Module Three Practice

1.       Spend 8000 on a new machine. You think it will provide after tax cash inflows of 3500 per year for the next three years.
The cost of funds is 8%. Find the NPV, IRR, and MIRR. Should you buy it? (1019.84, .1493, .1241, yes)
$1,019.84
14.9%
12.41%

2.       Let the machine in number one be Machine A. An alternative is Machine B. It costs 8000 and will provide after tax cash
inflows of 5000 per year for 2 years. It has the same risk as A. Should you buy A or B? (1829.42<2375.4453, 395.73<513.84,
buy B)

3.       Spend 100000 on Machine C. You will need 5000 more in net working capital. C is three year MACRS. The cost of funds
is 8% and the tax rate is 40%. C is expected to increase revenues by 45000 and costs by 7000 for each of the next three years.
You think you can sell C for 10000 at the end of the three year period.
a.       Find the year zero cash flow. (-105000)
b.      Find the depreciation for each year on the machine. (33330; 44450; 14810; 7410)
c.       Find the depreciation tax shield for the three operating years. (13332, 17780, 5924)
d.      What is the projects contribution to operations each year, ignoring depreciation effects. (22800)
e.      What is the cash flow effect of selling the machine? (8964)
f.        Find the total CF for each year.
0: (105000)
1: 36132
2: 40580
3: 42688

g.       Should you buy it? (NPV=-2866.52, NO)

4.       Timco shares are currently valued at 53 each. There are two million outstanding. Last year, the dividend was 2, but we
expect it to grow at 8% forever. Net Income is expected to be 10 million. The firm uses 40% debt in their capital structure.
They can borrow more at 4%. The tax rate is 35%. New shares can be sold for 6% flotation costs. Find the breakpoint and the
WACC before and after. (9.47, .083, .0844).
$1,019.84 -8000 8
3500 3.5 8000(1+MIRR)^3=1,019.84
3500 3.5
3500 3.5
Valuing Real Assets (Capital Budgeting)
Capital Budgeting

Capital budgeting is extremely important for the firm. It is the heart of the investing decision. To increase firm value, the comp
improve the way they are using the existing resources. These can be expensive choices. Careful consideration and planning are
reallocated. In addition, based in part on poor real asset secondary markets, once one of these “investment projects” begins, t
additional costs. So, when making an expensive decision that will affect the firm for a long time, it is only natural to proceed w
budgeting is that it requires a lot of input from functional areas throughout the firm. It is a firm decision that all managers are
careers.
We will first address the different methods of evaluating investment projects. Then we will calculate the cost of funds for the fi
budgeting techniques. Finally, we will address the basics of valuing the firm.
Net Present Value
The Net Present Value (NPV) is the present value of all the cash flows associated with a project:
NPV = ∑ (CFt/(1+r)t), where t ranges from 0 to T, the end of the projects life

All incremental cash flows (addressed later in this module) are included, even tax effects. The discount rate used is often taken
cost them to raise new financial capital. Thus, when the benefits outweigh the costs of a project, the NPV will be positive and

There are numerous ways to solve for NPV. I put a list of videos in the module to show how to do it with the most popular fina
mathematically. For some practice, assume we could spend $100,000 on a new machine, let’s call it X, that would generate aft
next 4 years. Let the firm’s cost of funds be 6%. The calculated NPV is $3953.17. The NPV decision rule indicates we should ac
$4000 more than the costs.

In Excel, =NPV(0.06,30000,30000,30000,30000)-100000 will return the correct answer. Notice that the NPV function ignores y

Example 3-1: We are considering spending 5 million on a new factory. It is producing a new product that we think will not be v
generate after tax cash flow of 2 million in year one, 1.5 million in year two, then 3 million, including the costs of dismantling t
WACC is 14%. Find the NPV. Should we build the factory?
NPV= -5 + 2/1.14 + 1.5/(1.14)^2 + 3/(1.14)^3 = -66498.19. Even though this project provides an accounting profit of 1.5 million
outweighs the benefits. We should not buy it. In Excel, =NPV(0.14,2,1.5,3)-5.

Before we describe the other methods, a discussion of the implications of NPV is in order. NPV is a direct measure of value cre
managerial goal used in the most empirically successful theories in financial management. As with any mathematical model th
Overly optimistic forecasting is a danger here. One thing that I like to do is to re-estimate the cash flows after NPV has been es
net cash flow would have to go to find an NPV of zero. If this level of cash flow seems very conservative, the investment is pro
companies do not operate in a vacuum. If a firm does in fact stumble upon an idea that has a large NPV, competitors will be att
competition will drive the remaining portion of the realized NPV down to zero, unless the firm has some sort of advantage tha
monopolistic industry power. Another thing to keep in mind is that a manager should never make a decision based only on a s
Internal Rate of Return
The internal rate of return (IRR) is the discount rate that forces the NPV to equal 0:
0 = ∑ (CFt/(1+IRR)t)
The calculated value for the IRR is compared to some predetermined hurdle rate. If IRR > hurdle rate, accept the project.

Going back to our example, Machine X, the project’s IRR is 7.71%. Since it is larger than 6% capital cost, typically used as the h
the IRR are the same formula, they will always give us the same decision on a particular project. =IRR(A5:A9) in Excel, where A
Example 3-2: For the factory in 3-1, =IRR(F4:F7) returns the solution 13.261%. This is less than the hurdle rate of 14%, so we do
more complicated using math.

Modified Internal Rate of Return

The rate that forces the present value of the costs (PVCOF) to equal the FV of the benefits (FVCIF) if they are reinvested at the
There is not really a simple, elegant formula for this method. Take all of the net cash inflows and move them to time period T
outflows as of period zero. The rate that would cause these to have equal value is the MIRR.

The present value of our Machine X out flows is $100,000. The FV of the inflows is $131,238.48. The MIRR is 7.03%. This is high
Notice that the value for the MIRR is between the cost of funds and the IRR. This will always be the case for both good and ba

Example 3-3: We spend 5 on the factory. This is the only net out flow, so the PV of the outflows is 5. At the end of the first yea
grows for two years to equal 2.6 at the end. We invest the 1.5 for one year. It grows to 1.71. The FVCIF is 2.6+1.71+3=7.31. So
13.5%. We reject the project again, since this is less than 14%.

The MIRR reconciles some of the problems associated with the IRR. Implicit in the math for time value of money is the assump
chosen discount rate. In rare instances, this reinvestment assumption results in disagreement between the IRR and the NPV. T
capital. The IRR assumes reinvestment at the projects IRR. It may be, in fact perhaps it should be, the case that no additional in
projects earning a large IRR are available, why didn’t a value maximizing manager buy them already? Regardless, it is certainly
the firm can earn its own cost of funds instead of the high IRR associated with a good project. Remember when we talked abo
reinvestment. This is the same principle here. The yield to maturity is the IRR of the bond.

The disagreement between IRR and NPV only matters when a manager is evaluating multiple projects and these projects have
mutually exclusive projects. If we accept one of them, it decreases the cash flows of the other. An example might be consideri
least part of a particular service area. A better example would be Walmart. Every time they build a new store, they steal their
there is a disagreement, use the NPV or the MIRR because of the more realistic reinvestment assumption. Most of the time, th
if the cost of capital is very low, giving the reinvestment assumption of IRR an unrealistic advantage.
Unequal Lives

Another issue with mutually exclusive projects relates to the length of time. If projects are being compared and happen to hav
For example, if project A has 2 years and B has 3 years, but are similar in other respects, NPV would likely choose B because it
not explicitly consider what will happen with Project A in that third year. There are several approaches to this issue.

One is the replacement chain: Assume that once A is over, it can be repeated exactly has before. In effect, in the third year, we
again. Before this assumption A has CF0, CF1, and CF2. After this assumption, add CF0 back to CF2 because we are restarting t
the same as CF2. Now A has 4 years and B has 3. We assume we can extend B, now. So extend each project out to the least co
find the replacement chain NPV (RCNPV).
Example 3-4: Let Project V cost 4 and provide cash inflow of 2.8 for two years. Let Project R cost 4 and provide inflow of 1.6 pe
projects are mutually exclusive, which should we choose?
The regular NPV of V is .8595; that for R is 1.072. This might make a careless analyst favor R. This is due to the two extra years
chain to V, we get the following cash flows: -4, 2.8, -1.2 (2.8-4), 2.8, 2.8. This results in an RCNPV of 1.57, clearly better than Pr
Another method is the Equivalent Annual Annuity (EAA). Find an annuity that has the same NPV the project. Then assume the
least to the least common multiple of the periods.
Example 3-5: Find the EAA for Project’s V and R.
The NPV for V was .8595. At 10%, this is equivalent to a 2 year annuity of PMT=.4952 for V. The NPV of R was 1.072, translatin
and EAA like project V better.

There are numerous other methods for handling the unequal lives issue. Going back to Project A, for example, we could just a
capital could be invested into the firm’s average project, thus earning the firm’s ROA or ROIC. So like an MIRR, assume reinves
how much would be there at the end of the longer projects life.
Cash Flow Analysis

Perhaps the most important part of capital budgeting is identifying which cash flows are actually relevant to the decision. Fore
Some general guidelines are in order. Only include incremental cash flows. These are cash flows that only occur if the project i
money that is already spent whether or not a project is actually pursued. Try to include opportunity costs when possible. If yo
using that land for some other purpose. Even the fair market value of the land if sold could be considered an opportunity cost
away from an existing location, that loss of sales at the old store is an opportunity cost. Opportunity costs are especially impor
sales are 200 million and we open a new store that raises sales to 500 million, the incremental sales are 300 million.
Mathematically, the cash flow at the start of a project, before operations begin, can be modelled like:

CF(0) = Cost of the long term assets purchased (including installation and modification) and any additional short term assets ne
assets minus Δ current liabilities). Some of these changes in the current accounts will be spontaneous, i.e. they will occur natu
During the operating life of the project CF(1), CF(2) through CF(T) be sure to account for:

(Δ Sales – Δ Operating costs- Δ Depreciation) * (1-tax rate) + Δ Depreciation. Depreciation is not a cash flow, but it is a tax dedu
estimating the tax effect. This equation is sometimes rewritten as (ΔS-ΔC)*(1-t) +ΔD*t. The ΔD*t term is sometimes referred to
(Modified Accelerated Cost Recovery System) for tax purposes to realize tax advantages earlier. The MACRS table is shown be

Year
In the final year of the project’s life, in addition to any operating cash flows, there are some special things to account for. Typic
NWC cash flow included earlier will be reversed. In addition, it is usually assumed the fixed assets will be sold off. This too has
Salvage price – book value)*(1-t) + book value. The book value is the undepreciated portion of the assets original cash price. If
analysis) we would sell the old assets in year zero and recognize the lost chance to sell the old assets at the end as an opportu

Example 3-6: Timco is considering the construction of a new retail outlet. The construction cost will be 400000. Net working ca
year MACRS. The new location will increase sales by 90000 and increase costs by 40000 per year. The tax rate is 40%. Assume
tenth year. The WACC is 8%. Find the NPV. Should we buy it?
Year zero cash outflow is 400000 (purchase) +10000 (NWC) =410000. Using the MACRS table, depreciation by year is 40000, 7
26240, 26200, 13120.
Year Zero: (410000)
Years One through Nine: (ΔS-ΔC)*(1-t) +ΔD*t. This is the after tax operating cash flow and the depreciation tax shield.
Year One: (90000-40000)*(.6) + 40000*.4 = 30000 + 16000 = 46000
Year Two: 30000 + 28800 = 58800
Year Three: 30000 + 23040 = 53040
Year Four: 30000 + 18432 = 48432
Year Five: 30000 + 14752 = 44752
Year Six: 30000 + 11792 = 41792
Year Seven: 30000 + 10480 = 40480
Year Eight: 30000 + 10480 = 40480
Year Nine: 30000 + 10496 = 40496
In Year Ten we get the operating flow and the tax shield, plus we sell off what we can from the assets and recover our net wor

Year Ten: 30000 + 10480 + [(50000-13120)*.6 + 13120] + 10000 = 30000 + 10480 + 35248 + 10000 = 85728.
The NPV is (77042.04), so we should not open the new store. To get to an NPV of zero, we would have to raise the net cash in
reduce the year zero cash flow by 77042.

Example 3-7: Jeremy Pruitt Ltd is considering the replacement of a delivery truck. The current truck could last for three more y
currently depreciating it at 4000 per year. We could sell it at the end of the three years for 2000 with a book value of zero. If w
three year MACRS. We could sell the old truck now for 7000. Operating costs would drop to 1000 per year. We can sell the ne
rate is 40%. The WACC is 10%. Should we replace the truck?
Year Zero: Buy the new truck (32000), sell the old truck (7000-12000)*(.6) + 12000 = 9000. This is greater than the cash paid fo
selling at a loss compared to the book value.
Depreciation for the new truck will be 10665.6, 14224, 4739.2, leaving a book value of 2371.2 at the end. Change in tax shield
it will be 4089.6, in three it will be 295.68.
The after tax change in operating cash flow is (0 - - 4000)*(.6) = 2400.
Sell the new truck in year three: (15000-2371.2)*.6 + 2371.2 = 9948.48.
The opportunity cost of not getting to sell the old truck in year three is (2000)*.6=1200
Putting it all together
Year 0: (32000) + 9000 = (23000)
Year 1: 2400 + 2666.24 = 5066.24
Year 2: 2400 + 4089.6 = 6489.6
Year 3: 2400 + 295.68 +9948.48 + (1200) = 11444.16
The NPV of this is (4432.86), so we should not buy.
Throughout our capital budgeting analysis so far, we have assumed that the WACC was a valid discount rate and hurdle rate. T
substantially different risk than other things the firm is doing, adjust the cost of funds accordingly: raising it above the WACC f
Try to think of the risk in a portfolio context, a firm is basically just a portfolio of investment projects.
Weighted Average Cost of Capital

The WACC is the cost to the firm of raising an additional dollar of new financial capital while maintaining the optimal or best ca
WACC=w(d)*r(d)*(1-t) + w(s)*r(s). Both of the r’s represent an opportunity cost. To raise money in the financial markets, the b
fair, risk adjusted rate of return. In order to retain earnings, the first source of new equity, the owners must believe they can e
Relying on our discussion of an efficient market, r = rf + β (rm– rf) = D1/P0 + g.
Example 3-8: Let Timco use a capital structure that is 30% debt and 70% equity, The firm can borrow at 5%. The tax rate is 40%
the risk free rate 2%. Find the WACC.

Let’s find r(s) first. The information here appears to be for CAPM, so .02+1.5*(.14-.02) = .20. If we had information about the e
have used the GGM. Say that the next dividend will be 4, the current stock price is 32, and that the dividend is expected to gro
WACC as .3*.05*.6 + .7*.20 = .149.

Part of the reason finance and economics are important is because of scarcity. This is certainly the case with retained earnings
that the equity portion (ws*RE) needed is greater than the expected retained earnings. If this is the case, a firm can enlist inve
shares of stock. The costs paid to the investment banks are called flotation cost. For our purposes we will represent this cost a
paid to the financial institutions. We will also assume that the new shares are the same as the old shares. This expense will rai
external equity is found with a variation of the GGM. It looks like this: r(s)= (D(1)/P(n)) + g, where P(n) is the net price, P(0)*(1-

Example 3-9: Let’s return to Timco from 3-8. Let the flotation costs be 5%. P(N)=32*.95=30.40. This raises the equity cost to 4/

So the firm begins using new debt and retained earnings at a cost of .149. Then they run out of retained earnings and must be
1536. The total amount of money the firm can raise while using retained earnings can be measured with the equity breakpoin
Example 3-10: Let Timco expect to have 12 million in net income. They have 2 million shares outstanding. Find the equity brea

2 million shares getting a dividend of 4 each would give us total dividends of 8 million. Subtracting this from Net Income leave
So the new money Timco can get at .149 will be 5.714, 1.714 in debt and 4 in retained earnings. Any amount above this level w
stock.
Our discussion for the fourth test will be based on how financial decisions might affect the values used to estimate WACC.
The Firm

The value of the firm, getting back to our equation V = sum[(FCF(t)/(1+wacc)^t], is the sum of the PV of all the expected future
the firm is a going concern, t would be infinity here. Ultimately, value depends on the firm’s ability to generate cash flow, how
the cost of attracting the financing needed to support the assets. If the firm’s assets traded in a well-functioning market, we co
together to get total firm value. Unfortunately, most real asset markets don’t meet this requirement. For publicly traded firms
would be much easier to look up the secondary market values of the firm’s stocks and bonds (which do have good secondary m
the assets are worth. This would be much easier than estimating the cash flows from the assets, but would be subject to possi
of the firm.

Another approach to firm valuation is based on option pricing theory. When a firm borrows, it is like the firm has sold the asse
The option gives the firm owners the right to force the sale of the assets back from the creditors for an exercise price that is eq
either exercise the option, thereby paying off the debt and keeping the firm, or they can let the option expire unused by defau
be found as the price of a call option. Thinking about the firm this way has led to several insights about things we observe com
the variance of the underlying assets increases call option value. Managers and owners have an incentive to substitute riskier
substitution problem would cause a wealth transfer from creditors to owners. This is part of the agency problem between own
NPV - net present value, the present value of all the
cash flows asscociated with a project. when the
benefits outweigh the costs of a project, the NPV will
be positive and the project should be accepted. NPV =
∑ (CFt/(1+r)t)

IRR - Internal Rate of Return, the discount rae that

forces the npv to equal 0. 0 = ∑ (CFt/(1+IRR)t) If IRR >
hurdle rate, accept the project https://www.investopedia.com/terms/i/irr.asp

.3-3
-100000 -5

30000 2
 30000 2.6

7.71% 30000 1.71

30000 13.31%

mrr Modified rate of return - the rate that forces the

present value of the costs (PVCOF) to equal the FV of
the benefits (FVCIF) if they are reinvested at the firm’s
cost of funds rather than the project’s IRR

pvcof - present value of the costs -5

2 1 year 5(1+MIRR)^3=7.31

NPV assumes reinvesting at cost of capitol while IRR

assumes reinvestment at the comapany's IRR, more
conservative to assumes co can earn cost of capital on
project. IRR the yield of the bond 2.6 2 years 5(1+MIRR)^3=7.31.MIRR = (7.31/5)^(1/3) -

mutually exclusive projects - multiple projects with

inter-related cashflows 1.71 0.134965
13.31% Project V Project R

12.89% CF0 4 4

CF1 2.8 1.6

minus CF0 becau

CF2 -1.2 1.6

2.8 1.6

2.8 1.6
original npv $0.86
 rcnpv $1.57 $1.07

Depreciation Rate in % for Recovery Period

3-year 5-year 7-year 10-year 15-year
33.33 20 14.29 10 5
44.45 32 24.49 18 9.5
14.81 19.2 17.49 14.4 8.55
7.41 11.52 12.49 11.52 7.7
11.52 8.93 9.22 6.93
5.76 8.92 7.37 6.23
8.93 6.55 5.9
4.46 6.55 5.9
6.56 5.91
6.55 5.9
3.28 5.91
5.9
5.91
5.9
5.91
2.95
nwm=net working capital

36880 22128

(sales-cost)*(1-tax) + depreciation*t 35248

410000
46000 32750
58800 40000
53040 7250
48432
44752
41792
40480
40480
40496
85728 4000
($77,042.04) 10742

.+(cash salvage price - book value)*(1-t) + book value

{(50000-13120)*.6+13120}+10000=85728
.3-1
-5

2
 1.5

3
13.26%

)^3=7.31.MIRR = (7.31/5)^(1/3) -1

.3-4
20-year
3.75
7.219
6.677
6.177
5.713
5.285
4.888
4.522
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
 2.231

400000 macrs 10 yr deprciation

1 10.00 0.1 40000 40000, 72000, 57600, 46080, 36880, 29480, 26200, 26200, 26240,
2 18.00 0.18 72000
3 14.40 0.144 57600
4 11.52 0.1152 46080
5 9.22 0.0922 36880
6 7.37 0.0737 29480
7 6.55 0.0655 26200
8 6.55 0.0655 26200
9 6.56 0.0656 26240
10 6.55 0.0655 26200
11 3.28 0.0328 13120
0, 26200, 26200, 26240, 26200, 13120
 91 I was confused by the grading scale too.  Vines mentioned the questions are worth 5 points ea

45.5
45.6
45
45
90.55
uestions are worth 5 points each but aren't they actually 10 points each individually? In one of his docs with info on the class he says the t
info on the class he says the tests are worth 25 points a piece.  
Slide 2

•The primary difference between a replacement analysis and a new project analysis is that you must
consider the cash flows associated with abandoning the project that is being replaced. But even these
cash flows associated with the “old” project are calculated the same way as they are for the “new”
project.
Slide 3
•Year Zero

•In addition to buying and possibly modifying new assets, and accounting for any change in net working
capital that this would provide, replacement analysis typically includes a cash flow associated with
selling the existing project. This is calculated the same way as when you sell the new asset in a new
project analysis:
•(Selling Price – Book Value)*(1-tax rate) + Book Value
•Remember the book value is the undepreciated amount of the asset being sold. Book Value is not a
cash flow, but the profit or loss on the sale could have tax effects.
Slide 4
•The operating cash flows are now based on the change in variables involved in switching to the new
from the old.
•(Change in sales-change in operating costs)*(1-tax rate)
•The depreciation tax shield is also based on the change
•(New depreciation-old depreciation)*tax rate
•Do these calculations for each year that the new project operates
Slide 5

•The last difference occurs in the final year. It involves the opportunity cost of not being able to sell the
old machine now, because we already sold it in year Zero. The formula is the same, but the sign is the
opposite.
•(Selling Price-Book Value)*(1-t) + Book Value
•Now just add all these calculations together for each year and find the NPV
Slide 2

•WACC is the expected cost of the next money raised by the firm while maintaining the optimal capital structure.
•It is the average cost of new debt and equity.
•It is the marginal cost of new funds.

•The optimal capital structure is the financial decision believed to help the firm achieve maximum value. It is
summarized by the relative amount of debt used to finance the firm, the weight of debt (w(d)) and the weight of
equity (w(s)), the relative use of retained earnings or stock.
Slide 3
•WACC = w(d) r(d) (1-t) + w(s) r(s)
•W(d) percentage of all financing from debt
•R(d) interest rate on new debt
•T is the tax rate, accounts for the tax savings of interest deductions
•W(s) percentage of all financing from retained earnings or stock
•R(s) is the cost of equity
Slide 4
•R(s) the cost of equity varies by type of equity used
•First the firm uses retained earnings
•We can find the cost of retained earnings with CAPM or GGM.
• r(f) + beta*(r(m)-r(f)) or D(1)/P(0) + g

•When the firm runs out of retained earnings (breakpoint) they must issue new stock to raise more equity.
•Cost of new stock, r(e), is D(1)/(P(0)*(1-F)) + g
•F stands for the % flotation costs paid to create and issue the new shares
Slide 5
•Firm’s use retained earnings as new equity first, because it is cheaper than new stock.
•When they reach the breakpoint (total amount of new funding until retained earnings are used up) they begin to
issue new stock, thus raising the cost of funds.
•BR=RE/w(s)
•This gives the firm a two step WACC schedule to use in calculating value and for capital budgeting. Use the WACC
appropriate for the new level of funding being acquired.
Slide 6

•Timco uses 30% debt and 70% equity in their capital structure. New debt will cost 5%. The firm expects to have net
income of $14 million in the coming year. They will pay 3 per share in dividends, consistent with their long term 3%
growth rate. The Timco beta is 1.6. The marginal tax rate is 40%, the risk free rate is 2% and the market is expected to
return 13%. Flotation costs will be 4%. There are 2 million shares outstanding. Find Timco’s WACC schedule.
Slide 7
•To find r(s), we have CAPM information rather than GGM in this case
•.02+1.6*(.13-.02)=.196
•To find r(e) we need price, so now use GGM
•3/(.196-.03)=18.072
•Now r(e)=3/(18.072*(1-.04)) + .03 = .2029
•Dividends need to be 3*2M=6M, so retained earnings is 14M-6M=8M
•The breakpoint is thus 8M/.7=11.428M
Slide 8
•The WACC for all financing less than 11.428 cumulatively is
•.3*.05*(1-.4) + .7*.196=.1462
•For all amounts above this it is .3*.05*(.6) + .7*.2029=.15103