FINS1613: Business Finance

Semester 1, 2015

Section II:
Capital Budgeting
School of Banking and Finance
Australian School of Business
UNSW
Robert Tumarkin
r.tumarkin@unsw.edu.au

Introduction to
financial statements

Disclosure of financial information

Accurate and reliable financial information is critical to
financial market health
Accounting boards provide rules by which corporations
prepare financial statements

Australian Accounting Standards Board

International Accounting Standards Board (IASB)
Financial Accounting Standards Board (U.S.)

Auditors are neutral third parties that verify annual

financial statements

Attest that statement prepared according to rules

Provide evidence that information is reliable

Financial Statements
Accounting reports a firm issues to provide a
snapshot of financial health...

Balance sheet

... and describe past performance

Income statement
Cash flows statement

Balance sheet

Balance sheet
A snapshot of a firms financial assets and liabilities at a
single point in time.
Liabilities

Assets
Current assets
Cash
Accounts receivable
Inventories

Current liabilities
Accounts payable
Short-term debt

Long-term assets
Property, plant, equipment

Long-term liabilities
Long-term debt
Total liabilities
Shareholders equity
Total liabilities & shareholders
equity

Total assets
6

Balance sheet terminology

Assets
The firms cash, inventory, property and any
other investments
Liabilities
The firms obligations to creditors
Shareholders equity
The difference between the firms assets and
liabilities. It is the book value of the firms
equity.
7

Balance sheet
Liabilities

Assets

Current assets

Current assets
Cash
Accounts receivable
Inventories

Current liabilities
Accounts
Cashpayable
or assets that can be
Short-term
debt to cash within a
converted

year

Accounts receivable: amount

owed
to firm by customers who
Long-term
liabilities
purchase
Long-term
debt on credit

Long-term assets
Property, plant, and equipment

Inventories: value of finished

progress, and raw
materials

Total liabilities
goods, work
Shareholders
equityin
Total liabilities &
shareholders equity

Total assets

Balance sheet
Long-termLiabilities
assets

Assets

Current
liabilitiesthat produce
Assets
Accounts
payable
more
than one year
Short-term debt

Current assets
Cash
Accounts receivable
Inventories

benefits for

Property, plant, and equipment:

includes real estate, machinery,
etc...liabilities
Long-term

Long-term assets
Property, plant, and equipment

Long-term debt

Book value (balance sheet value)

Totaldecreased
liabilities each year to match
assets useful
Shareholders
equitylife. Equal to

acquisition cost less accumulated

Totaldepreciation.
liabilities &
shareholders equity

Total assets

Balance sheet
Current liabilitiesAssets

Liabilities

Current assets payable: amount

Accounts

Cash to suppliers for purchases

owed
Accounts receivable
by
the firm on credit

Current liabilities
Accounts payable
Short-term debt

Inventories

Short-term debt: loans that

Long-term
must
be assets
repaid in the next year
Property, plant, equipment

Long-term liabilities

Long-term debt: loans and debt

(bonds) that must be repaid
after one year
Total assets

Long-term liabilities
Long-term debt
Total liabilities
Shareholders equity
Total liabilities &
shareholders equity

10

Liquidation
Definition
The process of closing a firm by selling its assets and paying its
liabilities.

11

Liquidation example
What is an estimate of the liquidation value of the firm as of 2009?
Why is this only an estimate?

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Ltd)

9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition

12

Balance sheet
Shareholders equity

Liabilities

Assets

Represents
the net worth of
Current
assets
the firm from an accounting
Cash
Accounts
receivable
perspective.
Inventories

Current liabilities
Accounts payable
Short-term debt

Long-term
assets
value of
the firm.
Property, plant, equipment

Long-term liabilities
Long-term debt

An estimate of the liquidation

It is not the market value of

the firm (the value to
investors) because it is a
snapshot in time and ignores
potential
Total
assets future earnings.

Total liabilities
Shareholders equity
Total liabilities &
shareholders equity

13

The balance sheet identity

Definition
The two sides of the balance sheet must balance.

Assets = Liabilities + Shareholders0 equity

14

Income statement

15

Income statement
Lists the firms revenues and expenses over a period of time
Net profit is a measure of firm profitability over the period. Net
profit may also be referred to as:

The bottom line due to its location on the income statement

Net income
Earnings

Determined using rules of accrual basis accounting

Revenues and expenses are matched and recognised when

incurred, not when paid

16

Income statement

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Ltd)

9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition

17

Cash flow statement

18

Cash flow statement

Lists the cash generate by a firm and how the cash has been
allocated over a period of time

Operating activities: main activities of the firm

Investing activities: capital expenditures, acquisitions
Financing activities: dividend payments, net borrowing

Determined using rules of cash basis accounting

Revenues and expenses are recognised when paid

19

Cash flow statement

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Ltd)

9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition

20

Preparing basic financial

statements for project evaluation

21

Scenario
Year 0
At the start of the project, the firm expects to buy manufacturing equipment for $5,000. The
manufacturing equipment has a useful life of 5-years and will be depreciated at prime cost.
Year 1
The firm expects to sell 600 finished products at a price of $8.00 each. The raw materials
required are expected to cost $2.50 each. The firm will depreciate the manufacturing
equipment and pay taxes.
Year 2
The firm expects to manufacture 400 products, with raw materials costing $3.00 each. It
expects to sell 300 finished products at $7.00 each. The firm will depreciate the manufacturing
equipment and pay taxes.

22

Scenario (continued)
Year 3
The firm expects to sell 400 finished products at $6.00 each. 300 items will be sold in cash
and the remaining 100 on credit. It also expects to manufacture 400 products, with raw
materials costing $3.00 each. It will pay 70% of the costs to the supplier in cash and will
receive credit on the remainder. The firm depreciates the manufacturing equipment and pay
taxes.
Year 4
The firm will manufacture 200 items at $4.00 per each. It will sell these items and any
remaining inventory. It will close out all outstanding debt accounts. It will depreciate the
manufacturing equipment and pay taxes. Finally, it will sell the manufacturing equipment for
$2,000 and end the project.

23

Income statement
Determined using rules of accrual basis accounting

Revenues and expenses are matched and recognised when

incurred, not when paid
Property, plant, and equipment is depreciated over time. This
matches the long-term life of these items to their period of
use.
Taxes are based on Earnings before Interest and Taxes (EBIT).
Debt payments are ignored when evaluating projects. The tax
benefits of debt are addressed through an appropriate
discount-rate.

24

Income statement example

Year

Revenues
Costs
Depreciation
Earnings before interest
and taxes (EBIT)
Income tax (30%)
Earnings

25

Depreciation
Definition
The systematic allocation of the acquisition cost of long-lived or fixed
assets to the expense accounts of particular periods that benefit from
the use of the assets. Required by accrual basis accounting.

In order to calculate depreciation, we

require:
1. Initial acquisition cost of the asset
2. Useful life of the asset
3. Depreciation method

26

Prime cost depreciation

Prime cost (straight-line)

1. Set initial book value to acquisition cost
2. Compute annual depreciation as:
Initial book value / Depreciation Life
3. Depreciate the book value by the annual depreciation each
year.

27

Prime cost depreciation

Example
A laptop purchased for
$2,000 has a 4 year useful
life. Compute the annual
depreciation and book
value of the laptop for
each year using prime
cost (straight-line)
depreciation

Year

Depreciation

Book Value

$2,000

$500

$1,500

$500

$1,000

$500

$500

$500

28

Cash flow statement

Determined using rules of cash basis accounting

Revenues and expenses are recognised when paid, not

matched to when they are incurred.
Property, plant, and equipment costs are recognized when
paid.
Tax payments are based on the income statements Earnings
before Interest and Taxes (EBIT). Debt payments are ignored
when evaluating projects. The tax benefits of debt are
addressed through an appropriate discount-rate..

29

Cash flow statement example

Year
Operating activities
Cash collected from revenues
Cash payments on expenses
Taxes (30% of EBIT)
Cash provided by operating
activities

Investment activities
Capital expenditures
After-tax salvage
Cash from investing activities
Total cash flow

30

After-tax salvage
Definition
The cash received for selling an asset adjusted for taxes overor under-paid because the selling price differs from the book
value.

31

After-tax salvage

Example
A laptop purchased for $2,000 has a 4 year useful life. It will be
depreciated using prime cost (straight-line) depreciation.You
expected to sell the computer after 3 years for $750.
What is the after-tax salvage value?

32

After-tax salvage
Sale Price

Sale Price

$750

Book Value (Year 3)

500

Taxes

Capital gain (loss)

250

After-tax salvage

Taxes (30%)

75

Af ter tax salvage = Salvage price

33

T ax rate Capital gains

$750
75
675

Capital budgeting

34

Capital budgeting
The project life cycle

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Ltd)

9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition

35

Capital budgeting
A capital budget lists the projects and investments that
a company plans to undertake during future years.
To create this list, firms analyse alternate projects and
decide which ones to accept through a process called
capital budgeting.
Pro-forma statements consist of financial projections
under a set of hypothetical assumptions

36

Capital budgeting
A few questions need to be answered:
What measure of performance matters for project
valuation?
How can we value a project independent of the rest of
the firm?
What is an effective way to derive our performance
estimates?

37

The stand-alone principal

(Incremental earnings and cash flows)

38

Example
Original firm cash flows
$10

Cash
flows

$10
t=1

t=0

$10

t=2

t=3

Time

Cash flows after adding new project investment

$18

$15
Cash
flows
t=0

$6
t=1

t=2

$5

39

t=3

Time

Example
Values at 10% discount rate
Scenario

Firm NPV

Original

$24.87

After new investment

28.02

Difference

3.15

Decision: Proceed with investment in new

project as firm NPV increases.

40

Example
Imagine doing this in a large company
Requires gathering information on EVERY
expected cash flow the company will ever
receive
Is there a better way?

41

Example
Difference in cash flows
$8

$5

Cash
flows
t=0

t=1

t=2

$5

t=3
$4

The NPV is $3.15 when discounted at 10%.

42

Time

Incremental Earnings and Cash Flows

Incremental Earnings
The incremental earnings for project evaluation
consist of any and all changes in the firms future net
operating profit that are a direct consequence of
taking the project.
Incremental cash flows
The incremental cash flows for project evaluation
consist of any and all changes in the firms future
cash flows that are a direct consequence of taking
the project.
43

Stand-alone principle
Definition
A project can be evaluated by finding the incremental cash
flows from undertaking the project and discounting at the rate
appropriate for the project.

Stand-Along Principle Decision Rule

An investment is acceptable if the NPV of the incremental cash flows
is positive. It should be rejected otherwise.

44

Sunk costs
Definition
A cost that has already been incurred and
cannot be recouped, and therefore should not
be considered in an investment decision.
Why?
Our interest is in expected outcomes. We value
the future, not the past.

45

Side Effects
Definition
Cash flows gained or lost in the firms existing
projects due to taking a new project are
considered incremental cash flows.
Why?
Changes in other projects that are a direct
consequence of a new project impact overall
firm value.

46

Opportunity costs
Definition
The most valuable alternative that is given up if a
particular investment is undertaken.
Why?
Eliminating a future cash flow is equivalent to
losing money on the investment.

47

Opportunity costs

Useful for addressing profits from assets already in place

when projects are mutually exclusive.
Hard to generalise to many mutually exclusive projects.
Always possible to evaluate all options as separate
projects without opportunity costs and pick the best
alternative.

48

Project Pro Forma cash flow

analysis

49

A difference in perspectives
Accrual
basis

Cash flow
basis

Income
Statement

Cash Flow
Statement

Philosophy

Describe average firm

performance

Money money money

Revenues

Recognised when earned/

realised and payment is
expected

Recognised when cash flows

received

Expenses

Recognised in period where

related revenue is recognised

Recognised when cash flows

paid

50

A difference in perspectives

In finance, we are interested in cash flows.

However, we cannot simply compute the cash
flow statement because taxes are determined
from income statements.

51

A difference in perspectives
Accrual
basis

Cash flow
basis

Income
Statement

Cash Flow
Statement

Incremental earnings + Adjustments =

Incremental
Cash Flows

52

Incremental cash flows

Determined under cash flow basis accounting by
one of two methods

Direct: compute gross cash received and paid,

requires tax payment in incremental earnings

Indirect: adjust incremental earnings for missing

cash-related activities

53

Indirect method
Incremental earnings + Adjustments =

Incremental
Cash Flows

To understand adjustments for the indirect method, we will:

1

Analyse problem step-by-step.

Build a balance sheet, income statement, and cash flow

statement.

Determine adjustments for indirect method

54

Incremental earnings

55

Incremental earnings
Definition
For incremental earnings (and when valuing firms in general),
we use incremental net operating profit, the change in net
operating profit from undertaking a project or investment. It is
the incremental operating income less taxes directly related to
the project. Incremental earnings does not include financing
costs, such as interest payments to bond holders.

Incremental Earnings = Incremental EBIT (1

tax rate)

56

Incremental earnings example

Year

3
200

Incremental revenues

500

800

Incremental costs

-150

-300

-50

Incremental depreciation

-204

-204

-204

Incremental earnings before interest and

taxes (EBIT)

146

296

-54

Incremental income tax (30%)

-43.8

-88.8

16.2

Incremental earnings

102.2

207.2

-37.8

When analysing projects, incremental values are always implied.

We may, on occassion, omit the term incremental for brevity.
57

Financing costs and incremental earnings

Why do we ignore financing costs in evaluating projects?

Borrowing and lending do not affect project value in

competitive markets by the Law of One Price

If borrowing and lending do not affect project value,

then financing costs do not factor in the investment
decision

Implication: The particular mixture of debt and equity

a firm actually chooses to use in financing a project is
analyzed separately.

58

Taxes

In general, we envision projects as part of a large,

profitable firm which affects how we
(i) determine the tax rate, and
(ii) handle negative taxes.

59

Marginal tax rate

Definition
The tax rate a company pays on an incremental dollar of pretax income. This should be used in capital budgeting decisions.

60

organizations.
3. Dividends (other than capital gain
distributions) received from a REIT that,
for the tax year of the trust in which the
dividends are paid, qualifies under
sections 856 through 860.
4. Dividends not eligible for a
dividends-received deduction, which
include the following.
a. Dividends received on any share of
stock held for less than 46 days during
the 91-day period beginning 45 days
before the ex-dividend date. When
counting the number of days the
corporation held the stock, you cannot
count certain days during which the
corporations risk of loss was diminished.
See section 246(c)(4) and Regulations
section 1.246-5 for more details.
b. Dividends attributable to periods
totaling more than 366 days that the
corporation received on any share of
Example:preferred stock held for less than 91 days
during the 181-day period that began 90
U.S. IRS
1120
days Form
before the
ex-dividend date. When
counting the number of days the
A firm
has a potential project
corporation held the stock, you cannot
generating
4 million
in which the
count certain
days during
corporations
risk of loss was diminished.
incremental
income.
See section 246(c)(4) and Regulations
1.246-5
more details.
The section
firm has
totalfortaxable
Preferred dividends attributable to periods
income
of less
10.5than
million
totaling
367 days are subject to
the 46-day holding period rule, above.
What tax
rate should be used
c. Dividends on any share of stock to
to evaluate
project? is under an
the extentthe
the corporation
obligation (including a short sale) to make
related payments with respect to positions
in substantially similar or related property.
5. Any other taxable dividend income
not properly reported elsewhere on
Schedule C.

Marginal tax rate

61

If patronage dividends or per-unit

retain allocations are included on line 17,
identify the total of these amounts in a
statement attached to Form 1120.

If the corporation is a member of a

controlled group, check the box on line 1.
Complete and attach Schedule O (Form
1120), Consent Plan and Apportionment
Schedule for a Controlled Group.
Component members of a controlled
group must use Schedule O to report the
apportionment of taxable income, income
tax, and certain tax benefits between the
members of the group. See Schedule O
and the Instructions for Schedule O for
more information.

Line 2
If the corporation is a member of a
controlled group and is filing Schedule O
(Form 1120), enter the corporations tax
from Part III of Schedule O. Most
corporations that are not members of a
controlled group and not filing a
consolidated return figure their tax by
using the Tax Rate Schedule below.
Qualified personal service corporations
should see instructions below.
Tax Rate Schedule
If taxable income (line 30, Form 1120) on page 1
is:

Over

But not
over

Section 247 allows public utilities a

deduction of 40% of the smaller of
(a) dividends paid on their preferred stock
during the tax year, or (b) taxable income
computed without regard to this
deduction. In a year in which an NOL
occurs, compute the deduction without
regard to section 247(a)(1)(B). See
section 172(d).

$0
$50,000
15%
$0
50,000
75,000
$ 7,500 + 25%
50,000
75,000
100,000
13,750 + 34%
75,000
100,000
335,000
22,250 + 39% 100,000
335,000 10,000,000
113,900 + 34% 335,000
10,000,000 15,000,000 3,400,000 + 35% 10,000,000
15,000,000 18,333,333 5,150,000 + 38% 15,000,000
18,333,333
----35%
0

Qualified personal service corporation.

A qualified personal service corporation
is taxed at a flat rate of 35% on taxable
income. If the corporation is a qualified
personal service corporation, check the
box on line 2 even if the corporation has
no tax liability.

Negative tax payments

Firm
original

Of the
amount
over

A corporation is a qualified personal

service corporation if it meets both of the
following tests.
1. Substantially all of the corporations
activities involve the performance of
services in the fields of health, law,
engineering, architecture, accounting,
actuarial science, performing arts, or
consulting.
2. At least 95% of the corporations
stock, by value, is directly or indirectly
owned by
a. Employees performing the
services,
b. Retired employees who had
performed the services listed above,

Line 18, Column (c)

Year

Tax is:

Project
incremental

-16-

Firm
+ project

5000

300

5300

Costs

-1500

-100

-1600

-500

-500

Earnings before interest and

taxes (EBIT)

3500

-300

3200

Income tax (30%)

-1050

90

-960

Earnings

2450

-210

2240

62

Negative tax payments

Taxes and negative earnings creates tax savings

that must be considered in cash flow estimates.

63

Line 3
A corporation that is not a small
corporation exempt from the AMT
may be required to file Form 4626,
Alternative Minimum Tax Corporations,
if it claims certain credits, even though it
does not owe any AMT. See Instructions
for Form 4626 for details.
Unless the corporation is treated as a
small corporation exempt from the AMT, it

CAUTION

Instructions for Form 1120

Revenues

Depreciation

section 594 consists of the sum of (a), a

partial tax computed on Form 1120 on the
taxable income of the bank, determined
without regard to income or deductions
allocable to the life insurance department,
and (b), a partial tax on the taxable
income computed on Form 1120-L of the
life insurance department. Enter the
combined tax on line 2. Attach Form
1120-L as a schedule (and identify it as
such), together with the annual
statements and schedules required to be
filed with Form 1120-L. See Regulations
section 1.6012-2(c)(1)(ii).
Exception for insurance companies
filing their Federal income tax returns
electronically. If an insurance company
files its income tax return electronically, it
should not include the annual statements
and schedules required to be filed with
Form 1120-L. However, such statements
must be available at all times for
inspection by the IRS and retained for so
long as such statements may be material
in the administration of any internal
revenue law.
Deferred tax under section 1291. If the
corporation was a shareholder in a PFIC
and received an excess distribution or
disposed of its investment in the PFIC
during the year, it must include the
increase in taxes due under section
1291(c)(2) (from Form 8621, Part IV, line
11e) in the total for line 2. On the dotted
line next to line 2, enter Section 1291
and the amount.
Do not include on line 2 any interest
due under section 1291(c)(3). Instead,
show the amount of interest owed in the
bottom margin of page 1, Form 1120, and
label it as Section 1291 interest.
See the instructions for Form 8621,
Part IV, lines 11e and 11f.
Additional tax under section 197(f). A
corporation that elects to pay tax on the
gain from the sale of an intangible under
the related person exception to the
anti-churning rules should include any
additional tax due under section
197(f)(9)(B) in the total for line 2. On the
dotted line next to line 2, enter Section
197 and the amount.

Capital expenditures,
depreciation, and salvage

64

Property, plant, and equipment during project life

Capital expenditures

Does not appear as part of incremental

earnings, but is a cash investment. Must
be subtracted from incremental
earnings to find cash flows

Purchases of new property, plant and

equipment.

Depreciation
The systematic allocation of the acquisition
cost of long-lived or fixed assets to the
expense accounts of particular periods that
benefit from the use of the assets. Required
by accrual basis accounting.

Appears in incremental earnings, but is

not a cash expense. Must be added back
to incremental earnings to find cash
flows.

Salvage

Does not appear as part of incremental

earnings, but is a cash recovery of
equipment. Must be added to
incremental earnings to find cash flows.

The sale of used property, plant, and

equipment.

65

Capital expenditures
Adjustments under the indirect method
How: Subtract capital expenditures from incremental earnings
Why: Under accrual accounting,

Capital expenditures entered as Property, Plant, and

Equipment on the balance sheet

Cost depreciated over time reducing balance sheet book

value

66

Depreciation
Adjustments under the indirect method

How: Add back depreciation to incremental earnings

Why: Under accrual accounting,

Depreciation arises from matching principle, matching costs

to period of use

Subtracted from gross profit, reducing income statement

incremental earnings

Not a cash flow

67

After-tax salvage
Adjustments under the indirect method
How: Add after-tax salvage value to incremental earnings
Why: Under accrual accounting,

Salvage eliminates Property, Plant, and Equipment and

appears as cash on the balance sheet

Salvage is not considered operating income, instead it is

considered part of the firms investment activities

68

Net working capital

69

Indirect method for working capital

Inventories

Increase subtracted from

incremental earnings to find
operating cash flows.

Items needed for the continued

operation of the business.
Accounts receivable

Increase subtracted from

incremental earnings to find
operating cash flows.

Sales that have been recognised in

incremental earnings, but have not
yet been received.
Accounts payable

Increase added to
incremental earnings to
find operating cash flows.

Expenses that have been recognised

in incremental earnings, but have not
yet been paid.

70

Net working capital

Definition
The difference between current assets and current liabilities is
the firms net working capital. It is the capital available in the
short term to run the business.
N et W orking Capital = W orking Capital Assets
W orking Capital Liabilities

Net working capital is an asset!

71

Net working capital

For most of our problems:
N et W orking Capital
= Accounts Receivable + Inventories
Accounts P ayable

As net working capital is an asset, an increase in NWC should be

subtracted from incremental earnings when computing operating
cash flows.

72

Net working capital

A note about cash:

Cash held for some purposes may be included as in net

working capital

Examples:

Cash required for firm operations (e.g. cash held to

purchase inventories or pay suppliers) is counted as

net working capital

Cash held from profits before distribution to share

holders is not net working capital

In this class, we will not concern ourselves with a cash

component of net working capital to simplify analysis.
73

Net working capital

Adjustments under the indirect method

How: Subtract changes in book value of net working capital

from incremental earnings

Why: Under accrual accounting,

Net working capital is an asset

Timing of cash receipt or payment does not matter

Expenses are recognised only when related sales are made

under the matching principle

74

The indirect method

75

The indirect method

Incremental earnings
+

Depreciation

Capital expenditures

After-tax salvage

Change in net working capital

Incremental free cash flows

76

Analysing the indirect method

It can be useful to separately analyse the tax benefits of
depreciation
F CF = Incremental EBIT (1
+ Depreciation

= (Revenues

Costs

+ Depreciation
= (Revenues
CapEx

CapEx

T ax rate)
Change in N W C

Depreciation) (1

CapEx

Costs) (1

T ax rate)

Change in N W C

T ax rate)

Change in N W C + Depreciation T ax rate

Depreciation tax shield = Depreciation T ax rate

77

Evaluating projects

78

Evaluating projects
First create Pro Forma:
Incremental earnings
Capital expenditures and after-tax salvage
Net working capital requirements
Incremental project cash flows

79

Evaluating projects
Then determine the NPV per the following general
framework:
1. Determine expected cash flows for period until project
stabilizes
2. Determine stable, long-term project cash flows
3. Compute value of long-term cash flows using perpetuity or
annuity formula, this is called the terminal value
4. Compute NPV using all cash flows and terminal value

80