Capital Budgeting

Initial Outlay
Purchase Price +Shipping +Installation
Costs(if any) +Increase in NWC

ATCF=
Sales
- Costs(add if any expenses beingsaved)
- Depreciation(calculated off FC Investment ONLY)
X (1- Tax Rate)
+Depreciation

Terminal Year NonOperatingCF=

Sale Price
+Recovery of NWC
- Tax Rate X (Profit on Sale)

– When calculating NPV make sure to add Terminal Year amount to last year of
ATCF. IT IS NOT A SEPARATE YEAR CF AMOUNT!
– Be careful when asked for terminal year non-operating CF vs TOTAL
terminal year CF

Change inDepreciationMethod Effect onNPV Effect onOperatingIncome

Increase due to
Straight Line to Accelerated shift of CF's from
Decrease in earlier years.
Depreciation later years to
earlier ones.
 Inflation Depreciation Tax Shield Effect
Decreased since it reduces the
Higher than expected value of the tax shield
Increased since tax shelter is
Lower than expected more valuable
Interest Expense Expense
Decreased b/c value of
payments made to
bondholders worth less.
Increased b/c value of
payments made ot
bondholders worth more.

– Sensitivity analysis only checks changes in project’s NPV for ONE VARIABLE.
Scenario analysis uses multiple variables

Calculating Economic Income, Economic Profit, Market Value Add(NPV)

– Economic Income = ATCF – Change in Market Value

1) Calculate ATCF for each year
2) Calculate beg year market value by discounting future year ATCF’s(incl
current year) at discount rate. For example, for a 2 year project, discount
Year 1 and 2 ATCF’s at discount rate to get Value at time 0.
3) Calculate change in market value
4) Subtract from ATCF for current year to get economic income.

Economic Profit in each year = EBIT(1-Tax Rate) X [WACC X BV of

Investment]

– Each year BV of Investment will depend on depreciation rate

– measures excess return to ALL capital providers

MVA = NPV = Discount all EP’s at WACC

Calculating Residual Income – measures excess return to equity capital

providers ONLY

RI = Net Income – [ Cost of Equity X Beg Book Value ]

Comparing Projects with Unequal Lives

Equivalent Annual Annuity

1) Calculate NPV for each project(remember salvage value is added to last year
CF). Then plug as follows:
a. NPV = PV(make negative per convention)
b. N=# of years of project
c. I/Y=Interest Rate
d. FV=0
e. CPT PMT
 2) Project with highest EAA is best investment. However if asked for which
service life of a set of options is best, choose lowest EAA as it has the lowest
cost.

Evaluating Capital Project With Options

To calculate without the option:

1) calculate NPV of both possible paths, with and without.

2) Use weighted probabilities to come up with weighted NPV. This is NPV without
option

To calculate with the option

1) Calculate NPV at point in time where option is evaluated(abandon/continue,

etc). This usually involves waiting a year or more so amount of periods to
discount will be smaller than calc’ing w/o option. Do this for each possibility.
2) Since option only gives you one choice, use weighted probability given of
optimal decision(path with +NPV) and discount back to time 0.
3) Add NPV w/o option + NOV with option to evaluate if option adds enough
value to make it a positive NPV project.

Option Value = NPV(w option) – NPV(w/o option) + Option Cost(if any)

Capital Structure and Leverage

– Only difference is that total breakeven(on left) includes interest expense
Dividend Policy

DividendType Effect onShare Price Ratio Impacts

Debt/Equity
Increases due to
Cash No effect
lower equity
amount
No effect but
Stock Decrease, all else equal reclassification of RE
to PIC
No effect. No
Reduced to leave
Stock Split reclassification of RE
owner's %unchanged
to PIC
No effect. No
Increaed to leave
Reverse Stock Split reclassification of RE
owners %unchanged
to PIC

Share Repurchases
Cost of Borrowing vs Share Repurchases
Effect on EPS
Earnings Yield Market Price vs BVPS Effect on BVPS
Higher EPS Lower Higher BVPSLower
Lower EPS Higher Lower BVPSHigher
Equal EPS the Same Equal BVPSthe Same

– Calculate earnings yield as inverse of P/E or Earnings/Current Stock Price

Declaration Date – date board declares the dividend

Ex-Dividend Date – first date shares trade without dividend. Purchasers before
this date are entitled to dividend. 2 days before Date of Record
Date of Record – 2 days after Ex-Dividend rate

Payment Date – Dividends paid out

– When calculating new share amount after a dividend is paid and reinvested,
reduce share price by amount of dividend.

Calculating the Target Payout Ratio

1) Take last year’s earnings. Add:

2) Increase in Earnings X Target Payout Ration X ( 1/# of years to adjust)

Residual Dividend Approach

1) Use Debt/Equity ratio given and calculate the amount of capital spending
financed with earnings. This is Equity percentage times capital budget.
2) Subtract amount from 1 from Net Income.
3) This is dividend amount
4) To calculate payout ratio, divide dividend amount/net income.

Mergers and Acquisitions

Bootstrapping Earnings

1) If acquirer is paying in stock, calculate how many of acquirer’s shares will be

exchanged for targets:
a. # of outstanding shares of acquirer/# of outstanding shares of target
b. Divide outstanding # of shares of target by result from a. This gives
you the amount of shares of target that will be required to complete
deal.
2) Add result to acquirer’s pre-deal outstanding share amount.
3) Use new amount to calculate new P/E based on any additional information
given.

Valuing Earnings

1) Using constant growth model to determine terminal value

a. Compute NPV (initial CF is 0). Make sure last CF is final year CF +
terminal value computed as:
i. [ Final year CF X (1 + Constant Growth Rate) ]/ ( Required
Return – Constant Growth Rate)
 b. Divide by outstanding # of shares to get per share price
2) Using CF multiple method to determine terminal value
a. Compute NPV (initial CF is 0). Make sure last CF is final year CF +
terminal value computed as:
i. Final year CF X CF Multiplier
b. Divide by outstanding # of shares to get per share price
3) Using relative valuation ratios of comparable companies. (Can use current
stock price or acquisition price, same approach)
a. Calculate P/E, P/S, P/BV of comparable companies.
b. Take average for each
c. Multiple by relevant figures for target company
i. P/S X Sales
ii.P/E X Earnings
iii.PPV x Book Value
d. Take average. This is stock price
e. If asked to calculate using mean takeover premium of comparable
deals
i. Calculate takeover premium of deals as
1. [Acquisition Price/Current Stock Price] -1
ii.Take stock price calculated using comparable ratios and add
premium calculated above.