Capital Budgeting and Financing

Capital Budgeting and Financing

Capital Budgeting = invest in projects that are worthy or not ? Involves estimating the expected future cash flows are enough to justify the costs

Financing = providing money ( equity or debt)

1. Time value of money

• $100 today > $100 in one year : save it in the bank to receive interest, TVM changes, better to have money earlier than later

[pic 1]

Compounding = FV= PV (1+ R)^n 

Discounting = PV=FV/ (1+R)^n 

R= period interest rate / n= number of periods

Simple interest =  interest earned on the original investment/ Compound interest = interest earned on reinvestment of previous payments

Perpetuity= infinite series of equal payments : [pic 2][pic 3][pic 4][pic 5][pic 6][pic 7]

Annuity = finite series of equal payments at regular intervals :[pic 8][pic 9][pic 10][pic 11][pic 12][pic 13]

Exo :

1. PV= 570/ (1.10)^1 + 430/ (1,10)^2 + 840/ ( 1,10)^3 + 1230/ ( 1,10)^4
2. PV= 25000/ .04= 625000
3. PV= 6125/.08(1-1/(1.08)^15)) = 52426, 8

1. Investment Decision Rules

NPV > 0 = accept this project, Benefits > Costs ( PV > Investment 0), added value

NPV = -CF0 + CF1/ (1+ R)^1 + CF2/(1+R)^2 + …

Excel : =VAN (R ;CF1 : CFD) + CF0

IRR= rate of return of an investment, discount rate that makes the NPV=0, communicate the value of the project, provides indication of risk,

IRR > required return : accept the project

Invest $1, get $2 un 1 year : IRR= 100%

[pic 14][pic 15][pic 16][pic 17]

100= 121/ (1+R) ^2

(1+R) ^2= 121/100

1+R= racine 121/100

Excel : =TRI (CF0 :CFD)

Payback = number of period. How long does it take to recover the initial cost of a project ?

The year before the year where Cumul CF=0 +  (CF year before/ CF year after)

Profitability index = measures the benefit per unit cost, based on the time value of money

[pic 18][pic 19][pic 20][pic 21][pic 22]

PI > 1.0, accept the project

Exo :

1. -9430 + 2620/.08 ( 1- 1/ (1,08)^8)
2. -7800 + 3100 + 3200 + 2200 > 0 : Payback = 2 + 1500/ 2200 = 2,… years
3. (CF1/ (1+R) + CF2/(1+R)^2 + CF3/ (1+R)^3) / 29500

3-Calculating Free CF

Sunk costs= costs already paid before the new project

Free CF : incremental cash available to the firm, independent of any financing decisions, include CF that will only occur if the project is accepted

=   [pic 23]

OCF (Operating CF) = NI (Net income) + Depreciation  

Net working capital = current assets ( customers, cash, inventories) – current liabilities

= capital that is consistantly at work in the firm day to day, ∆NWC > 0 => the firm either increased its current assets or decreased it, or both

After-tax salvage value = resale price – (resale price – book value) x marginal tax

Book value= initial cost – accumulated depreciation (= initial cost/ years depreciation)x years used))

CS= Capital spending

Depreciation = initial equipment / years

Net income = Net sales – variable cost– fixed costs - depreciation  (= EBIT) x  taxes ) x (1-TC) =

= 200 000 – 125 000 -  17 430 - 30 000 = 27570 x 21% = Net income

Ex 3

1. After-tax salvage value = resale price – (resale price – book value) x marginal tax

Book value= initial cost – accumulated depreciation (= initial cost/ years depreciation)x years used))

= 635k – (79375 x 5) = 238125

= 105k - (105k – 238125) x 0,22 = 134 287

EBIT= Net sales – cost of goods sold – fixed costs – (Dépréciation= sales/ years)

Net income = EBIT – (EBIT/tax)

Operating cash-flow = Net income + Depreciation

= 2 230 000 – 1 250 000 – (2 150 000/ 3) = 263 333

= 263 333 – 60566 = 202 766

=  202 766 + (2 15 000/ 3) = 919 439

1. FCF= OCF – variation NWC – CS + After salavage

= 919 439 – 150 000 – 2 150 000 + 142 450 =
CF0=  2 150 000 + NWC ( =150 000)

VAN= - 2 300 000 + CF1/ (1,14)  + CF2/ (1,14)

1. Cost of Equity

Firms raise capital :

• Equity financing : sell part of the ownership to investors = shareholders who expect returns = cost of equity
• Debt financing : borrow money = debt holders

Bank charge you an interest rate = cost of debt

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