Ch 7 - CFcapinvestdec_1

8/9/2019 Ch 7 - CFcapinvestdec_1

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6-1

Making Capital Investment

Decisions

Topic 7 -

EXAM

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights resere!. McGraw-Hill"Irwin


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Key Concepts and Skills

• Understand how to determine therelevant cash fows or vario!s typeso capital investments

• "e a#le to comp!te depreciatione$pense or ta$ p!rposes

• Apply the E%!ivalent Ann!al Cost

approach


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6-3

&ncremental Cash 'lows

• Cash fows matter(not acco!ntin)earnin)s*

• S!nk costs do not matter*

• Incremental cash fows matter*

• +pport!nity costs matter*

• Ta$es matter, we want incremental ater-

ta$ cash fows*• &nterest e$pense is ignored it is e$cl!ded

rom the cash fow calc!lation .#eca!sewe are !sin) the /01 techni%!e2


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&nterest E$pense is &)nored

• Even i the p!rchase o the 3$edasset is thro!)h #orrowin)s

.de#t2 the interest e$pense isnot incl!ded in the cash fowcalc!lation

•."eca!se we are !sin) the /01techni%!e to eval!ate theinvestment2


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elevant Cash 'lows &nvolved

82 &nitial o!tlayCost o investment 9 &ncrease in

/4C 9 +pport!nity Cost .i any2

:2 Ann!al cash fows .As shown earlier2

;2 Terminal val!e

Salva)e 1al!e .i any2 9 ecovery o/4C


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E$ample < "aldwin Company•

"aldwin company is considerin) to p!rchase anew #owlin) #all machine at a price oM8===== and install it on a vacant land it owns#esides the c!rrent actory* The machine has a!se!l-lie o >-years and will #e depreciated

!sin) a simpli3ed strai)ht-line method*

• The operations o the new machine re%!ires aninitial net workin) capital o M8==== and it?llremain constant thro!)ho!t the >-year period

and is recovera#le at the end o the period*• The company paid M:>==== to hire a

cons!ltant to cond!ct a easi#ility st!dy on the#owlin) #alls market*


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E$ample < "aldwin Company

• The machine is e$pected to provide ann!alsales o M8:==== and the company?soperatin) costs are >=@ o the sales val!e*

• The ta$ rate applica#le to the company is:>@*

• The cost o capital applica#le is 8=@*

• ecent val!ation showed that the c!rrent

market val!e o the vacant land isM====


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• &nitial +!tlay .M2Cost o Machine 8=====

&ncrease in /4C 8====

+pport!nity Cost ====

Total 8B====


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• Ann!al Cash 'lows .M2Sales 8:====

+peratin) costs -====

Depreciation -:====

0ro3t "eore Ta$ ====

Ta$ation .:>@2 8====

/et &ncome ;====

Depreciation :====

Ann!al cash 'low >====


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• Terminal 1al!e .M2ecovery o /4C 8====


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• Calc!lation o /01

/01 5 M>====F.82G=*8=H

9 M8====.8*8=2-> < M8B====

/01 5 8B>7*>>

Decision 5 Accept ./01 is positive2

• &I


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&nvestments o Une%!al6ives

• This overlooks the act that theCadillac cleaner lasts twice as

lon)*• 4hen we incorporate the

dierence in lives the Cadillac

cleaner is act!ally cheaper .i*e*has a hi)her /012*


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E%!ivalent Ann!al Cost.EAC2

• The EAC is the val!e o the levelpayment ann!ity that has the same !

as o!r ori)inal set o cash fows* – 'or e$ample the EAC or the Cadillac air

cleaner is L7>=*B*

– The EAC or the Cheapskate air cleaner isL7;*= th!s we sho!ld reNect it*


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E$ample < Te)!h Corp* "hd


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Te)!h Corporation "hd* is a man!act!rer o oOces!pplies* "!siness is )rowin) and the company isdecidin) whether or not to #!ild a new actory on anempty land it owns adNacent to its c!rrent actory* Thecost o the new actory is M= million depreciatedthro!)h simpli3ed strai)ht-line method over ten years*

The company spent M:==== to pay or a cons!ltant toanalyPe the easi#ility o the new actory*

The new actory will help the company to increase itssales to M>= million per year rom only M;> millionc!rrently* Costs and e$penses are e$pected to #e =@

o sales and the ta$ rate applica#le to the company is:>@* The operations o the new actory re%!ires totalc!rrent assets o M7===== and c!rrent lia#ilities oM:===== and this amo!nt is ass!med to #e the sameevery year*


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The company plans to 3nance the new actory with 7=@ de#t iss!e and ;=@e%!ity iss!e* The yield-to-mat!rity o its #onds is already calc!lated at *>=@* The cost o e%!ity has to #e calc!lated #ased on the ollowin), the avera)eyield o Malaysian ;-months treas!ry #ills is ;@ the company?s #eta is 8*:=

and the '"MK6C& ann!al ret!rns or the past 8= years are as ollows, ** [Hint: change the annual percentage return to holding period yieldfrst]

Rearet!rn .@2 ** Holding period yield !"#

:=8: *= "$%&

:=88 :*> "$%'(:=8= :*= "$%'

:==B -8*>

:== 8*>

:==7 :*=

:== -=*>

:==> 8*:

:== :*:

:==; 8*

ecently a real-estate #roker has oered to p!rchase the empty land at M8

million*


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A* Calc!late the )eometric avera)e market ret!rn!sin) the '"MK6C& ann!al ret!rns Fint, chan)e the

ann!al percenta)e ret!rn to holdin) period yield3rstH

.; Marks2

"eometric Average = #$%&' x $%&() x $%&( x &%*) x

$%&$) x $%&( x &%**) x $%&$( x $%&(( x $%&$,1/10 – $ = 1.509%

** FBMKLCI of 10 years

"* "ased on yo!r answer in .A2 calc!late the cost oe%!ity or Te)!h Corporation*

.; Marks2

-e = &%&. + $%(#&%&$)&* – &%&., = 1.2108 %


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C* 4hat is the wei)hted avera)e cost o capital.4ACC2 o the companyI

.; Marks2

ACC = #&%0 (70% debt) x &%&) x &%0), + #&%.(0% e!"#ty) x &%&$($&, = $.82%

&a' rate 10.25%D* Calc!late the initial o!tlay o the new actoryproNect*

.: Marks2

Factory2 34'&5&&&5&&&

Increase in 6C 2 34)&&5&&&

7pportunity Cost 2 34$5&&&5&&&

34'$5)&&5&&&


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E* Calc!late the ann!al cash fow o the new actoryproNect*

. Marks2

Annual depreciation expense = 34'&5&&&5&&&/$& =34'5&&&5&&&

Incremental Sales34$)5&&&5&&& 50 + 5

Costs 8*5&&&5&&&

Depreciation 8'5&&&5&&&

ro9t :efore tax (5&&&5&&&Tax #();, )&&5&&&

6et pro9t $5)&&5&&&

Depreciation addba, '5&&&5&&&

-"a Caso 535003000


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'* Calc!late the /01 o the new actory proNect*

.; Marks2 !sin) 0resent 1al!e ann!ity orm!la

6! = 34)5)&&5&&&


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* Calc!late the & o the new actory proNect*

.> Marks2

At '%();5 6! = 34$5>''5*$>

** Calculate at )hat rate the +, is %

At @ /01 5 34)5)&&5&&&,8$& ,/&%&> +

34)&&5&&$%&>,8$& – 34'$5)&&5&&& = 8340'&5.(.%>$(as ,rossed o6er te 03 so to #teroate)

?sing Interpolation5

#&%&'() – I33,/#&%&'() – &%&>, = $5>''5*$>(5.)5(.*%>$.

I44 5.$% **so #ts ,os#stet #t :;< ,os

#ts 6e


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Ch 7 - CFcapinvestdec_1