: otto.yung@alumni.utoronto.ca 27 Mutually Exclusive Projects Equivalent Annual NPV (EANPV) Approach (or Equivalent Annual Cost) An approach to compare projects (or purchases) with unequal lives Find NPV of each project or find PV of costs to purchase Convert to annuity equivalent (to choose one and reject the other) EANPV (Higher the better) Contact: otto.yung@alumni.utoronto.ca EAC (Lower the better) 28 International Considerations Capital Investment Decisions that involve foreign investment should consider the additional factors: Political risk Potential legal and regulatory issues Foreign Exchange risk Foreign Taxation Sources of financing if local capital market is unsuitable Export Development Canada (EDC) Helps Canadian firms export & make foreign direct investment (FDI) Provides insurance products to mitigate risks of FDI Encourages FDI beyond the U.S. Contact: otto.yung@alumni.utoronto.ca 29 Session 1 Project Evaluation (Chapter 13) Capital Expenditures and Capital Budgeting Evaluation of Investment Alternatives (DCF) NPV, Payback Period, IRR, PI Equivalent Annual NPV Approach (or Equivalent Annual Cost) International Considerations Project Evaluation (Chapter 14) Estimating Relevant Cash Flows Capital Budgeting (Project) Cash Flows: By Timing By Component Brennan Co - New Milling Machine CCA Tax Shield (Savings) Salvage Value UCC Salvage Value > Initial Cost 30 Session 1 Project Evaluation (Chapter 13) Capital Expenditures and Capital Budgeting Evaluation of Investment Alternatives (DCF) NPV, Payback Period, IRR, PI Equivalent Annual NPV Approach (or Equivalent Annual Cost) International Considerations Project Evaluation (Chapter 14) Estimating Relevant Cash Flows Capital Budgeting (Project) Cash Flows: By Timing By Component Brennan Co - New Milling Machine CCA Tax Shield (Savings) Salvage Value UCC Salvage Value > Initial Cost 31 Estimating Relevant Cash Flows Cash Flows Use incremental cash flows contributed by the project Use expected values Discount rate (later in course: Weighted Average Cost of Capital - WACC) Separate investment from financing decision Opportunity Costs and Taxes matter Sunk costs do not matter (only care about future cash flows) 32 Required Information and Estimates NPV, Discounted Payback, IRR, and PI require the same data: Estimate of initial cost (CF0) Net incremental after-tax cash flows (ATCFi) Estimate of salvage value on assets (CFn) Cost of Capital (k) Estimate of useful life (n) Corporate tax rate (T) Capital Cost Allowance (depreciation) Rate (d) 33 Required Information and Estimates NPV, Discounted Payback, IRR, and PI require the same data: Estimate of initial cost (CF0) Net incremental after-tax cash flows (ATCFi) Estimate of salvage value on assets (CFn) Cost of Capital (k) Estimate of useful life (n) Corporate tax rate (T) Capital Cost Allowance (depreciation) Rate (d) 34 Capital Budgeting Cash Flows Project Cash Flows can be deconstructed in 2 ways: 1. By Timing For long-time horizon use Excel Spreadsheet 2. By Component Formula Driven 35 Capital Budgeting Cash Flows 1. By Timing: Initial After-Tax Cash Flow (CF0) Expected Annual After-Tax Cash Flows (CFt) Ending After-Tax Cash Flow (ECFn) 36 Capital Budgeting Cash Flows 1. By Timing: Initial After-Tax Cash Flow (CF0): C0 = Capital Cost NWC0 = Change in Net Working Capital OC = PV of Opportunity Costs 37 Capital Budgeting Cash Flows 1. By Timing: Expected Annual After-Tax Cash Flows (CFt): CFBTt = Cash Flow Before Taxes (i.e. incremental pre-tax operating income) CCAt = CCA Expense for Year t (i.e. CCA Rate x UCC) T = Firm's marginal (or effective) tax rate Capital Cost Allowance (CCA) is a tax deduction that Canadian tax laws allow a business to claim for the loss in value of capital assets due to wear and tear or obsolescence. Canada Revenue Agency (CRA) has assigned classes to particular types of depreciable property, and there are assigned rates for each class. 38 Capital Budgeting Cash Flows 1. By Timing: Expected Annual After-Tax Cash Flows (CFt): CFBTt = Cash Flow Before Taxes (i.e. incremental pre-tax operating income) CCAt = CCA Expense for Year t (i.e. CCA Rate x UCC) T = Firm's marginal (or effective) tax rate Asset Class Type of Assets CCA Rate Class 1 Buildings 4% Class 8 Office Equipment 20% Class 30 Automobiles, system software, etc. 30% Class 43 Manufacturing Equipment 30% Class 45 Computers 45% Table 14-1 (Booth and Cleary) - Common Asset Classes Established by CRA 39 Capital Budgeting Cash Flows 1. By Timing: Expected Annual After-Tax Cash Flows (CFt): CFBTt = Cash Flow Before Taxes (i.e. incremental pre-tax operating income) CCAt = CCA Expense for Year t (i.e. CCA Rate x UCC) T = Firm's marginal (or effective) tax rate Example: Capital Cost = $100,000 (Undepreciated Capital Cost - UCC) CCA Expense: 1st Year = $100,000 x 0.10 x (0.5) = $5,000 CCA Expense: 2nd Year = $95,000 x 0.10 = $9,500 Review - Chapter 3 (The Canadian Tax System) 40 Capital Budgeting Cash Flows 1. By Timing: Example: Capital Cost = $100,000 (Undepreciated Capital Cost - UCC) CCA Expense: 1st Year = $100,000 x 0.10 x (0.5) = $5,000 CCA Expense: 2nd Year = $95,000 x 0.10 = $9,500 41 Capital Budgeting Cash Flows 42 Capital Budgeting Cash Flows T(CCA) at 10% on $100,000 4000 3500 3000 2500 Tax Shield 2000 1500 1000 500 0 1 3 5 7 9 11 13 15 17 19 Year 43 Capital Budgeting Cash Flows T(CCA) at 10% on $100,000 4000 3500 3000 2500 Tax Shield 2000 1500 1000 500 0 By selling the asset after the end of the 10th fiscal year, we lose CCA in years 11 through infinity. 1 3 5 7 9 11 13 15 17 19 Year 44 Capital Budgeting Cash Flows 1. By Timing: Expected Annual After-Tax Cash Flows (CFt): CFBTt = Cash Flow Before Taxes (i.e. incremental pre-tax operating income) CCAt = CCA Expense for Year t (i.e. CCA Rate x UCC) T = Firm's marginal (or effective) tax rate Example: Capital Cost = $100,000 (Undepreciated Capital Cost - UCC) CCA Expense: 1st Year = $100,000 x 0.10 x (0.5) = $5,000 CCA Expense: 2nd Year = $95,000 x 0.10 = $9,500 Review - Chapter 3 (The Canadian Tax System) 45 Capital Budgeting Cash Flows 1. By Timing: Ending After-Tax Cash Flow (ECFn): SVn = Estimated Salvage Value in Year n NWC0 = Change in Net Working Capital UCCn = Asset (or asset class) ending UCC balance (UCC = Undepreciated Capital Cost) 46 Capital Budgeting Cash Flows 1. By Timing: Initial After-Tax Cash Flow (CF0) Expected Annual After-Tax Cash Flows (CFt) Ending After-Tax Cash Flow (ECFn) 47 Capital Budgeting Cash Flows 1. By Timing: Initial After-Tax Cash Flow (CF0) Expected Annual After-Tax Cash Flows (CFt) Ending After-Tax Cash Flow (ECFn) 48 Chapter 14 (Brennan Co. - New Milling Machine) Milling is the machining process of using rotary cutters to remove material[1] from a workpiece advancing (or feeding) in a direction at an angle with the axis of the tool.[2][3] It covers a wide variety of different operations and machines, on scales from small individual parts to large, heavy-duty gang milling operations. It is one of the most commonly used processes in industry and machine shops today for machining parts to precise sizes and shapes. Source: http://en.wikipedia.org/wiki/Milling_(machining) 49 Chapter 14 (Brennan Co. - New Milling Machine) (Economic Life of Machine is 5 years) 50 51 52 53 54 Chapter 14 (Brennan Co. - New Milling Machine) 55 Chapter 14 (Brennan Co. - New Milling Machine) NPV of Project (Acquiring New Milling Machine) Initial Cash Outlay = $750,000 PV of Annual Cash Flows = $421,370 PV of Ending Cash Flow = $132,015 NPV = -$196,616 = -$750,000 + $421,370 + $132,015 Brennan Co. should reject the project 56 Capital Budgeting Cash Flows Project Cash Flows can be deconstructed in 2 ways: 1. By Timing For long-time horizon use Excel Spreadsheet 2. By Component Formula Driven 57 Capital Budgeting Cash Flows 2. By Component (Brennan Co. Example): Initial After-Tax Cash Flow (CF0) PV of Operating Cash Flows (or After-Tax Operating Income) PV of Capital Cost Allowance Tax Shield (PVCCATS) PV of Ending Cash Flow (ECFn) PV of Capital Gains Taxes Paid 58 Capital Budgeting Cash Flows 2. By Component: PV of Operating Cash Flows PV (OCF) = $247,828 (After-Tax Operating Income) (Assume Cash Flow Before Tax - CFBT - is constant (or Operating Income) 59 60 Capital Budgeting Cash Flows 2. By Component: PV of Capital Cost Allowance Tax Shield (PVCCATS) 1 2 3 4 5 (Note: CCA Tax Savings = CCA Expense x Tax Rate) (Note: CCA Expense = UCC x CCA Rate) 61 Capital Budgeting Cash Flows 2. By Component: PV of Capital Cost Allowance Tax Shield (PVCCATS) Brennan Co. Example 1 2 3 4 5 62 63 Capital Budgeting Cash Flows 2. By Component: PV of Capital Cost Allowance Tax Shield (PVCCATS) PV (CCATax Shield ) C0 dT 1 0.5k d k 1 k SVn dT 1 d k (1 k ) n See Additional Notes for Details 64 Capital Budgeting Cash Flows 2. By Component: PV of Capital Cost Allowance Tax Shield (PVCCATS) PV (CCATax Shield ) C0 dT 1 0.5k d k 1 k SVn dT 1 d k (1 k ) n PV of CCA Tax Savings (without half-year rule) if asset held indefinitely 65 Capital Budgeting Cash Flows 2. By Component: PV of Capital Cost Allowance Tax Shield (PVCCATS) PV (CCATax Shield ) C0 dT 1 0.5k d k 1 k SVn dT 1 d k (1 k ) n PV of CCA Tax Savings (with half-year rule) if asset held indefinitely 66 Capital Budgeting Cash Flows 2. By Component: PV of Capital Cost Allowance Tax Shield (PVCCATS) PV (CCATax Shield ) C0 dT 1 0.5k d k 1 k SVn dT 1 d k (1 k ) n PV of CCA Tax Savings at time of sale (year n) 67 Capital Budgeting Cash Flows 2. By Component: PV of Capital Cost Allowance Tax Shield (PVCCATS) PV (CCATax Shield ) C0 dT 1 0.5k d k 1 k SVn dT 1 d k (1 k ) n PV of CCA Tax Savings at time of sale (year n) (at time 0) 68 CCA Tax Savings (Shield) 80000 70000 60000 50000 Tax Shield 40000 30000 20000 10000 0 By selling the asset after the end of the 5th fiscal year, we lose CCA in years 6th through infinity. 1 3 5 7 9 11 13 15 17 19 Year 69 Capital Budgeting Cash Flows 2. By Component: PV of Capital Cost Allowance Tax Shield (PVCCATS) PV (CCATax Shield ) C0 dT 1 0.5k d k 1 k SVn dT 1 d k (1 k ) n PV (CCATS) = $173,541 1 2 3 4 5 Equation applies if Salvage Value = UCC 70 Capital Budgeting Cash Flows 2. By Component (Brennan Co. Example): Initial After-Tax Cash Flow (CF0) ($750,000) PV of Operating Cash Flows ($247,828) PV of Capital Cost Allowance Tax Shield (PVCCATS) ($173,541) PV of Ending Cash Flow (ECFn) ($132,015) PV of Capital Gains Taxes Paid ($0) NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 NPV = $247,828 + $173,541 + $132,015 - $750,000 NPV = $421,370 + $132,015 - $750,000 NPV = -$196,616 Note: $421,370 = PV of Annual Cash Flows 71 Capital Budgeting Cash Flows Project Cash Flows can be deconstructed in 2 ways: 1. By Timing (NPV = -$196,616) For long-time horizon use Excel Spreadsheet 2. By Component (NPV = -$196,616) Formula Driven 72 Capital Budgeting Cash Flows Case when Salvage Value = UCC and Salvage Value Ending UCC and Salvage Value > Capital Cost 1. By Timing ECFn 2. SVn NWCn 0.5T (SVn C0 ) T (SVn UCCn ) By Component PV(CCATax Shield ) C0dT 1 0.5k d k 1 k UCCn (d)(T) 1 d k (1 k ) n PV (Capital Gains Taxes ) (SVn UCCn )(T) (1 k ) n 0.5T ( SVn C0 ) (1 k ) n 74 Session 1 Project Evaluation (Chapter 13) Capital Expenditures and Capital Budgeting Evaluation of Investment Alternatives (DCF) NPV, Payback Period, IRR, PI Equivalent Annual NPV Approach (or Equivalent Annual Cost) International Considerations Project Evaluation (Chapter 14) Estimating Relevant Cash Flows Capital Budgeting (Project) Cash Flows: By Timing By Component Brennan Co - New Milling Machine CCA Tax Shield (Savings) Salvage Value UCC Salvage Value > Initial Cost 75 CORPORATE FINANCE RSM 333 - Welcome to Session 1 Session 1 - Project Evaluation Session 2 - Special Cases in Capital Budgeting Session 3 - Project Evaluation under Uncertainty Session 4 - Options Session 5 - Working Capital Management Session 6 - Cost of Capital Session 7 - Midterm (Monday, February, 27th) (6:00pm - 8:00pm) Session 8- Capital Structure Session 9 - Dividend Policy Session 10 - Firm Valuation Session 11 - Mergers & Acquisitions Session 12 - Corporate Governance Contact: otto.yung@utoronto.ca 76 CORPORATE FINANCE RSM 333 - Welcome to Session 2 Session 1 - Project Evaluation Session 2 - Special Cases in Capital Budgeting Session 3 - Project Evaluation under Uncertainty Session 4 - Options Session 5 - Working Capital Management Session 6 - Cost of Capital Session 7 - Midterm (Monday, February, 27th) (6:00pm - 8:00pm) Session 8- Capital Structure Session 9 - Dividend Policy Session 10 - Firm Valuation Session 11 - Mergers & Acquisitions Session 12 - Corporate Governance Contact: otto.yung@utoronto.ca 1 CORPORATE FINANCE RSM 333 - Session 2 AGENDA 1. 2. Project Evaluation (Chapters 13-14) Capital Expenditures Capital Budgeting Cash Flows Special Cases in Capital Budgeting (Chapters 13-14) Capital Rationing Replacement Decisions Contact: otto.yung@alumni.utoronto.ca 2 Session 1 (cont'd) - Project Evaluation Project Evaluation (Chapter 13) Capital Expenditures and Capital Budgeting Evaluation of Investment Alternatives (DCF) NPV, Payback Period, IRR, PI Equivalent Annual NPV Approach (or Equivalent Annual Cost) International Considerations Project Evaluation (Chapter 14) Estimating Relevant Cash Flows Capital Budgeting (Project) Cash Flows: By Timing By Component Brennan Co - New Milling Machine CCA Tax Shield (Savings) Salvage Value Undepreciated Capital Cost (UCC) Salvage Value > Initial Cost Background Reading (Chapter 3) 3 Session 1 - Capital Budgeting Cash Flows Salvage Value (assume the equipment is the only asset in this CCA asset class) Purchase price = $650,000 At end of Year 2 (UCC = $386,750) 4 Session 1 - Capital Budgeting Cash Flows Salvage Value (assume the equipment is the only asset in this CCA asset class) Purchase price = $650,000 At end of Year 2 (UCC = $386,750) Various scenarios at end of Year 2: Salvage Value = $700,000 CCA Recapture & Capital Gain Salvage Value = $650,000 CCA Recapture & No Capital Gain Salvage Value = $400,000 Salvage Value = $386,750 No CCA Recapture (No Terminal Loss) & No Capital Gain Salvage Value = $200,000 Terminal Loss & No Capital Gain 5 Session 1 - Capital Budgeting Cash Flows Note: Salvage Value (assume the equipment is the only asset in this CCA asset class) See excel spreadsheet 6 Session 1 - Capital Budgeting Cash Flows Salvage Value (the equipment is NOT the only asset in this CCA asset class) Purchase price = $650,000 At end of Year 2 (UCCPool = $500,000) Various scenarios at end of Year 2: Salvage Value = $700,000 CCA Recapture* & Capital Gain Salvage Value = $650,000 CCA Recapture* & No Capital Gain Salvage Value = $400,000 CCA Recapture* & No Capital Gain Salvage Value = $386,750 No CCA Recapture (No Terminal Loss) & No Capital Gain Salvage Value = $200,000 Terminal Loss* & No Capital Gain UCCAsset = $386,750 7 Session 1 - Capital Budgeting Cash Flows UCCAsset = $386,750 Note: Salvage Value (assume the equipment is NOT the only asset in this CCA asset class) See excel spreadsheet Reconcile by adjusting UCCPool* (Adjusted cost of disposal) 8 Session 1 - Capital Budgeting Cash Flows Only asset in CCA class, No CCA recapture (or terminal loss) and No Capital Gain Case when Salvage Value = UCC and Salvage Value Ending UCC and Salvage Value > Capital Cost 1. By Timing ECFn 2. SVn NWCn 0.5T (SVn C0 ) T (SVn UCCn ) By Component PV(CCATax Shield ) C0dT 1 0.5k d k 1 k UCCn (d)(T) 1 d k (1 k ) n PV (Capital Gains Taxes ) (SVn UCCn )(T) (1 k ) n 0.5T ( SVn C0 ) (1 k ) n 10 Session 1 - Capital Budgeting Cash Flows Adjusted Cost of Disposal (Not the only asset and SVAsset > UCCPool) Case when Salvage Value Ending UCC and Salvage Value > Capital Cost 1. By Timing ECFn 2. SVn NWCn 0.5T (SVn C0 ) T (SVn UCCn ) By Component PV(CCATax Shield ) C0dT 1 0.5k d k 1 k UCCn (d)(T) 1 d k (1 k ) n PV (Capital Gains Taxes ) (SVn UCCn )(T) (1 k ) n 0.5T ( SVn C0 ) (1 k ) n 11 Session 1 - Capital Budgeting Cash Flows Adjusted Cost of Disposal (Not the only asset and SVAsset > UCCPool) Case when Salvage Value Ending UCC and Salvage Value > Capital Cost 1. By Timing ECFn 2. SVn NWCn 0.5T (SVn C0 ) T (SVn UCCn ) By Component PV(CCATax Shield ) C0dT 1 0.5k d k 1 k UCCn (d)(T) 1 d k (1 k ) n PV (Capital Gains Taxes ) (SVn UCCn )(T) (1 k ) n 0.5T ( SVn C0 ) (1 k ) n (SVasset is usually less than the Initial Cost \"C0\") 12 Session 1 - Capital Budgeting Cash Flows (Not the only asset, SVasset is usually less than the UCCPOOL) Case when Salvage Value Ending UCC and Salvage Value > Capital Cost 1. By Timing ECFn 2. SVn NWCn 0.5T (SVn C0 ) T (SVn UCCn ) By Component PV(CCATax Shield ) C0dT 1 0.5k d k 1 k UCCn (d)(T) 1 d k (1 k ) n PV (Capital Gains Taxes ) (SVn UCCn )(T) (1 k ) n 0.5T ( SVn C0 ) (1 k ) n 13 Session 1 - Capital Budgeting Cash Flows (Not the only asset, SVasset is usually less than the UCCPOOL) Case when Salvage Value Ending UCC and Salvage Value > Capital Cost 1. By Timing ECFn 2. SVn NWCn 0.5T (SVn C0 ) T (SVn UCCn ) By Component PV(CCATax Shield ) C0dT 1 0.5k d k 1 k UCCn (d)(T) 1 d k (1 k ) n PV (Capital Gains Taxes ) (SVn UCCn )(T) (1 k ) n 0.5T ( SVn C0 ) (1 k ) n 14 Session 1 - Capital Budgeting Cash Flows (Not the only asset, SVasset is usually less than the UCCPOOL) Case when Salvage Value Ending UCC and Salvage Value > Capital Cost 1. By Timing ECFn 2. SVn NWCn 0.5T (SVn C0 ) T (SVn UCCn ) By Component PV(CCATax Shield ) C0dT 1 0.5k d k 1 k UCCn (d)(T) 1 d k (1 k ) n PV (Capital Gains Taxes ) (SVn UCCn )(T) (1 k ) n 0.5T ( SVn C0 ) (1 k ) n (SVasset is usually less than the Initial Cost \"C0\") 15 Session 1 - Capital Budgeting Cash Flows (Not the only asset, SVasset is usually less than the UCCPOOL) Case when Salvage Value Ending UCC and Salvage Value > Capital Cost 1. By Timing ECFn 2. SVn NWCn 0.5T (SVn C0 ) T (SVn UCCn ) By Component SVn PV(CCATax Shield ) C0dT 1 0.5k d k 1 k UCCn (d)(T) 1 d k (1 k ) n PV (Capital Gains Taxes ) (SVn UCCn )(T) (1 k ) n 0.5T ( SVn C0 ) (1 k ) n (SVasset is usually less than the Initial Cost \"C0\") 16 Session 1 - Capital Budgeting Cash Flows (Not the only asset, SVasset is usually less than the UCCPOOL) 1. By Timing ECFn 2. SVn NWCn By Component PV (CCATax Shield ) C0 dT 1 0.5k d k 1 k SVn dT 1 d k (1 k ) n 17 Session 1 - Project Evaluation Project Evaluation (Chapter 13) Capital Expenditures and Capital Budgeting Evaluation of Investment Alternatives (DCF) NPV, Payback Period, IRR, PI Equivalent Annual NPV Approach (or Equivalent Annual Cost) International Considerations Project Evaluation (Chapter 14) Estimating Relevant Cash Flows Capital Budgeting (Project) Cash Flows: By Timing By Component Brennan Co - New Milling Machine CCA Tax Shield (Savings) Salvage Value Undepreciated Capital Cost (UCC) Salvage Value > Initial Cost Background Reading (Chapter 3) 18 Session 2 - Special Cases in Capital Budgeting Capital Rationing Investment Opportunity Schedule (prioritize capital projects) Replacement Decisions Replace an existing asset (or assets) with a new one Use incremental cash flows for NPV 19 SPECIAL CASES IN CAPITAL BUDGETING (Chapter 13 - cont'd) (Capital Budgeting, Risk Considerations, and Other Special Issues) 20 Capital Rationing Theoretically: Accept all independent projects with positive NPVs Practically (not possible): Unable to raise funds in the capital markets Management sets budget limits Existing shareholders do not want ownership dilution Available projects exceed managerial capacity in the short-term INVESTMENT CAPITAL MUST BE RATIONED AMONG AVAILABLE PROJECTS Contact: otto.yung@alumni.utoronto.ca 21 Capital Rationing Investment Opportunity Schedule (IOS): Prioritized list of capital projects Investments ranked by NPV, IRR, PI, etc. Example (10% cost of capital, Six projects and $6M budget limit): Project Initial Cost ($) Annual ATCF ($) Useful Life NPV ($) IRR (%) PI A 1,500,000 290,000 7 -88,159 8.19 0.94 B 3,000,000 700,000 6 48,682 10.55 1.02 C 4,000,000 1,040,000 6 529,471 14.40 1.13 D 70,000 20,000 7 27,368 21.08 1.39 E 1,000,000 290,000 5 99,328 13.82 1.10 F 960,000 200,000 Contact: otto.yung@alumni.utoronto.ca 8 106,985 12.99 1.11 22 Capital Rationing Example (10% cost of capital, Six projects and $6M budget limit): Rank NPV IRR PI 1st C D D 2nd F C C 3rd E E F 4th B F E 5th D B B Rejected A A A Contact: otto.yung@alumni.utoronto.ca 23 Capital Rationing Example (10% cost of capital, Six projects and $6M budget limit): Rank NPV IRR PI 1st C D D 2nd F C C 3rd E E F Capital Budget $5,960,000 $5,070,000 $5,030,000 Total NPV $735,785 $656,168 $663,825 We assumed these 6 projects were independent What if we have contingent projects (e.g. GO Train station, additional railway)? What if we have mutually exclusive projects (e.g. Subway or Light Rail)? 24 Contact: otto.yung@alumni.utoronto.ca Session 2 - Special Cases in Capital Budgeting Capital Rationing Investment Opportunity Schedule (prioritize capital projects) Replacement Decisions Replace an existing asset (or assets) with a new one Use incremental cash flows for NPV 25 SPECIAL CASES IN CAPITAL BUDGETING (Chapter 14 - cont'd) (Cash Flow Estimation and Capital Budgeting Decisions) 26 Replacement Decisions Expansion Projects Add extra sales, cost savings, etc. Incremental cash flows Replacement Projects Replace an existing asset (or assets) with a new one Incremental cash flows: Incremental Capital Cost (C0) (i.e. PurchaseNew - SalvageOld) Incremental CCA Tax Savings (CCATS) Contact: otto.yung@alumni.utoronto.ca 27 Replacement Decisions By Component (Formula Approach) Expansion: NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 Replacement: NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 PV ( CCA Tax Shield ) ( C0 )(d )(T ) d k Contact: otto.yung@alumni.utoronto.ca (1 0.5k ) (1 k ) ( SVn )(d )(T ) (d k ) 1 (1 k ) n 28 Replacement Decisions (Effect on CCATS) The replacement of old with new results in a change in the tax shield and affects both the net cost of the new as well as the salvage value. PV ( CCA Tax Shield ) ( C0 )(d )(T ) d k Contact: otto.yung@alumni.utoronto.ca (1 0.5k ) (1 k ) ( SVn )(d )(T ) (d k ) 1 (1 k ) n 29 Replacement Decisions Alternatively, you can calculate: 1. 2. 3. Remaining NPV of the existing asset NPV of the replacement Select the one with the higher NPV This method is time consuming but may be less prone to errors Remember to ignore sunk costs to existing asset Contact: otto.yung@alumni.utoronto.ca 30 Replacement Decisions Example (8 year time horizon): New Machine: Purchase Price = $350,000 Salvage Value in 8 years = $100,000 Reduce Annual Operating Expenses by $50,000 Existing Machine: Current Market Value = $50,000 Salvage Value in 8 years = $15,000 Marginal Tax Rate: 40% Marginal Cost of Capital: 15% CCA Class 10 (CCA Rate = 30%) CCA class will remain open What is the NPV of the Replacement Decision? NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 Contact: otto.yung@alumni.utoronto.ca 31 Replacement Decisions Example (8 year time horizon): NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 PV ( Operating CFs) CFBT (1 T ) 1 1 k (1 k ) n $50,000(1 0.4) 1 1 0.15 1.158 $134,620 Contact: otto.yung@alumni.utoronto.ca 32 Replacement Decisions Example (8 year time horizon): NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 PV ( CCA Tax Shield ) ( C0 )(d )(T ) d k Contact: otto.yung@alumni.utoronto.ca (1 0.5k ) (1 k ) ( SVn )(d )(T ) (d k ) 1 (1 k ) n 33 Replacement Decisions Example (8 year time horizon): NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 C0 = 350,000 - 50,000 = $300,000 SVn = 100,000 - 15,000 = $85,000 PV ( CCA Tax Shield ) ( C0 )(d )(T ) d k Contact: otto.yung@alumni.utoronto.ca (1 0.5k ) (1 k ) ( SVn )(d )(T ) (d k ) 1 (1 k ) n 34 Replacement Decisions Example (8 year time horizon): NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 C0 = 350,000 - 50,000 = $300,000 SVn = 100,000 - 15,000 = $85,000 PV (CCATax Shield ) $300,000(0.3)(0.4) 1 0.5(0.15) 0.3 0.15 1.15 $67,373 Contact: otto.yung@alumni.utoronto.ca $85,000(0.3)(0.4) 1 0.3 0.15 1.158 35 Replacement Decisions Example (8 year time horizon): NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 ECFn = $85,000 (i.e. in Salvage Value = $100,000 - $15,000) PV ( ECFn ) ECFn (1 k ) n Contact: otto.yung@alumni.utoronto.ca $85,000 1.158 $27,787 36 Replacement Decisions Example (8 year time horizon): NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 CF0 = C0 + NWC0 + OC CF0 = ($350,000 - $50,000) + $0 + $0 CF0 = $300,000 Contact: otto.yung@alumni.utoronto.ca 37 Replacement Decisions Example (8 year time horizon): NPV = PV (OCF) + PV (CCATS) + PV (ECFn) - CF0 NPV NPV $134,620 $67,373 $27,787 $300,000 $70,221 DO NOT REPLACE EXISTING MACHINE Contact: otto.yung@alumni.utoronto.ca 38 SPECIAL CASES IN CAPITAL BUDGETING (Chapter 14) (Cash Flow Estimation and Capital Budgeting Decisions) (We will come back to Chapter 14 - e.g. Real Options) PROJECT EVALUATION UNDER UNCERTAINTY 39 Session 2 - Special Cases in Capital Budgeting Capital Rationing Investment Opportunity Schedule (prioritize capital projects) Replacement Decisions Replace an existing asset (or assets) with a new one Use incremental cash flows for NPV 40 CORPORATE FINANCE RSM 333 - Welcome to Session 2 Session 1 - Project Evaluation Session 2 - Special Cases in Capital Budgeting Session 3 - Project Evaluation under Uncertainty Session 4 - Options Session 5 - Working Capital Management Session 6 - Cost of Capital Session 7 - Midterm (Monday, February, 27th) (6:00pm - 8:00pm) Session 8- Capital Structure Session 9 - Dividend Policy Session 10 - Firm Valuation Session 11 - Mergers & Acquisitions Session 12 - Corporate Governance Contact: otto.yung@utoronto.ca 41 CORPORATE FINANCE RSM 333 - Welcome to Session 3 Session 1 - Project Evaluation Session 2 - Special Cases in Capital Budgeting Session 3 - Project Evaluation under Uncertainty Session 4 - Options Session 5 - Working Capital Management Session 6 - Cost of Capital Session 7 - Midterm (Monday, February, 27th) (6:00pm - 8:00pm) Session 8- Capital Structure Session 9 - Dividend Policy Session 10 - Firm Valuation Session 11 - Mergers & Acquisitions Session 12 - Corporate Governance Contact: otto.yung@utoronto.ca 1 CORPORATE FINANCE RSM 333 - Session 3 AGENDA 1. 2. Quick Review Session 1 - Project Evaluation Session 2 - Special Cases in Capital Budgeting Project Evaluation under Uncertainty Contact: otto.yung@alumni.utoronto.ca 2 Session 1 - Project Evaluation Project Evaluation (Chapter 13) Capital Expenditures and Capital Budgeting Evaluation of Investment Alternatives (DCF) NPV, Payback Period, IRR, PI Equivalent Annual NPV Approach (or Equivalent Annual Cost) International Considerations Project Evaluation (Chapter 14) Estimating Relevant Cash Flows Capital Budgeting (Project) Cash Flows: By Timing By Component Brennan Co - New Milling Machine CCA Tax Shield (Savings) Salvage Value Undepreciated Capital Cost (UCC) Salvage Value > Initial Cost Background Reading (Chapter 3) 3 Session 2 - Special Cases in Capital Budgeting Capital Rationing Investment Opportunity Schedule (prioritize capital projects) Replacement Decisions Replace an existing asset (or assets) with a new one Use incremental cash flows for NPV 4 Session 3 - Project Evaluation under Uncertainty Risk Management Consider risk factors that could impact a project during its life Risks can be assessed, mitigated and transferred Assessed by evaluating how the outcome of the project changes with variation of its inputs: Sensitivity analysis (change an input variable in NPV) Scenario analysis (e.g. sales forecast - base, optimistic and pessimistic) Simulation (e.g. develop distribution of NPV using a random number generator to select value(s) for the input variables) Mitigated by making the project flexible so that changes can be implemented at subsequent dates (i.e. Real options) Transferred by implementing strategies that will insulate the firm against those risks (i.e. Hedging strategies) 5 Session 3 Decision to Proceed with a New Product/Project Static NPV vs. Dynamic NPV (Real Options) Real Options Base Case 1 Scenario of Future Cash Flows (no option available) Multiple Scenarios of Future Cash Flows Option to abandon project Value the option to abandon Mining Example - Expected cash flows Ore Price = $10 only Ore Price = \"$8 or $12\" vs. \"$6 or $14\" vs. \"$4 or $16\" Greater the uncertainty in outcomes, the greater the value in retaining flexibility 6 Session 3 (cont'd) Hedging Natural Hedge (without derivatives) vs. Financial Hedge (with derivatives) Example - Canadian Firm will receive $1 Million USD in 30 days Forward Contracts Futures Contracts Starbucks - Futures Contracts (Coffee) Barrick - Futures Contracts (Gold) Chicago Mercantile Exchange (CME) Group Agriculture, Energy, Equity Index, FX, Interest Rate, Metals Various Exchanges around the world/etc... Montreal Exchange (Canadian bonds/TSX/S&P 60 Index) London Metal Exchange (Lead/Nickel/Tin/Aluminum/Zinc) Swaps (Interest Rate, Currency and Credit Default) 7 PROJECT EVALUATION UNDER UNCERTAINTY (Chapter 14 - cont'd) (Sensitivity To Inputs - Real Option Valuation) \"Background Reading\" (Sections 11.1 & 11.2) (Forward Contracts & Futures Contracts) 8 Decision to Proceed with a New Product/Project Static NPV vs. Dynamic NPV Decision to Proceed with a New Product/Project Static NPV Traditional capital budgeting assumes a static view of the world Assumes once a decision has been made, management has no flexibility to revise its planned project outlays, as a result of new information Shortfalls: Assumes future cash flows will arise as predicted. This is a poor assumption for new product introductions. Assumes that decisions made will not be revisited NPV is typically understated for the value of highly uncertain projects Acceptable for product extension decisions 10 Decision to Proceed with a New Product/Project Dynamic NPV Management has significant flexibility to: Expand production and/or make follow-on investments (i.e. more successful than anticipated) Abandon production and/or delay further investments (i.e. much worse than anticipated) Sell the project As project proceeds with uncertainty, managers can make corrections through changes in strategies and tactics (Note: Static NPV ignores this) How to value these embedded options? 11 Decision to Proceed with a New Product/Project Real Options (a.k.a. Dynamic NPV) Management can make adjustments after a project has been accepted Adjustments (e.g. expand or suspend operations, invest in more research, delay production, etc.) Real Options are managerial choices which can enhance project value NPV model Incorporates new information as it becomes available Assumes future cash flows will change as new information is revealed Decisions to abandon, expand, delay, etc. can follow from the revised analysis Decision making is reduced from one big bet to a series of smaller bets. 12 Real Option Example Base Case: $150 ............ $150 ............ ............ 1 $1,100 Invest $1,100 now and expect sales (cash) of $150/year in perpetuity NPV @ 15% = -$1,100 + $150/0.15 = -$100 Decision to not proceed 13 Real Option Example Additional Info (Expect 3 Scenarios of equal probability): Good $350 ............ $350 ............ ............ 1 Fair $170 ............ $170 ............ ............ 1 Bad $50 ............ $50 ............ ............ 1 You can abandon the project in 1 year and recover $900 You won't know for 1 year what the actual level of sales (cash) will be 14 Real Option Example Additional Info (Expect 3 Scenarios of equal probability): Good $350/0.15 = $2,333 Fair $170/0.15 = $1,133 Bad $50/0.15 = $333 Invest $1,100 (at time 0) NPV (without option to abandon) = -$1,100 + (1/3) ($2,333 + $1,133 + $333) NPV = -$1,100 + $1,266.33 = $166.33 15 Real Option Example Additional Info (Expect 3 Scenarios of equal probability): Good $350/0.15 = $2,333 Fair $170/0.15 = $1,133 Bad $50/0.15 = $333 Abandon Project since 0 Invest $1,100 (at time 0) NPV (without option to abandon) ~ -$1,100 + (1/3) ($1,666 + $1,133 + $333) NPV = -$1,100 + $1,044.44 = -$55.56 (will not proceed) 18 Real Option Example Additional Info (Expect 3 Scenarios of equal probability): Good $250/0.15 = $1,666 Fair $170/0.15 = $1,133 Bad $50/0.15 = $333 Special Case: Project NPV without the option 0 Abandon Project since