I need help answering two essay questions which are due 10/18 Weds. You must choose 2 out of 4 essay topics to write on and have a 2 hr time limit once we start.

I will provide slides and supporting chapter info that the questions may be based off of.

US 640 Financial Principles and Practice BUS 640 Week 5 September 22, 2016 Chapter 8 CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 2 Learning Objectives The \"time value of money\" and its importance to business. The future value and present value of a single amount. The future value and present value of an annuity. The present value of a series of uneven cash flows. CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 3 The Time Value of Money Money grows over time when it earns interest. Therefore, money that is to be received at some time in the future is worth less than the same dollar amount to be received today. Similarly, a debt of a given amount to be paid in the future are less burdensome than that debt to be paid now. CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 4 The Future Value of a Single Amount Suppose that you have $100 today and plan to put it in a bank account that earns 8% per year. How much will you have after 1 year? 5 years? 15 years? After one year: $100 + (.08 x $100) = $100 + $8 = $108 OR: $100 x (1.08)1 = $108 CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 5 The Future Value of a Single Amount Suppose that you have $100 today and plan to put it in a bank account that earns 8% per year. How much will you have after 1 year? 5? 15? After one year: $100 x (1.08)1 = $108 After five years: $100 x 1.08 x 1.08 x 1.08 x 1.08 x 1.08 = 146.93 $100 x (1.08)5 = $146.93 After fifteen years: $100 x (1.08)15 = $317.22 CH 08: The Time Value of Money Equation: Gallagher 7e: Textbook Media Press FV = PV (1 + k)n 6 The Future Value of a Single Amount Graphical Presentation: Different Interest Rates $1000 900 k = 8% 800 700 600 k = 4% 500 400 300 200 0 CH 08: The Time Value of Money k = 0% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Year Gallagher 7e: Textbook Media Press 7 Present Value of a Single Amount Value today of an amount to be received or paid in the future. PV = FVn x 1 (1 + k)n Example: Expect to receive $100 in one year. If can invest at 10%, what is it worth today? PV = 100 = 90.90 (1+10)1 CH 08: The Time Value of Money $100 Gallagher 7e: Textbook Media Press 8 Present Value of a Single Amount (continued) Value today of an amount to be received or paid in the future. PV = FVn x 1 (1 + k)n Example: Expect to receive $100 in EIGHT years. If can invest at 10%, what is it worth today? 100 PV =(1+.10)8 = 46.65 CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press $100 9 Present Value of a Single Amount Graphical Presentation $100 90 k = 0% 80 70 60 k = 5% 50 40 k = 10% 30 20 0 CH 08: The Time Value of Money 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Year Gallagher 7e: Textbook Media Press 10 Financial Calculator Solution - PV Previous Example: Expect to receive $100 in EIGHT years. If can invest at 10%, what is it worth today? Using Formula: Calculator Enter: N = 8 I/Y = 10 FV = 100 CPT PV = ? CH 08: The Time Value of Money PV = 100 = 46.65 (1+.10)8 - 46.65 N I/YR PV 8 10 ? Gallagher 7e: Textbook Media Press PMT FV 100 11 Financial Calculator Solution - FV (continued) Previous Example: You invest $200 at 10%. How much is it worth after 5 years? Using Formula: CH 08: The Time Value of Money FV = $200 (1.10)5 = $322.10 Gallagher 7e: Textbook Media Press 12 Financial Calculator Solution - PV (continued) Previous Example: You invest $200 at 10%. How much is it worth after 5 years? Using Formula: Calculator Enter: N = 5 I/Y = 10 FV = -200 CPT FV = ? CH 08: The Time Value of Money FV = $200 (1.10)5 = $322.10 322.10 N I/YR PV 5 10 -200 Gallagher 7e: Textbook Media Press PMT FV ? 13 Annuities An annuity is a series of equal cash flows spaced evenly over time. For example, you pay your landlord an annuity since your rent is the same amount, paid on the same day of the month for the entire year. Jan Feb $500 CH 08: The Time Value of Money Mar $500 Dec $500 $500 Gallagher 7e: Textbook Media Press $500 14 Future Value of an Annuity You deposit $100 each year (end of year) into a savings account. How much would this account have in it at the end of 3 years if interest were earned at a rate of 8% annually? CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 15 Future Value of an Annuity (continued) $100(1.08)2 $100(1.08)1 $100(1.08)0 $100.00 $108.00 $116.64 $324.64 You deposit $100 each year (end of year) into a savings account. How much would this account have in it at the end of 3 years if interest were earned at a rate of 8% annually? CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 16 Future Value of an Annuity (continued) $100(1.08)2 $100(1.08)1 $100(1.08)0 $100.00 $108.00 $116.64 $324.64 How much would this account have in it at the end of 3 years if interest were earned at a rate of 8% annually? n (1+k) - 1 FVA = PMTx( k CH 08: The Time Value of Money ) 3 (1+.08) -1 = 100 .08 = 100(3.2464) = 324.64 ( Gallagher 7e: Textbook Media Press ) 17 Future Value of an Annuity Calculator Solution Enter: N =3 I/Y =8 PMT = -100 CPT FV = ? CH 08: The Time Value of Money 324.64 N I/YR 3 8 PV Gallagher 7e: Textbook Media Press PMT FV -100 ? 18 Present Value of an Annuity How much would the following cash flows be worth to you today if you could earn 8% on your deposits? CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 19 Present Value of an Annuity (continued) How much would the following cash flows be worth to you today if you could earn 8% on your deposits? $100/(1.08)1 $100 / (1.08)2 $100 / (1.08)3 $92.60 $85.73 $79.38 $257.71 CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 20 Present Value of an Annuity (continued) PVA = PMT x CH 08: The Time Value of Money ( 1- 1 (1+k)n k ) = 100 ( 1 1(1.08)3 .08 ) = 100(2.5771) = 257.71 Gallagher 7e: Textbook Media Press 21 Present Value of an Annuity Calculator Solution PV=? Enter: N =3 I/Y =8 PMT = 100 CPT PV = ? CH 08: The Time Value of Money -257.71 N I/YR 3 8 PV PMT FV ? -100 Gallagher 7e: Textbook Media Press 22 Annuities An annuity is a series of equal cash payments spaced evenly over time. Ordinary Annuity: The cash payments occur at the END of each time period. Annuity Due: The cash payments occur at the BEGINNING of each time period. CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 23 Future Value of an Annuity Due You deposit $100 each year (beginning of year) into a savings account. How much would this account have in it at the end of 3 years if interest were earned at a rate of 8% annually? CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 24 Future Value of an Annuity Due (continued) $100(1.08)3 $100(1.08)2 $100(1.08)1 FVA= ? $108 $116.64 $125.97 $ 350.61 You deposit $100 each year (beginning of year) into a savings account. How much would this account have in it at the end of 3 years if interest were earned at a rate of 8% annually? CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 25 Future Value of an Annuity Due (continued) FVA=? $100(1.08)2 $100(1.08)3 $100(1.08)1 You deposit $100 each year (beginning of year) into a savings account. How much would this account have in it at the end of 3 years if interest were earned at a rate of 8% annually? (1+.08)3 - 1 (1.08) = 100 .08 (1+k)n - 1 FVA = PMTx ( CH 08: The Time Value of Money k ) (1+k) ( $108 $116.64 $125.97 $ 350.61 ) = 100(3.2464)(1.08)=350.61 Gallagher 7e: Textbook Media Press 26 Present Value of an Annuity Due How much would the following cash flows be worth to you today if you could earn 8% on your deposits? FVA=? PV=? CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 27 Present Value of an Annuity Due (continued) $100/(1.08)0 $100/(1.08)1 $100 / (1.08)2 $100.00 $92.60 $85.73 $278.33 CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 28 Present Value of an Annuity Due (continued) 1 1 - (1+k)n PVA = PMTx k ( CH 08: The Time Value of Money 1 (1.08)3 (1.08) (1+k) = 100 .08 = 100(2.5771)(1.08) = 278.33 ) ( 1- Gallagher 7e: Textbook Media Press ) 29 Amortized Loans A loan that is paid off in equal amounts that include principal as well as interest. Solving for loan payments. CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 30 Amortized Loans (continued) You borrow $5,000 from your parents to purchase a used car. You agree to make payments at the end of each year for the next 5 years. If the interest rate on this loan is 6%, how much is your annual payment? 0 1 2 3 $5,000 $? $? $? ENTER: N =5 I/Y =6 PV = 5,000 CPT PMT = ? CH 08: The Time Value of Money 4 5 $? $? -1,186.98 N 5 I/YR 6 PV PMT FV 5,000 ? Gallagher 7e: Textbook Media Press 31 Amortized Loans (continued) You borrow $20,000 from the bank to purchase a used car. You agree to make payments at the end of each month for the next 4 years. If the annual interest rate on this loan is 9%, how much is your monthly payment? 1 1 - (1+k)n PVA = PMTx k ( $20,000 = PMT ) ( 1- 1 (1.0075)48 .0075 ) $20,000 = PMT(40.184782) PMT = 497.70 CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 32 Amortized Loans (continued) You borrow $20,000 from the bank to purchase a used car. You agree to make payments at the end of each month for the next 4 years. If the annual interest rate on this loan is 9%, how much is your monthly payment? ENTER: N = 48 I/YR = .75 PV = 20,000 CPT PMT = ? - 497.70 Note: N = 4 x 12 = 48 I/YR = 9/12 = .75 CH 08: The Time Value of Money N 48 I/YR PV PMT FV .75 20,000 ? Gallagher 7e: Textbook Media Press 33 Perpetuities A perpetuity is a series of equal payments at equal time intervals (an annuity) that will be received into infinity. PVP = PMT k CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 34 Perpetuities A perpetuity is a series of equal payments at equal time intervals (an annuity) that will be received into infinity. Example: A share of preferred stock pays a constant dividend of $5 per year. What is the present value if k =8%? PVP = PMT k CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 35 Perpetuities A perpetuity is a series of equal payments at equal time intervals (an annuity) that will be received into infinity. Example: A share of preferred stock pays a constant dividend of $5 per year. What is the present value if k =8%? PVP = PMT k If k = 8%: PVP = $5/.08 = $62.50 CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 36 Solving for k Example: A $200 investment has grown to $230 over two years. What is the ANNUAL return on this investment? 0 1 $200 2 $230 FV = PV(1+ k)n 230 = 200(1+ k)2 1.15 = (1+ k)2 1.151/2 = [(1+ k)2]1/2 1.0724 = 1+ k k = .0724 = 7.24% CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 37 Solving for k - Calculator Solution Example: A $200 investment has grown to $230 over two years. What is the ANNUAL return on this investment? Enter known values: N =2 I/Y = ? PV = -200 FV = 230 Solve for: CPT I/Y = ? 7.24 N 2 CH 08: The Time Value of Money I/YR PV ? -200 Gallagher 7e: Textbook Media Press PMT FV 230 38 Compounding More than Once per Year $500 invested at 9% annual interest for 2 years. Compute FV. Compounding Frequency $500(1.09)2 $500(1.045)4 $500(1.0225)8 $500(1.0075)24 $500(1.000246575)730 CH 08: The Time Value of Money = $594.05 = $596.26 = $597.42 = $598.21 = $598.60 Gallagher 7e: Textbook Media Press Annual Semi-annual Quarterly Monthly Daily 39 Continuous Compounding Compounding frequency is infinitely large. Compounding period is infinitely small. Example: $500 invested at 9% annual interest for 2 years with continuous compounding. FV = PV x ekn FV = $500 x e.09 x 2 = $598.61 CH 08: The Time Value of Money Gallagher 7e: Textbook Media Press 40 US 640 Financial Principles and Practice BUS 640 Week 6 September 29, 2016 Chapter 10 Chapter 10 CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 2 Learning Objectives 1. Explain the capital budgeting process. 2. Calculate the payback period, net present value, internal rate of return, and modified internal rate of return for a proposed capital budgeting project. 3. Describe capital rationing and how firms decide which projects to select. 4. Measure the risk of a capital budgeting project. 5. Explain risk-adjusted discount rates. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 3 The Capital Budgeting Process Capital budgeting is the process of evaluating proposed investment projects for a firm. Managers must determine which projects are acceptable and must rank mutually exclusive projects by order of desirability to the firm. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 4 The Accept/Reject Decision Four methods: Payback Period - years to recoup the initial investment Net Present Value (NPV) - change in value of firm if project is under taken Internal Rate of Return (IRR) - projected percent rate of return project will earn Modified Internal Rate of Return (MIRR) CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 5 Capital Budgeting Methods Consider Projects A and B that have the following expected cashflows: P R O J E C T Time 0 1 2 3 4 CH 10: Capital Budgeting Decision Methods A (10,000.) 3,500 3,500 3,500 3,500 B (10,000.) 500 500 4,600 10,000 Gallagher 7e: Textbook Media Press 6 Capital Budgeting Methods (continued) What is the payback for Project A? P R O J E C T Time 0 1 2 3 4 CH 10: Capital Budgeting Decision Methods A (10,000.) 3,500 3,500 3,500 3,500 B (10,000.) 500 500 4,600 10,000 Gallagher 7e: Textbook Media Press 7 Capital Budgeting Methods (continued) What is the payback for Project A? P R O J E C T Time 0 1 2 3 4 0 A (10,000.) 3,500 3,500 3,500 3,500 1 3,500 (10,000) Cumulative CF -6,500 CH 10: Capital Budgeting Decision Methods B (10,000.) 500 500 4,600 10,000 2 3 3,500 -3,000 3,500 +500 Gallagher 7e: Textbook Media Press 4 3,500 8 Capital Budgeting Methods (continued) What is the payback for Project A? P R O J E C T Time 0 1 2 3 4 0 A (10,000.) 3,500 3,500 3,500 3,500 1 3,500 (10,000) Cumulative CF -6,500 CH 10: Capital Budgeting Decision Methods B (10,000.) 500 500 4,600 10,000 2 3 3,500 -3,000 3,500 +500 Gallagher 7e: Textbook Media Press Payback in 2.9 years 4 3,500 9 Capital Budgeting Methods (continued) What is the payback for Project B? P R O J E C T Time 0 1 2 3 4 0 (10,000) CH 10: Capital Budgeting Decision Methods A (10,000.) 3,500 3,500 3,500 3,500 B (10,000.) 500 500 4,600 10,000 1 2 3 4 500 500 4,600 10,000 Gallagher 7e: Textbook Media Press 10 Capital Budgeting Methods (continued) What is the payback for Project B? P R O J E C T Time 0 1 2 3 4 0 (10,000) CH 10: Capital Budgeting Decision Methods A (10,000.) 3,500 3,500 3,500 3,500 B (10,000.) 500 500 4,600 10,000 Payback in 3.44 years 1 2 3 4 500 500 4,600 10,000 Gallagher 7e: Textbook Media Press 11 Payback Decision Rule Accept project if payback is less than the company's predetermined maximum. If company has determined that it requires payback in three years or less, then you would: - accept Project A - reject Project B CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 12 Capital Budgeting Methods (continued) Net Present Value Present value of all costs and benefits (measured in terms of incremental cash flows) of a project. Concept is similar to Discounted Cashflow model for valuing securities but subtracts the cost of the project. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 13 Capital Budgeting Methods (continued) Net Present Value Present value of all costs and benefits (measured in terms of incremental cash flows) of a project. Concept is similar to Discounted Cashflow model for valuing securities but subtracts of cost of project. NPV = PV of Inflows - Initial Investment NPV = CH 10: Capital Budgeting Decision Methods CF1 1 + (1+ k) CF2 (1+ k)2 + CFn .... (1+ k )n Gallagher 7e: Textbook Media Press - Initial Investment 14 What is the NPV for Project B? P R O J E C T Time 0 1 2 3 4 k=10% 0 (10,000) CH 10: Capital Budgeting Decision Methods 1 2 500 500 A (10,000) 3,500 3,500 3,500 3,500 B (10,000) 500 500 4,600 10,000 3 4 4,600 10,000 Gallagher 7e: Textbook Media Press 15 What is the NPV for Project B? P R O J E C T Time 0 1 2 3 4 k=10% 0 (10,000) 455 $500 (1.10) 1 413 1 2 500 500 $500 (1.10) 2 A (10,000.) 3,500 3,500 3,500 3,500 B (10,000.) 500 500 4,600 10,000 3 4 4,600 10,000 $4,600 (1.10) 3 3,456 CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 16 What is the NPV for Project B? P R O J E C T Time 0 1 2 3 4 k=10% 0 (10,000) 455 1 2 500 500 $500 (1.10) 1 413 3,456 6,830 CH 10: Capital Budgeting Decision Methods $500 (1.10) 2 A (10,000.) 3,500 3,500 3,500 3,500 B (10,000.) 500 500 4,600 10,000 3 4 4,600 10,000 $4,600 (1.10) 3 $10,000 (1.10) 4 Gallagher 7e: Textbook Media Press 17 P R O J E C T Time 0 1 2 3 4 What is the NPV for Project B? k=10% 0 (10,000) 1 2 500 500 A (10,000.) 3,500 3,500 3,500 3,500 B (10,000.) 500 500 4,600 10,000 3 4 4,600 10,000 455 413 3,456 6,830 $11,154 CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 18 P R O J E C T Time 0 1 2 3 4 What is the NPV for Project B? k=10% 0 (10,000) 455 413 3,456 6,830 $11,154 CH 10: Capital Budgeting Decision Methods 1 2 500 500 A (10,000.) 3,500 3,500 3,500 3,500 B (10,000.) 500 500 4,600 10,000 3 4 4,600 10,000 PV Benefits > PV Costs $11,154 > $ 10,000 Gallagher 7e: Textbook Media Press 19 P R O J E C T Time 0 1 2 3 4 What is the NPV for Project B? k=10% 0 (10,000) 455 413 1 2 500 500 A (10,000.) 3,500 3,500 3,500 3,500 B (10,000.) 500 500 4,600 10,000 3 4 4,600 10,000 PV Benefits > PV Costs $11,154 > $ 10,000 3,456 6,830 $11,154 - $10,000 = $1,154 = NPV CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press NPV > $0 $1,154 > $0 20 NPV Decision Rule Accept the project if the NPV is greater than or equal to 0. Example: NPVA = $1,095 >0 Accept NPVB = $1,154 >0 Accept If projects are independent, accept both projects. If projects are mutually exclusive, accept the project with the higher NPV. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 21 Capital Budgeting Methods (continued) IRR (Internal Rate of Return) - IRR is the discount rate that forces the NPV to equal zero. - It is the rate of return on the project given its initial investment and future cash flows. The IRR is the rate earned only if all CFs are reinvested at the IRR rate. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 22 Calculate the IRR (through trial and error) IRRA NPVA = 0 =(3,500 x 1- 1 (1 + k)4 k ) - 10,000 k = .1496 = 14.96% = IRRA IRRB 500 500 4600 10000 NPVB = 0 = + + + - 10,000 1 2 3 4 (1+k) (1+k) (1+k) (1+k) k = .135 = 13.5% = IRRB CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 23 IRR Decision Rule Accept the project if the IRR is greater than or equal to the required rate of return (k). Reject the project if the IRR is less than the required rate of return (k). Example: k = 10% IRRA = 14.96% > 10% Accept IRRB = 13.50% > 10% Accept CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 24 Capital Budgeting Methods (continued) MIRR (Modified Internal Rate of Return) - This is the discount rate which causes the project's PV of the outflows to equal the project's TV (terminal value) of the inflows. TVinflows PVoutflow = n (1 + MIRR) - Assumes cash inflows are reinvested at k, the cost of capital. - MIRR avoids the problem of multiple IRRs (described later). CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 25 P R O J E C T What is the MIRR for Project B? Time 0 1 2 3 4 k=10% 0 1 (10,000) A (10,000.) 3,500 3,500 3,500 3,500 2 500 500 500(1.10)3 500(1.10)2 B (10,000.) 500 500 4,600 10,000 3 4 4,600 4,600(1.10)1 10,000 10,000(1.10)0 10,000 5,060 605 666 (10,000) 10,000 = CH 10: Capital Budgeting Decision Methods 16,331 (1 + MIRR)4 Gallagher 7e: Textbook Media Press 16,331 MIRR = .1305 = 13.05% 26 Calculate NPV and IRR for Project A NPV = $1,094.53 IRR = 14.96% Which project(s) should the firm accept? NPV IRR A $1,095 14.96% B $1,154 13.5% CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 27 NPV/IRR Decision Rules IRRProject A > IRRProject B NPVProject B > NPVProject A If projects A & B are independent, accept both projects If projects A & B are mutually exclusive, there is a ranking conflict. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 28 Net Present Value Profile Graphs the Net Present Value of the project with different required rates 6,000 Project A N P V P R O J E C T Time 0 1 2 3 4 3,000 0 A (10,000) 3,500 3,500 3,500 3,500 B (10,000) 500 500 4,600 10,000 Cost of Capital 5% 10% 15% 20% Intersects the X axis at the IRR CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 29 Risk in Capital Budgeting Project risk needs to be considered in comparing projects with different levels of risk. The discount rate can be adjusted for risk when NPV is used to evaluate projects. The hurdle rate can be adjusted when IRR is used to evaluate projects. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 30 Crossover Point N P V Crossover Point 6,000 Project B There is a ranking conflict between NPV and IRR to the left of the crossover point. 3,000 Project A Cost of Capital 0 5% CH 10: Capital Budgeting Decision Methods 10% 15% Gallagher 7e: Textbook Media Press 20% 31 What Is Capital Rationing? Capital rationing is the practice of placing a dollar limit on the total size of the capital budget. This practice may not be consistent with maximizing shareholder value but may be necessary for other reasons. Choose between projects by selecting the combination of projects that yields the highest total NPV without exceeding the capital budget limit. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 32 Comparing Risky Projects Using Risk Adjusted Discount Rates (RADRs) Firms often compensate for risk by adjusting the discount rate used to calculate NPV. - Higher risk, use a higher discount rate. - Lower risk, use a lower discount rate The risk-adjusted discount rate (RADR) can also be used as a risk-adjusted hurdle rate for IRR comparisons. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 33 Non-simple Projects Non-simple projects have one or more negative future cash flows after the initial investment. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 34 Non-simple Projects (continued) How would a negative cash flow in year 4 affect Project Z's NPV? k=10% 0 (10,000) 1 2 3 5,000 5,000 5,000 4 -6,000 4,545 4,132 3,757 -4,098 8,336 - $10,000 = -$1,664 NPV Project Z should be rejected in this case. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 35 Multiple IRRs Some non-simple projects may have more than one discount rate that results in an NPV of zero (IRRs). Example: - Cash Flows: - to: (160,000) - t1: 1,000,000 - t2: (1,000,000) CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 36 Multiple IRRs (continued) When k=25% - $1,000,000 - $1,000,000 - $160,000 (1+.25)1 (1+.25)2 = $800,000 - $640,000 - $160,000 - NPV= $0 Note: When k = .25, the NPV = 0 CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 37 Multiple IRRs (continued) When k=400% - $1,000,000 - $1,000,000 - $160,000 (1+4.00)1 (1+4.00)2 = $200,000 - $40,000 - $160,000 - NPV = 0 Note: When k = 4.00, the NPV also = 0 THIS PROJECT HAS TWO IRRS!!! CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 38 Multiple IRRs (continued) Non-simple projects may have, but do not have to have, as many IRRs as there are sign changes. If a project has more than one IRR, use the NPV method for project accept/reject decisions. CH 10: Capital Budgeting Decision Methods Gallagher 7e: Textbook Media Press 39 US 640 Financial Principles and Practice BUS 640 Week 6 September 29, 2016 Chapter 11 Chapter 11 CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 2 Learning Objectives Difference between incremental cash flows and sunk costs. Identify different types of incremental cash flows. Know why financing cash flows are not included in the analysis. CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 3 What is an \"Incremental Cash Flow\"? Incremental cash flows are cash flows that will occur if a capital budgeting project is accepted, but that will not occur if the investment is rejected. The cash flows of the firm with the project minus the cash flows of the firm without the project. CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 4 Types of Incremental Cash Flows Initial investment cash flow Includes purchase price of asset, installation and delivery costs, and any investment for needed additions to net working capital tied to the project. Operating cash flows Includes revenues and expenses, taxes (including CFs due to tax-deductible depreciation expense), opportunity costs and externalities. Shut down cash flows Include after-tax salvage value and reduction in net working capital. CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 5 Measure Incremental Cash Flows Measure cash flows that change if a project is undertaken. Do not include sunk costs. Do not include allocation of existing overhead (do include additions to overhead tied to the proposed project). Do subtract lost sales of other products if they occur only if this project is accepted. Include cost savings as a positive cash flow. CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 6 Illustration of Project Cash Flows Initial Investment Cash Flow 0 1 2 3 Initial Investment CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 7 Illustration of Project Cash Flows (continued) Initial Investment Cash Flow Operating Cash Flows 0 1 Initial Investment CH 11: Estimating Incremental Cash Flows 2 3 Operating Cash Flows Gallagher 7e: Textbook Media Press 8 Illustration of Project Cash Flows (continued) Initial Investment Cash Flow Operating Cash Flows Shut Down Cash Flow 0 1 Initial Investment CH 11: Estimating Incremental Cash Flows 2 3 Operating Cash Flows Gallagher 7e: Textbook Media Press Shutdown Cash Flow 9 Estimating Cash Flows Example: Example: Gasperini GasperiniCorp. Corp. isisconsidering consideringreplacing replacingtheir theirold old production productionmachine machinewith withaa new new one. one. cost of the new machine $48,000 cost of the new machine $48,000 installation and delivery cost $2,000 installation and delivery cost $2,000 investment in additional NWC $3,000 investment in additional NWC $3,000 training costs $4,000 training costs $4,000 old machine salvage $10,000 old machine salvage $10,000 old machine book value $$00 old machine book value marginal tax rate 40% marginal tax rate 40% CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 10 Estimating Cash Flows (continued) Initial Investment Cost of Machine CH 11: Estimating Incremental Cash Flows 48,000 Gallagher 7e: Textbook Media Press 11 Estimating Cash Flows (continued) Initial Investment Cost of Machine Installation & Shipping Net Working Capital Training (after tax) 48,000 2,000 3,000 2,400 4,000(1-.4) 55,400 CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 12 Estimating Cash Flows (continued) Initial Investment Cost of Machine Installation & Shipping Net Working Capital Training (after tax) 48,000 2,000 3,000 2,400 55,400 Less: Sale of Old Machine Salvage Value -Taxes (40%) Tax rate x (Salvage Value-Book Value) 10,000 - 4,000 Initial Outlay CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 13 Estimating Cash Flows (continued) Initial Investment Cost of Machine Installation & Shipping Net Working Capital Training (after tax) 48,000 2,000 3,000 2,400 55,400 Less: Sale of Old Machine Salvage Value -Taxes 10,000 - 4,000 - 6,000 49,400 Initial Outlay 0 1 2 3 4 5 -49,400 CF CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 14 Estimating Cash Flows Operating Cash Flows Example Example (continued): (continued): Expected Expected increase increasein inrevenues revenues Decrease Decreasein incosts costs Life Lifeof ofproject project Sale Saleprice priceof ofmachine machine in in44yrs. yrs. Assume AssumeMACRS MACRS33year yearlife life CH 11: Estimating Incremental Cash Flows $5,000/yr. $5,000/yr. $8,000/ $8,000/ yr. yr. 44years years $15,000 $15,000 Gallagher 7e: Textbook Media Press 15 MACRS (Modified Accelerated Cost Recovery System) Depreciation Half year convention: Assumes asset put in place in middle of year. Therefore, can deduct 1/2 year expense in first and last year. Three-year life gets deductions spread over four years. MACRS table in text provides percentage deductions for different lives. 1 33% CH 11: Estimating Incremental Cash Flows 2 45% 3 15% Gallagher 7e: Textbook Media Press 4 7% (rounded) 16 Calculation of Depreciation Depreciable basis equals purchase price plus shipping and installation = $48,000 (purchase price) + 2,000 (shipping and delivery) $50,000 Deductions: CH 11: Estimating Incremental Cash Flows .33 x $50,000 = .45 x $50,000 = .15 x $50,000 = .07 x $50,000 = $16,500 $22,500 $7,500 $3,500 Gallagher 7e: Textbook Media Press 17 Project Operating Cash Flows 1 + Inc. Rev. 5,000 + Decr. Costs 8,000 - Inc.Depr. Exp.16,500 2 5,000 8,000 22,500 3 5,000 8,000 7,500 4 5,000 8,000 3,500 Change in Oper. Income -9,500 5,500 9,500 CH 11: Estimating Incremental Cash Flows -3,500 Gallagher 7e: Textbook Media Press 18 Project Operating Cash Flows (continued) 1 45,000 + Inc. Rev. + Decr. Costs 8,000 - Inc. Depr. Exp.16,500 Change in Oper. Income -3,500 -Tax (40%) (1,400) After Tax -2,100 CH 11: Estimating Incremental Cash Flows 2 5,000 8,000 22,500 3 5,000 8,000 7,500 5,000 8,000 3,500 -9,500 (3,800) -5,700 5,500 2,200 3,300 9,500 3,800 5,700 Gallagher 7e: Textbook Media Press 19 Project Operating Cash Flows (continued) 1 2 + Inc. Rev. 5,000 + Decr. Costs 8,000 - Inc. Depr. Exp. 16,500 Change in Oper. Income -3,500 -Tax (40%) (1,400) After Tax Inc -2,100 +Depr. 16,500 Net Op. CF 14,400 CH 11: Estimating Incremental Cash Flows 3 4 5,000 8,000 22,500 5,000 8,000 7,500 5,000 8,000 3,500 -9,500 (3,800) -5,700 22,500 16,800 5,500 2,200 3,300 7,500 10,800 9,500 3,800 5,700 3,500 9,200 Gallagher 7e: Textbook Media Press 20 Externalities Positive or negative effects on existing projects Part of incremental cash flow analysis Often difficult to estimate CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 21 Real Options Opportunity to revise a project at a later date that exists for some projects Link to real-options.com CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 22 Real Options (continued) Opportunity to revise a project at a later date that exists for some projects If present, the flexibility existing in this real option adds value to the project Link to Charted Financial Analyst CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 23 Real Options (continued) Opportunity to revise a project at a later date that exists for some projects If present, the flexibility existing in this real option adds value to the project The option to revise the project is only exercised when it is in the firm's interest to do so Link to Charted Financial Analyst CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 24 Real Options (continued) Opportunity to revise a project at a later date that exists for some projects If present, the flexibility existing in this real option adds value to the project. The option to revise the project is only exercised when it is in the firm's interest to do so. The value added to a project from a real option is often difficult to estimate. CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 25 Real Options (continued) There are financial models, such as the BlackScholes Model, that can help to estimate the value added to a project by a real option. The use of such models is usually covered in an advanced finance course. Many companies use an ad-hoc approach to estimate the real value created when a project has a real option associated with it. CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 26 Real Options (example) t0 t1 t2 8,000 t3 8,000 t4 8,000 .40 .20 6,000 4,000 -5,000 6,000 5,000 .30 5,000 .40 5,000 -10,000 .40 3,000 .32,000 0 2,000 Sum: 1.00 3,000 2,000 t5 0.12 Prob. NPV 5,946 Product 714 6,000 0.06 1,836 0.12 -220 -26 3,000 3,000 2,000 2,000 3,000 0.30 110 0.40 1,372 -2,418 -725 549 Exp. NPV = $622 Required rate of return (k) = 10% CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 27 Shut Down Cash Flows Sale price of asset at the end of 4 years has tax consequences. Taxable amount : Sale price - basis. Depreciation basis is the original basis minus accumulated depreciation. In this problem, the asset is fully depreciated in year 4, so the basis = 0. The sale price is thus fully taxable. Firm also recovers the increase in NWC. CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 28 Shut Down Cash Flows Summary of shut down cash flows: Sale of asset $15,000 Tax on sale 6,000 Net Sale $ 9,000 Return of NWC 3,000 Total shutdown $12,000 CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 29 Summary of Project Cash Flows 0 1 2 3 4 Init. Invest. 49,400 Net Op. CF 14,400 16,800 10,800 Shut down CF 12,000 TOTAL CF -49,400 CH 11: Estimating Incremental Cash Flows 9,200 14,400 16,800 10,800 Gallagher 7e: Textbook Media Press 21,200 30 Calculate NPV and IRR For the project if cost of capital = 10% P/YR CF CH 11: Estimating Incremental Cash Flows NPV IRR Enter Net Cash Flows: CF0 = -49,400 C01 = 14,400 C02 = 16,800 C03 = 10,800 C04 = 21,200 Gallagher 7e: Textbook Media Press 31 Calculate NPV and IRR For the project if cost of capital = 10% P/YR CF NPV IRR Enter Net Cash Flows: CF0 = -49,400 C01 = 14,400 C02 = 16,800 C03 = 10,800 C04 = 21,200 NPV: I = 10% CPT NPV = $169.29 CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 32 Financing Cash Flows Why are financing cash flows not included in our analysis of incremental cash flows of a project? Consider the NPV equation: CFt (1+k)t -The financing costs are already included in the discount rate k. If we also included them in the CF, we would be double counting. CH 11: Estimating Incremental Cash Flows Gallagher 7e: Textbook Media Press 33 US 640 Financial Principles and Practice BUS 640 Week 7 October 6, 2016 Chapter 13 Chapter 13 CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 2 Learning Objectives Break-even level of sales. Operating and financial leverage and risk. Risks and returns of leveraged buy-outs (LBOs). Effect of capital structure on value. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 3 Break-even Analysis Steps to Solution Construct a chart to find the sales break-even point = level of sales necessary to cover operating (not financial) costs. This requires that you calculate EBIT for different unit sales amounts. The point at which EBIT = 0 is the break-even level of sales. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 4 Break-even Analysis (continued) Assumptions - Fixed costs remain constant as quantity changes. - Variable costs vary as quantity of output changes. Costs $ Variable Costs Fixed Costs Units Produced CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 5 Fixed vs. Variable Costs Fixed costs may include salaries, depreciation, rent. Variable costs may include commissions, materials, labor. This is a generalization. For example, some salaries may be considered fixed and others variable. In the long-run all costs are variable. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 6 Break-even Analysis (continued) Calculation of Break-even Quantity EBIT = Sales - Variable Costs - Fixed Costs Find Quantity which results in EBIT = $0 CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 7 Break-even Analysis (continued) Calculation of Break-even Quantity Unit Salesbe = FC p - vc Where: Unit Salesbe= Break-even quantity FC = Total fixed costs p = Sales price per unit vc = Variable costs per unit CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 8 Break-even Analysis (continued) Calculation of Break-even Quantity Unit Salesbe = Example: Fixed Costs Price Variable Costs CH 13: Capital Structure Basics FC p - vc = $1,000,000/year = $800/unit = $400/unit Gallagher 7e: Textbook Media Press 9 Break-even Analysis (continued) Calculation of Break-even Quantity Unit Salesbe = Example: Fixed Costs Price Variable Costs CH 13: Capital Structure Basics FC p - vc = $1,000,000/year = $800/unit = $400/unit = $1,000,000 $800 - $400 = 2,500 units Gallagher 7e: Textbook Media Press 10 Break-even Analysis (continued) Now calculate total revenue. TR = p x Q p = sales price per unit Q = unit sales CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 11 Break-even Analysis (continued) Calculate total revenue for different levels of sales. TR = p x Q Unit sales (Q) x 0 x 500 x 1,000 x 2,000 x 2,500 x CH 13: Capital Structure Basics Price (p) $800 $800 $800 $800 $800 = Total Revenue (TR) = $ 0 = $ 400,000 = $ 800,000 = $1,600,000 = $2,000,000 Gallagher 7e: Textbook Media Press 12 Graphical Analysis of Break-even Point Total Costs Step 1: Variable Costs Fixed Costs Quantity Produced CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 13 Graphical Analysis of Break-even Point (continued) Total Costs Step 2: Total Costs Variable Costs $1,000,000 Fixed Costs Quantity Produced CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 14 Graphical Analysis of Break-even Point (continued) Total Costs & Revenue Total Revenue Step 3: Total Costs $1,000,000 Variable Costs Fixed Costs Quantity Produced and Sold CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 15 The Break-even Graph The slope of the total revenue line is p, the price per unit. The slope of the total cost line is vc, the variable cost per unit. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 16 Graphical Analysis of Break-even Point (continued) Total Costs & Revenue Total Revenue Total Costs $2,000,000 $1,000,000 Variable Costs Fixed Qbe = 2,500 Costs Quantity Produced and Sold CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 17 The Concept of Leverage You cannot easily move a large boulder. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 18 The Concept of Leverage (continued) However, with the aid of a lever you can move an object many times your size. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 19 The Concept of Leverage (continued) The longer the lever, the bigger the rock you can move. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 20 The Concept of Leverage (continued) In a financial context, the magnifying power of leverage can be used to help (or hurt) a firm's financial performance. Operating leverage occurs due to fixed costs in the production process. With high fixed operating costs, a small change in sales will trigger a large change in operating income (EBIT). CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 21 Operating Leverage Measurement of Operating Leverage - Degree of Operating Leverage (DOL) DOL = % Change in EBIT % Change in Sales DOL > 1 means the firm has operating leverage. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 22 Operating Leverage (continued) DOL = DOL= CH 13: Capital Structure Basics % Change in EBIT % Change in Sales ($1 - $.5) / $.5 ($4 - $3) / $3 = 100 33.33 Gallagher 7e: Textbook Media Press = 3.0 23 Operating Leverage (continued) Measurement of DOL - Calculation using alternate formula: DOL = Sales - Total VC Sales -Total VC - FC CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 24 Operating Leverage (continued) Measurement of DOL - Calculation using alternate formula: DOL = Sales - Total VC Sales -Total VC - FC DOL = ($3 - $1.5) / ($3 - $1.5 - $1) = 1.5 / .5 =3 CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 25 Operating Leverage (continued) Measurement of DOL - Calculation using alternate formula: DOL = Sales - Total VC Sales -Total VC - FC Example: Q P VC FC CH 13: Capital Structure Basics = = = = 3,750 units $800 per unit $400 per unit $1,000,000 per year. Gallagher 7e: Textbook Media Press 26 Operating Leverage (continued) Measurement of DOL - Calculation using alternate formula: DOL = Sales - Total VC Sales -Total VC - FC DOL3,750 units = 3,750(800) - 3,750(400) 3,750(800) -3,750(400) - 1,000,000 = 3 CH 13: Capital Structure Basics Interpretation: If sales change 1%, then EBIT will change 3% (same direction). Gallagher 7e: Textbook Media Press 27 Operating Leverage (continued) Degree of Operating Leverage falls as sales rise Quantity 2,500 (Qbe) 3,250 3,750 5,000 CH 13: Capital Structure Basics DOL Undefined 4.33 3 2 Gallagher 7e: Textbook Media Press 28 Operating Leverage (continued) Degree of Operating Leverage falls as sales rise Quantity 2,500 (Qbe) 3,250 3,750 5,000 - DOL Undefined 4.33 3 2 The higher the sales level above break-even, the less the percent change in EBIT for a given percent change in sales. If FC = $0, DOL = 1 CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 29 Financial Leverage Degree of Financial Leverage - Finance a portion of the firm's assets with securities that have fixed financial costs Debt Preferred Stock - Financial Leverage measures changes in earnings per share as EBIT changes. DFLEBIT = % Change in NI % Change in EBIT Base Level of EBIT CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 30 Financial Leverage (continued) Example: EBIT1 = $500,000 EBIT2 = $1,000,000 NI1 = $180,000 NI2 = $480,600 DFL = DFL= CH 13: Capital Structure Basics % Change in NI % Change in EBIT (480.6 - 180) / 180 ($1 - $.5) / $.5 = 167 Gallagher 7e: Textbook Media Press 100 = 1.67 31 Financial Leverage (continued) Measurement of DFL (Alternate formula) DFLEBIT = - EBIT EBIT - I - If DFL > 1, the firm has financial leverage. A given percent change in EBIT will result in a larger percent change in NI. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 32 Financial Leverage (continued) Example: EBIT = $500,000 Interest Charges = $200,000 DFLEBIT=500,000 = 500,000 500,000 - 200,000 = 1.67 times Interpretation: When EBIT changes 1% (from an existing level of $50,000) Net Income will change 1.67% in the same direction. Link to CBS Market Watch CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 33 Combined Leverage Degree of Combined Leverage - Measures changes in Net Income given changes in Sales - Combines both operating and financial leverage - Computed for a specific level of sales % Change in NI DCLS = % Change in Sales Base Level of Sales CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 34 Combined Leverage (continued) Example: SALES1 = $3,000,000 SALES2 = $4,000,000 NI1 = $180,000 NI2 = $480,600 % Change in NI DCL = % Change in Sales DCL= CH 13: Capital Structure Basics (480.6 - 180) / .180 ($4 - $3) / $3 = Gallagher 7e: Textbook Media Press 166.7 33.3 = 5.0 35 Combined Leverage (continued) DCLS = DOLS x DFLEBIT Example: DOLS = 3.0 DFLEBIT = 1.67 DCL3,750 = 3.0 x 1.67 = 5.0 times CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 36 Combined Leverage (continued) DCLS = Sales - VC Sales - VC - FC - I Example: 3,750(800) - 3,750(400) DCL3,750 = 3,750(800) - 3,750(400) - 1,000,000 - $200,000 = 3 mil - 1.5 mil 3 mil - 1.5 mil - 1 mil - .2 mil = 1,500,000 300,000 = 5 CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 37 Combined Leverage (continued) DCLSS = DOLSS x DFLEBIT EBIT Example: DOLS = 3.0 DFLEBIT = 1.67 DCL3,750 = 3.0 x 1.67 = 5.0 times Interpretation: When sales change 1%, Net Income will change 5.0% in the same direction CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 38 Effect of Leverage Leverage can help the firm or hurt it. If EBIT increases, financial leverage will magnify the increase in net income. If EBIT decreases, financial leverage will magnify the decrease in net income. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 39 Capital Structure Theory Capital structure is the mixture of sources of funds a firm uses. - Debt - Preferred Stock - Common Stock CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 40 Capital Structure Theory (continued) A benefit of debt financing is that interest is tax deductible to the paying firm whereas payments to equity providers are not. Firms must trade-off this benefit against the increased financial risk associated with higher debt levels. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 41 Capital Structure Theory Modigliani and Miller (M&M) M&M wrote an important paper in 1958 in which they proved that with certain assumptions there is no optimal capital structure. One is as good as any other. M&M's Assumptions: No transaction costs, no taxes, everyone has same information and borrowing rates, debt is riskless, debt does not affect operations. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 42 Capital Structure Theory Modigliani and Miller (M&M) (continued) In a later paper, M&M showed that when the tax deductibility of interest is considered, their model indicates that a capital structure of 100% debt is optimal. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 43 Capital Structure in the Real World Firms attempt to balance the costs and benefits of debt to reach the optimal mix that maximizes the value of the firm. Affect on costs of capital: - Since debt is cheaper than equity, use of debt will initially lower the WACC. - At high levels of debt, the WACC will increase as investors perceive the risk of the firm to be increasing substantially. CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 44 Cost of Capital and Capital Structure CH 13: Capital Structure Basics Gallagher 7e: Textbook Media Press 45 US 640 Financial Principles and Practice BUS 640 Week 7 October 6, 2016 Chapter 9 Learning Objectives Sources of capital Cost of each type of funding Calculation of the weighted average cost of capital (WACC) Construction and use of the marginal cost of capital schedule (MCC) CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 3 Factors Affecting the Cost of Capital General Economic Conditions - Affect interest rates Market Conditions - Affect risk premiums Operating Decisions - Affect business risk Financial Decisions - Affect financial risk Amount of Financing - Affects flotation costs and market price of security CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 4 Weighted Cost of Capital Model Compute the cost of each source of capital Determine percentage of each source of capital in the optimal capital structure Calculate Weighted Average Cost of Capital (WACC) CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 5 Weighted Cost of Capital Model (continued) 1. Compute Cost of Debt Required rate of return for creditors. Same cost found in Chapter 12 as yield to maturity on bonds (k d). e.g., Suppose that a company issues bonds with a before tax cost of 10%. Since interest payments are tax deductible, the true cost of the debt is the after tax cost. If the company's tax rate (state and federal combined) is 40%, the after tax cost of debt AT kd = 10%(1-.4) = 6%. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 6 Weighted Cost of Capital Model (continued) 2. Compute Cost Preferred Stock Cost to raise a dollar of preferred stock. Required rate kp = Dividend (Dp) Market Price (PP) - F Example: You can issue preferred stock for a net price of $42 and the preferred stock pays a $5 dividend. The cost of preferred stock: kp = CH 09: The Cost of Capital $5.00 = 11.90% $42.00 Gallagher 7e: Textbook Media Press 7 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Two Types of Common Equity Financing: - Retained Earnings (internal common equity) - Issuing new shares of common stock (external common equity) CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 8 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of Internal Common Equity - Management should retain earnings only if they earn as much as stockholders' next best investment opportunity of the same risk. - Cost of Internal Equity = opportunity cost of common stockholders' funds. - Two methods to determine Dividend Growth Model Capital Asset Pricing Model CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 9 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity - Dividend Growth Model kS = CH 09: The Cost of Capital D1 P0 + g Gallagher 7e: Textbook Media Press 10 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity - Dividend Growth Model kS = D1 P0 + g Example: The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 11 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity - Dividend Growth Model kS = Example: D1 P0 + g The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 12 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity - Capital Asset Pricing Model (Chapter 7) kS = kRF + (kM - kRF) CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 13 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity - Capital Asset Pricing Model (Chapter 7) kS = kRF + (kM - kRF) Example: The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 14 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity - Capital Asset Pricing Model (Chapter 7) kS = kRF + (kM - kRF) Example: The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%. kS = 5% + 1.2(13% - 5%) = 14.6% CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 15 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of New Common Stock - Must adjust the Dividend Growth Model equation for floatation costs of the new common shares. D1 kn = + g P0 - F Link to Daily Stocks CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 16 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of New Common Stock - Must adjust the Dividend Growth Model equation for floatation costs of the new common shares. D1 kn = + g P0 - F Example: If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%, Price is $60 as before. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 17 Weighted Cost of Capital Model (continued) 3. Compute Cost of Common Equity Cost of New Common Stock - Must adjust the Dividend Growth Model equation for floatation costs of the new common shares. D1 kn = + g P0 - F Example: If additional shares are issued floatation costs will be 12%. D 0 = $3.00 and estimated growth is 10%, Price is $60 as before. kn = 3(1+0.10) + .10 = .1625 = 16.25% 52.80 CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 18 Weighted Cost of Capital Gallagher Corporation estimates the following costs for each component in its capital structure: Source of Capital Bonds Preferred Stock Common Stock Retained Earnings New Shares Cost kd = 10% kp = 11.9% ks = 15% kn = 16.25% Gallagher's tax rate is 40% CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 19 Weighted Cost of Capital (continued) If using retained earnings to finance the common stock portion the capital structure: WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 20 Weighted Cost of Capital (continued) If using retained earnings to finance the common stock portion the capital structure: WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) Assume that Gallagher's desired capital structure is 40% debt, 10% preferred and 50% common equity. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 21 Weighted Cost of Capital (continued) If using retained earnings to finance the common stock portion the capital structure: WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) Assume that Gallagher's desired capital structure is 40% debt, 10% preferred and 50% common equity. WACC = .40 x 10% (1-.4) + .10 x 11.9% + .50 x 15% = 11.09% CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 22 Weighted Cost of Capital (continued) If using a new equity issue to finance the common stock portion the capital structure: WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 23 Weighted Cost of Capital (continued) If using a new equity issue to finance the common stock portion the capital structure: WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) WACC = .40 x 10% (1-.4) + .10 x 11.9% + .50 x 16.25% = 11.72% CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 24 Marginal Cost of Capital Gallagher's weighted average cost will change if one component cost of capital changes. This may occur when a firm raises a particularly large amount of capital such that investors think that the firm is riskier. The WACC of the next dollar of capital raised in called the marginal cost of capital (MCC). CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 25 Graphing the MCC curve Assume now that Gallagher Corporation has $100,000 in retained earnings with which to finance its capital budget. We can calculate the point at which they will need to issue new equity since we know that Gallagher's desired capital structure calls for 50% common equity. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 26 Graphing the MCC curve (continued) Assume now that Gallagher Corporation has $100,000 in retained earnings with which to finance its capital budget. We can calculate the point at which they will need to issue new equity since we know that Gallagher's desired capital structure calls for 50% common equity. Available Retained Earnings Breakpoint = Percentage of Total CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 27 Graphing the MCC curve (continued) Breakpoint = ($100,000)/.5 = $200,000 CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 28 Making Decisions Using MCC Weighted Cost of Capital Marginal weighted cost of capital curve: CH 09: The Cost of Capital 11.72% 12% 11% 11.09% 10% Using new common equity Using internal common equity 9% 0 100,000 200,000 Total Financing Gallagher 7e: Textbook Media Press 300,000 400,000 29 Making Decisions Using MCC Graph IRRs of potential projects Weighted Cost of Capital Marginal weighted cost of capital curve: CH 09: The Cost of Capital 12% 11% Project 1 IRR = 12.4% 10% Project 2 IRR = 12.1% Project 3 IRR = 11.5% 9% 0 100,000 200,000 Total Financing Gallagher 7e: Textbook Media Press 300,000 400,000 30 Making Decisions Using MCC (continued) Graph IRRs of potential projects Graph MCC Curve Weighted Cost of Capital Marginal weighted cost of capital curve: CH 09: The Cost of Capital 11.72% 12% 11.09% 11% Project 1 IRR = 12.4% 10% Project 2 IRR = 12.1% Project 3 IRR = 11.5% 9% 0 100,000 200,000 Total Financing Gallagher 7e: Textbook Media Press 300,000 400,000 31 Making Decisions Using MCC (continued) Graph IRRs of potential projects Graph MCC Curve Weighted Cost of Capital Marginal weighted cost of capital curve: CH 09: The Cost of Capital 12% 11.72% 11.09% 11% Project 1 IRR = 12.4% 10% Project 2 IRR = 12.1% Project 3 IRR = 11.5% Accept Projects #1 & #2 9% 0 100,000 200,000 Total Financing Gallagher 7e: Textbook Media Press 300,000 400,000 32 Crowdfunding Crowdfunding is a relatively recent phenomenon whereby companies raise capital from a large number of different people who have a connection with the company. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 33 Crowdfunding (continued) These suppliers of capital could be customers of the company. The word \"company\" is used loosely here. The suppliers of the capital could be fans of a musical group. Those fans could offer capital to the musicians to finance the group's tour. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 34 Crowdfunding (continued) Crowdfunding is usually done through a website on the Internet such as Kickstarter. In April of 2012 President Obama signed the Jumpstart Our Business Startups (JOBS) Act. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 35 Jumpstart Our Business Startups (JOBS) Act Eligible companies, designated as emerging growth companies (EGCs) Allowed to raise up to $1 million over a twelve-month period from small investors without going through the normal Securities and Exchange Commission (SEC) registration process. CH 09: The Cost of Capital Gallagher 7e: Textbook Media Press 36 US 640 Financial Principles and Practice BUS 640 Week 8 October 13, 2016 Chapter 21 CH 21: International Finance Gallagher 7e Textbook Media Press 2 Learning Objectives What are multinational corporations (MNCs) and why are international issues important? How does comparative advantage lead to beneficial international trade? Understand exchange rates and their risk. Understand political and cultural risks. How do international trade agreements affect business? CH 21: International Finance Gallagher 7e Textbook Media Press 3 What Is a Multinational Corporation? AA corporation corporation that that has has operations operations in in more more than than one one country country is is called called aa multinational multinational corporation corporation (MNC) (MNC) What What percent percent of of sales sales do do you you believe believe Nokia Nokia has has in in its its home home country country of of Finland? Finland? Link to European Market News CH 21: International Finance Gallagher 7e Textbook Media Press 4 Advantages of Foreign Operations Potential for growth in demand for products or services. - e.g., Eastern Europe Lower costs of labor or materials. - e.g., manufacturing of clothes and toys in Asia Political and tax advantages Link to Global Financial Info CH 21: International Finance Gallagher 7e Textbook Media Press 5 Comparative Advantage The \"law of comparative advantage\" says that each country should concentrate on that with which it has a comparative advantage. Comparative advantage is not the same as absolute advantage. Lebron James could be the best car mechanic in the world. He would have an absolute advantage over others. Others would have a comparative advantage, however. CH 21: International Finance Gallagher 7e Textbook Media Press 6 Comparative Advantage (continued) Coffee Coffee doesn't doesn't grow grow well well in in the the United United States States but but itit grows grows well well in in Brazil. Brazil. - e.g., The US generally produces better high technology products than does Brazil. CH 21: International Finance Trade benefits both countries. Gallagher 7e Textbook Media Press 7 Exchange Rates An exchange rate is an expression of the value of one country's currency in terms of another country's currency. e.g., How many Japanese yen per U.S. dollar or how many dollars per yen? Assume the exchange rate is 120.00 Japanese yen per U.S. dollar. If this value goes down, the U.S. dollar is said to be weakening relative to the yen. If the rate goes up, the dollar is strengthening (one dollar can buy more yen). Link to International And Foreign Exchange Data CH 21: International Finance Gallagher 7e Textbook Media Press 8 Exchange Rates (continued) e.g., How many U.S. dollars does it take to purchase one British pound? Assume the exchange rate is 1.54 U.S. dollars per British pound. If this value goes down, the U.S. dollar is said to be strengthening relative to the pound. The pound is less expensive to buy for a person holding dollars. If the rate goes up, the dollar is weakening. A pound is more expensive to buy with dollars. CH 21: International Finance Gallagher 7e Textbook Media Press 9 Cross Rates Computation of exchange rate from two other exchange rates: $/ rate = 1.54 /$ rate = 120.00 Example: Currency A Currency B Currency A Currency B x Currency C = Currency C How many yen per pound? = $ x $ = 1.54 x 120.00 = 184.80 Link to exchange rate and global financial info CH 21: International Finance Gallagher 7e Textbook Media Press 10 Exchange Rate Risk If a U.S. company buys products from foreign companies it is exposed to exchange rate risk. - Foreign exporters may ask for payment in their currency. - The U.S. company knows the current price in $ given today's exchange rate, but does not know the future exchange rate. If a company has sales in a foreign market, dollar sales receipts will fluctuate as exchange rates change. CH 21: International Finance Gallagher 7e Textbook Media Press 11 Exchange Rate Risk (continued) Translation Exposure - Assets and liabilities denominated in foreign currency may lose book value if the exchange rate changes. - Profits earned in other countries (in a foreign currency) may increase or decrease when converted to the home currency as they are repatriated. Transactions Exposure - A fixed price contract (receivables, payables, purchase or sale contracts) denominated in foreign currency is subject to transactions exposure. CH 21: International Finance Gallagher 7e Textbook Media Press 12 Exchange Rate Risk (continued) Economic Exposure - Overall effects of currency fluctuations on firm value - Caused by: Foreign competition Exports to foreign markets Imports of foreign supplies CH 21: International Finance Gallagher 7e Textbook Media Press 13 American Depository Receipts (ADRs) Special trusts are created in the U.S. and foreign stock is purchased and placed in these trusts. These trusts then issue their own securities, called American Depository Receipts (ADRs). These ADRs are denominated in U.S. dollars. CH 21: International Finance Gallagher 7e Textbook Media Press 14 Managing Risk Diversification - Foreign investments often help reduce overall risk when added to a portfolio of domestic assets. Hedging - Purchase or sale of financial contracts that have values that vary inversely with exchange rate risk. - Examples: futures contracts, forward contracts, and swap. Link to International Stock Info CH 21: International Finance Gallagher 7e Textbook Media Press 15 Standard Deviation of the Portfolio Returns Portfolio Risk as Diversification Changes Domestic investment only With foreign investment | | | | 10 20 30 40 Number of Securities in Portfolio CH 21: International Finance Gallagher 7e Textbook Media Press 16 Purchasing Power Parity Theory Purchasing power parity (PPP) theory says that the relative prices in two countries determine the exchange rate. Example: If a given basket of goods costs 100 euros and 110 U.S. dollars, the exchange rate should be 100 euros per 110 U.S. dollars (1.1 dollars per euro) according to PPP. CH 21: International Finance Gallagher 7e Textbook Media Press 17 The International Fisher Effect According to the Fisher effect, interest rates reflect not only the real rate of return but the expected inflation rate. The international Fisher effect (IFE) suggests that the exchange rate adjusts to cover the interest rate differential between two countries. e.g., If inflation increases in the U.S. but remains unchanged in Germany, the excha