Capital Budgeting and cash flows

Initial Investment

Cost of new asset 500 000

+ Installation cost 50 000

Installed cost (new) 550 000

Installed cost (Old) 300 000

-Accumulated Depreciation (200 000)

Book Value 100 000

Proceeds from sale (Old) (150 000) – 50 000 Profit

- Tax on proceeds (40%) (20 000) [50 000x0.4]

After TAX Proceeds (Old) 30 000

Increase in A/R 4000

Increase inventory 2000

Increase A/P (2000)

Increase Accruals (3000)

Change in Working Capital 1000

Initial Investment 590 000

Operating Cash Flow

OCF = NOPAT + Depreciation

Where NOPAT = EBIT x (1-T)

Terminal Cash Flow

Installed cost (New) 300 000

-Accumulated Depreciation (200 000)

Book Value 100 000

Proceeds from sale (New) (150 000) – 50 000 Profit

- Tax on proceeds (40%) (20 000)

After TAX Proceeds (New) 30 000

Installed cost (Old) 200 000

-Accumulated Depreciation (150 000)

Book Value 50 000

Proceeds from sale (Old) (75 000) – 25 000 Profit

- Tax on proceeds (40%) (10 000)

After TAX Proceeds (Old) 15 000

Change in Working Capital 8000

Terminal Cash Flow 53 000

Capital Budgeting techniques

Payback period

Pb = Pb Year – (Profit in Pb year/Cash flow in Pb year)

Pb = 5 – (50000/150 000) = 4.667

Net Present Value (NPV) / Internal Rate of Return (IRR)

Cf0 – (1500 000)

Cf1 – 600 000

Cf2 – 550 000

Cf3 – 380 000

Cf4 – 350 000

I/YR – 10%

N – 4

NPV – 24 554.33

IRR – 10.838

IRR Accept/reject decision

Always select the project with the highest NPV and then you look at the highest IRR

Projects with (Negative NPV) should not be accepted

Risk and refinement in Capital budgeting

Certainty Equivalent adjustment

N – 4

I/YR – 10%

Year / Cash Inflows / Certainty Equivalent (CE) / Cash flow
x
CE
0 / (100 000) / 1 / (100 000)
1 / 30 000 / 0.2 / 6000
2 / 40 000 / 0.4 / 16 000
3 / 50 000 / 0.6 / 30 000
4 / 9 000 / 0.8 / 7 200
NPV / (53 865.17)
IRR / - 17.57

Risk Adjusted Discount Rate (RADR)

Where no other Information available RADR = Required return

RADR = Rf + PI(Rm-Rf)

Annualised NPV (ANVP)

N – 4

I/YR – 10%

Year / Cash Inflows
0 / (100 000)
1 / 30 000
2 / 40 000
3 / 50 000
4 / 9 000
NPV / 4043.43
PV / 4043.43
N / 4
I/YR / 10
PMT / (1275.59)

Calculating the cost of Capital

Preference Shares

Ordinary Shares / Retained Earnings

New issue Shares /Equity

Cost of L-t Debt

Ri = Rd x (1-T)

WACC, WMCC and Investment opportunity Schedule (IOS)

Working Average cost of Capital

WACC = Weight x rate

Company with 40% Debt and 60% Equity structure, cost of Debt is 8% and Equity 10%

WACC (Debt) – 0.4 x 0.08 = 0.032

WACC (Equity) – 0.6 x 0.10 = 0.06

WACC (Total) = 0.032 + 0.06 = 0.092 (9.2%)

Source of Capital / Weight / Cost / WACC
L-T Debt / 0.40 / 6.6% / 0.4 x 0.066 = 0.02640
Preference Shares / 0.10 / 10.6% / 0.1 x 0.106 = 0.0106
Ordinary Shares / 0.50 / 13% / 0.5 x 0.130 = 0.065
1.00 (100%) / 0.102 (10.2%)

Working Marginal cost of Capital (WMCC)

1 - Find Break Points

AF – Available funding

W - Weight

2 – Calculate cost of capital

See “Calculating cost of Capital”

3 – Calculate WACC

Leverage

Degree of operating Leverage (DOL)

Degree of Financial Leverage (DFL)

Degree of Total Leverage (DTL)

Operating break-even point

Capital structure and firm value

Value of firm

Where NOPAT = EBIT x (1-T)

Where all earning are paid out as dividends:

r – Required rate

Earnings per share (EPS)

Coefficient of variation (CV)

Dividend policy

Relevance theory of dividends

  • Advanced by Gordon and Linther
  • Direct relationship between a firms dividend policy and its market value
  • Bird-in-the-hand argument
  • Investors see current dividends as less risky than future dividends or capital gain
  • I.e. a bird in the hand is worth two in the bush

Irrelevance theory of dividends

  • Advanced by Miller and Modigliani’s
  • Firms value is determined solely by the earnings power and risk of assets (investments) and the way in which it is split between dividends and retained earnings

Residual theory of dividends

  • Amount left over after all acceptable investment opportunities have been undertaken
  • Dividend decision treated in 3 steps
  • Determine optimal level of capital expenditure
  • Estimate the total amount of equity finance
  • Because cost of retained earnings is less than cost of new ordinary shares, retained earnings should be used to meet equity requirements and where inadequate sell new share

Factors affecting dividend policy

  • Legal constraints
  • Contractual constraints
  • Internal constraints
  • Flotation cost
  • Growth prospects
  • Taxation
  • Owner/Market consideration

Types of dividend policies

  • Constant-pay out-ratio
  • % paid to owner in each dividend period
  • Regular
  • Fixed-rand dividend in each period
  • Low-regular-and-extra
  • Pays low regular dividends, supplemented by an additional ‘extra’ dividend when earning are higher

Share split

Method used to lower the market price of a firms share

Mergers

Types of Mergers

  • Horizontal merger
  • Merger of two firms in the same line of business
  • Shoprite & Checkers
  • Vertical merger
  • Merger where a firm acquires a supplier or a customer
  • Parmalat acquire JPA Diary Ltd
  • Congeneric merger
  • Where a firms acquires another firm that is in the same line of industry but not the same line of business, supplier or customer
  • Bovis Lend Lease acquires Construction Tool Manufacturing business
  • Conglomerate merger
  • Merger of firms in unrelated businesses
  • BMW merges with Nokia

Reasons for Mergers

  • Growth or diversification
  • Synergy
  • Fund raising
  • Increase managerial skills or technology
  • Tax consideration
  • Increase ownership liquidity
  • Defence against takeover