PRINCIPLES OF FINANCIAL MANAGEMENT Capital Budgeting Decisions 1. Learning Objectives (a) Develop pro-forma Project Income Statement Using Excel Spreadsheet (b) Compute Net Project Cash flows, NPV, IRR and PayBack Period (c) Develop Problem Solving and Critical Thinking Skills 1) Project Life (years) 2) New equipment cost 3) Shipping & installment costs 4) Related start up cost 5) Inventory increase 6) Accounts Payable increase 7) Equip. Salvage Value Estimated at the End of Year 4 8) Sales for first year (1) 9) Sales increase per year 10) Operating cost (60 Percent of Sales) 11) Depreciation Straight Line = Initial Cost/YR 12) Tax rate 13) Cost of Capital (WACC) $(200,000) $ (35,000) $ (5,000) $ (25,000) $ (5,000) $ 15,000 $ 200,000 5% 60.00% $ (60,000) 35% 10% 1 2 3 4 YEAR Equipment cost Shipping and Install cost Start up expenses Total Capital Spending After Tax Salvage Value in Year 4: Salvage - T*(Salvage - Book Value) Net Working Capital (Inventory Increase - A/P Increase) 0 $ (200,000) $ (35,000) $ (5,000) $(240,000) $ 20,000 ? $ (20,000) Income Statement Revenue Operating Cost Depreciation EBIT Taxes Net Income (LOSS) $ 200,000 $210,000 $ 220,500 $ 231,525 $(120,000) $ (60,000) $ 20,000 $ 7,000 $ 13,000 ol 1 IN 3 4 Capital Spending NWC OCF Cash Flow from Assets NPV IRR Payback Q#1 Would you accept the project based on NPV, IRR? Would you accept the project based on Payback rule if project cut-off period is 3 years? Q#2 SENSITIVITY and SCENARIO ANALYIS: Capital Budgeting Investment ) Decisions (a) Estimate NPV, IRR and Payback Period of the project if the Marginal Corporate Tax is reduced to 20%. Would you accept or reject the project? Assume Straight-Line Depreciation. (b) Estimate NPV, IRR and Payback period of the project if Equipment is fully depreciated in first year and tax rate is reduced to 20%. Would you accept or reject the project? (c) As a CFO of the firm, which of the above two scenarios (a) or (b) would you choose? Why? Q#3 Explain to your CEO what the NPV results mean. Q#4 What are the advantages and disadvantages of using only the Payback method? Q#5 What are the advantages and disadvantages of using NPV versus IRR? Q#6 Explain the difference between independent projects and mutually exclusive projects. When you are confronted with Mutually Exclusive Projects and have conflicts with NPV and IRR results, which criterion would you use (NPV or IRR) and why? PRINCIPLES OF FINANCIAL MANAGEMENT Capital Budgeting Decisions 1. Learning Objectives (a) Develop pro-forma Project Income Statement Using Excel Spreadsheet (b) Compute Net Project Cash flows, NPV, IRR and PayBack Period (c) Develop Problem Solving and Critical Thinking Skills 1) Project Life (years) 2) New equipment cost 3) Shipping & installment costs 4) Related start up cost 5) Inventory increase 6) Accounts Payable increase 7) Equip. Salvage Value Estimated at the End of Year 4 8) Sales for first year (1) 9) Sales increase per year 10) Operating cost (60 Percent of Sales) 11) Depreciation Straight Line = Initial Cost/YR 12) Tax rate 13) Cost of Capital (WACC) $(200,000) $ (35,000) $ (5,000) $ (25,000) $ (5,000) $ 15,000 $ 200,000 5% 60.00% $ (60,000) 35% 10% 1 2 3 4 YEAR Equipment cost Shipping and Install cost Start up expenses Total Capital Spending After Tax Salvage Value in Year 4: Salvage - T*(Salvage - Book Value) Net Working Capital (Inventory Increase - A/P Increase) 0 $ (200,000) $ (35,000) $ (5,000) $(240,000) $ 20,000 ? $ (20,000) Income Statement Revenue Operating Cost Depreciation EBIT Taxes Net Income (LOSS) $ 200,000 $210,000 $ 220,500 $ 231,525 $(120,000) $ (60,000) $ 20,000 $ 7,000 $ 13,000 ol 1 IN 3 4 Capital Spending NWC OCF Cash Flow from Assets NPV IRR Payback Q#1 Would you accept the project based on NPV, IRR? Would you accept the project based on Payback rule if project cut-off period is 3 years? Q#2 SENSITIVITY and SCENARIO ANALYIS: Capital Budgeting Investment ) Decisions (a) Estimate NPV, IRR and Payback Period of the project if the Marginal Corporate Tax is reduced to 20%. Would you accept or reject the project? Assume Straight-Line Depreciation. (b) Estimate NPV, IRR and Payback period of the project if Equipment is fully depreciated in first year and tax rate is reduced to 20%. Would you accept or reject the project? (c) As a CFO of the firm, which of the above two scenarios (a) or (b) would you choose? Why? Q#3 Explain to your CEO what the NPV results mean. Q#4 What are the advantages and disadvantages of using only the Payback method? Q#5 What are the advantages and disadvantages of using NPV versus IRR? Q#6 Explain the difference between independent projects and mutually exclusive projects. When you are confronted with Mutually Exclusive Projects and have conflicts with NPV and IRR results, which criterion would you use (NPV or IRR) and why