Corporate Finance – Tutorial 8

Chapter 11 – Project Analysis and Evaluation

There are two circumstances under which a Discounted Cash Flow analysis could lead us to conclude that a
project has a positive NPV:
1. The project really does have a positive NPV.
2. A project may appear to have a positive NPV because our estimate is inaccurate.
Forecasting risk: The possibility that errors in projected cash flows will lead to incorrect decisions. Also known
as estimation risk.
Scenario Analysis: What happens to NPV under different Cash Flow Scenario.
There are 3 case:
1. Base case/Normal case: initial project.
2. Best case: high revenues, low costs.
3. Worst case: low revenues, high costs.
Calculating Lower Bound & Upper Bound
Lower Bound Upper Bound
Component Base Case
If Deviation in X % If Deviation in X %
Unit Sales Q Q * (100% - X%) Q * (100% + X%)
Price/Unit P P * (100% - X%) P * (100% + X%)
Variable Cost/Unit VC VC * (100% - X%) VC * (100% + X%)
Fixed Cost/Year FC FC * (100% - X%) FC * (100% + X%)

Constructing Base Case, Best Case, Worst Case

Component Base Case Best Case Worst Case
Unit Sales Q Upper Bound Lower Bound
Price/Unit P Upper Bound Lower Bound
Variable Cost/Unit VC Lower Bound Upper Bound
Fixed Cost/Year FC Lower Bound Upper Bound

Calculating OCF
1. The Bottom-Up Approach
OCF = Net income + Depreciation
2. The Top-Down Approach
OCF = Sales – Costs – Taxes
3. The Tax Shield Approach
OCF = (Sales – Costs) X (1 – T) + Depreciation X T
Calculating NPV
In this chapter we only consider the OCF as the CF of the project, we will not consider NCS and Changes in
NWC. We also assume that the cash flow for the project will be the same for each year. Therefore, when we
calculate NPV we will use the annuity formula since the cash flows are fixed and definite.
1
1−
(1 + 𝑅)𝑡
𝑁𝑃𝑉 = −𝐼𝑂 + 𝑂𝐶𝐹 ×
𝑅
Sensitivity Analysis: Investigation of what happens to NPV when only one variable is changed.
If our NPV estimate turns out to be very sensitive to relatively small changes in the projected value of some
component of project cash flow, then the forecasting risk associated with that variable is high. For example, we
want to now the sensitivity of NPV to changes in VC.
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Corporate Finance – Tutorial 8
Chapter 11 – Project Analysis and Evaluation

∆𝑁𝑃𝑉 𝑁𝑃𝑉1 − 𝑁𝑃𝑉2

𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 𝑜𝑓 𝑁𝑃𝑉 𝑡𝑜 𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑉𝐶 = =
∆𝑉𝐶 𝑉𝐶1 − 𝑉𝐶2
Simulation Analysis: A combination of scenario and sensitivity analysis.
Break-Even Analysis: A tool for analyzing the relationship between sales volume and profitability.
Two Types of Cost:
1. Variable Cost: Costs that change when the quantity of output changes.
2. Fixed Cost: Costs that do not change when the quantity of output changes during a particular time period.
Marginal/Incremental Cost: The change in costs that occurs when there is one additional output.
Marginal/Incremental Revenue: The change in revenue that occurs when there is one additional output.
The Accounting Break-Even Point: when Net Income is zero.
A project that always just breaks even on an accounting basis has a
payback exactly equal to its life, a negative NPV, and an IRR of zero.
Without Tax: With Tax
𝐹𝐶 + 𝐷 𝐹𝐶 (1 − 𝑇) + 𝐷 − 𝐷𝑇 Where:
𝑄= 𝑄=
𝑃 − 𝑉𝐶 (𝑃 − 𝑉𝐶) (1 − 𝑇) P = Price/Unit
The Cash Break-Even Point: when Operating Cash Flow is zero. FC = Total Fixed Cost
A project that always just breaks even on a cash basis never pays back, VC = Variable Cost/Unit
has an NPV that is negative and equal to the initial outlay and has an IRR D = Depreciation/Year
of 100 percent. T = Tax Rate
Without Tax: With Tax OCF* = OCF when NPV = 0
𝐹𝐶 𝐹𝐶 (1 − 𝑇) − 𝐷𝑇
𝑄= 𝑄= 𝐼𝑂 𝐼𝑂
𝑃 − 𝑉𝐶 (𝑃 − 𝑉𝐶) (1 − 𝑇) 𝑂𝐶𝐹 ∗ = =
𝑃𝑉𝐼𝐹𝐴 1 − 1
The Financial Break-Even Point: the NPV of the project is zero
(1 + 𝑅)𝑡
A project that breaks even on a financial basis has a discounted payback 𝑅
equal to its life, a zero NPV, and an IRR just equal to the required return.
Without Tax: With Tax
𝐹𝐶 + 𝑂𝐶𝐹 ∗ 𝐹𝐶 (1 − 𝑇) + 𝑂𝐶𝐹 ∗ − 𝐷𝑇
𝑄= 𝑄=
𝑃 − 𝑉𝐶 (𝑃 − 𝑉𝐶) (1 − 𝑇)

Operating Leverage: The degree to which a firm or project relies on fixed costs.
Degree of Operating Leverage (DOL): The percentage change in operating cash flow relative
to the percentage change in quantity sold.
With Tax (Rarely Use)
𝐹𝐶 ( 1 − 𝑇) − 𝐷𝑇
𝐷𝑂𝐿 = 1 +
𝑂𝐶𝐹
Without Tax
𝐹𝐶
𝐷𝑂𝐿 = 1 +
𝑂𝐶𝐹
If a project has DOL = 7. It means that a 1 percent increase in the number of cans of dog food sold will increase
operating cash flow by a substantial 7 percent.

4
Corporate Finance – Tutorial 9
Chapter 12 Some Lessons from Capital Market History | Chapter 13 Return, Risk, and the SML

Return: Gain or loss form investment.

% 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛 𝑜𝑟 𝐿𝑜𝑠𝑠

𝐷𝑡+1 (𝑃𝑡+1 − 𝑃𝑡 )
% 𝑅𝑒𝑡𝑢𝑟𝑛 = +
𝑃𝑡 𝑃𝑡

Geometric Average Return: The average compound return earned per year over a multiyear period.

Arithmetic Average Return: The return earned in an average year over a multiyear period.

Risk Premium: The excess return required from an investment in a risky asset over that required from a risk-
free investment.

Risk premium = Expected return - Risk-free rate = E(R) - Rf

Expected Return: The return on a risky asset expected in the future.

Portfolio: A group of assets such as stocks and bonds held by an investor.

Portfolio Weight: The percentage of a portfolio’s total value that is invested in a particular asset.

Formula Table

Expected Return Stock

Variance of Stock

Expected Return Portfolio (2

Stocks)
Expected Return Portfolio (3
Stocks)

Variance Portfolio (2 Stocks)

Variance Portfolio (3 Stocks)

𝑛
Covariance 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝐴, 𝐵 = ∑ 𝑃𝑖 (𝑟𝑎𝑖 − 𝐸(𝑅𝑎))((𝑟𝑎𝑖 − 𝐸(𝑅𝑏))
𝑖=1

Correlation

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Corporate Finance – Tutorial 9
Chapter 12 Some Lessons from Capital Market History | Chapter 13 Return, Risk, and the SML

Total return = Expected return + Unexpected return → R = E(R) + U

Systematic Risk: A risk that influences a large number of assets. Also, market risk and non-diversifiable risk.

Unsystematic Risk: A risk that affects at most a small number of assets. Also, diversifiable risk, unique or
asset-specific risk.

Total Risk = Systematic Risk + Unsystematic Risk

Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost
no unsystematic risk.

Beta Coefficient: The amount of systematic risk present in a particular risky asset relative to that in an average
risky asset.

Security Market line (SML): A positively sloped straight line displaying the relationship between expected
return and beta.

𝐸(𝑅𝑀 ) − 𝑅𝑓
𝑆𝑀𝐿 𝑆𝑙𝑜𝑝𝑒 =
𝛽𝑀
Capital Asset Pricing Model (CAPM): The equation of the SML showing the relationship between expected
return and beta.

E(Ra) = RF + βa (Rm –Rf)

The expected return on a risky asset thus has three components. The first is the pure time value of money (Rf),
the second is the market risk premium [E(RM)- Rf], and the third is the beta for that asset (βi).

4
Corporate Finance – Tutorial 10
Chapter 14 Cost of Capital | Chapter 16 Financial Leverage and Capital Structure Policy

Problem 5
Suppose your company needs $20 million to build a new assembly line. Your target debt−equity ratio is .75.
The flotation cost for new equity is 8 percent, but the flotation cost for debt is only 5 percent. Your boss has
decided to fund the project by borrowing money because the flotation costs are lower, and the needed funds
are relatively small.
a. What do you think about the rationale behind borrowing the entire amount?
b. What is your company’s weighted average flotation cost, assuming all equity is raised externally?
c. What is the true cost of building the new assembly line after taking flotation costs into account? Does
it matter in this case that the entire amount is being raised from debt?

Problem 6
Skillet Industries has a debt–equity ratio of 1.5. Its WACC is 10 percent, and its cost of debt is 7 percent. The
corporate tax rate is 35 percent.
a. What is the company’s cost of equity capital?
b. What is the company’s unlevered cost of equity capital?
c. What would the cost of equity be if the debt–equity ratio 1.0?

The terms required return, appropriate discount rate, and cost of capital more or less interchangeably
because, they all mean essentially the same thing.
The cost of capital depends primarily on the use of the funds, not the source.

Cost of Equity: The return that equity investors require on their investment in the firm.
a. Dividend Growth Model Approach
D1
P0 =
RE − g
D1
RE = +g
P0
b. Security Market Line Approach
RE = R f +  E (E (RM ) − R f )
Approach Dividend Growth Model Approach Security Market Line Approach
Easy to understand and use ▪ Explicitly adjusts for systematic risk
Advantage ▪ Applicable to all companies, as long as
we can estimate beta
▪ Only applicable to companies currently ▪ Have to estimate the expected market risk
paying dividends premium, which does vary over time
▪ Not applicable if dividends aren’t growing ▪ Have to estimate beta, which also varies
at a reasonably constant rate over time
Disadvantage
▪ Extremely sensitive to the estimated ▪ We are using the past to predict the future,
growth rate --- an increase in g of 1% which is not always reliable
increases the cost of equity by 1%
▪ Does not explicitly consider risk

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Corporate Finance – Tutorial 10
Chapter 14 Cost of Capital | Chapter 16 Financial Leverage and Capital Structure Policy

Cost of Debt: The return that lenders require on the firm’s debt.
Now to find YTM we use interpolation or trial and error. Basically, what we do is guessing YTM by trial and
error.
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 − 𝐵𝑜𝑛𝑑 𝑉𝑎𝑙𝑢𝑒 1 𝑌𝑇𝑀 − 𝑅1
=
𝐵𝑜𝑛𝑑 𝑉𝑎𝑙𝑢𝑒 2 − 𝐵𝑜𝑛𝑑 𝑉𝑎𝑙𝑢𝑒 1 𝑅2 − 𝑅1
Example:
A Japanese company has an outstanding bond that sells for 87 percent of its ¥ 100,000 par value. The bond
has a coupon rate of 4.3 percent paid annually and features in 18 years. What is the yield to maturity of this
bond?
We know that the bonds were sold at 87,000. Now try to make a table.

Bond Value 1: R1:

Bond Price: YTM:
Bond Value 2: R2:
Start what we know. That Bond Price is 87,000 and YTM is what we are looking for, then fill YTM with X.

Bond Value 1: R1:

Bond Price: 87.000 YTM: X
Bond Value 2: R2:
For bond value 1 and R1 we mean that we try to find bond values with random rate. There is an easy way, we
can use the coupon rate that we have. As explained earlier, if a bond has the same YTM as the coupon rate,
then the bond price/bond value is the same as par. Then we can fill the bond value 1 with the par value, and
R1 with the coupon rate.

Bond Value 1: 100.000 R1: 4,3%

Bond Price: 87.000 YTM: X
Bond Value 2: R2:
For bond value 2 and R2 we can fill it in the following way. We know that bond value 1 has a value above the
bond price, then bond value 2 must have a value below the bond price. Then what do we do? Bases on chart
at the page 2, if we want to find a lower bond value then we increase the r/YTM. So if in finding Bond Value
1 we use 4.3%. Then, for R2 we look for a lower one. For the shortcut, just add 3% to the R1. Then, for R2
we use 7.3% for R. After that, we find the bond value using the known formula:

Bond Value 1: 100.000 R1: 4,3%

Bond Price: 87.000 YTM: X
Bond Value 2: 70465.32 R2: 7,3%
After we get Bond Value 2, we can use the interpolation formula to find YTM.
87.000 − 100.000 𝑋 − 4.3%
=
70.465,32 − 100.000 7.3% − 4.3%
After solving the equation, you will find that X is 5.452%. Therefore, the bond yield/YTM is 5.452%.
Cost of Preferred Stock
Preferred stock generally pays a constant dividend each period. Dividends are expected to be paid every period
forever. Preferred stock is a perpetuity, so we take the perpetuity formula, rearrange and solve for RP.
RP = D / P0
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Corporate Finance – Tutorial 10
Chapter 14 Cost of Capital | Chapter 16 Financial Leverage and Capital Structure Policy

Weighted Average Cost of Capital (WACC): The weighted average of the cost of equity and the after-tax
cost of debt.
WACC Formula without Preferred Stock:

WACC Formula with Preferred Stock:

Divisional and Project Costs of Capital

Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm’s
current operations. If we are looking at a project that does NOT have the same risk as the firm, then we need
to determine the appropriate discount rate for that project. Divisions also often require separate discount rates.
Floating Cost: Cost of issuing or floating new bonds of stocks.

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Corporate Finance – Tutorial 12
Chapter 18 Short-Term Finance and Planning

Net Working Capital = Current Assets – Current Liabilities

Activities that Increase Cash Activities that Decrease Cash
Increasing LTD (borrowing over the long term) Decreasing LTD (paying off a long-term debt)
Increasing equity (selling some stock) Decreasing equity (repurchasing some stock)
Increasing CL (getting a 90-day loan) Decreasing CL (paying off a 90-day loan)
Decreasing CA other than cash (selling some Increasing CA other than cash (buying some inventory
inventory for cash) for cash)
Decreasing fixed assets (selling some property) Increasing fixed assets (buying some property)

Inventory Period: The time Inventory TO = COGS/Av. Inventory

it takes to acquire and sell Interpretation: The firm bought and sold off their inventory … times during the
inventory. year.
Inventory Period = 365/Inventory TO
Interpretation: inventory sat for about … days before it was sold.
Accounts Receivable ARTO = Credit Sales/Av. AR
Period: The time between Interpretation: The firm turn over their receivables … times during the year.
sale of inventory and AR Period = 365/ARTO
collection of the receivable. Interpretation: Firm’s customers took an average of … days to pay.
Operating Cycle: The Operating Cycle = Inventory Period + Accounts Receivable Period
period between the Interpretation: On average, … days elapse between the time the firm acquire
acquisition of inventory and inventory and, having sold it, collect for the sale.
the collection of cash from
receivables.
Accounts Payable Period: APTO = COGS/Av. AP
The time between receipt of Interpretation: The firm turn over their payables … times during the year.
inventory and payment for it. AP Period = 365/APTO
Interpretation: The firm took an average of … days to pay their bills.
Cash Cycle: The time Cash Cycle = Operating Cycle - Accounts Payable Period
between cash disbursement Interpretation: On average, there is a … day delay between the time the firm
and cash collection. pay for merchandise and the time they collect on the sale.
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Corporate Finance – Tutorial 12
Chapter 18 Short-Term Finance and Planning

Cash Budget: A forecast of cash receipts and disbursements for the next planning period.
Steps in Cash Budget
1. Construct A/R Collection
• Old Sales = AR Period/90 X Previous Sales
• New Sales= (90 – AR Period)/90 X Current Sales
*Note: The beginning AR usually given.
2. Construct A/P Payment
• Inventory Purchase = (Inv. Purchase % X Next Quarter Sales)
• Old Purchase = AP Period/90 X Inventory Purchase
• New Purchase = (90 – AP Period)/90 X Inventory Purchase
3. Construct Net Cash Inflow
4. Cash Budget
• New Short-Term Investment = Beginning Cash Balance + Net Cash Flow - Minimum Cash Balance
(Positive Result)
• Income from Short-Term Investment = Previous Ending Short-Term Investment*Investment Rate
• New Short-Term Borrowing = Beginning Cash Balance + Net Cashflow - Minimum Cash Balance
(Negative Result)
• Interest on Short-Term Borrowing = Previous Ending Short-Term Borrowing*Borrowing Rate
• Ending Cash Balance = Beg. Cash Bal. + Net Cash Flow - New Investment + Investment Income +
Investment Sold + New Borrowing - Borrowing Interest - Borrowing Repaid
• Beginning short term Investment = Previous Quarter's Ending Short-Term Investment
• Ending Short Term Investment = Beginning Short-term Investment + New Short-term Investment -
Short-term Investment Sold
• Beginning short term Borrowing = Previous Quarter's Ending Short-Term Borrowing
• Ending Short Term Borrowing = Beginning Short-term Borrowing + New Short-term Borrowing -
Short-term Borrowing Repaid

Example of Cash Budget (Problem 3)

Q1 Q2 Q3 Q4 Q1*
Sales 160 175 190 215 170

A/R Beginning 68 Millions

A/R Collection Period 45 days
Inventory Purchase 45% of Next Quarter Sales
A/P Payment Period 36 days
Wages, Taxes, and Other Expenses 25% Sales
Interest and Dividends 12 per quarter
Beginning Cash Balance 49 Million
Minimum Cash Balance 30 Millions

A/R Collection
Cut Off Q1 Q2 Q3 Q4
Old Sales 0.5 68 80 87.5 95
Current Sales 0.5 80 87.5 95 107.5
148 167.5 182.5 202.5

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Corporate Finance – Tutorial 12
Chapter 18 Short-Term Finance and Planning

A/P Payment
Q4* Q1 Q2 Q3 Q4
Inventory Purchase 45% 72 78.75 85.5 96.75 76.5
Cut Off
Old Purchase 0.4 28.8 31.5 34.2 38.7
New Purchase 0.6 47.25 51.3 58.05 45.9
76.05 82.8 92.25 84.6

Net Cash Inflow

Q1 Q2 Q3 Q4
Cash Collection 148 167.5 182.5 202.5
Cash Disbursement
A/P Payment 76.05 82.8 92.25 84.6
Wages, taxes, other exp. 40 43.75 47.5 53.75
Interest and dividends 12 12 12 12
Capital outlay 75
Total Cash Disbursement 128.05 213.55 151.75 150.35
Net Cash Inflow 19.95 -46.05 30.75 52.15

Cash Budget
Q1 Q2 Q3 Q4
Beginning cash balance 49 30 30 30
Net cash inflow 19.95 -46.05 30.75 52.15
New Short-Term Investment 38.95 24.23937 52.6347874
Income from Short Term Investment (2%/Quarter) 0.779 0.4847874
Short Term Investment Sold 38.95
New Short-Term Borrowing 6.321
Interest on Short Term Borrowing (3%/Quarter) 0.18963
Short Term Borrowing Repaid 6.321
Ending Cash Balance 30 30 30 30
Minimum Cash Balance 30 30 30 30
Cumulative Surplus (Deficit) 0 0 0 0

Beginning Short Term Investment 0 38.95 0 24.23937

Ending Short Term Investment 38.95 0 24.23937 76.8741574
Beginning short term Borrowing 0 0 6.321 0
Ending Short Term Borrowing 0 6.321 0 0

4
Corporate Finance
Chapter 20 – Credit Policy and Inventory Management

• Credit Policy:
1.) CF Old
2.) CF New
3.) Incremental CF = CF new – CF old
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐶𝐹
4.) PV of Perpetuity = 𝑟
5.) Cost of Switching = (𝑉𝐶 𝑛𝑒𝑤 ∗ (∆𝑄) + 𝑄 𝑛𝑒𝑤 ∗ (∆𝑉𝐶)) + (𝑄 𝑂𝑙𝑑 ∗ 𝑃𝑟𝑖𝑐𝑒 𝑂𝑙𝑑)
6.) NPV = PV of Perpetuity – Cost of Switching
• Inventory Management:
Total Carrying Cost = Average Inventory * Carrying Cost per unit
Restocking Cost = Number of Order * Ordering Cost

2∗𝑌𝑒𝑎𝑟𝑙𝑦 𝐷𝑒𝑚𝑎𝑛𝑑∗𝑂𝑟𝑑𝑒𝑟 𝐶𝑜𝑠𝑡

EOQ = 𝑄 ∗ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡

2𝐷𝑆
𝑄∗ = √
𝐶𝐶