CF 473.32 12 Winter 2014. Questions 1. What cash flows should I consider? 2. How does the market set r ? 3. How should I set r ?

CF

473.32

12

Winter 2014

Questions

1. What cash flows should I consider?

2. How does the market set r?

3. How should I set r?

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at time 0 at the very beginning of the project

• when decision to go ahead made any costs incurred to make decision ignored

when added all together• almost always < $0

CF1

at time 0 includes

• capital cost usually equipment

• shipping, installation, training, etc. everything needed to get it up & running

• working capital cash

• flotation costs

start-up costs

CF1

at time 0 also includes

• present value of Capital Cost Allowance minus the CCA of salvage revenue

PVCCA tax shield

• PV of getting working capital back

PVworking capital

CF1

workingshieldCCA tax outlay initial1 PVPVPVCF

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1outlay initial

start-up costs

weighted average flotation cost

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Flotation Costs

issuing new stocks or bonds isn’t free weighted average flotation cost

fd=2%

debt

fe=5%

equity1/2

.5

1/1

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wd=.50 wd=.33wd=.67

we=.50 we=.67we=.33

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Flotation Costs

issuing new stocks or bonds isn’t free weighted average flotation cost

• use target weights over the long term,

firm will issue securities in these percentages

Flotation Costs

project firm’s target D/E ratio is .6 flotation costs

• 5% equity

• 3% debt

Flotation Costs

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Flotation Costs

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104,438.64$outlay initial PV

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you get the cash (working capital) back at end of project

what’s that refund worth to you today?

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CCA tax shield

tCCA CCA tax shield rate

tc corporate tax rate

r discount rate

s salvage value

n number of periods in the project

nCCA

cCCA

CCA

cCCAoninstallatiequipment

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tst

r

r.

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ttccPV

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501 shieldCCA tax

Equipment cost c $100,000

Installation & delivery cost c $10,000

Salvage s $17,000

when? n 6

Marginal tax rate tc40%

CCA tax rate tCCA20%

discount rate r 10%

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“hurdle rate”

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cCCA

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Productivity

considering new production system

• initial cost $1 million

• save $300,000/yr in inventory & receivables management costs

• last for 5 years

• CCA tax shield rate of 20%

• salvage value of $50,000

• no impact on Net Working Capital

• marginal tax rate is 40%

• required return is 8%.

Productivity

Equipment cost cequipment$1,000,000

Installation & delivery cost cinstallation$0

Working capital cworking$0

Benefit CF2…CFn+1$300,000

Salvage s $50,000

when? n 5

Flotation cost fa0%



discount rate r 8%

Applications

cost-cutting proposals replacing an asset setting a bid price comparing equipment with different lifespans

Cost-Cutting Proposal

equip• $80,000

to buy & install

save• $35,000

pretax

lifespan• 5 years

NWC• $0

CCA tax rate• 20%

salvage• $0

tax rate• 40%

discount rate• 10%


Equipment cost cequipment$80,000



Benefit CF2…CFn+1$35,000·(1-tC)

Salvage s $0

Lifespan n 5

Flotation cost fa0%



discount rate r 10%


n

working

nCCA

cCCA

CCA


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c

r)(rt

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r.

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1

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5

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Replacement?

original machine initial cost

• $150,000

purchased• 4 yrs ago

salvage today• $50,000

salvage in 6 yrs• $10,000

new machine initial cost

• $200,000

6-year life salvage in 6 yrs

• $30,000

cost savings• $75,000/year

net working capital• $0

CCA rate = 20%

required return = 15%

marginal tax rate = 44%

$150,000

-PV PV

PV

only question: What will be different if we do project?

Replacement?

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salvage foregone

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Replacement?

Equipment costnetcequipment

$150,000



Benefit CF2…CFn+1$75,000·(1-TC)

Salvagenets $30,000

Lifespan n 6

Flotation cost fa0%



discount rate r 15%

Replacement?

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44.20.000,10$000,30$

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CF

Setting a Bid Price

required return • 20%

5 trucks/year • for 4 years

truck platforms• $10,000 ea

facilities lease• $24,000/year

labor & material • $4,000/truck

new equipment• $60,000

salvage• $5,000

NWC• $40,000

CCA• 20%

tax• 43.5%

Setting a Bid Price

Equipment cost cequipment$60,000.00


Working capital cworking$40,000.00

Benefit CF2…CFn+1$94,000.00·(1-

tc)

Salvage s $5,000.00

Lifespan n 4

Flotation cost fa0%

Marginal tax rate tc43.5%


discount rate r 20%

Documents

CF 473.32 12 Winter 2014. Questions 1. What cash flows should I consider? 2. How does the market set r ? 3. How should I set r ?