Course Workbook By Peter Wood January 2022 2 Table of Contents Contents 1 The NPV Rule.......................................................................................................................................3 2 Investment rules....................................................................................................................................3 3 Capital Budgeting .................................................................................................................................4 4 Risk and Return.....................................................................................................................................7 5 CAPM ...................................................................................................................................................8 6 Arbitrage Pricing Theory ....................................................................................................................11 7 Risk, Return and Capital Budgeting ...................................................................................................13 8 Efficient Capital Markets....................................................................................................................14 9 Long-term Financing: Introduction.....................................................................................................15 10 Capital Structure .............................................................................................................................16 11 Limits to the use of Debt.................................................................................................................17 12 Capital Budgeting in the levered firm.............................................................................................18 13 Dividends........................................................................................................................................20 14 Options............................................................................................................................................21 15 Utility Theory..................................................................................................................................22 3 1 The NPV Rule 1. Compute the NPV of a project that costs $100,000 now and generate $10,000 per year in perpetuity. Assume a discount rate of 8%. 2 Investment rules 1. Consider the following cash flows from 2 projects: Year Project A Project B 0 -700,000 -1,400,000 1 290,000 880,000 2 380,000 680,000 3 360,000 820,000 As a financial analyst, you are asked the following questions: a. If you decision is to accept the project with the greatest IRR, which project would you choose? b. Compute the NPV for both projects at a discount rate of 15%. Which project should you choose? c. Find the payback period, discounted payback period and the PI for each project. Assume a discount rate of 15%. 2. Prove that a project has a PI>1 if and only if NPV>0. 3. Consider a project where all future cash flows (after the initial investment today) are positive. Prove that you would never accept a negative NPV project with the discounted payback period rule. Is the same true for the regular payback period rule? 4. What is the difference between a mutually exclusive projects and an independent projects? 4 3 Capital Budgeting This chapter focuses on more practical examples of capital budgeting. 1. Super Manufacturing Inc is considering launching a new product. In order to make the product, the company must purchase a new machine. Consider the following data: • The company has already spent $175,000 on test marketing for the new product. • The machine costs $1 million. The machine will have no salvage value at the end of the project. • Taxes are 30%. • The project is expected to last 10 years. • Sales in year 1 will be 75,000 units. In years 2-10 sales will be 100,000 units. • Revenue in year 1 is expected to be $10 per unit. Unit revenue will increase by 3% per year. • Production costs are expected to be $6.50 per unit and are expected to increase at 5% per year. • Other fixed costs are expected to be $90,000 per year, increasing at 2% per year. (a) Compute the NPV of this project ignoring CCA. Use a discount rate of 10%. 2) Build a CCA schedule assuming an asset is purchased for $1 million in a pool with a CCA rate of 20%. Provide the first 10 years of the table. What is the annual value of the CCA deductions assuming a tax rate of 30% and a discount rate of 10%? What is the PV of these deductions over these 10 years? 3) I am considering buying an apartment building and renting the units out to students. Should we invest? Here are some details: • The building has 60 units. Each unit will rent for $500 per month. • Utilities and maintenance costs are $300 per month. • The building is listed for sale at $1.5 million. Assume the entire cost of the building can be places into a CCA class with a CCA rate of 4%. • Assume the building will last forever. • For simplicity, assume all the operating cash flows are received at year-end. Use a discount rate of 8% and assume taxes are 20% 4) Prove the PVCCATS formula. 5) Why do large companies prefer to discount real cash flows at real rates, rather than nominal cash flows at nominal rates? 6) Consider 2 projects, A and B. Which would you choose? Assume the following: • Project A costs $15,000 and will generate a one-time $25,000 (nominal) cash flow in 5 years. 5 • Project B costs $12,000 and will generate a one-time $18,000 (real) cash flow in 4 years. • Assume a nominal discount rate of 5% and an inflation rate of 2%.