Financial Forecasting and Project Analysis 1-10-11-1

FINANCIAL FORECASTING AND CAPITAL
BUDGETING ANALYSIS
Ronald W. Spahr
Professor and Chair, Department of Finance, Insurance and Real Estate
Fogelman College of Business and Economics
University of Memphis, Memphis, TN 38152-3120
Office phone: (901) 678-1747 or 5930, Fax: (901) 678-0839
spahr@memphis.edu
January 10, 2011

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FINANCIAL FORECASTING AND CAPITAL
BUDGETING ANALYSIS
Course Description
This course covers fundamental concepts and techniques of financial forecasting and
financial analysis including time value of money, cost of capital, capital investment
decisions, product costing and lease-buy analysis.
Course Outline
I. Time Value of Money ....................................................................................4

A. Present Value and Future Value
1. Discrete Compounding
2. Compound Interest Tables
3. Continuous Compounding
4. Effective Annual Rate
5. Calculations Involving Fractional Years
B. Annuities
1. Ordinary Annuities (Annuities in Arrears)
2. Annuities Due
3. Deferred Annuities
4. Continuous Payment Annuities
5. Perpetuities
6. Calculations Involving Fractional Years
7. Amortization Schedules
II. Break-Even Analysis and Financial Forecasting 20
III. Cost of Capital........................................................................................ 23

A. Component Costs
B. Concept of Weighted Average Cost of Capital (WACC)
IV. Capital Budgeting.................................................................................... 31
A. Definitions
1. Conventional vs. Nonconventional Cash Flows
2. Independent, Mutually Exclusive, Contingent, Competitive
and Complementary Projects
3
B. Decision Rules for Project Evaluation/Comparison
1. Net Present Value (NPV)
3. Payback Period
C. Estimation of Cash Flows

1. Incremental Cash Flows
2. Sunk Costs
3. Opportunity Costs
4. After-Tax Cash Flows
5. Financing Costs
6. Inflation: Real vs. Nominal Cash Flows
D. Annual Equivalent Cost
1. Capital Recovery Cost
E. Product Costing
1. Level Production
V. Lease versus Purchase Decision 55
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I. TIME VALUE OF MONEY
PRESENT VALUE AND FUTURE VALUE
Methods of computing interest:
1. simple interest: you do not earn interest on your interest
2. compound interest: you do earn interest on your interest
Example: You deposit $100 in a bank account. Compute the account balance after three
years assuming:
a. 8% simple interest
Year BOY Balance Interest EOY Balance

1 $100.00 $8.00 $108.00
2 $108.00 $8.00 $116.00
3 $116.00 $8.00 $124.00
b. 8% interest compounded annually
Year BOY Balance Interest EOY Balance

1 $100.00 $8.00 $108.00
2 $108.00 $8.64 $116.64
3 $116.64 $9.33 $125.97
c. 8% interest compounded quarterly
Qtr BOQ Balance Interest EOQ Balance

1 $100.00 $2.00 $102.00
2 $102.00 $2.04 $104.04
3 $104.04 $2.08 $106.12
. . . .
. . . .
. . . .
12 $124.34 $2.49 $126.83
Computing Future Value (FV) of a Lump Sum Under Annual Compounding
notation: r = nominal annual interest rate
basic principle: Think of the term (1+r) as a multiplicative growth factor; i.e., each year
the account balance grows by a multiplicative factor of (1+r); this implies that over an n-
year period the account balance grows by a factor of (1+r)n.
5
FV formula: Let C denote a single lump sum cash flow in dollars; the future value after n
years is: FV = C(1+r)n
t=0 n=(years)
________________________
C t
FV = C(1+r)n
Computing Present Value (PV) of a Lump Sum Under Annual Compounding
basic principle: In this case we know the future value, which is the single lump sum cash
flow C. We wish to compute the present value. The present value is the
dollar amount which, if invested at r percent compounded annually,
would grow to an amount C after n years.
PV formula: Let C denote a single lump sum cash flow to be received in n years; the
present value is computed as follows: PV = C(1+r)-n
t=0 n =(years)
_______________________
↑ C
PV = C(1+r)-n
Remark: The higher the interest rate, the lower the present value.
Example: Suppose the interest rate is 8% compounded annually. This implies that the
multiplicative growth factor per year is 1.08.
a. A payment of $300 will occur today. Compute the future value of this
cash flow ten years from now.
0 10
_______________________
$300 ↑
FV = ?
Solution: FV = $300(1.08)10 = $300(2.1589) = $647.68
Intuition: Someone who can borrow and lend at 8% would be

indifferent between receiving $300 today or $647.68 ten
years from now.
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b. A payment of $1,000 will occur ten years from now. Compute the present value of this
cash flow.
t=0 10
_______________________
↑ $1,000
PV = ?
Solution: PV = $1,000(1.08)-10 = $1,000(.4632) = $463.19

indifferent between receiving $463.19 today or $1,000 ten
years from now.
COMPOUNDING MORE FREQUENTLY THAN ONCE PER YEAR
Discrete Compounding
A compounding scheme is described by two parameters:
1. nominal rate of interest (denoted by r)
- this is the stated annual rate, also called the quoted rate or the annual
percentage rate (APR).
2. compounding frequency (denoted by m)

- this is the number of times per year that interest is compounded,i.e., the
number of compounding periods per year.
Compound interest is computed as follows:
1. The length of each compounding period is 1/m years.
2. The effective rate per compounding period is r/m.

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3. The multiplicative growth factor per compounding period is:
[1 + r/m]
4. The multiplicative growth factor over a one-year period is:

[1 + r/m]m
5. The multiplicative growth factor over an n-year period is:

{1 + r/m]mn
6. When doing PV and FV computations, it is convenient to think in terms of

compounding periods, as in the following examples.
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Example: Suppose the interest rate is 8% compounded quarterly. This means there are four
compounding periods per year (m=4) and the effective rate of interest per quarter
is 2% (r/m = .08/4 = .02). The multiplicative growth factor per quarter is 1.02.
cash flow ten years from now assuming a rate of 8% compounded
quarterly.
0 40 =(no. of quarters)
_______________________
$300 ↑
FV = ?
Solution: FV = $300(1.02)40 = $300(2.2080) = $662.41
b. A payment of $1,000 will occur ten years from now. Compute the present value
of this cash flow assuming a rate of 8% compounded quarterly.
0 40 =(no. of quarters)
_______________________
$1,000
PV = ?
Solution: PV = $1,000(1.02)-40 = $1,000(.4529) = $452.89
Example: Suppose the interest rate is 8% compounded daily. This means there are 365
compounding periods per year (m=365) and the effective rate of interest per day
is 0.0219% (r/m = .08/365 = .000219). The multiplicative growth factor per day
is 1.000219.
cash flow ten years from now assuming a rate of 8% compounded daily.
0 3650 =(no. of days)

__________________________
$300 ↑
FV = ?
Solution: FV = $300(1.000219)3650 = $300(2.2253) = $667.60
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cash flow assuming a rate of 8% compounded daily.
0 3650 =(no. of days)

_________________________↓
↑ $1,000
PV = ?
Solution: PV = $1,000(1.000219)-3650 = $1,000(.4494) = $449.37

Remark
The more frequent the compounding, the faster the accumulation of interest. The extreme
case in which interest is compounded every instant is called continuous compounding.
Continuous Compounding
Continuous compounding is when the compounding period is infinitely small, or,

equivalently, when m is infinitely large (m = ∞).
Under continuous compounding with nominal rate r, the one-year multiplicative growth
factor is:
lim [1 + r/m]m = er
m→∞
The multiplicative growth factor for an n-year period is:
[er]n = ern
Example: Suppose the interest rate is 8% compounded continuously. This implies that the
multiplicative growth factor per year is e.08.
cash flow ten years from now under this compounding scheme.
0 10 =(years)
________________________↓
300 FV = ?
Solution: FV = $300e(.08x10) = $300(2.2255) = $667.66
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cash flow under this compounding scheme.
0 10 =(years)
________________________
↑ $1,000
PV = ?
Solution: PV = $1,000e-(.08x10) = $1,000(.4493) = $449.33
SUMMARY OF FORMULAS: FUTURE VALUE OF A LUMP SUM
a. simple interest FV = C[1 + (rn)]

for n years
b. interest compounded FV = C(1+r)n

annually for n years
c. interest compounded FV = C[1+(r/m)]mn

m times per year
for n years
d. interest compounded FV = Cern

continuously for
n years
Note: In all of the above formulas, r denotes the nominal rate, or APR.
SUMMARY OF FORMULAS: PRESENT VALUE OF A LUMP SUM
a. simple interest PV = C[1 + (rn)]-1

for n years
b. interest compounded PV = C(1+r)-n

annually for n years
c. interest compounded PV = C[1+(r/m)]-mn

m times per year
for n years
d. interest compounded PV = Ce-rn

continuously for
n years
Note: In all of the above formulas, r denotes the nominal rate, or APR.
Remark
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Throughout this course, we will assume annual compounding unless otherwise specified.
Effective Annual Rate (EAR)

For any given compounding scheme there exists an annually compounded rate of interest
that is equivalent in the sense that if interest was compounded annually at that rate it would
yield the exact same growth pattern of account balances over time as would the specified
compounding scheme. This annually compounded rate is called the effective annual rate
(EAR).
To compute EAR:
1. Suppose you are given a compounding scheme with a nominal rate r (i.e., the APR)
compounded at some frequency other than one year.
2. Consider a one-year period. To get an expression for (1+EAR), simply compute the
amount that one dollar invested under this compounding scheme would grow to in one
year's time. Or, equivalently, substitute r and m into one of the formulas below and
solve for EAR:
a. discrete compounding:(1 + EAR) = [1 + (r/m)]m
b. continuous compounding: (1 + EAR) = er

These formulas can also be used to compute the APR given the EAR.
3. Note: In the case of annual compounding, the EAR is equal to the APR.
4. For a given nominal rate, the more frequent the compounding, the higher the EAR.
Example: A bank pays interest at the rate of 6% compounded semiannually. Compute the
effective annual rate.
Solution: (1+EAR) = (1.03)2 → EAR = .0609 or 6.09%
Example: A bank pays interest at the rate of 6% compounded continuously. Compute the
effective annual rate.
Solution: (1+EAR) = e.06 → EAR = .0618 or 6.18%
Example: A bank that compounds interest daily advertises an effective annual rate of 4.6%.
Compute the APR.
Solution: (1.046) = (1 + r/365)365 → r = .0450 or 4.5%
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Calculations Involving Fractional Years
It is possible to take the present value or future value of a lump sum payment over a
fractional time period, such as 1/2 month or 16.5 years. The following formulas may be
used:
PV = C(1+j)-t
FV = C(1+j)t
where: C = dollar cash flow

t = length of time (not necessarily an integer)
j = effective rate of interest per time period
Examples:
a. A payment of $400 will occur today. Compute the future value of this cash flow two
months from now assuming a rate of 9% compounded annually.
0 2/12 =(no. of years)

________________________
$400 ↑
FV = ?
Solution: FV = $400(1.09)2/12 = $400(1.0145) = $405.79
b. A payment of $2,000 will occur three years and five days from now. Compute the
present value of this cash flow assuming a rate of 12% compounded monthly.
0 36.1667 =(no. of months: 36 plus 5/30 )

_______________________________
↑ $2,000
PV = ?
Solution: PV = $2,000(1.01)-36.1667 = $2,000(.6978) = $1,395.53
note: effective rate per month = 1%
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Present Value of Cash Flow Stream With Multiple Payments
Take present value of each payment separately, then add them up.
Example: You are given the following cash flow stream:
0 1 2 3
____________________________________________________________
-$500 $800 $700 -$100
↑
PV = ?
a. Compute the PV of this cash flow stream assuming 9% interest:

Solution: PV = -500 + 800(1.09)-1 + 700(1.09)-2 - 100(1.09)-3
= $745.90
Intuition: Someone who can borrow and lend at 9% would be indifferent between
receiving the specified cash flow stream or a lump sum today
of $745.90.
b. Compute the PV of the above cash flow stream assuming 15% interest:
Solution: PV = -500 + 800(1.15)-1 + 700(1.15)-2 - 100(1.15)-3

= $659.20

indifferent between receiving the specified cash flow stream
or a lump sum of $659.20 today.
ANNUITIES
An annuity is a series of equal periodic payments over a finite number of periods.
1. ordinary annuity: payments occur at the end of each period
Period
0 1 2 n
↓_________________________………_______
C C C
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2. annuity due: payments occur at the beginning of each period
0 1 n-1 n
____________…..___________
C C C C
(note: C = constant dollar amount received each period)
We will derive annuity factors that can be used to compute the PV or FV of an annuity. To
derive the factors we need the following results from mathematics:
sum of a finite geometric series:
(a + ab + ab2 + … + abn-1) = (a – abn)/(1 – b)
Note: Think of this formula as follows:

numerator = (first term) - [(last term)(ratio)]
denominator = 1 - (ratio)
sum of an infinite geometric series:
if -1 < b < 1 then
(a + ab + ab2 + … ) = a/ (1-b)
Note: Think of this formula as follows:

numerator = (first term)
denominator = 1 - (ratio)
We now derive annuity factors. An annuity factor represents the PV or FV of an annuity that
has a level payment of $1. To compute the value of an annuity we will multiply the annuity
factor by the dollar amount of the periodic payment.
Annuity Factors for Ordinary Annuities
Consider an n-period ordinary annuity that pays $1 per period.
0 1 2 …… n
_______________________…..________
$1 $1 $1 ↑
↑
PVA = ? FVA = ?
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Present Value Factor for Ordinary Annuity
The present value at time 0 is equal to:
PVA = (1+r)-1 + (1+r)-2 + …. + (1+r)-n.
Note that this is a finite geometric series. It can be shown that the sum of this geometric
series is equal to the following, which we call the present value annuity factor (PVAF):
PVAF = [1 – (1+r)-n]/r
The PVAF represents the present value of a $1 n-period annuity, one period before the
first payment.
Example: Compute the present value of an ordinary annuity that pays $500 per year for ten
years assuming an interest rate of 14%
Solution: PVA = $500[(1.14)-1 + (1.14)-2 + ….. + (1.14)-10]

= $500PVAF
= $500[1-(1.14)-10]/(.14)
= $500(5.2161)
= $2,608.06
Future Value Factor for Ordinary Annuity

The future value at time n is equal to:
FVA = 1 + (1+r) + (1+r)2 + ….. + (1+r)n-1.
series is equal to the following, which we call the future value annuity factor (FVAF):
FVAF = [(1+r)n –1]/r
The FVAF represents the future value of a $1 n-period annuity, at the time of the last
payment.
Example: Compute the future value of an ordinary annuity that pays $500 per year for ten
Solution: FVA = $500[1 + (1.14) + (1.14)2 + ……. + (1.14)9]

= $500FVAF
= $500[(1.14)10 - 1]/(.14)
= $500(19.3373)
= $9,668.65
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Annuity Factors for Annuities Due
Consider an n-period annuity due that pays $1 per period.
0 1 2 ………… n-1 n
________________________________________
$1 $1 $1 $1 $1
↑ ↑
PVA = ? FVA = ?
Present Value Factor for Annuity Due

The present value at time 0 is equal to:
PV = 1 + (1+r)-1 + (1+r)-2 + ….. + (1+r)-(n-1).
series is equal to the following:
PV = {[1 – (1+r)-n]/r}(1+r) =PVAF (1+r)
This is the present value factor for an annuity due. This factor represents the present
value of a $1 n-period annuity, at the time of the first payment.
Example: Compute the present value of an annuity due that pays $500 per year for ten
Solution: PV = $500[1 + (1.14)-1 + (1.14)-2 + ……. + (1.14)-9]

= $500PVAF(1.14)
= $500(5.2161)(1.14)
= $2,973.19
Future Value Factor for Annuity Due

The future value at time n is equal to:
FV = (1+r) + (1+r)2 + …… + (1+r)n-1 + (1+r)n.
series is equal to the following:
FV = {[(1+r)n-1]/r}(1+r) = FVAF (1+r)
This is the future value factor for an annuity due. This factor represents the future value
of a $1 n-period annuity, one period after the last payment.
Example: Compute the future value of an annuity due that pays $500 per year for ten years
assuming an interest rate of 14%
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Solution: FV = $500[(1.14) + (1.14)2 + …… + (1.14)9 + (1.14)10]
= $500FVAF(1.14)
= $500(19.3373)(1.14)
= $11,022.26
Deferred Annuities
Example: An annuity makes payments of $200 per year with the first payment at time 5
and the last payment at time 12. Compute the present value at time 0 assuming
the interest rate is 7%.
Solution: PV at time 4 = $200(PVAF for 8 years at 7%)

= $200[1 - (1.07)-8]/(.07)
= $200(5.9713)
= $1,194.26
PV at time 0 = ($1,194.26)(1.07)-4 = $911.10
Continuous Payment Annuities
Suppose that an annuity makes a continuous payment at a rate of C dollars per year for n
years.
1. To compute the present value of this annuity we need an annuity factor that represents
the PV of a continuous payment stream at the rate of $1 per year for n years. It can be
shown that this factor is:
PVAF for continuous payment annuity = (1 – e-rn)/r
where r is the nominal rate compounded continuously.
The PV of a continuous payment annuity that pays C dollars per year for n years is:
PV = C[1 – e-rn]/r
2. To compute the future value of this annuity we need an annuity factor that represents
the FV of a continuous payment stream at the rate of $1 per year for n years. It can be
shown that this factor is:
FVAF for continuous payment annuity = [ern –1]/r
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where r is the nominal rate compounded continuously.
The FV of a continuous payment annuity that pays C dollars per year for n years is:
FV = C [ern –1]/r
Example: Compute the present value of a continuous payment annuity that pays $100 per
year for ten years assuming an interest rate of 13% compounded continuously.
Solution: PV = $100(PVAF for continuous annuity)

= $100[1-e-(.13)(10)]/(.13)
= $100(5.5959)
= $559.59
Example: Compute the future value of a continuous payment annuity that pays $100 per
year for ten years assuming an interest rate of 13% compounded continuously.
Solution: FV = $100(FVAF for continuous annuity)

= $100[e(.13)(10) - 1]/(.13)
= $100(20.5331)
= $2,053.31
Perpetuities
Definition: A perpetuity is an annuity that makes payments forever.
Present Value Perpetuity Factor

Consider a perpetuity that pays $1 per period forever, with the first payment occurring one
period from now. The present value of this perpetuity is:
PV = (1+r)-1 + (1+r)-2 + ……….
Note that this is an infinite geometric series. It can be shown that for any positive interest
rate the series converges to:
PV = 1/r.
This is the present value factor for a perpetuity. It represents the PV of a $1 perpetuity, one
period before the first payment.
Example: Compute the PV of a perpetuity that pays $40 per year with the first payment
occurring one year from now, assuming the interest rate is 8%.
Solution: PV = $40(PVAF for a perpetuity)
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= ($40)(1/.08)
= $500
Deferred Perpetuities
Example: A perpetuity pays $60 per year with the first payment occurring at time 20.
Compute the PV of this perpetuity, assuming the interest rate is 3%.
Solution: PV at time 19 = ($60)(1/.03)

= $2,000
PV at time 0 = ($2000)(1.03)-19
= $1,140.57
Calculations Involving Fractional Years
Example: A firm borrows $3 million to be repaid in four equal annual installments, with
the first payment to occur fifteen months from now. The interest rate on the loan
is 16%. Compute the annual payment amount.
Payment = 3,000,000 (1.16)3/12/[{1-(1.16)-4}/.16] = $1,112,653.67
Amortization Schedules
Amortization refers to the method of dividing loan payments between principal and interest.
We will consider only one loan type: where level payments are made at regular intervals
over the life of the loan.
let L = loan amount

R = periodic payment
j = effective rate of interest per period
v = 1/(1+j)
n = total number of compounding periods over life of loan
Basic principles:
1. The PV of scheduled repayments (taken at the rate specified in the loan contract) equals
the amount borrowed.
2. the dollar amount of interest in any given payment is equal to the beginning-of-period
outstanding balance multiplied by the effective rate of interest per period.
3. the dollar amount of principal and interest in any given payment may be computed as
follows:
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amount of principal in kth payment = Rvn-k+1
amount of interest in kth payment = R(1-vn-k+1)
(note: the kth payment occurs at time k)
example: A firm borrows $50,000 to buy a machine; the loan calls for equal monthly
payments over three years; the first payment is due one month from now; the
APR is 18%
a. compute the firm's monthly loan payment.
b. compute the dollar amount of principal included in the sixth payment.
c. compute the dollar amount of interest included in the ninth payment.
d. construct the first three lines of the amortization table for this loan:
beginning total interest principal ending

period balance payment paid paid balance
. . . .
. . . .
. . . .
_________ _________ ________
$65,074.32 $15,074.32 $50,000
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II. FINANCIAL FORECASTING AND BREAK-EVEN ANALYSIS
COST-VOLUME-PROFITANALYSIS
When managers know the cost behavior patterns that are applicable to their situation, they
can make planning and control decisions based on the relationships between output
volume, costs, revenue, and profit. The study of these relationships is called cost-
volume-profit (CVP) analysis. CVP analysis can provide answers to such questions as:
1. How much revenue must I obtain in order to at least cover fixed costs?
2. How much I sell in order to achieve a given level of profit?
3. Should the company increase variable cost per unit in order to decrease fixed
costs, or should it do the opposite?
Before we get into CVP, let’s discuss the different types of costs that we can have.
1. Fixed Costs—These are costs that do not change with the activity level. For example,
the foreman’s salary: the foreman gets paid the same amount of salary whether he is
doing anything or not. Another example would be rent on your office space. You
pay the same amount for the office space no matter how much or how little you are
using it. One rule of thumb is that Total Fixed Costs stay the same during the
production cycle, but the average per unit decreases.
2. Variable Costs—These are costs that change with the activity level. That is, the more
you produce, the higher will be your variable cost. A good example is material: the
more you are producing, the more material you will use and the greater your cost will
be. If you don’t produce anything, you will have zero variable cost. The rule of
thumb here is that Total Variable Costs change over the production cycle, but the
average cost per unit stays the same.
3. Mixed Costs---These are combinations of the fixed and variable costs. An.
example here would be your water bill. You pay a fixed amount for the hookup
each period whether or not you use the water, and you pay for the water that is
used, the variable part. The more water that you use, the higher the variable
part of the bill, but the hookup part stays the same.
These 3 types of costs cover all of your possible cost versions. The trick is to figure out
whether you have a fixed or a variable cost or a combination of the two (mixed). Once
you have identified the nature of the cost, the rest is relatively easy.
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Examples
A. Variable Cost
If Concrete is $.50/lb., and you use 100 lbs. your Total Variable Cost is $50, but
your average cost per pound remains at $.50.
If you use 1000 lbs., your Total Variable Cost would be $500 but your average
cost per pound remains at $.50.
B. Fixed Cost
You lease a truck for a year for $8,000. Assuming 2,000 work hours in the year,
if you use the truck on the job for 1600 hours, Your Total Fixed Cost is $8,000,
but your average cost per hour is $5.00.
If instead, you used the truck only 1000 hours, you r Total Fixed Cost would still
be $8,000 but your average cost per hour would be $8.00.
BREAK-EVEN ANALYSIS
Break-even Analysis is a subset of Cost-Volume–Profit Analysis. Lenders and investors

are interested in Break-even analysis because it relates to the financial riskiness of your
business.
Under Break-even analysis we determine how much your Revenues have to be in order
for you not to lose money. Not make a profit but also not have a loss; that is to break-
even.
If you have a business, you automatically have fixed costs (office space, phone, licenses,
etc.), that you have to pay whether or not you actually do anything in the business.
Therefore by not doing anything you are already in the loss column.
By doing something, producing and selling a product or service, you gain revenue to
offset the fixed costs but you also now acquire the variable costs that go along with
providing that good or service.
Example: You have a small business with various fixed costs totaling $10,000. If you do
nothing you still have to pay out $10,000. So you decide to produce and sell a product.
To make and sell the product you need materials and labor. Materials will cost you
$50/unit of product and labor will cost $100/unit of product. So each unit has $150 of
variable cost.
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Remember, that the more we make of a product, the higher the Total Variable Costs. If
you make 10 units of product, it will cost you $1,500 of variable costs plus $10,000 of
fixed costs. If you make 100 units of product it will cost you $15,000 of variable costs
and $10,000 of fixed costs.
Next, you have to be concerned about the price at which you sell the product. Too high a
price and nobody buys it, too low a price and you are selling it for less than it costs you to
make it (and we all know that only the car dealers can make money by selling for less
than dealer cost). Therefore, the determination of price is a very important part of the
management function.
Using Break-even analysis, we can determine how many units you have to produce and
sell in order to break-even.
S = Selling Price per unit

VC = Variable Cost to produce and sell each unit
FC = Total Fixed Cost
BE = Break-even in terms of units
BE = FC/(S-VC)
In our example, FC was $10,000 and the VC per unit was $150. Let’s assume that our
selling price is $250 per unit. Now using Break-even analysis we get
BE = 10,000/(250-150) = 100 units or in terms of dollars $25,000 must be sold in

order to breakeven.
Another way to look at this is by using a variable costing income statement.
Sales (100 * $250) $25,000
-Variable Cost of Goods Sold

(100 * 150) (15,000)
Contribution Margin $10,000
- Fixed Costs 10,000
Net Income $ 0
You can try this same example with other combinations of numbers, changing the Fixed
Costs, Variable Costs, and the Selling Price, to get different results. This is an excellent
method to determine how small changes can affect your bottom line.
23
FINANCIAL FORECASTING
Financial forecasting is essentially built upon the same concepts that we have been
discussing. How much are going to have at the end of your business year? What are the
profits or losses going to be on each job? If you use the principles of the Cost-Volume-
Profit (CVP) model, you can readily tell what your profit will be at various levels of
activity.
Lets use the same example to see how these changes affect our financial forecast.
Selling Price = $250

Variable Cost Per Unit = $150
Fixed Cost = $10,000
Sales in Units Sales in $ Variable Cost Fixed Costs Profit/(Loss)

0 0 0 10000 (10000)
25 6250 3750 10000 (7500)
50 12500 7500 10000 (5000)
75 18750 11250 10000 (2500)
100 25000 15000 10000 0
125 31250 18750 10000 2500
150 37500 22500 10000 5000
175 43750 26250 10000 7500
200 50000 30000 10000 10000
225 56250 33750 10000 12500
250 62500 37500 10000 15000
275 68750 41250 10000 17500
300 75000 45000 10000 20000
325 81250 48750 10000 22500
350 87500 52500 10000 25000
375 93750 56250 10000 27500
400 100000 60000 10000 30000
As we can see, up until we get to 100 units, we continue to have a loss, although a
declining one. That is because our units are being sold for $100 more than the variable
cost to produce and sell them. This means that they have an average “contributing
margin” or are contributing $100 towards the payment of Fixed Costs. Once Fixed Costs
are paid, they contribute $100 per unit sold toward profit.
The Table indicates this by showing that the first 100 units paid for themselves and fixed
costs. But the next 100 units paid for themselves and gave us a profit of $10,000. The
reason for this difference is that after the first 100 units there were no fixed costs to be
paid.
The faster you can get your fixed costs paid the quicker you start making a profit. With
Financial Forecasting, we can see what our profit or loss will be at different levels of
activity or with various changes to our basic assumptions. Thanks to spreadsheets these
days the calculating of forecasts is a fairly easy task. The hard part is still determining
the costs and the price that the market is willing to pay for our goods and services.
24
III. TYPES AND COST OF CAPITAL
TYPES OF CAPITAL
1. Common Stock (Equity)

2. Corporate Bonds
3. Preferred Stock
4. Bank Loans
5. Municipal Bonds
EQUITY OR COMMON STOCK
Equity Funding involves selling a partial interest (ownership) in the business. Equity
investors are willing to risk their money in your business for a share of the profits as their
compensation.
Equity Funding could be used to satisfy all of your business funding needs. You
would be ill advised to fund your business with 100% outside equity. Even if you could
find someone to supply all of the money you need, it would not make sense to accept if it
meant that you would give up ownership and control of the business. That situation would
be the same as being employed by someone else. There are positives and negatives
involved with equity funding. These are:
ADVANTAGES:
• Equity funding has no fixed costs.
• Higher equity will provide debt capacity and the ability to negotiate favorable loan
terms.
• Equity funding still provides for control by the owner and allows freedom of decision
making.
DISADVANTAGES:
• Payment of dividends on equity is not tax deductible
• May have to sacrifice ownership and future profits to attract sufficient funding for start-
up.
• Minority stockholders (owners) (less than 50% ownership) may be a nuisance.
There are three basic sources of Equity Funding:
Personal Sources
Private Sources
Public Issues
25
LOANS OR DEBT
Debt Funding borrowing money from a bank, the bond market or private sources to
finance the operations of your business. This type of funding will generally be the least
expensive form of financing because the interest you pay is tax deductible. Debt funding
must be attainable, and once you get it, you must be able to pay it back as agreed in your
loan papers. There are advantages and disadvantages of debt funding.
ADVANTAGES:
• Payments on debt are fixed and predetermined.
• Cost of debt is more easily determined.
• Debt funding is less expensive that equity because interest is tax deductable.
• Through debt and paying it back as agreed, you develop a good credit rating.
• There are many different types of debt and innovative loan programs.
DISADVANTAGES:
• Debt funding may involve limiting covenants and very restrictive terms.
• Debt is not permanent capital.
• Debt funding is usually not available for high risk ventures.
• Previous debt problems may prevent you from obtaining debt funding.
• Debt funding sources operate under very strict guidelines which allow little flexibility if
you do not pay as agreed.
Types of Debt
a. Personal Loans
b. Operation related debt
c. Business loans
d. Corporate Bonds
The ability to secure debt funding depends on the creditworthiness of you and your
business. Creditworthiness means that you can successfully meet all the standards set by
creditors in order for a loan to be extended. At the foundation of this concept is your
ability to receive a favorable credit rating. Creditworthiness is absolutely critical to your
success in obtaining debt funding.
The 5 C’s Of Creditworthiness
• Character
• Capacity
• Capital
26
• Conditions
• Collateral
PRICING OR VALUATION OF COMMON STOCK
Value = the present value of all dividends to be received from the stock.
Value = D1/(1+k)1 + D2/(1+k)2 + D3/(1+k)3 +….+DN/(1+k)N

where
Dt = dividend in period t
N = a large number when the last dividend is expected.
However, we usually assume that dividends will grow over time at a rate of "g." Therefore,
assuming a constant growth in dividends over time
Value = D0(1+g)/(1+k)1 + D0(1+g)2/(1+k)2 +……+ D0(1+g)N/(1+k)N
This is a geometric series and may be reduced to
Value = D0(1+g)/(k-g)
if we can assume that k > g, and D1 = D0(1 + g).
Example: A share of Amoco stock has an expected dividend D1 = $2.40, g = 11%, and k =
15%. What should it sell for?
Value = $2.40/(.15-.11) = $60 per share
However, what if we know that the value is $60 per share, but we do not know the cost
of equity (k)?
k = D1/P + g
= $2.40/$60 + .11 = .15 or 15%
Given this example, it was previously assumed that we know what the growth rate is
for Amoco stock; in practice, however, this must be determined. We could estimate the
growth rate by observing the earnings per share (EPS) or dividend per share (DPS) over
some historical time horizon (let's use 7 years).
Year EPS DPS

1991 $1.70 $1.16
1992 $1.89 $1.28
1993 $2.90 $1.42
1994 $2.33 $1.58
1995 $2.58 $1.75
1996 $2.87 $1.95
1997 $3.18 $2.16
1998 $3.53 $2.40
27
Using EPS,
(1+g)7 = 3.53/1.70 ⇒ g = .11 or 11%
Using DPS,
(1+g)7 = 2.40/1.16 ⇒ g = .11 or 11%
Thus, using the above model, often called the "Discounted Cash Flow Model" or also called
the "Constant Growth Model," we have estimated the cost of equity capital for Amoco.
CAPM MODEL
An alternative approach for estimating the cost of equity capital is to use the Capital
Asset Pricing Model (CAPM) or
k = Rf + [E(RM) - Rf]β
where
Rf = the risk free rate,
E(RM) = the expected rate of return for the entire stock market, and
β = the beta coefficient.
Example: For our Amoco example let's assume that
Rf = 7.5% for 20-year Treasury bonds

[E(RM) - Rf] = 7.3% since 1926 on average
β = 1.05.
Then
k = 7.5% + [7.3%]1.05 = 15.17%.
COST OF DEBT OR LOAN FUNDING
If you borrow money from a bank or other source, the interest payment is tax
deductible, thus your cost is decreased by the decrease in your taxes.
Example: Suppose that you borrow $100,000 from BB&T bank for one-year at an interest
rate of 8%, and that you are in the 28% tax bracket. At the end of the year, you would pay
$8,000 in interest, but the $8,000 is tax deductible, thus you save
.28 x $8,000 = $2,240
in taxes and your cost of debt is actually only $8,000 – $2,240 = $5,760
or your cost of debt is $5,760/$100,000 = 5.76%
28
BOND PRICING ON VALUATION
Corporate bonds are a common form of debt financing where a bond agreement will
specify the bond terms and commit the firm to a contractual obligation. The bond
agreement will specify the maturity, coupon or interest payment, and the face value of the
bond to be paid at maturity.
Example: Assume that Amoco has talked with its investment banker and has determined
that it could issue new bonds at a coupon rate of 8.25% that would sell to the public at par
with a 20-year maturity.
F = face value = $1000

C = coupon rate = 8.25% (paid semiannually)
M = maturity = 20 years
r = yield to maturity
If the yield to maturity, r, is 8.25%, the bond will have a market price of $1000.
Price = $41.25/(1+.0825/2) + $41.25/(1+.0825/2)2 +…..+($41.25+$1000)/(1+.0825/2)40
= $41.25[{1-(1+.0825/2)-40}/(.0825/2)] + $1000/(1+.0825/2)40
Price = $41.25[19.4299] + 1000[.1985] = $801.48 + $198.52 = $1000.00
Thus, the before tax cost of this bond to Amoco is 8.25%.
After-Tax Bond Cost
Bond interest is tax deductible to most corporations; thus, if we want to know the after-
tax cost of the bond it will be
After-tax bond cost = 8.25% (1 - tax rate)
Assuming a tax rate of 34% for Amoco, the after-tax rate is
After-tax bond cost = 8.25%(1 - .34) = 5.45%.
PREFERRED STOCK
Preferred stock is a hybrid form of capital that is somewhat like debt but also like
common stock. Dividends are paid on preferred stock usually for perpetuity as a percentage
of face or par value.
Example: Assume that Amoco has found that it may issue new perpetual preferred stock to
the public at a cost of 8.50 percent. The characteristics of the preferred stock issue is
29
F = face value = $100
kp = dividend rate = 8.50% (paid quarterly)
The price of the preferred stock is
Price = [.085(100)/4]/(kp/4)
If kp is 8.5%, then the price to the public is $100 per share, and the cost to Amoco of the
preferred stock is 8.5 percent.
Municipal Bonds
Municipal bonds are issued by states, counties, cities, and other political subdivisions.
They comprise slightly more than 10 percent of the total U.S. bond market. Municipalities
in the US issue two types of bonds: general obligation bonds and revenue bonds. General
obligation bonds (GOs) are backed by the full faith and credit of the issuer and its entire
taxing power. Revenue bonds, in turn are serviced by the income generated from specific
revenue-producing projects of the municipality, for example, bridges, toll roads, hospitals,
municipal coliseums, and waterworks. Revenue bonds generally have a higher cost due to
their higher level of default risk. The cost to the issuer may be determined in the same
manner as for corporate bonds, above.
WEIGHTED AVERAGE (AFTER-TAX) COST OF CAPITAL
Example 1:
Suppose that you wish to finance $5,000,000 of the cost of you construction project
with 20 percent of your own equity and 80 percent bank financing. You would like a 20%
return on your own equity and assume that the bank requires an interest rate of 8% on the
bank loan. Still assume that you are in the 28% income tax bracket, what is your weighted
average cost of capital for your project?
Type of Funding $ Amount Proportion Cost Product
Bank Loan $4,000,000 .80 5.76% 4.61%

Equity $1,000,000 .20 20.00% 4.00
WACC = 8.61%
Example 2:
Given Example 1 above, assume that the bank will still charge you 8% interest on the
$4,000,000 for one year, but the loan is on a discount basis, and they require a 10 percent
compensating balance. A discount loan means that you must pay the interest immediately
before you get any funds from the bank, and you must leave 10 percent of the borrowed
30
amount in the bank at all times during the period that you borrow the money. Thus, to be
able to take $4,000,000 out of the bank, you need to borrow $4,878,049. This is determined
as:
$4,000,000 = Borrowed Amount (1 - .08 -.10)
Thus, Borrowed Amount = $4,000,000/0.82 = $4,878,049
We may also express this in the following analysis:
Borrowed Amount $4,878,049

Less:Interest Paid up Front $ 390,244
Less: Compensating Balance $ 487,805
Net Amount Borrowed $4,000,000
Net Cost of Loan = [$390,241 (1-.28)]/$4,000,000
= $280,974/$4,000,000 = .0702 or 7.02% after taxes
Type of Funding $ Amount Proportion Cost Product
Bank Loan $4,000,000 .80 7.02% 5.62%

Equity $1,000,000 .20 20.00% 4.00
WACC = 9.62%
Example 3:
If we assume that Amoco will finance new capital investments using 20 percent debt,
10 percent preferred stock, and 70 percent equity, the weighted average cost of capital is
After-tax
Proportion Cost Product
Debt .20 5.45% 1.09
Preferred Stock .10 8.50% 0.85
Equity .70 15.00% 10.50
1.00 12.44%
COST OF NEW ISSUE COMMON STOCK
The previous calculation for the cost of equity was for retained earnings of the firm.
If new common stock must be issued, the flotation cost of issuing new common stock must
be incorporated in the cost.
Example: Assume that Amoco must raise new equity by issuing new stock rather than
using retained earnings and that the flotation cost is $5.00 per share.
31
kN = $2.40/($60-$5) + .11 = .1536 or 15.36%
The weighted average cost of capital assuming new equity (stock) issued is
Proportion Cost Product
Debt .20 5.45% 1.09
Preferred Stock .10 8.50% 0.85
New Common .70 15.36% 10.75
1.00 12.69%
The weighted average (after-tax) cost of capital for Amoco is the minimum return that the
company can receive on a new capital investment and justify the use of the capital it must
invest.
Example of Weighted Average Cost of Capital:
The North Carolina Paper Company wishes to determine its after-tax weighted
average cost of capital. Its capital structure is
Proportion
Debt 40%
Preferred Stock 10
Common Stock 50%
100%
They have discussed with an investment banker the cost of issuing new debt, preferred stock
and common stock. New debt (20-year bonds) will have a 10% interest rate and will be sold
at par. New preferred stock may be sold at 97 and have a 10% dividend rate. Common
stock currently selling at $50 a share can be sold to net the firm $45 a share. Currently, the
dividend yield on the stock is 10% and the earnings per share has gone from $6.35 to $8.50
over the last five years. This growth is expected to continue. The beta for NC Paper is
1.024; the current 20-year risk premium, [E(RM) - Rf] = 7.30. There are currently 500,000
shares of stock outstanding and all earnings of the current year (EPS = 8.50) not paid out in
dividends are available for capital expansion. The tax rate is 34%.
a. What is the WACC if retained earnings is used?
b. What is the WACC if new stock is sold?
32
IV. CAPITAL BUDGETING
DEFINITIONS
cash flow streams associated with projects
1. conventional cash flows
- one or more periods of negative cash flow followed by one or more periods of
positive cash flow
2. nonconventional cash flows
- any pattern of signs that does not meet the definition of conventional CFs
Project Interdependence
1. mutually exclusive projects
- cannot do both projects; accepting one project forces the firm to reject the other
project
-
2. contingent projects
- the feasibility of one project depends on a second project being accepted
3. Economically dependent projects
- there are project interactions; the cash flows of one project depend on whether a
second project is accepted or rejected
a. complementary projects
- the cash flows from one project are favorably affected if the other project is
accepted
b. competitive projects
- the cash flows from one project are adversely affected if the other project is
33
accepted
4. Economically independent projects
- there are no project interactions; the cash flows of one project do not depend on
whether the other project is accepted or rejected
5. Statistically dependent projects
- the covariance between one project's cash flows and another project's cash flows
is not zero; for example, if both projects have cash flows that tend to rise or fall
in a similar systematic fashion in response to external factors such as the
business cycle of the economy.
6. statistically independent projects
- the covariance between one project's cash flows and another project's cash flows
is zero
DECISION RULES FOR PROJECT EVALUATION/COMPARISON
We will illustrate each decision rule using two hypothetical projects with the following cash
flows:
time project A project B

0 -100 -150
1 90 80
2 80 80
3 -10 80
For the illustrative examples that follow we will assume the firm's required rate of return is
20%.
1. Net Present Value (NPV)
Definition: The NPV of a project is the PV of the project's cash flows (including the
original investment, which is typically negative) discounted at the required
rate of return.
Independent Projects
To evaluate an (economically) independent project:
a. Accept the project if NPV > 0.
34
b. Reject the project if NPV < 0.
Accepting a positive NPV project increases the value of the firm. Other capital
budgeting decision rules will accomplish the goal of maximizing firm value only to the
extent that they agree with the NPV rule.
Mutually Exclusive Projects

To rank mutually exclusive projects:
a. In general, the rule is to accept the project with the highest NPV. But this is subject
to the following qualifications:
(i). When projects have unequal lives (i.e., unequal time horizons) it is not
appropriate to simply compare NPVs; certain adjustments are necessary; this
topic will be addressed in more detail later.
(ii). When all projects have NPV < 0, it may or may not be appropriate to reject all
of them. It depends on whether or not some type of action is mandatory.
Example: Consider the two projects A and B whose cash flows are given above.
a. Compute the NPV of project A.
Solution: NPV(A) = -100 + 90(1.20) + 80(1.20)-2 - 10(1.20)-3

= $24.77
b. Compute the NPV of project B.
Solution: NPV(B) = -150 + 80(PVAF)

= -150 + 80[1 - (1.20)-3]/(.20)
= -150 + 80(2.1065)
= $18.52
c. Suppose project A is economically independent of other projects; should

project A be accepted according to the NPV rule?
d. Suppose project B is economically independent of other projects; should

project B be accepted according to the NPV rule?
e. Suppose projects A and B are mutually exclusive; which project, if any,

should be accepted according to the NPV rule?
2. Internal Rate of Return (IRR)
definition: IRR = the discount rate at which NPV is exactly zero.
35
To evaluate an (economically) independent project:
a. Accept the project if IRR > hurdle rate.
b. Reject the project if IRR < hurdle rate.
Note: This is assuming the NPV profile (which we will cover later) is downward
sloping over the relevant range of discount rates. Sometimes there are
multiple IRRs, in which case this decision rule is ambiguous.
Note: If a project has conventional cash flows, then the IRR will be unique and the
following will hold:
(i). {IRR > hurdle rate} implies that NPV > 0.
(ii). {IRR < hurdle rate} implies that NPV < 0.
a. Compute the IRR of project A.
Solution: Solve the following equation for r:
-100 + 90(1+r) + 80(1+r)-2 - 10(1+r)-3 = 0
This is a polynomial of degree three, which implies that as many as three roots could exist.
Descartes' Rule of Signs implies that the maximum possible number of roots is equal to the
number of sign changes in the polynomial (this is true for a polynomial of any degree). In
this case there are two sign changes, so there are at most two roots. It turns out there are
exactly two:
IRR1 = .4153 or 41.53%

IRR2 = -.8875 or -88.75%
b. Compute the IRR of project B.
Solution: Solve the following equation for r:
-150 + 80(PVAF) = 0
-150 + 80[1 - (1+r)-3]/r = 0
Here the cash flows change sign only once, so there is at most
one unique root. The solution is:
r = .2776 or 27.76%
36
b. Suppose project A is economically independent of other projects; should
project A be accepted according to the IRR rule?
d. suppose project B is economically independent of other projects; should

project B be accepted according to the IRR rule?
3. Payback Period
definition: payback period = the number of years necessary to recover the original
investment.
To evaluate an (economically) independent project, compare the expected payback period to
some "required" payback period:
a. Accept the project if expected payback < required payback.
b. Reject the project if expected payback > required payback.
a. Compute the expected payback of project A.
Solution: Because the cash flows switch from negative to positive and then
become negative again later in the project, this rule is not
applicable to project A.
b. Compute the expected payback of project B.
Solution:
time CF
0 -150
1 80
2 80
3 80
expected payback = 80/80 + 70/80 = 1.875 years.
c. suppose project B is economically independent of other projects and assume

the required payback is two years; should project B be accepted according to
the payback rule?
Evaluation of Decision Rules
37
Accepting an NPV project adds value to the firm. The larger the NPV, the larger the
incremental value. The NPV rule is the standard by which other decision rules are judged.
That is, a rule gives the "correct" decision if it agrees with the NPV rule. We now examine
which decision rules agree with the NPV rule.
--------------------------------------------------------------------------------------------------------
Does it Necessarily Does it Necessarily
Agree with NPV Rule Agree with NPV Rule
When Evaluating When Ranking
Decision Rule Independent Projects? Mutually Exclusive Projects?
1. IRR No* No
2. Payback No No
*
Only in the special case of conventional cash flows does the IRR rule necessarily
agree with the NPV rule when evaluating independent projects.
------------------------------------------------------------------------------------------------------------
Weaknesses of IRR Rule
a. There may be multiple IRRs if cash flows are not conventional.
b. Implicitly assumes cash flows can be reinvested at IRR rate.
c. May rank mutually exclusive projects incorrectly, for example when there are
differences in scale between different projects.
d. May disagree with NPV rule when evaluating independent projects if cash flows are
not conventional.
Weaknesses of Payback Rule

a. Does not consider all relevant cash flows (i.e., ignores cash flows beyond the
required payback period).
b. Does not take time value of money into account.
3 c. May rank mutually exclusive projects incorrectly.

4
5 d. May disagree with NPV rule when evaluating independent projects.
4. NPV Profile
38
A NPV profile is a graph of NPV as a function of the discount rate.
Using the NPV profile to make decisions:

a. IRR is where the graph crosses the horizontal axis
b. NPV is the distance from the graph to the horizontal axis
(i). NPV is positive over regions where the graph lies above the horizontal axis
(ii).NPV is negative over regions where the graph lies below the horizontal axis
a. Construct an NPV profile for projects A and B on the same set of axes.
b. Which project has the higher NPV assuming that the firm's required rate of
return is 20%?
c. Which project would have the higher NPV if the firm's required rate of
return was 10%?
d. Which project would have the higher NPV if the firm's required rate of
return was 30%?
e. At what required rate of return is the firm indifferent between projects

A and B?
Note: To compute the crossover point exactly look at the differential cash flows (B-
A) or (A-B). The crossover point is found by computing the IRR of the
differential cash flows.
ESTIMATION OF CASH FLOWS
INCREMENTAL CASH FLOWS
The cash flows that are relevant to the capital budgeting decision are incremental cash
flows. The definition of incremental cash flows are those that will change the magnitude or
the pattern of cash flows for the firm if the project is adopted.
39
One method of estimating incremental cash flows is to compare the proforma income
statements of the firm with the new project as compared to the proforma income statement
without the new project.
Example: The following proforma statement of XYZ Corporation for next year will
compare the firm with the new project being adopted minus the statement without adopting
the project.
XYZ Corporation
Proforma Income Statement
FY 1999
Incremental
With Project Without Project Difference
Sales $60,000 $50,000 $10,000
Operating Costs 25,000 30,000 -5,000
Depreciation 5,000 3,000 2,000
Taxable Income 30,000 17,000 13,000
Income Taxes (40%) 12,000 6,800 5,200
Net Income 18,000 10,200 7,800
Cash Flows 23,000 13,200 9,800
Thus, the new capital project being considered by XYZ Corporation results in an increase of
$9,800 for FY 1999 in incremental cash flows. This results from the project being
considered as having an increase in sales for the firm of $10,000, a reduction in operating
cost of $5,000, and an increase in depreciation of $2,000.
Now, to complete our evaluation of this new project for XYZ Corporation, assume
that the initial cost is $55,000 and that the incremental after-tax cash flows are $9,800 each
year for a total of ten years. Also, we assume that the before-tax salvage value for the
project is $10,000 when the project is terminated in year 10 (assume cost of capital is 10%).
Initial Cash Flow

Cost of the Project $55,000
Operating Cash Flow

Increase Cost Incremental Taxable Taxes
Sales Savings CFBT Income @ 40% CFAT
Yea Depreciatio
r n
1 10,000 5,000 15,000 2,000 13,000 5,200 9,800
2 10,000 5,000 15,000 2,000 13,000 5,200 9,800
3 " " " " " " "
| | | | | | | |
40
10 " " " " " " "
Terminal Cash Flow

Recapture*
Year Salvage Depreciation CFAT
10 10,000 4,000 6,000
*Assuming the adjusted basis for the project in year 10 is zero.
The cash flow pattern is
Year 0 1 2 3 4 5 6 7 8 9 10
CF -55,000 9,800 9,800 9,800 9,800 9,800 9,800 9,800 9,800 9,800 9,800
+6,000
15,800
Net Preset Value = -55,000 + 9800 [{1 – (1.10)-10}/.10] + 6000 (1.10)-10
= -55,000 + 9800[6.14457] + 6000(.38554)
= -55,000 + 60,217 + 2313 = $7,530
The project has a NPV > 0, thus adopt the project.
Sunk Costs
Opportunity Costs
Financing Costs
Inflation: Real vs. Nominal Cash Flows
Example (Replacement Problem)
The Bosler Company is considering the purchase of a new machine tool to replace an
obsolete one. The machine being used for the operation has both a tax book value and
market value of zero; it is in good working order and will last, physically, for at least an
additional ten years. The proposed machine will perform the operation so much more
efficiently that Bosler Company engineers estimate that labor, material, and other direct
costs of operation will be reduced $6,000 a year if it is installed. The proposed machine
costs $24,000 delivered and installed, and its economic life is estimated to be ten years with
zero salvage value. The company expects to earn 14% on its investment after taxes, and the
firm's tax rate is 34%.
41
a. What are Bosler's cash flows for the new project? (Assume straight line
depreciation.)
Since the same savings will be realized in each of the next 10 years, the cash flows will be
the same during each period. This is a cost savings, not a revenue generating capital
investment.
Initial investment = $24,000
Operating Cash Flows

Additional Cost Depreciation Taxable
Year Revenue Savings CFBT (Change in) Income
1 0 $6000 6000 $2400 $3600
2 " " " " "
| | | | | |
10 " " " " "
Taxes CFAT
@ 34%(CFBT - Tax)
1224 4776
Thus, the cash flows due to this new project will be 4776 for each of the next ten years.
Terminal Cash Flows

Salvage New Salvage Existing
Year Project a-T Project a-T CFAT
10 0 0 0
NPV = 124,000 + 4776 [{1 – (1.14)-10}/.14] = $912

⇓
5.21612
b. Assume that the tax book value or adjusted basis of the old machine had been
$8000, that the annual depreciation charge would have been $800, and that it had no sale
value. How do these assumptions affect your answer?
Initial Investment
Price of new machine -$24,000

Less: Tax savings ($8,000 * .34) + 2,720
Net Cash Outflow -$21,280
42
Additional Cost Depreciation* Taxable
Year Revenue Savings CFBT Change Income
1 0 $6000 6000 1600 $4400
Taxes CFAT
@ 34% (CFBT - Tax)
$1496 $4504
Again, since cash flows are the same for each of the subsequent 9 years, they need not be
considered.
*(Depreciation New Machine - Depreciation Old Machine) = 2400 - 800 = $1600/year
Terminal Cash Flow
Year CFAT
10 0
NPV = 12,280 + 4504 [{1 – (1.14)-10}/.14] = $2213

⇓
5.21612
c. Change part b to give the old machine a market value of $4,000.
Initial Investment
Adjusted basis of old machine $8,000

Less: Salvage value (4,000)
Operating Loss Due to Sale $4,000
Tax Savings
(Operating loss * .34) $1,360

Less: Tax savings on old machine + 1,360
Salvage on old machine + 4,000
Operating Cash Flow
Since nothing has changed since b, the cash flow in each of the ten years is $4,504.
43
Terminal Cash Flow = 0
NPV = -18,640 + 4504[5.21612] = $4,853
We may work this problem using the short (equation) approach.
NPV = -$24,000 + 4,000 + (8,000 - 4,000).34
+ 6000 (1 - .34) [{1 – (1.14)-10}/.14]
+ (24,000/10) .34 [{1 – (1.14)-10}/.14]
- (8,000/10) .34 [{1 – (1.14)-10}/.14]
NPV = -24,000 + 4,000 + 1,360 + 20,656 + 4,256 - 1,419 = $4,853.
d. Change part c so that the salvage or market value of the old machine is $12,000.
(The initial adjusted basis for the old machine was 12,000.)
Initial Investment
Salvage value of old machine $12,000

Less: Adjusted basis of old machine (8,000)
Recapture of Depreciation $4,000
Tax Cost
(Recapture of Depreciation x .34) $1,360

Plus: Tax cost of recapture - 1,360
Less: Salvage on old machine +12,000
Net Cash Outflows -$13,360
Again, since nothing has changed since part b, the cash flows in each of the ten subsequent
years is $4,504.
Terminal Cash Flow = 0
NPV = $10,133
e. Assuming that the original adjusted basis (cost) of the existing machine was
$12,000, and that the salvage value is now $15,000, the C.F. analysis is:
Initial Investment
44
Salvage value of old machine $15,000
Original cost (adjusted basis) old 12,000
Capital Gain on Sale of Old $ 3,000
Tax Cost
Recapture of Depreciation (4,000 * .34) $1,360
Capital Gain (3,000 * .20) 600
Taxes on Sale of Old Machine $1,960

Tax on sale of old machine - 1,960
Salvage old machine 15,000
Operating Cash Flows = $4,504
Terminal Cash Flows = 0
NPV = $12,533
Tables C and D
Another Example:
1. The Brasel-Gray Construction Company located in Pembroke, North Carolina is

considering the replacement of one of their scrapers. A new scraper delivered to Pembroke
will cost $250,000 and will be depreciated using MACRS with a five-year life. The
economic life of the scraper is expected to be five years with a salvage value of $35,000.
Because of fuel savings, the new scraper is expected to save $25,000 per year, and because
of a new computer controlled operating system, the new scraper is expected to generate an
additional $30,000 of business per year.
The existing scraper was purchased for $200,000 three years ago and was placed on
the MACRS 5-year-life-depreciation schedule. The existing scraper is expected to
physically last for five additional years if an additional $50,000 reconditioning is done in
two years. The existing scraper could be sold today for $75,000. If it is retained for an
additional five years (assuming the reconditioning in two years), it will have a salvage value
of $25,000.
Brasel-Gray operates with 60 percent bank debt and 40 percent equity. The
purchase of the new scraper would use funds from a new bank loan and retained earnings.
Bank debt has a 10 percent compensating balance where the bank will require 10 percent of
the amount borrowed to be retained as a checking account balance. The loan rate is 9.5
percent. Brasel-Gray has experienced steady growth in earnings per share from $10 five
years ago to $14.03 today. This growth rate is expected to continue. Also, the most recent
45
dividend (Do) was $7.00 per share. The stock price is $935/8 per share. Brasel-Gray is in the
34-percent marginal income tax bracket.
a. How much money are you going to ask your banker for (remember the
compensating balance)?
b. What is your cost of capital?
c. Should you accept the project?
MACRS - 5 Year Depreciation Schedule (Old Scraper)

Depreciation BOY Adjusted EOY Adjusted
Year Rate Basis Depreciation Basis
(1996) 1 .2000 $ 200,000 $ 40,000 $ 160,000

(1997) 2 .3200 160,000 64,000 96,000
(1998) 3 .1920 96,000 38,000 57,600
(1999) 4 .1152 57,600 23,040 34,560
(2000) 5 .1152 34,560 23,040 11,520
(2001) 6 .0576 11,520 11,520 0
Today's Adjusted Basis for Old Scraper = $57,600
Initial Cash Flows
New Scraper -$250,000

Salvage (Old) 75,000
Recapture of Depreciation
(75,000 - 57,600).34 -5,916
Initial Cash Flows -$180,916
Thus, we must obtain from our bank loan .60(180,916) = $108,550; however, because of the
10 percent compensatory balance, we must borrow (108,550/.90) = $120,611.
Cost of Capital
Drop After-tax Cost Product

Debt* .6 6.97% 4.18
Equity** .4 15.00% 6.00
10.18% ~ use 10%
*Debt Cost = [ {120,611 * .095}{1 - .34}/ 108,550] = 6.97%
**The Cost of Equity Capital
k = 7.00(1.07)/93.625 + .07 = .15 or 15%
46
where
(1 + g)5 = $14.03/10.00 ⇒ g = 7%
Added Cost Incremental Taxes Taxes

Savings CFBT Income @ .34 CFAT
Yea Revenu Depreciatio
r e n
1999 1 $30,000 $25,000 $~ $ 26,960 $28,040 $9,534 $45,466
2000 2 " 75,000 55,000 56,960 48,040 16,334 88,666
2001 3 " 25,000 105,000 36,480 18,520 6,297 48,703
2002 4 " " 55,000 28,800 26,200 8,908 46,092
2003 5 " " " 28,800 26,200 8,908 46,092
"
MACRS - 5 Year Depreciation Schedule (New Scraper)

Depreciation BOY Adjusted EOY Adjusted
Year Rate Basis Depreciation Basis
(1999) 1 .2000 $ 250,000 $ 50,000 $ 200,000

(2000) 2 .3200 200,000 80,000 120,000
(2001) 3 .1920 120,000 48,000 72,000
(2002) 4 .1152 72,000 28,800 43,200
(2003) 5 .1152 43,200 28,800 14,400
(2004) 6 .0576 14,400 14,400 0
Terminal Cash Flow

(1) (2) (3) (4)
Salvage Recapture* Salvage Recapture** (1-2-3-4)
Year New Scraper Tax (New) Old Scraper Tax (Old) CFAT
(2003) 5 35,000 7,004 25,000 8,500 *11,496
* (35,000 - 14,400).34
**(25,000).34
NPV = -180,916 + 45,466(1.10)-1 + 88,666(1.10)-2 + 58,703(1.10)-3

+ 46,092(1.10)-4 + 46,092(1.10)-5 + 11,496(1.10)-5
47
= -180,916 + 41,333 + 73,278 + 36,591 + 31,481 + 28,620 + 7,139
= $37,525
Short (Equation) Approach

NPV = -180,916 + 55,000(1-.34) [{1 – (1+.10)-5}/.10]
3.7908
+ 50,000(1 - .34)(1.10)-2
+ 250,000(.34)(.77326)
- .0576(250,000)(.34)(1.10)-6
- 23,040(.34)(1.10)-1 - 23,040(.34)(1.10)-2
- 11,520(.34)(1.10)-3 + 35,000(1.10)-5
- (35,000 - 14,400).34(1.10)-5
- 25,000(1 - .34)(1.10)-5
NPV = -180,916 _ 137,606 + 27,273 + 65,727 - 2,764 - 7,121 - 6,474

- 2,943 + 21,732 - 4,349 - 10,245 = $37,526
Projects with Unequal Lives
Previously, we have always compared mutually exclusive capital projects that have
the same life or duration. This is the case where we compared two projects in our
replacement decision. We would either buy the new machine or stay with the old machine,
but we assumed that both alternatives had the same remaining life. If, however, we were
choosing between two mutually exclusive alternatives with significantly different lives, an
adjustment would be necessary to compare the two projects. Two procedures that will allow
the comparison between two mutually exclusive projects with different lives are:
1. Replacement Chains
2. Equivalent Annual Annuity
The Replacement Chain Approach
Suppose you could choose one of two different machines that will accomplish the
same job -- a conveyor system (Project C) or a truck (Project T) with the following cash
flows:
Year Project C Project T
0 $-400,000 $-200,000
48
1 80,000 70,000
2 140,000 130,000
3 130,000 120,000
4 120,000
5 110,000
6 100,000
NPV @ 11.5% $71,651 $53,915
Even though Project C has a higher NPV, the decision to choose Project C is
incorrect because its expected life is twice that of Project T. The Replacement Chain
Approach assumes that we will begin a second Project T in year 3 with the following cash
flows:
Year First Project T Second Project T Total Cash Flows
0 $-200,000 $-200,000
1 70,000 70,000
2 130,000 130,000
3 120,000 $-200,000 -80,000
4 70,000 70,000
5 130,000 130,000
6 120,000 120,000
NPV @ 11.5% $53,915 $38,894 $92,809
Thus, Project T with one replacement will have the same life as Project C, and it will have a
higher NPV. Decision: use the truck.
The Equivalent Annual Annuity (EAA) Approach
An alternative criteria for comparing projects with unequal lives is the Equivalent
Annual Annuity (EAA).
We find the EAA for each project as follows:
EAAC = 71,651/[{1 – (1.115)-6}/.115] = 71,651/4.1703 = $17,181.26
EAAT = 53,915/[{1 – (1.115)-3}/.115] = 53,915/2.4226 = $22,255.02
The EAA for a given project is the annual dollar amount the firm would receive if the
project's cash flows were converted to an equivalent annuity spanning the life of the project;
the annuity is equivalent to the project's cash flows in the sense that both have the same
NPV. For example, an NPV of $71,651 for Project C is equivalent to the firm receiving
$17,181.26 per year for six years. Since the EAA is higher for Project T and assuming that
Project T as well as Project C can be undertaken repeatedly in replacement chains, the
correct decision is to adopt Project T.
49
PRODUCT COSTING AND CAPITAL COST ALLOCATION
One of the significant costs associated with construction projects is the cost of
invested capital. This cost can be broken down into two components: capital recovery and
return on invested capital. When production levels are constant over the life of the project,
the standard practice is to use the concept called Annual Equivalent Annuity (also called
Annual Equivalent Cost) to allocate the combined capital costs equally over each unit of
production over the life of the project.
Example 1 will assume that a project has level production over its five year life. We
will determine the cost per hour and show the yearly breakdown of this cost between capital
recovery and return on invested capital. The assumptions for this project are:
1. Five year project life (annual cash flows)
2. $5,000,000 initial capital investment (no additional investment in subsequent

years).
3. Level production each year at 1,920 hours.
4. Ten percent cost of capital.
The Annual Equivalent Cost (AEC) is:
AEC = $5,000,000/[{1 – (1.10)-5}/.10] = $5,000,000/3.7908 = $1,318,987
This annual equivalent cost figure represents Return on Invested Capital plus Capital
Recovery Cost, and can be expressed on a per hour basis as follows:
Cost/Hour = $1,318,987 / 1,940 hours = $679.89 / hour
Table of Capital Recovery & Return on Invested Capital:

Return on Capital EOY Capital
Year AEC Invested Capital Recovery Invested
1 $1,318,987 $500,000 $818,987 $4,181,013
2 " 418,101 900,886 3,280,127
3 " 328,013 990,974 2,289,153
4 " 228,915 1,090,072 1,199,081
5 " 119,908 1,199,079 ----
Total 5,000,000
Note that the capital recovered each year increases but averages $1,000,000/year. Return on
invested capital is 10% of BOY capital employed. Also note that:
Annual Capital Recovery and Return on Invested Capital
50
= 1,318,987/1,940 = 1,318,987/1,940 = ….=$679.89/hour
Another Example:
1. The Brasel-Gray Construction Company, from the above example, located in

Pembroke, North Carolina has decided to buy the new scraper today for $250,000
and plans to operate it for 1000 hours per year for the next five years. Operating
cost for the scraper, including the cost of the operator is $95,000 per year. The
scraper is expected to be sold at the end of five years for $35,000. How much must
we charge per hour for the scraper (minimum) to cover all costs?
AEC = Capital Recovery Amount per year = $250,000/ [{1 – (1.10)-5}/0.1]

= $250,000/ 3.7908 = $65,949.37
AEC or
CAPITAL A-T TOTAL
RECOVERY DEPRECIATION* OPERATING RECOVERED
YEAR PER YEAR TAX SHIELD COST COST______
1999 (1) $65,949.37 $17,000 $62,700 $111,649.37
2000 (2) “ 27,200 “ 101,449.37
2001 (3) “ 16,320 “ 112,329.37
2002 (4) “ 9,792 “ 118,857.37
2003 (5) “ 9,792 “ 118,857.37
2003 (5) Less After-tax Salvage Value** -27,996.00
*For example, the 1999 Dep Tax Shield = .34 * $50,000 = $17,000
**Salvage after taxes = $35,000 – (35,000 – 14,400)*.34

= $35,000 - $7,004 = $27,996.00
PRESENT VALUE OF COSTS
TOTAL
-t
YEAR (t) (1.10) COST PRESENT VALUE
1999 (1) 0.9091 $111,649.37 $101,449.43
2000 (2) 0.8254 101,449.37 83,842.45
2001 (3) 0.7513 112,329.37 84,394.72
2002 (4) 0.6830 118,857.37 81,181.18
2003 (5) 0.6209 118,857.37 73,801.08
2003 (5) 0.6209 -27,996.00 -17,383.31
TOTAL PV $407,335.55
ANNUAL EQUIVALENT COST
AEC= $407,335.55/ [{1 – (1.10)-5}/ .10] = $407,335.55/3.7908 = $107,453.72
51
This is an after-tax amount, thus to convert to before-tax cost:
Before-tax AEC = 107,453.72/ (1 - .34) = $162,808.66
COST PER HOUR FOR THE SCRAPER:
Cost/Hour = $162,808.66/ 1,000 hours per year = $162.81 per hour.
Declining Production
Now, let's change the above example so that we no longer have level production.
All parameters from above are the same except the anticipated production over the next five
years (life of the project) is:
Total Relative
Year Hours Hours
1 2,328 1.20
2 2,134 1.10
3 1,940 1.00
4 1,746 0.90
5 1,552 0.80
Total 9,700
Average 1,940/year
Our objective is the same as above in that we desire to charge each ton of coal (unit
of production) the same capital recovery and return on invested capital cost over the
expected life of the project. To obtain the appropriate capital recovery factor, we may use
the following geometric series:
Initial Capital Employed = A[1.20/(1.10) + 1.10/(1.10)2 + 1.00/(1.10)3 + 0.90/(1.10)4 + 0.80/

(1.10)5]
where
A = Annual capital recovery and return on invested capital in dollars.
This equation simplifies to:
5,000,000 = A[3.8627]
A = $5,000,000/3.8627= $1,294,431
52
Table of Capital Recovery and Return on Invested Capital:
Relative Total Return on Capital EOY Capital

Year A Production Cost Inv. Cap. Recovery Employed
1 1,294,431 1.20 1,553,317 500,000 1,053,317 3,946,683
2 " 1.10 1,423,874 394,668 1,029,206 2,917,477
3 " 1.00 1,294,431 291,748 1,002,683 1,914,794
4 " 0.90 1,164,988 191,479 973,508 941,285
5 " 0.80 1,035,545 94,129 941,417 -132
Total 5,000,000
Thus,
Capital Recovery plus Return on Invested Capital
= 1,553,317/2.328 = 1,423,874/2,134 =….= $667.23/ hour
Alternatively, using a different approach in the evaluation of the capital recovery and
return on invested capital cost per hour, the next table will result in the same cost per unit:
Total Expected * Discount
Year Hours Factor = Product
1 2,328 (1.10)-1 = 2,116.36
2 2,134 (1.10)-2 = 1,763.64
3 1,940 (1.10)-3 = 1,457.55
4 1,746 (1.10)-4 = 1,192.54
5 1,552 (1.10)-5 = 963.67
Total 9,700 7,493.76
Annual Capital Recovery and

Return on Invested Capital per Ton = 5,000,000/7,493.76 = $667.23/hour
THE VALUE OF MANAGERIAL OPTIONS
Example: Dynamic Sales Corporation is considering a project that would increase its
production by 10,000 units each year over the next ten years. The project
53
requires an initial investment of $300,000. Although production costs are fairly
stable, the future market price of the product is uncertain. The firm estimates that
with equal probability the sales price over the next ten years will be either $12
per unit or $8 per unit. Production costs are estimated at $4 per unit over the next
ten years.
a. Based on the information given above, compute the NPV of the project.
Solution: The expected cash flows are as follows:
time: 0 1 2 ……. 10__
-300,000 60,000 60,000 …. 60,000
NPV = -300,000 + 60,000[1 - (1.16)-10]/(.16)

= -$10,006
The above analysis ignores the value of managerial options to alter the firm's
course of action once new information becomes available in the future. We now
modify the example to take into account the value of managerial options.
OPTION TO EXPAND
The firm has an option to expand if it is possible to increase the scale of the
project once future information becomes known that makes the project more
attractive.
OPTION TO ABANDON
The firm has an option to abandon if it is possible to terminate the project and
recover a portion of the initial investment if future circumstances render the
project less attractive.
We now modify the above example as follows:
If the firm accepts the project today there are two possible outcomes. The market
price in the first year may turn out to be $12, in which case it would remain at
that level for the remainder of the product's life. Alternatively, the market price
54
in the first year may turn out to be $8, in which case it would remain at that level
for the remainder of the product's life.
If the market price turns out to be $12 the firm would be able to increase the
scale of the project. For an additional investment of $285,000 at time 1 the firm
could double the project's output over the remaining 9 years to 20,000 units.
If the market price turns out to be $8 the firm would be able to dismantle the
project and sell the assets to recover a portion of the original investment. The
liquidated assets would net the firm $200,000.
b. Compute the NPV of the project taking into account the option to expand and
the option to abandon.
Solution: Consider two cases separately:
If price = $12:
In this case the firm increases its investment at time 1 and the
cash flows are as follows:
time: 0 1 2 ………… 10
-300,000 80,000 80,000 ……… 80,000
________ -285,000 80,000 ……… 80,000
-300,000 -205,000 160,000 … 160,000
NPV = -300,000 - 205,000(1.16)-1

+ 160,000[1 - (1.16)-9]/(.16)(1.16)-1
= $158,661
If price = $8:
In this case the firm abandons the projects and liquidates the
project's assets at time 1 and the cash flows are as follows:
time: 0 1__
-300,000 40,000
___ 200,000
-300,000 240,000
NPV = -300,000 + 240,000(1.16)-1 = -$93,103
NPV of the project:

Each case is equally likely; therefore the expected NPV of the
project is:
NPV = (.5)($158,661) + (.5)(-$93,103) = $32,779
55
Compare this to part (a) where the expected NPV was equal
to -$10,006. This is a difference of $42,785, which represents
the combined value of the two options taken into account in
part (b).
We now consider a third managerial option:
OPTION TO WAIT
Sometimes it is possible for the firm to defer investment in the project, without losing
the opportunity to invest, in order to collect more information that is not currently
available.
We now modify the above example as follows:
Suppose that the firm has the option to do nothing the first year and defer its decision
until time 1 when the market price of the product becomes known. If the market price
turns out to be $12 the firm will invest in the project; if the price turns out to be $8 the
firm will not make the investment.
c. Compute the NPV of the project taking into account the option to wait.
Solution: Consider two cases separately:
If price = $12:
In this case the firm invests in the project at time 1 and the
cash flows are as follows:
time: 0 1 2 ……….. 11
0 300,000 80,000 ……… 80,000
NPV = [-300,000 + 80,000[1 - (1.16)-10]/(.16)](1.16)-1

= $74,705
If price = $8:
In this case the firm does not invest in the project and the cash
flows are zero:
56
NPV = $0
NPV of the project:

Each case is equally likely; therefore the expected NPV of the
project is:
NPV = (.5)($74,705) + (.5)(-$0) = $37,353
Compare this to part (a) where the expected NPV was equal
to -$10,006. This is a difference of $47,359, which represents
the value of the option to wait.
VI. LEASE VERSUS PURCHASE DECISION
Acknowledgements: The content of this handout are based on materials prepared for the
North Carolina Department of Transportation’s Prime Builders Program by Dr. Betty L.
Brewer, and on information contained in the U.S. Small Business Administration
publication, “Should You Lease or Buy Equipment.”
1. Things you already know about equipment decisions.

A. Construction Requires the use of very costly equipment.
B. Different Pieces of Equipment have different operation and maintenance costs.
C. Different Pieces of Equipment have different useful lives.
D. Whether Leased or Purchased with a bank loan, significant cash outflows are
required over a period of years.
2. Things you need to understand about lease versus buy decisions

A.The ability to use assets effectively is more important than owning assets.
B. Under some circumstances, ownership is better.
C. Under some circumstances, leasing is better.
D.A calculator cannot make a good equipment decision: It can only crunch numbers you
put into it.
E. The best-thought-out plans and calculations can be upset by changing economic
conditions, changes in government spending, changes in tax laws, etc.
3. What are we going to do?

A.Briefly look at the characteristics of lease versus loan financed purchase of
equipment.
B. Identify the kinds of information needed to make a good lease versus buy analysis.
C. Show the procedure for analyzing a lease versus buy situation.
57
D.Briefly identify potential problem areas.
4. Borrowing to buy equipment

A.Possible lenders
a) Commercial Banks.
b) Commercial Finance Companies.
c) Equipment manufacturers (installment sales of equipment which they produce)
B. Loan Characteristics.
a) Equipment serves as collateral or security
b) Usually requires a downpayment (cannot be financed 100%)
c) Requires periodic payments of principal and interest, usually monthly.
d) Failure to make payments puts the loan in default-if continued in default, this
can force you into bankruptcy.
e) When the loan is repaid, you own the equipment.
f) Interest on the loan is a tax-deductible expense.
g) Depreciation is a tax deductible expense (depreciation is based on the cost of the
equipment, not the amount of the loan).
h) Operating costs, including maintenance and Insurance, are tax-deductible
expenses.
C. Advantages of purchase using a loan.

a) Ownership of the equipment.
b) Interest and depreciation are tax-deductible.
C. Disadvantages of purchase using a loan.

a) Down payment.
b) Loan term is shorter than life of the equipment
c) Noncancellable.
5. Leasing Equipment.
A.Possible lessors
a) Special leasing unts of Bank or Finance Companies.
b) Some equipment manufacturers (offer leases on equipment they produce).
B. Lease Characteristics.
a) The lessor owns the equipment.
b) Requires periodic payments, usually monthly.
c) The entire lease payment is tax-deductible expense as long as the IRS agrees that
a lease exists. (Operating lease vs. Capitalized lease)
d) Failure to make lease payments can have the same effect as failure to make loan
payments-Bankruptcy.
e) You do not depreciate equipment that you lease.
f) Operating costs, including maintenance and insurance, are tax-deductible
expenses.
g) Most common types of leases:
i. Written for a period up to but not exceeding useful life.
58
ii. Noncancellable.
iii. Equipment maintenance may or may not be included in lease payment.
iv. Useful life lease provides rental payments equal to full price of
equipment plus a rate of return to the lessor; Less than useful life
lease may cover a period of weeks, months, or years.
v. May contain an option allowing the lessee to purchase the equipment at
fair market value when original lease expires.
C. Advantages of Leasing.
a) May or may not be a down payment.
b) Lease terms can be longer than loan terms.
c) Lease payment is a fully tax-deductible expense.
D.Disadvantages of Leasing
a) May be more costly than the purchase of equipment.
b) At expiration, you do not own the equipment.
c) Noncancellable.
6. Information needed to compare lease versus a borrow-buy decision.
A.Lease Information.
a) Terms of lease (how many months or years).
b) Payment schedule (how much and when).
c) Your (Lessee) marginal tax rate.
d) Interest rate you would be charged on a loan.
B. Loan Information.
a) Total Price of equipment.
b) Down payment required.
c) Interest rate charged on the loan.
d) Terms of loan (how many months or years).
e) Loan payment schedule.
f) Your (borrower) marginal tax bracket.
g) Salvage value, if any.
h) Expected useful life of equipment.
i) Depreciation Method.
7. Example of a lease versus borrow-buy decision.
Your company, Acme Construction, must purchase a major piece of equipment that costs
$1.5 million. You can obtain a bank loan for most of the required amount. Alternatively,
you can arrange a lease financing plan from the same bank. The following facts apply:
A. The equipment falls in the MACRS 3-year class.
B. Estimated maintenance expenses are $75,000 per year.
C. Your federal plus state tax rate is 40%.
59
D. If the money is borrowed, the bank loan will be at a rate of 15%, amortized in 4 equal
installments to be paid at the end of each year.
E. The tentative lease terms call for end-of-year payments of $400,000 per year for 4
years.
F. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and
maintenance.
G. Your firm must use the equipment if it is to continue in business. After four years,
assume that you would sell the equipment if you purchase it or alternatively, you
would give it back to the lessor if you lease. You estimate that the market value of
the equipment will be $250,000 in four years.
H. COST OF OWNING
______ Year______________________________
0 1 2 3 4
Net Purchase Price -$1,500,000

Depreciation 500,000 675,000 225,000 105,000
Depr. Tax Savings 198,000 270,000 90,000 42,000
Salvage Value 250,000
After-Tax Salvage 150,000
Net Cash Flow -$1,500,000 198,000 270,000 90,000 192,000
Present Value of Owning at 9% where: [15% x (1-.4)] = 9%
PV = -1,500,000 + 198,000 (1.09)-1 + 270,000 (1.09)-2 + 90,000 (1.09)-3 + 192,000 (1.09)-4

PV = -$885,580
I. COST OF LEASING
____________________Year______________________________
0 1 2 3 4
Lease Payments -$400,000 -400,000 -400,000 -400,000

A-T Lease payments -$240,000 -240,000 -240,000 -240,000
Net Cash Flow -240,000 -240,000 -240,000 -240,000
Present Value of Leasing at 9%
PV = -240,000 [{1- (1.09)-4}/.09] = -240,000 x 3.2397 = -$777,528
60

Financial Forecasting and Project Analysis 1-10-11-1

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Financial Forecasting and Project Analysis 1-10-11-1

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FINANCIAL FORECASTING AND CAPITAL

January 10, 2011

I. Time Value of Money ....................................................................................4

II. Break-Even Analysis and Financial Forecasting 20

III. Cost of Capital........................................................................................ 23

IV. Capital Budgeting.................................................................................... 31

C. Estimation of Cash Flows

V. Lease versus Purchase Decision 55

PRESENT VALUE AND FUTURE VALUE

Methods of computing interest:

1. simple interest: you do not earn interest on your interest

2. compound interest: you do earn interest on your interest

Year BOY Balance Interest EOY Balance

b. 8% interest compounded annually

Year BOY Balance Interest EOY Balance

c. 8% interest compounded quarterly

Qtr BOQ Balance Interest EOQ Balance

Computing Future Value (FV) of a Lump Sum Under Annual Compounding

notation: r = nominal annual interest rate

Computing Present Value (PV) of a Lump Sum Under Annual Compounding

Solution: FV = $300(1.08)10 = $300(2.1589) = $647.68

Intuition: Someone who can borrow and lend at 8% would be

Solution: PV = $1,000(1.08)-10 = $1,000(.4632) = $463.19

Intuition: Someone who can borrow and lend at 8% would be

COMPOUNDING MORE FREQUENTLY THAN ONCE PER YEAR

2. compounding frequency (denoted by m)

Compound interest is computed as follows:

1. The length of each compounding period is 1/m years.

2. The effective rate per compounding period is r/m.

4. The multiplicative growth factor over a one-year period is:

5. The multiplicative growth factor over an n-year period is:

6. When doing PV and FV computations, it is convenient to think in terms of

Solution: FV = $300(1.02)40 = $300(2.2080) = $662.41

Solution: PV = $1,000(1.02)-40 = $1,000(.4529) = $452.89

0 3650 =(no. of days)

Solution: FV = $300(1.000219)3650 = $300(2.2253) = $667.60

0 3650 =(no. of days)

Solution: PV = $1,000(1.000219)-3650 = $1,000(.4494) = $449.37

Continuous compounding is when the compounding period is infinitely small, or,

The multiplicative growth factor for an n-year period is:

Solution: FV = $300e(.08x10) = $300(2.2255) = $667.66

Solution: PV = $1,000e-(.08x10) = $1,000(.4493) = $449.33

SUMMARY OF FORMULAS: FUTURE VALUE OF A LUMP SUM

a. simple interest FV = C[1 + (rn)]

b. interest compounded FV = C(1+r)n

c. interest compounded FV = C[1+(r/m)]mn

d. interest compounded FV = Cern

SUMMARY OF FORMULAS: PRESENT VALUE OF A LUMP SUM

a. simple interest PV = C[1 + (rn)]-1

b. interest compounded PV = C(1+r)-n

c. interest compounded PV = C[1+(r/m)]-mn

d. interest compounded PV = Ce-rn

Effective Annual Rate (EAR)

a. discrete compounding:(1 + EAR) = [1 + (r/m)]m

b. continuous compounding: (1 + EAR) = er

Solution: (1+EAR) = (1.03)2 → EAR = .0609 or 6.09%

Solution: (1+EAR) = e.06 → EAR = .0618 or 6.18%

Solution: (1.046) = (1 + r/365)365 → r = .0450 or 4.5%

where: C = dollar cash flow

0 2/12 =(no. of years)

Solution: FV = $400(1.09)2/12 = $400(1.0145) = $405.79

0 36.1667 =(no. of months: 36 plus 5/30 )

Solution: PV = $2,000(1.01)-36.1667 = $2,000(.6978) = $1,395.53