Lecture 6: Capital Budgeting
Lecture 6: Capital Budgeting For Capital Budgeting, you are only concerned with Free Cash Flow (FCF) associated with the project. This is the difference between the firm’s cash flow if the project is undertaken and if it’s not. Relevant cash flows include: Revenues, expenses, capital expenditure, depreciation associated with the project Irrelevant cash flows include: Sunk costs (costs that have already been incurred and will not change if the project is taken or not)
OR
Table Calculation of Free Cash Flows Revenue
Any Income
Less Operating Expenses
Any expenses: maintenance, utilities etc.
Less/Add Opportunity Cost
Less revenue lost or add discounts received by accepting project
Less Depreciation
= (Cost – Salvage Value) / Useful Life
= EBIT
Earnings Before Interest and Tax
Less Income Tax
= EBIT * Tax Rate
= Unlevered Net Income
= EBIT – (EBIT * Tax Rate) = EBIT * (1 – t)
Add Back Depreciation
As it is a Non-Cash Expense (it is only used above to calculate EBIT)
Less Capital Expenditure
= Cost of PPE (i.e. Non-Current Assets)
Add Cash from Sale
Cash received when PPE is sold at the end of the project
Less Tax on Gain
= (Cash from Sale – Book Value) * Tax Rate
Less ∆Net Working Capital
i.e. change in Inventory + change in A/cs Receivable – change in A/cs Payable
= FCF Externalities must also be considered. These are indirect effects of the project that may affect the profits of other activities of the firm. There are two types: Cannibalisation: sales of a new product replace sales of an existing product (therefore, you must subtract sales of the old product that you will no longer receive)
Side Effects: costs of another product are reduced due to the new project (therefore, you must add back the costs that you will not have to pay due to the new product; this is a benefit)
Change in Net Working Capital It is rare that you have to calculate the change in net working capital but I’ll provide an example just in case. The best way to do this is simply compare the net working capital from one period with the next. If NWC increased, that means we bought inventory, sold on credit or paid back a supplier. Buying inventory and paying a supplier are clear examples of cash outflows but the reason selling on credit is an “outflow” is because it wasn’t a cash flow when included in sales and therefore must be considered as an outflow to cancel out the amount it is connected to in sales. If NWC decreases, that means inventory is sold, cash is received from customers or we buy on credit. Again, buying on credit is an “inflow” to cancel out the cost that would have been recorded. Example: Net Working Capital Say you currently have an inventory balance of $20,000, A/cs Receivable is $10,000 and A/cs Payable is $3,000. To commence your project, you will need additional inventory of $10,000 and to decrease A/cs Payable to $3,000 (as a condition of a loan). This means you will need an outflow of $10,000 and $3,000.
As the change is positive, we have paid money, we subtract it in our formula as an outflow of $13,000.
CONTINUES
Lecture 7: Valuing Stock The main thing to remember about valuing stock is the price of any share will simply be the present value of future cash flows. The cash flows that you receive from shares are dividends so the valuation is basically finding the present value of dividends that will be received in the future.
Basic Dividend Policies Single Dividends Over Multiple Periods
You will use this approach when you are given a list of dividends and there is no apparent growth rate i.e. year 1 div = $2, Year 2 div = $5, year 3 div = $4. If we were to price the share related to this example, assuming r = 10%, we would get:
Constant Dividends Indefinitely
This is simply a perpetuity formula where dividends will be paid indefinitely with the amount staying the same i.e. you will receive a dividend of $2.50 next year and have been advised that dividends will remain unchanged in the future, given a cost of capital of 10% (r), what is the price of this share?
Indefinite Dividends with Constant Growth
Use the above formula when you are given next year’s dividend and a constant growth rate i.e. earnings are expected to grow at a rate of 2% forever. If you expect to receive a dividend of $4 next year, that is the price of the share today?
NOTE: you will always start with next year’s dividends in your calculations. Occasionally, they will give you the price of a dividend you have just received. DO NOT use it in the equation! You will have to multiply the dividend by whatever growth rate you are given e.g. you have just received a
dividend of $3.92, if you expect earnings to grow at a 2% rate indefinitely, what is the price of the share?
Problem Solving Changing Growth Rates This is the same concept as terminal values but instead of being given the short term dividends, they will give you a short term growth rate as well as the long term growth rate (constant growth). Example: Growth Rates You are considering purchasing shares in Telstra. You know that shareholders just received a dividend of $1.90 and that the growth rate for the next 3 years will be 5%. After this point, earnings will grow at a constant rate of 4%. Assuming cost of capital (r) is 10%, what is the price of this share?
Because we are given the current dividend (D0), we must use the short term growth rate to calculate D1. To get D2, multiple D1 by 1.05 i.e. D2 = D1 * 1.05 = (1.90 * 1.05) * 1.05 = 1.90 * 1.05 2. For the terminal value, you will multiple the last dividend (D3 = 1.90 * 1.053) by the new, long term growth rate to get the next dividend. All else stays the same:
By putting both parts together, you will see that you will get roughly the same answer as the previous example as all the information is the same:
CONTINUES
OR
Table Calculation of Free Cash Flows Revenue
Any Income
Less Operating Expenses
Any expenses: maintenance, utilities etc.
Less/Add Opportunity Cost
Less revenue lost or add discounts received by accepting project
Less Depreciation
= (Cost – Salvage Value) / Useful Life
= EBIT
Earnings Before Interest and Tax
Less Income Tax
= EBIT * Tax Rate
= Unlevered Net Income
= EBIT – (EBIT * Tax Rate) = EBIT * (1 – t)
Add Back Depreciation
As it is a Non-Cash Expense (it is only used above to calculate EBIT)
Less Capital Expenditure
= Cost of PPE (i.e. Non-Current Assets)
Add Cash from Sale
Cash received when PPE is sold at the end of the project
Less Tax on Gain
= (Cash from Sale – Book Value) * Tax Rate
Less ∆Net Working Capital
i.e. change in Inventory + change in A/cs Receivable – change in A/cs Payable
= FCF Externalities must also be considered. These are indirect effects of the project that may affect the profits of other activities of the firm. There are two types: Cannibalisation: sales of a new product replace sales of an existing product (therefore, you must subtract sales of the old product that you will no longer receive)
Side Effects: costs of another product are reduced due to the new project (therefore, you must add back the costs that you will not have to pay due to the new product; this is a benefit)
Change in Net Working Capital It is rare that you have to calculate the change in net working capital but I’ll provide an example just in case. The best way to do this is simply compare the net working capital from one period with the next. If NWC increased, that means we bought inventory, sold on credit or paid back a supplier. Buying inventory and paying a supplier are clear examples of cash outflows but the reason selling on credit is an “outflow” is because it wasn’t a cash flow when included in sales and therefore must be considered as an outflow to cancel out the amount it is connected to in sales. If NWC decreases, that means inventory is sold, cash is received from customers or we buy on credit. Again, buying on credit is an “inflow” to cancel out the cost that would have been recorded. Example: Net Working Capital Say you currently have an inventory balance of $20,000, A/cs Receivable is $10,000 and A/cs Payable is $3,000. To commence your project, you will need additional inventory of $10,000 and to decrease A/cs Payable to $3,000 (as a condition of a loan). This means you will need an outflow of $10,000 and $3,000.
As the change is positive, we have paid money, we subtract it in our formula as an outflow of $13,000.
CONTINUES
Lecture 7: Valuing Stock The main thing to remember about valuing stock is the price of any share will simply be the present value of future cash flows. The cash flows that you receive from shares are dividends so the valuation is basically finding the present value of dividends that will be received in the future.
Basic Dividend Policies Single Dividends Over Multiple Periods
You will use this approach when you are given a list of dividends and there is no apparent growth rate i.e. year 1 div = $2, Year 2 div = $5, year 3 div = $4. If we were to price the share related to this example, assuming r = 10%, we would get:
Constant Dividends Indefinitely
This is simply a perpetuity formula where dividends will be paid indefinitely with the amount staying the same i.e. you will receive a dividend of $2.50 next year and have been advised that dividends will remain unchanged in the future, given a cost of capital of 10% (r), what is the price of this share?
Indefinite Dividends with Constant Growth
Use the above formula when you are given next year’s dividend and a constant growth rate i.e. earnings are expected to grow at a rate of 2% forever. If you expect to receive a dividend of $4 next year, that is the price of the share today?
NOTE: you will always start with next year’s dividends in your calculations. Occasionally, they will give you the price of a dividend you have just received. DO NOT use it in the equation! You will have to multiply the dividend by whatever growth rate you are given e.g. you have just received a
dividend of $3.92, if you expect earnings to grow at a 2% rate indefinitely, what is the price of the share?
Problem Solving Changing Growth Rates This is the same concept as terminal values but instead of being given the short term dividends, they will give you a short term growth rate as well as the long term growth rate (constant growth). Example: Growth Rates You are considering purchasing shares in Telstra. You know that shareholders just received a dividend of $1.90 and that the growth rate for the next 3 years will be 5%. After this point, earnings will grow at a constant rate of 4%. Assuming cost of capital (r) is 10%, what is the price of this share?
Because we are given the current dividend (D0), we must use the short term growth rate to calculate D1. To get D2, multiple D1 by 1.05 i.e. D2 = D1 * 1.05 = (1.90 * 1.05) * 1.05 = 1.90 * 1.05 2. For the terminal value, you will multiple the last dividend (D3 = 1.90 * 1.053) by the new, long term growth rate to get the next dividend. All else stays the same:
By putting both parts together, you will see that you will get roughly the same answer as the previous example as all the information is the same:
CONTINUES
