Business Finance Notes PDF

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Summary

BUSINESS FINANCE Objectives. 1. Describe key finance goals and decisions and the environment in which financial decisions are made. 2. Evaluate the impact of ethics on financial decisions. Value. Value depends on expeted cash flows which are evaluated in terms of timing and risk o Distant cash flows...

Description

   

Expansion vs replacement decisions Relevant cash flows are the incremental after-tax cash flows Incremental cash flows are the additional cash flows directly attributable to the proposed project Three major cash flow components include;  Initial investment - time zero (outflow)  Operating cash flow -inflows (excl. interest and financing costs)  Terminal cash flow - final year (inflow)

Incremental cash flows . New asset cash flows

Initial investment 

Cost of new asset 

Operating cf

Terminal value

New asset operating cash flows

Proceeds, sale of new asset +/- tax or tax benefit on sale of new asset + decrease in net working capital

Installation costs 

Increase in net working capital + proceeds from sale of old asset 

/+ tax or tax benefit on sale of old asset Old asset cash flows

0

Incrememntal  cash flows New asset intital investment

Old asset operating Proceeds, sale cash flows of old asset +/- tax or tax benefit on sale of old asset New asset operating cash flows  Old asset operating cash flows

New asset terminal value - old asset terminal value

The initial investment  The initial investment is determined by subtracting all cash inflows at time zero from all cash outflows occurring at time zero. These include  Cost of new asset (-)  Installation costs (-)  Proceeds from sale on an old asset (+)  Change in net working capital - usually an outflow resulting from an increase in current assets and current liabilities directly attributable to the project; usually an outflow (-)



Taxes; an inflow or outflow depending upon the sale price of the old asset, its original cost and its book value

Example 3; Clearview - initial investment 



Clearview Ltd is considering the purchase of a new machine to replace an existing one. The existing machine was purchasing 3 years ago at a cost of $25k and has $15k accumulated depreciation. Depreciation on both machines is 5 years straight line. The old machine has already been depreciated for 3 years. The new machine cost $30k and require $5k installation costs. The existing machine can be sold today for $17500. Net working capital is expected to increase by $150 due to the replacement. Clearviews tax rate is 30%

o

Identify the known relevant cash flows arising at time zero

o

Determine time zero tax effects from sale of old machine. Cost -Accum.Dpn = Current book value of old machine $10 000 Gain/loss on sale = depreciation recaptured on sale Sales price -book value = gain on sale $7500 Tax to pay = 30% x gain on sale

o

$2250

Sum the time zero cash flows Cost of new machine Installation costs Proceeds of sale of old machine Change in net working capital Taxes on sale of old machine $21 250

Example 4; operating cash flow Clearview has estimated that the before-tax revenues and expenses (excl. depreciation) are $30 000 and $10 000 respectively for the 5 year useable life of the new machine. The old machine would also last 5 years but would earn only $15 000 in annual revenues while incurring $5 000 expenses per year. Depreciation on both machines is 5 years straight line. The old machine has already been depreciated for 3 years. First, calculate depreciation that we are allowed to claim each years

New machine = $7000 per year for five years. Old machine = $5000 per year for the next 2 years only. o Installed cost / expected life = o

New Machine

Year 1-5

Revenue

$30 000

Expenses (excl. depreciation)

$10 000

Less depreciation Tax @ 30% Net profit Plus depreciation Operating cash flow

Old Machine

Year 1-2

Year 3-5

Revenue

$15 000

$15 000

Expenses (excl. depreciation)

$5000

$5000

Less depreciation Profit before tax Tax @ 30% Net profit after tax Plus depreciation Operating Cash flow

Now we have estimated the operating cash flows Clearview would generate for both the new and old machines. From this we can determine the incremental net operating cash flows for each year .

New



Incremental

Old Year 1

16 100



7 600

8 500 Year 2

16 100



7 600

8 500 Year 3

16 100



9 100

7 000 Year 4

16 100



9 100

7 000 Year 5

16 100

9 100



7 000

Finding the terminal cash flow  The terminal cash flow is equal to  After-tax proceeds from sale of new asset  Less; after-tax proceeds from sale of old asset  +/- change in net working capital Proceeds from the sale of assets are net of any removal costs If an assets is sold for a price different than its book value, there will be tax

o o considerations o

Change in net working capital will reverse the earlier investment in NWC (i.e. if it was a cash outflow in the initial investment, then it will be a cash inflow in the terminal cash flow)

Example 5; terminal cash flow Assume the new machine can be liquidated for $9 000 after removal costs at the end of its 5-year useful life while the old machine would be worth $1 000. o

First identify cash flows

o

Then calculate any tax effects at end of year 5;

.

New Machine

Old machine

$2 700

$300

Selling price Book value



= Gain on sale Tax on sale = 30% x Gain on sale



Terminal cash flows

After-tax proceeds of new machine Sale price

$9000

.

Less tax to pay

$2 700

$6 300

Less after-tax proceeds of old machine Sale price

$1 000

Less tax to pay

$300

(700)

Plus change in net working capital

$1 500

Terminal cash flow

$7 100

A closer look at NWC (net working capital)

What is NWC? Why do we need to include NWC in capital budgeting evaluations?

1. 1.

1.

How do we determine whether the change in NWC is a cash inflow or outflow in initial investment?

Buy - Increase in fixed assets Buy - Increase in inventory Sell - Decrease in fixed assets Sell - Decrease in inventory 1. 

Why is NWC reversed in the terminal cash flow? Because account receivable are collected (an inflow), inventory is sold off (an inflow), and account payable are paid off (an outflow)

A closer look at incremental cash flows  Clearview limited faces two choices o Choice 1; buy the new machine *Do something o Choice 2; Continue to operate the old machine *do nothing The difference in the cash flows between these two choices are the incremental cash

 flows.

.

New (choice 1) Old (choice 2)

Difference (1-2)

-21 250

-21 250

Initial investment Year 0

o

0 Operating cash flow Year 1

16 100

7 600

o

8 500 Year 2

16 100

7 600

o

8 500 Year 3

16 100

9 100

o

7 000 Year 4

16 100

9 100

o

7 000 Year 5

16 100

9 100

o

7 000 Terminal cash flow Year 5

7 800

7 100

o

700 This is the format for determining initial invesment  Cash outflows are positive  Inflows are negative An alternative initial investment format After-tax proceeds from sale of old asset

.

Proceeds from old asset

Xxx

+/- Taxes on sale of old asset

Xxx

.

Xxxx

Less installed cost of new asset Cost of new asset + Installation costs

a. a.

(xxxx)

+/- change in net working capital

(xxxx)

Equals Initial investment

($xxxxx)

Shows - if any particular fash flow is inc. or decr. A firms cash balances. If cash outflow then we show sign as negative If cash inflow then positive

Depreciation



Straightline depreciation or diminishing value method o Most prefer diminishing value method as reduces income tax expense in early years of asset ownership

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If straight line rate applied depreciation allowance calculated as % of cost Diminishing value method allowance calculated as oercentage of book value of asset Particular percentage rate allowed depends on nature of asset and industry used

Acquiring assets  Depreciation can be claimed for each month or part-month asset owned. o E.g. firm has31 march year-end then $5k asset acquired on 29 jan can be depreciated at allowable rate muliplied by 3/12ths of a year o 5000 x 12.5% =3months/12 months = $156.25 o Even though asset only owned for 3 days in Jan, depreciation can be claimed for entire month

Basic Tax Rules DISPOSING OF AN ASSET  When asset sold any loss on sale can be written off as an expense  Profit on sale included in income for year  If useful life of asset expired with salvage value of 0, then remaining undepreciated cost can be expensed in final year of life. CAPITAL GAINS  Asset sold for more than initial purchase price = capital gains o Capital gains is amount by which sales price exceeds initial purchase price o Normally not applicable in NZ = Apart from income tax on realised gains on residential property purchased and sold within a 2-year period o In this course presume 0% rate of capital gains tax

Example Sales price

110 000

Initial purchase price

100 000

Non-taxable capital gain Initial purchase price

10 000 100 000

Book value, end of year 2

60 000

Recovered depreciation

40 000

 

The depreciation claimed in year 1 and 2 40k must be included in ordinary income in the year of sale (end of y2) In effect the company claims 40k too much depreciation and IRD now requires it to be added back into Y2 taxable income



Difference between initial purchase price and sales price is not subject to tax - non-taxable capital gain

Using example tax rate 30%, the taxes on recovered depreciation of 40k are calculated as follows Recovered depreciation

40 000

Tax rat

X 30%

Total tax, Y2

12 000

Checklist of depreciation and tax treatments  Assume company tax rate 28% unless specified  No capital gains tax - use 0%  Any installation and other incidential costs associated with buying an asset must be included in the initial cost of that asset. The total cost can then be depreciated  Assume any taxes arising from sale of asset are to be calculated as part of initial investment or terminal cash flow  When calculating depreciation firms usually claim the maximum allowed by IRD in any given year, as this reduces tax bill. Therefore depreciation is calculated on the assets initial purchase price incl. installation costs and no adjustment is made for assets expected salvage value.

Treatment of net working capital  If we need to spend cash to build up inventory in connection with long term investment, increase in inventory treated as cash outflow in initial investment  At end of project life, netw working capital reversees so a cash inflow arises  In example when projected is terminated inventory will be sold off, allowing funds to be released for investment elsewhere

Finding terminal cash flow  Must consider proceeds from sale of new asset and proceeds forgone from sale of old asset  If we purchase new asset at time 0, then we receive cash inflow when sold at end of life o But will forgo any sales proceeds which would've been earned on salvage value of old asset at end of its life o If we purchase new asset will sell old asset at time 0 o Consequently sales proceeds forgone from sale of old asset at end of life treated as cashoutflow    

There are tax implication if new asset sold at end of life If incur loss on sale, gain tax savings/cash inflow Incur gain on sale, additional tax to pay If had of kept old asset, incurred gain or loss on sale and additional tax or tax saving at end of life

 

Result of acquiring new asset, we either fail to icur additional tax or we forgo a tax saving on final year sale of old asset Failure to incur additional tax is created as cash inflow, while to forgo tax saving is treated as cash outflow

Example Book vaue = Cost - accumulated depreciation Book value = 240 000 - (48000 x 3 years) = $96 000 In order to estimate taxes apply following Take; lower cost 240 000 Or proceeds; 280 000 Lower cost

240 000

Less book value

96 000

Recovered depreciation

144 000

Tax to pay (30% tax rate)

43 200

Alternative initial investment format After-tax proceeds from sale of old asset

.

Proceeds from old asset

280 000

+/- Taxes on sale of old asset

43 2000

. 236 800

Less installed cost of new asset Cost of new asset

(380 000)

+ Installation costs

(20 000)

(400 000)

+/- change in net working capital

(17 000)

Equals Initial investment

($180 200)

Therefore outlay of 180 200 required to undertake capital budgeting project. Capital budgeting for small firms  

The NPV technique that we have studied is suitable for evaluating projects in the context of both large and small firms Approach for applying the technique differs according to sie of firm and number of projects evaluated

NPV Analysis for Large Firms 

Large firms have several projects under consideration, particular financing method used for accepted projects unlikely to materially affect target capital structure.



Actual overall capital structure will usually conform closely to target

Example Firm X has target capital structure of 30debt/70equity Actual financing raised for Firm X accepted projects resulted in very little deviation away from 30d/70e target

Actual financing employed Project 2007 A

100% d

B`

100% e

C

100% e

D

10%d, 90% e

2008

E

100% D

F

100%D

2009

G

100% E

H

100% E

I

100% E

Debt/Equity Ratio



 



 

30d/70e

32d/68e

29d/71 e

If each projected discounted at cost of capital consistent with actual financing employed for that particular project, then projects to be financed with more costly equity would have less chance of being accepted and projects to be financed with more costly equity would have less change of being accepted and projects to be financed with less costly debt would be more likely to be accepted. This likely to result in non-optimal decisions, so cash inflows from project need to be assessed independently of the particular method of financing Consequently for a large firm it is generally appropriate to discount all projects at an overall cost of capital that reflects the voerall target capital structure. In this analysis the operating cash inflows in the numerator of NPV should exclude interest on debt, as cost of debt has already been incorporated into denominator as part of cost of capital Loan proceeds and repayments should also be ignored This is approach taken by Gitman

NPV Analysis small firms  Very few projects under consideration  When accepted projects undertaken, act of raising new financing often causes significant deviations in capital structure of firm

Example  Firm X small manufacturing firm that carries 20d/80e  If it undertakes to purchase some new machinery to expand their product offerings, then additional debt will be raised  This causes capital structure to change to 40d/60e  The loan will be paid off over 5 year period  The debt-equity ratio will therefore cahgne every year over next 5 years as debt paid off  Given that the capital structure will change over time, the weighted average cost of capital is not suitable as a discount rate to assess the proposed project

Where debt-equity ratio of firm is expected to change as a result of accepting projects, it is necessary to undertake slightly different approach to calculating NPV  Modification to initial investment, numerator and denominator in NPV calculation   

Initial investment should reflect only proportion of investment financed with equity Numerator should includen ot only operating cash flow but financing cash flow (principal and interest repayments) The net cash inflows are then discounted at a risk-adjusted after-tax cost of equity capital

Example  Firm need deposit 20k in order to purchase machinery at 100k  Balance of 80k financed with bank loan @ 8% interest to be paid off ver 5 years with payments of 20 037/year  Operating cash inflows are expected to equal 25k per year (before depreciation, interest and taxes) for 10 years  Risk-adjusted after-tax cost of equity capital for this project is considered to be 11%  Tax rate is 28%

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Solution shown below Initial investment is = equity investment of 20k Net cash inflows are 25k - interest expense -taxes - principal repayments of debt Net cash inflows are discounted at 11% after-tax cost of equity, resulting in NPV of 32 883

Winkie LTD; Project Evaluation for small firms Initial investment Purchase price

100 000

Loan

80 000

Equity Investment

20 000

Net cash inflows Year

Equity Operating Depn investment cash flow

Interest Taxable Tax income

CF less Principal Net interest repayment CF and tax

0

20 000



20 000 1

25 000

10 000 6 400

8 600

2 408

16 192

13 637

2 555

2

25 000

10 000 5 309

9 691

2 713

16 978

14 728

2 250

Comparison of NPV calculations Component of NPV

Large Firms

Small Firms

Initial Investment

Full purchase Equity price investment only

Net cash inflow interest

Exclude

Include

Net cash inflows principal repayments of debt

Exclude

Include

Discount rate

Overall cost of capital

After-tax cost of equity capital

Analyse how sound financial management techniques are used to evaluate long and short term investment decisions

Capital budgeting 

Capital budgeting ...