Understanding Cash Flows and Capital-Budgeting DecisionsIndiana Wesleyan University FIN-310-01A
Dr. Sam OjoOctober 19, 2014
Understanding Cash Flows and Capital-Budgeting Decisions
When evaluating cash flows for determining whether or not to pursue constructing a building to manufacture cupcakes there are several things to consider. The most important would be looking at a Grammy’s incremental after tax cash flow. Then one needs to determine the projects initial outlay, the differential cash flows over the project’s life, and the terminal cash flow. Also what needs to be looked at is what is the net present value and its internal rate of return. When making the capital-budgeting decision for constructing a building to manufacture cupcakes one should focus on cash flows rather than accounting profits. Accounting profits cannot be reinvested. They are more like profits on paper. Cash flows can be reinvested as soon as it is received. So it is money in hand so to speak. After tax cash flows (also called free cash flows) are the most important to look at because they are the actual amount of money that is available for the company to work with. Looking at cash flows help to determine the timing of the benefits or costs of a constructing a building to manufacture the cupcakes. This is why accounting profits are not what one should look at when making capital-budgeting decisions. Also it is important to focus on incremental cash flows because when one looks at the construction project, incremental cash flows are benefits and therefore an increase to the company if they decide to accept the project. Annual depreciation is subtracted from profits because it is an expense. The higher the deprecation the lower the profits for the accounting profits. Depreciation is subtracted from income taxes and thus it helps reduce the amount of taxes Grammy’s company has to pay out. As the income taxes goes down it helps Grammy’s company cash flow increase. Sunk costs do not...

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Write Up: Mini Case ofChapter 10: The Basics of Capital Budgeting: Evaluation CashFlows
Oct 2, 2014
Executive Summary:
We heritage $1 million from our grandfather, and we just received our master degree in MBA, and because we love to be our own boss and, we don not have the skills to trade on the market, we decided to purchase an established franchise in the fast-food area to make some investments. We chose two franchises: L, Lisa’s Soups, Salads, & Stuff which serves breakfast and lunch; and S, Sam’s Fabulous Fried Chicken that serves dinner. We think these two franchises are perfect complement to each other, also we estimate that both projects has the same risk characteristics, and for that we required 10% for our return, but we do not have the ability to stay on the project for more than 3 years, for that reason we estimate the free cashflows for both projects for the next three years. The main problem here that we have to evaluate and determine whether one or both of the franchises should be accepted.
To solve this problem, we used 6 capital budgeting techniques: net present value (NPV), internal rate of return (IRR), modified IRR (MIRR), profitability index (PI), payback and discounted payback. Each approach provides a different piece of information, so it is better to look at all of them when evaluating projects. Each one of them has it’s own strengths and weaknesses, which may help us to understand...

...discounted cashflow (DCF
In finance, discounted cashflow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cashflows are estimated and discounted to give their present values (PVs) — the sum of all future cashflows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cashflows in question.
Using DCF analysis to compute the NPV takes as input cashflows and a discount rate and gives as output a price; the opposite process — taking cashflows and a price and inferring a discount rate, is called the yield.
Discounted cashflow analysis is widely used in investment finance, real estate development, and corporate financial management.
Discount rate
Main article: Discounting
The most widely used method of discounting is exponential discounting, which values future cashflows as "how much money would have to be invested currently, at a given rate of return, to yield the cashflow in future." Other methods of discounting, such as hyperbolic discounting, are studied in academia and said to reflect intuitive decision-making, but are not generally used in industry.
The discount...

...Higgins
Additional Problems
Chapter 7 – Discounted CashFlow Techniques page 247
A brief tutorial on Excel financial functions (problems to follow)
You may find the following Excel, built-in financial functions helpful when analyzing the problems below. (To access these functions, select Insert, Functions, and choose Financial.)
=PV(rate, nper, pmt, fv, type) returns the present value of a series of cashflows.
=FV(rate, nper, pmt, pv, type) returns the future value of a series of cashflows.
=PMT(rate, nper, pv, fv, type) calculates the periodic payment for a loan based on constant payments and a constant interest rate.
=NPER(rate, pmt, pv, fv, type) returns the number of periods for an investment based on periodic, constant payments and a constant interest rate.
=NPV(rate, range) returns the net present value of an investment based on a discount rate and a series of future payments (negative values) and income (positive values). (Warning: By convention, NPV calculates the net present value one period before the first cashflow.)
=IRR(range, guess) returns the internal rate of return for a series of cashflows.
In these functions,
rate = the discount, or interest rate.
nper = number of periods.
pmt = annual uniform payment.
fv = future...

...In finance, the discounted cashflow (DCF) analysis is a method of valuing a project, company or asset using the concepts of time value of money (Wikipedia, 2004). Three inputs are required to use the DCF, also called dividend-yield-plus-growth-rate approach, include: the current stock price, the current dividend, and the marginal investor’s expected dividend growth rate. The stock price and the dividend are east to obtain, but the expected growth rate is difficult to estimate (Ehrhardt & Brigham, 2011). The advantages and disadvantages of using DCF approach will be explained along with the further clarification on the cost of capital using DCF approach.
The cost of capital is a term used in the field of financial investment to refer to the cost of a company’s funds, both debt and equity, or from an investors’ point of view, the shareholders required return on a portfolio of a company’s existing securities. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet (Wikipedia, 2004). In other words, it is the expected return that is required on investments to compensate for the required risk. It represents the discount rate that should be used for capital budgeting calculations. The cost of capital is generally calculated on a weighted average, also called Weighted Average Cost of Capital (WACC).
To...

...The statement of cashflows.
The statement of net worth.
The statement of retained earnings.
The statement of working capital.
Efficiency ratio: Gateway Corp. has an inventory turnover ratio of 5.6. What is the firm's days's sales in inventory?
61.7 days
57.9 days
65.2 days
64.3 days
Leverage ratio: Your firm has an equity multiplier of 2.47. What is its debt-to-equity ratio?
1.74
0.60
1.47
0
Which of the following is not a method of “benchmarking”?
Evaluating a single firm’s performance over time.
Conduct an industry group analysis.
Utilize the DuPont system to analyze a firm’s performance.
Identify a group of firms that compete with the company being analyzed
Present value: Jack Robbins is saving for a new car. He needs to have $ 21,000 for the car in three years. How much will he have to invest today in an account paying 8 percent annually to achieve his target? (Round to nearest dollar.)
$26,454
$22,680
$16,670
$19,444
PV of multiple cashflows: Ferris, Inc., has borrowed from their bank at a rate of 8 percent and will repay the loan with interest over the next five years. Their scheduled payments, starting at the end of the year are as follows—$450,000, $560,000, $750,000, $875,000, and $1,000,000. What is the present value of these payments? (Round to the nearest dollar.)
$2,735,200
$2,431,224...

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1. A company needs to elect 10 directors. A shareholder owns 80 shares. What is the maximum number of votes that he or she can cast for a favorite candidate under (10 points)
a. Straight voting? 80
b. Cumulative voting? 80*10 = 800
2. “If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio by throwing darts at the Wall Street Journal.” Explain why this is not so. (10 points) This strategy does not consider risk.
3. The NuPress Valet Company has an improved version of its hotel stand. The investment cost is expected to be 72 million dollars and will return 13.50 million dollars for 5 years in net cashflows. The ratio of debt to equity is 1 to 1. The cost of equity is 13%, the cost of debt is 9%, and the tax rate is 34%. What is the NPV of the project? (10 points)
WACC = .5*13+.5*9*(1-.34) = 9.47%
PMT = 13,500,000, i=9.47%, n=5, PV = ?; NPV = PV – 72,000,000 = -20,123,870.16
4. TXI Corporation is a holding company with four main subsidiaries. The percentage of its business coming from each of the subsidiaries, and their respective betas, are as follows: (10 points)
Subsidiary
Percentage of Business
Beta
Electric Utility
60%
0.70
Cable Company
25%
0.90
Real Estate
10%
1.30
International Projects
5%
1.50
a. What is the holding company’s beta?
Β = .6*.7+.25*.9+.10*1.3 + .05*1.5 = 0.85
b. Assume that the risk-free rate is 6 percent and the market risk premium is 5 percent. What...

...6%
15.0%
Solution: B
r = 4% + 1.2 x (12% - 4%) = 13.6% and
$24.50 = $1.50 / (13.6% - g)
Leads to g = 7.48%
2. What is the yield to maturity on a 10-year zero-coupon bond with a $1,000 face value
selling at $742?
A)
B)
C)
D)
E)
3.03%
7.42%
13.48%
34.78
42.37%
Solution: A
YTM = (1000/742) 1/10 -1 = .03029 or 3.03%
3. Consider the following monthly cashflows (see the diagram below):
X
Today
Z
X
Z
X
Z
1
2
3
4
19
20
Cashflows of an amount X are made for months 1, 3, 5, …, 17 and 19 (the ten oddnumbered months) and cashflows of an amount Z are made for months 2, 4, 6, …, 18
and 20 (the ten even-numbered months). The APR is 6% and is compounded on a
monthly basis. What is the present value of these cashflows today if X = $2,000 and
Z = - $700?
A) 12,311
B) 12,406
C) 25,569
D) 25,664
E) 32,955
Solution: B
The monthly interest rate is 0.5% but since the X’s cashflows are made every two
months, we need to calculate the 2-months equivalent interest rate:
I2m = r = (1 + 0.5%) 2 − 1 = 1.0025%
The present value of the Z’s cashflows is given by:
Using your calculator:
I2m = 1.0025%, n=10, PMT = -700, FV=0, COMP PV
PVz0 = -$6629.02 at t=0 (Since fist payment begins at t=2 and “i" is calculated for every
2 month period, and last...

...had an ending share price of $104. Compute the percentage total return.
The return of any asset is the increase in price, plus any dividends or cashflows, all divided by the initial price. The return of this stock is:
R = [($104 – 92) + 1.45] / $92
R = 0.1462 or 14.62%
Calculating Returns
Rework the problem above, but this time assuming the ending share price is $81.
Using the equation for total return, we find:
R = [($81 – 92) + 1.45] / $92
R = – 0.1038 or –10.38%
Holding Period Return
A stock has had returns of 18.43 percent, 16.82 percent, 6.83 percent, 32.19 percent, and −19.87 percent over the past five years, respectively. What was the holding period return for the stock?
Apply the five-year holding-period return formula to calculate the total return of the stock over the five-year period, we find:
5-year holding-period return = [(1 + R1)(1 + R2)(1 +R3)(1 +R4)(1 +R5)] – 1
5-year holding-period return = [(1 + 0.1843)(1 + 0.1682)(1 + 0.0683)(1 + 0.3219)(1 – 0.1987)] – 1
5-year holding-period return = 0.5655 or 56.55%
Calculating Returns
You bought a share of 5 percent preferred stock for $92.85 last year. The market price for your stock is now $94.63. What was your total return for last year?
The return of any asset is the increase in price, plus any dividends or cashflows, all divided by the initial price. This preferred stock paid a dividend of $5, so...