Week 9 Tutorial Solutions PDF

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Week 9 Tutorial Solutions...

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FIN222Week9_TCH9:RQ3,P13(b),14,16,18,22,(6Questions) RQ3  Why do we convert from incremental earnings to free cash flow when performing capital budgeting?  Incremental earnings do not represent real profits, and cannot be used to buy goods, pay employees,fundnewinvestmentsorpaydividends(rememberitincludesanon‐cashitemsuchas depreciation).  Toevaluateacapitalbudgetingdecision,weneedtodetermineitseffectonthefirm’scash.  P13(b)  

ElmdaleEnterprisesisdecidingwhethertoexpanditsproductionfacilities. Althoughlong‐termcashflowsaredifficulttoestimate,managementhasprojectedthe followingcashflowsforthefirsttwoyears(inmillionsofdollars)  CorporateTaxrate:30% Whatarethefreecashflowsforthisprojectforthefirsttwoyears? Let’saddnecessarystepstotheexistinglinestoarriveatFCF(RefertoPage279).  1 2 3 4     5 6 

Year Revenue Operatingexpenses(otherthanDepreciation) Depreciation EBIT Taxat30% IncrementalEarnings Addbackdepreciation NWC CapEx FCF

            Page1of5 

1 125 ‐40 ‐25 60 ‐18 42 +25 ‐2 ‐30 35

2 160 ‐60 ‐36 64 ‐19.2 44.8 +36 ‐8 ‐40 32.8

P14    

MobileAccessLimitedisamobiletelephoneserviceproviderthatreportednetprofitof$250 millionforthemostrecentfinancialyear. Thefirmhaddepreciationexpensesof$100million,capitalexpendituresof$200million,and nointerestexpenses. Networkingcapitalincreasedby$10million.(Cashoutflow,right?) CalculatethefreecashflowforCellularAccessforthemostrecentfinancialyear.     Revenue NA Operatingexpenses(otherthanDepreciation) NA Depreciation NA EBIT NA Taxat30% NA IncrementalEarnings(Netprofitequivalent) 250 Addbackdepreciation +100 NWC ‐10 CapEx ‐200 FCF

140

 Earnings(=Netprofit)areanaccountingmeasureofthefirm’sperformance.Theydonotrepresent CASH‐BASEDrealprofits.  Thus,toevaluateacapitalbudgetingdecision,wemustfindtheincrementalfreecashflows(=FCF).             Page2of5 

**P16  

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Oneyearago,yourcompanypurchasedamachineusedinmanufacturingfor$110000. You have learned that a new machine is available that offers many advantages; you can purchaseitfor$150000today. (a) Capitalexpenditure0=150,000 It will be depreciated on a straight‐line basis over 10 years and has no salvage value. Depreciationnew=150000/10=15000(e) You expect that the new machine will produce a gross  margin (revenue minus operating expenses other than depreciation) of $40 000 per year for the next 10 years. Gross marginnew=40000(c) The current machine is expected to produce a gross margin of $20 000 per year. The currentmachineisbeingdepreciatedonastraight‐linebasisoverausefullifeof11 years, andhasnosalvagevalue,so depreciation expenseforthecurrentmachine is$10 000per year. Depreciationold=110000/11=10000(f) Grossmarginold=20000(d)  Themarketvaluetodayofthecurrentmachineis$50000.Yourcompany’staxrateis30%, MVold=50000, BVold=? Cost–accumulateddepreciation=110000‐10000=100000 Madeacapitallossof50000(BV>MV)  Taxsavingonloss(=50000*0.3) InYear0,Cashinflowfromsalesoftheold =50,000+(50,000)*(0.3)=$65,000(b) andtheopportunitycostofcapitalforthistypeofequipmentis10%. Shouldyourcompanyreplaceitsyear‐oldmachine?

Remember! WhatmattersisINCREMENTALCashflowswhicharisefrom theadoptionofthenew machine!   Revenue Operatingexpenses(other thanDepreciation) Grossprofit(=margin) Depreciation EBIT Taxat30% IncrementalEarnings Addbackdepreciation NWC CapEx

FCF

Year0  

Year1‐10

       ‐150,000(a) +65,000(b)  ‐85,000

20,000(c)‐(d) ‐5,000(e)‐(f) 15,000 ‐4,500 10,500 +5,000  

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15,500

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AformoftheFCFof15,500for10years?Annuity! 

NPV  85, 000 

15,500  1  1    $10, 240.79  0.10  1.1010 

NPV>0thereforereplacethecurrentmachinewiththenewmachine.   P18     

Youhavejustcompleteda$20000feasibilitystudyforanewcoffeeshopinsomeretailspace youown. Youboughtthespacetwoyearsagofor$100000,butifyousoldittoday,youwouldnet$115 000aftertaxes. Outfittingthespaceforacoffeeshopwouldrequireacapitalexpenditureof$30000plusan initialinvestmentof$5000ininventory. Whatisthecorrectinitialcashflowforyouranalysis ofthecoffeeshopopportunity?

 

Identifytherelevantincrementalcashflows.

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Thefeasibilitystudyisasunkcostandsoisirrelevant.

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CAPEXatYear0=CostoftheNEW=‐$30,000

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Opportunitycost*=‐$115,000 *Thenetamountyouwouldreceiveifyousoldthespacetoday(=$115,000)istheamountyouwould havetoforegoifyouusethespaceforacoffeeshop(i.e.anopportunitycostofusingthespacefora coffeeshop).Sowerecognisethatasacost(moneyyouwilllose).

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NWC=‐$5,000

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FCFatyear0=‐$30,000‐$115,000‐$5,000=‐$150,000

Note:Toproperlyrepresenttheinitialcashflowinyouranalysis,youneedtoignorethesunkcostsand recognise the opportunity costs as well as the long‐term investment (capital expenditures) and short‐ terminvestments(increaseinNWC).      Page4of5 

 P22 

Home Builder Supply, a retailer in the home improvement industry, currently operates sevenretailoutletsinNewSouthWales.  Management is contemplating building an eighth retail store across town from its most successfulretailoutlet.  The company already owns the land for this store, which currently has an abandoned warehouselocatedonit.Last month,themarketingdepartmentspent$10000onmarket researchtodeterminetheextentofcustomerdemandforthenewstore.  NowHomeBuilderSupplymustdecidewhethertobuildandopenthenewstore.

Whichofthefollowingshouldbeincludedaspartoftheincrementalearningsfortheproposed newretailstore? a. Theoriginalpurchasepriceofthelandwherethestorewillbelocated. No,thisisasunkcost. Ifnotgoingahead,thecostisstillthere?ThenSunkcost! b. Thecostofdemolishingtheabandonedwarehouseandclearingtheland. Yes,thisisacostofopeningthenewstore.Ifnotgoingahead,thecostwon’tbeincurred. c. Thelossofsalesintheexistingretailoutlet,ifcustomerswhopreviouslydroveacrosstownto shopattheexistingoutletbecomecustomersofthenewstoreinstead. Yes,thislossofsalesattheexistingstoreshouldbedeductedfromthesalesatthenewstore todeterminetheincrementalincreaseinsalesthatopeningthenewstorewillgeneratefor HBS. d. The$10000inmarketresearchspenttoevaluatecustomerdemand. No,thisisasunkcost. Ifnotgoingahead,thecostisstillthere?ThenSunkcost!  e.  Constructioncostsforthenewstore. Yes. This is a capital expenditure associated with opening the new store. These costs will thereforeincreaseHBS’sdepreciationexpenses. f.  Thevalueofthelandifsold. Yes,thisisanopportunitycostofopeningthenewstore.(Byopeningthenewstore,HBS forgoestheafter‐taxproceedsitcouldhaveearnedbysellingtheproperty.Theafter‐tax proceedswillbeeither Salesprice–(capitalgain)*(taxrate)or Salesprice+(capitalloss)*taxrate) g.  Interestexpenseonthedebtborrowedtopaytheconstructioncosts. No. For capital budgeting purposes we calculate the incremental earnings without including financingcoststodeterminetheproject’sunleverednetprofit.Incapitalbudgeting,thecostof borrowingisfeltthoughtheWACCwhichincorporatesthecostofdebt.   Page5of5 ...