FINANCIAL

MODELLING
Additional Slides for Capital
Budgeting
Basic Questions in Capital
Budgeting
What is it Worth?
Presented with an asset a stock, a bond,
real estate, a computer we would like to
know how to value the asset.
What does it Cost?
Comparing the different financing alternatives
for an investment
Getting Started Working Out the
Interest Rate
Quoted rates of interest are not
necessarily representative of costs.
We need to ensure that we compare like-
with-like
Find the Effective Annual Rate (EAR)
This can sometimes be more complicated
that simply changing compounding
frequencies
Example 1: Borrowing from a Bank
Consider the following alternatives
West Hampton Bank is lending at 8% interest. If you
borrow $100 from them today, youll have to repay
them $108 in a year.
East Hampton Bank is willing to lend you any amount
at a 6% rate. BUT: East Hampton has a loan initiation
charge of 4%.
This means that for each $100 you borrow, youll only get
$96, even though youll pay interest on the full $100.
 Example 1: Contd

LESSON: When Calculating the Cost of financial

alternatives, you must include the fees, even if the lender
does not include the fees.
Example 2: An Interest-Free Loan
Youre buying a used car, with a price-tag of
$2000.
The dealer explains that if you pay cash, youll get a
15% discount. In this case youll pay $1700 today.
Since you dont have the money today, you intend to
borrow the $1700 from your uncle, who charges 10%
interest.
On the other hand, the dealer will give you 0%
financing dont pay him anything now, and you can
pay the dealer the full $2000 at the end of the year.
Example 2: Contd

LESSON: Free loans are usually not free! To

compute the cost of a free loan, calculate the
Effective Annual Rate from the differential Cash
Flows.
Calculating the cost of a Mortgage

Mortgages are perhaps one of the most

common and practical situations in which
the skills of capital budgeting can prove
valuable.
Mortgages are also a good way to
introduce the similar problems in valuing
other financial assets.
Mortgage Example 1
Your bank has agreed to give you a
$100,000 mortgage, to be repaid over 10
years at 8% interest.
The bank calculates annual payment as
$14,902.95, using Excels PMT function
Note that in this example, the payments
are annual (which is unusual), so we can
use the IRR function to verify the result
Mortgage Example 1 Contd
Example 2: Mortgage Points
As in the previous example, youve asked the
bank for a $100,000 mortgage.
The loan officer explains that youll be asked to
pay $14,902.95 per year for 10 years, as in the
previous example.
However, the bank deducts 1.5 points from
your mortgage meaning you only get $98,500
in hand (100,000 1.5%)
How much more expensive is this loan?
A Mortgage with Points
Working out the interest and
principal paid each year
At the end of each year, you may need to
report to the tax office the amount of
interest paid on the mortgage.
To calculate this, we use a loan table,
separating each annual payment into an
interest and principal component.
As more payments are made, the
component of principal increases.
Mortgage Amortisation Table
Mortgages with Monthly
Repayments
Suppose now that the $100,000 mortgage
with 8% interest p.a., payable monthly
now has a one-year life.
This (usually) means that the monthly interest
rate is 8%/12 = 0.667%.
This is the way it is worded by many banks
How much are the monthly repayments,
and what is the effective annual rate?
Monthly Repayments (Contd)
Longer Term Mortgages
Suppose the mortgage in the previous example
has a thirty year term (meaning 30 x 12 = 360
repayments).
Each repayment would be $733.76 and the EAR
would be 8.4721%.
Note that it is preferable to use the RATE function
instead of IRR here, to avoid using a large (361 row)
table of values.
IRR is unreliable with a large number of values anyway
You could use NPV and then solve for the rate that sets the
NPV equal to zero as a workaround.
Longer Term Mortgages
Note that the effect of the initial mortgage fees
on mortgage Effective Annual Rate declines
when the mortgage is longer-term.
For the one-year mortgage, the 1.5% initial fee
increased the EAR from 8% to 11.41%
For the thirty-year mortgage, the same initial fees
increase the EAR from 8% to 8.4721%
The fees have a much smaller effect on the second
mortgage because they are spread out over a longer
term.
Ignore Sunk Costs and Consider
only Marginal Cash Flows
This is an important principle of capital
budgeting.
Sunk Costs are those that have already been
incurred and thus are not affected by future
capital budgeting decisions.
Examples of sunk costs include R&D work,
initial surveying and estimation of costs etc.
Sunk Costs Example
You recently bought a plot of land and built a
house on it. Your intention was to sell the house
immediately, but it turns out that the house was
really badly built and cannot be sold in its current
state.
The house and land cost you $100,000, and a local
repairman has quoted you $20,000 to make the
necessary repairs.
Your real estate broker estimates that even with these
repairs youll never sell the house for more than
$90,000.
Sunk Costs - Example
The $100,000 has already been spent. There is nothing that can be done about
it now. If you do not repair the house, you cannot sell it and hence will not
realise any profit. If you spend the $20,000 to fix the place, it can be sold for
$90,000. The IRR of spending the marginal $20,000 is 350%.
Dont Forget the Effects of Taxes

Lets consider the case of Sally and Dave,

two business school grads who are
considering buying a flat and renting it out
for the income.
The idea of this example is to emphasise
the importance of taxes in the capital
budgeting process.
Sally and Daves Flat
The Flat costs $100,000, and they are
planning to buy it with cash (perhaps an
inheritance)
Sally and Dave figure they can rent out the flat
for $24,000 per year.
Theyll have to pay property taxes of $1,500
annually
There are also miscellaneous expenses of $1,000
per year.
Sally and Daves Flat (Contd)
Their accountant explained to them that they can
depreciate the full cost of their flat over 10 years
each year they can charge $10,000
depreciation against the income from the flat.
This means they expect to pay $3,450 in income
taxes per year if they buy the flat and rent it out
and have a net income from the flat of $8,050
(see next slide).
Sally and Daves Flat
Depreciation
In computing the taxes they owe, Sally and Dave
get to subtract their expenses from their income.
Taxes are computed on the basis of income
before taxes.
Income expenses depreciation interest
When Sally and Dave get the rent from the flat,
this is income.
When Sally and Dave pay to fix the facilities in
the flat, this is an expense.
Depreciation (Contd)
The cost of the flat is neither income nor an
expense. Its a capital investment money paid
for an asset that will be used over many years.
Tax rules specify that each year part of the
capital investments can be taken off the income
(expensed)
This reduces the taxes paid by the owners of the
asset and takes into account the fact that the
asset has a limited life.
Depreciation (Contd)
Straight-line depreciation
Annual Depreciation = Asset Cost/Life Span
Where the Asset cost is the initial cost of the asset and Life
Span is the Depreciable Life Span of the Asset (i.e.
predetermined useful life).
Straight-line depreciation with Salvage Value
(Estimated Book Value at the end of an assets
useful life)
Annual Depreciation = (Asset Cost Salvage
Value)/Life Span
Depreciation (Contd)
In Australia, a commonly used method of
depreciation is the diminishing value method.
Base Value x 200% / (Assets Effective Life)
E.g. Laura purchases a photocopier for $1500 on 1 July 2006
with an effective life of five years. Using the diminishing value
method the amount of depreciation in the year 2006-07 is
1500x200%/5 = $600
In the year 2007-08 the depreciation on the photocopier would
then be
900x200%/5 = $360
Comparing Depreciation Methods
The ATOs Guide To Depreciation states (p. 6)
http://www.ato.gov.au/content/downloads/NAT1996_07.pdf

You generally have the choice of two methods to

work out the decline in value of a depreciating asset:
the prime-cost [straight-line] method or the
diminishing value method. You can generally choose
to use either method for each depreciating asset you
hold.
Once you have chosen a method for a particular
asset, you cannot change to the other method for that
asset.
Comparing Depreciation Methods
(Contd)
Back to Sally and Daves Flat
Dave and Sallys net income was $8,050.
However, the cash flow produced by the flat is
more than this amount.
Because the depreciation is an expense for tax
purposes but not a cash expense, the cash flow from
the flat is different to the net income.
To calculate the annual cash flow, we can simply
add back the depreciation.
Sally and Daves Flat
The longer process of explicitly accounting for
the depreciation tax shield yields the same result
as simply adding back the depreciation to
produce the cash flow.
How does this work? In this example, since Sally and
Daves property taxes of $1,500 are an expense for
tax purposes, the after-tax cost of property taxes is
(1-30%)x1,500 = 1,500 30%x1,500 = 1,050
The tax shield of $450 has reduced the cost of
property taxes
Depreciation on the Flat
Depreciation is a special case of a noncash expense that
generates a tax shield.
The $10,000 depreciation on the flat generates $3,000 of cash.
Because the depreciation reduces Sally and Daves reported
income, each dollar of depreciation saves them $0.30 of taxes,
without actually costing them anything in out-of-pocket expenses
(the $0.30 comes from the fact that their tax rate is 30%).
Thus $10,000 of depreciation is worth $3000 of cash.
This $3000 depreciation tax shield is a cash flow for Sally and
Dave.
Depreciation on the Flat
We took two steps in method 2.
We first calculate Sally and Daves net income
ignoring depreciation. If depreciation were not
an expense for tax purposes, Sally and
Daves net income would be $15,050.
We then add to this figure the depreciation tax
shield of $3,000. The result (cell B32) gives
the cash flow for the flat.
Is Sally and Daves investment
profitable? A preliminary calculation
Incorporating Terminal Value into
the Calculations
The previous spreadsheet shows that the investment is profitable,
even if we assume that the salvage value of the flat is zero.
To make a better calculation about their investment, Sally and Dave
will have to make an assumption about the flats terminal value.
Suppose they assume that at the end of 10 years, theyll be able to
sell the flat for $80,000.
The taxable gain relative to the sale of the flat is the difference
between the flats sale price and the book value at the time of the
sale.
Since Sally and Dave have been depreciating the flat by $10,000 per
year over the 10-year life of the investment, the book value at this time
will be zero.
We can see (next slide) that the sale of the flat for $80,000 will
generate a cash flow of $56,000
Incorporating Terminal Value
Incorporating Terminal Value
(Contd)
 Some sensitivity analysis
Using a Data Table we can see how much the IRR of the investment varies
with the Rental Yield and the Terminal (Salvage) Value of the flat. The Rental
Yield is clearly very important in the profitability of the project. Red figures
denote IRRs that are lower than Sally and Daves discount rate of 12%.
Applying Midyear Cash Flows to
Sally and Daves Flat
For payments like rental, it might be a better
approximation to assume that the cashflow
occurs mid year to approximate the weekly or
monthly payments throughout the year.
Lets examine the case of Sally and Daves flat,
assuming that the $24,000 rental payment
occurs in midyear (along with the $1,000
miscellaneous expenses), and property and
income taxes occur at the end of the year. Again
assume a terminal value of $80,00 for the flat.
Note some rows have been hidden (18 to 41) - just containing the cash flows
continuing the pattern.
Example Buying a Machine
In the Sally and Dave example we focused on
the effect of noncash expenses on cash flows
Accountants and tax authorities compute earnings by
subtracting certain kinds of expenses from sales,
even though these expenses are noncash expenses.
In order to compute the cash flow, we add back these
noncash expenses to accounting earnings. These
noncash expenses create tax shields they create
cash by saving taxes.
Buying a Machine (Contd)
In this example, we consider a capital
budgeting example in which a firm sells its
asset before it is fully depreciated.
The assets book value at the date of the
terminal value creates a tax shield on the
capital budgeting decision.
Buying a Machine (Contd)
Your firm is considering buying a new machine
The machine costs $800
Over the next 8 years (the machines life) the machine will
generate sales of $1,000
The annual cost of the goods sold (COGS) is $400 a year and
other costs selling, general, and administrative expenses
(SG&A) are $300 a year.
Depreciation on the machine is straight line over 8 years (i.e.
$100 a year)
At the end of the eight years the machines salvage value is
zero.
The firms tax rate is 40%
The firms discount rate for projects of this kind is 15%
Selling the Machine after year 8
Suppose the firm can sell the machine for
$300 at the end of year 8.
This brings about a taxable gain of $300
the difference of the market value over the
book value.
At the end of year 8, the machine has been
fully depreciated so its book value is zero.
Selling the Machine after year 7
Suppose, instead, the machine can be sold at
the end of year 7 for $450.
At this point the book value of the machine is
$100.
The net cash flow from the sale of the machine
is then
Salvage Value tax * (salvage value book value)
In this case 450 0.4(450 100) = $310
If the machine is sold for a loss
(here $50 at the end of year 7)
the negative taxable gain produces
a tax shield (-$20 in this case). Thus
even selling the machine at a loss
can produce a positive cash flow.
Dont forget the cost of Foregone Opportunities

This is another important

principle of capital
budgeting
E.g. Youve been offered a
project which involves
buying a widget-making
machine for $300 to make
a new product.
The cash flows have been
estimated as follows
Foregone Opportunities (Contd)
But now someone remembers that the widget process
makes use of some existing but underused equipment.
Should the value of this equipment somehow be taken into
account?
This depends on whether or not the equipment has an
alternative use.
For example, suppose that, if you dont buy the machine,
you can sell the equipment for $200.
Then the true year 0 cost for the project is $500, and the
project hence has a lower NPV.
Foregone Opportunities (Contd)
Working out the value of foregone
opportunities can be quite difficult.
For example: what if the machine is to occupy
space in a building that is currently unused?
Should the cost of this space be taken into
account?
It depends on whether there are alternative
uses, now or in the future.
In-House Copying or Outsourcing?

Your company is trying to decide whether

to outsource its photocopying or continue
to do it in-house.
The current photocopier is old, it either
has to be sold or thoroughly fixed up
In-House Copying or Outsourcing?
The companys tax rate is 40%
Doing the copying in-house requires an investment of
$17,000 to fix up the existing photocopy machine.
This $17,000 can be immediately booked as an expense, so that
its after tax cost is
(1-40%)*(17,000) = 10,200
Given this investment the photocopier will be good for another
five years.
Annual copying costs are estimated to be $25,000 on a before-
tax basis
After tax this is (1-40%)*25,000 = 15,000
In-House Copying or Outsourcing?
The photocopy machine is on your books for
$15,000, but its market value is much less it
could be sold today for only $5,000.
This means that the sale of the copier will generate a
loss for tax purposes of $10,000
At your tax rate of 40% this gives a tax shield of $4,000
Thus the sale of the copier will net a cash flow of $9,000
In-House Copying or Outsourcing?
If you decide to keep doing the copying in-house, the
remaining book-value of the copier will be depreciated
over 5 years at $3,000 per year.
Since your tax rate is 40%, this will produce a tax shield of
40%*3,000 = $1,200 per year
Outsourcing the copying will cost $33,000 per year -
$8,000 more expensive than doing it in-house on the
rehabilitated copier.
The $33,000 is an expense for tax purposes, so the net savings
from doing the copying in house are
(1 tax rate)*outsourcing costs = (1 40%)*33,000 =$19,800
The relevant discount rate is 12%
In-House Copying or Outsourcing?
There are two ways to analyse this decision
We can look at the alternatives separately
We can examine the differential cash flows

The first method is usually recommended

because it leads to fewer mistakes
The second method produces a cleaner set of
cash flows that take explicit account of the
foregone opportunity costs
In-House Copying or Outsourcing?
The NPV of the differential cash flows is positive.
Note that it is simply the difference between the two
projects NPVs.
In this situation, the differential cash flows were
worked out from the separate cash flows.
In some cases, only the differential cash flows may be
given so the second method is required.
If you look carefully at the differential cash flows,
youll see that they take into account the cost of
the foregone opportunities.
In-House Copying or Outsourcing?
In year 0, the differential cash flow is $19,200.
This is the after-tax cost of rehabilitating the old photocopier (-
$10,200) and the foregone opportunity cost of selling the copier
(-$9,000).
In other words, this is the cost in year 0 of deciding to do the
copying in house.
In Years 1 5 the differential cash flows are $9,000
This is the after-tax saving of doing the copying in-house: if you
do it in-house you save $8,000 pretax ($4,200 after tax) and you
get to take depreciation on the existing copier (a tax-shield of
$1,200).
Relative to in-house copying, the outsourcing alternative has a
foregone opportunity cost of the loss of the depreciation tax shield.