Bond Business School

FINC11-101
Fundamentals of Finance

TOPIC 08 – Capital Budgeting & Dividend Policy I

MMR Chapter 9: Capital Budgeting and Cash Flow Analysis

Question 1:
Explain how capital budgeting procedures might be used by each of the following:

a. Personnel managers

The value of training programs and pension (superannuation) plans can be evaluated
using discounted cash flow techniques when estimating the total cost of employment.

b. Research and development staffs

Investment in new product research and product improvement research, having benefits
that can reasonably be expected to accrue over several years, can be evaluated using
capital budgeting methods.

c. Advertising executives

Advertising campaigns normally generate benefits (in the form of increased sales) that
extend over several years; hence investments in these marketing initiatives can be
evaluated using capital budgeting methods.

Question 2:
What is a mutually exclusive investment project? An independent project? A contingent
project? Give an example of each.

Mutually exclusive project – acceptance of one project precludes the acceptance of

another
 Decision to buy one model of drillpress over a competing model

Independent project – acceptance of one project neither precludes nor requires the
acceptance of another
 The decision to buy a replacement delivery truck is independent of the decision to buy a
new data processing system
Contingent project – the acceptance of one project requires (is contingent upon) the
acceptance of another
 The decision to build additional brewery capacity may be contingent on the decision to
expand the company’s marketing and distribution channels

Question 3:
What effect does capital rationing have on a firm’s ability to maximise shareholder
wealth?

Capital rationing (being a constraint placed upon the amount of investable funds) is
normally not consistent with shareholder wealth maximisation. This type of constraint
forces the rejection of otherwise acceptable projects, thereby removing the opportunity
to increase shareholder wealth, and forcing independent projects to act as mutually
exclusive when competing for the scarce capital resource.

Question 5:
Cash flows for a particular project should be measured on an incremental basis and
should consider all the indirect effects of the project. What does this involve?

The objective of capital budgeting analysis is to estimate the total change in the firm’s
cash flows that result from acceptance of a project. Hence, indirect effects on the costs
and/or revenues associated with a firm’s other projects that occur as a result of
accepting the new project must be considered when estimating the incremental cash
flows to the firm.

Question 7:
Depreciation is a non-cash expense; why is it considered when estimating a project’s
net cash flow?

Although depreciation itself is a non-cash charge against the profits of the firm, it has
the effect of reducing taxable net income and, hence, reduces income tax payable,
which is a real cash outflow for the firm. The effect of depreciation on cash flow is
equal to the amount of depreciation multiplied by the firm’s marginal tax rate.

Question 9:
Why is it generally incorrect to consider interest charges when computing a project’s
net cash flows?

Interest expense is considered in the discounting process of capital budgeting analysis,

rather than estimated within the incremental cash flows of the project. If interest
expense was to be included within incremental cash flow estimates AND the discount
rate included the cost of debt, the analyst would effectively be double-counting the
impact of debt financing. It is generally incorrect to associate a particular method of
financing with the investment decision for a project, hence the cost of debt is included
in the cost of capital (discount rate) rather than deducted from project cash flows.

2
Question 10:
Distinguish between asset expansion and asset replacement projects. How does this
distinction affect the capital expenditure analysis process?

An asset expansion project requires a firm to invest funds in additional assets in order
to increase sales and/or reduce costs. Asset expansion projects frequently require a
significant, incremental investment in net working capital by the firm. Expansion
projects are often more risky than replacement investments because the revenues
generated by the project are more uncertain.

Asset replacement projects involve the retirement of one asset and the replacement of
that asset with a more efficient one. Replacement investments usually do not require
significant, incremental net working capital investments, and we typically have greater
certainty regarding the nature, amount and timing of project benefits.

Question 11:
How is the opportunity cost concept used in the capital budgeting process?

The opportunity cost concept is considered in the capital budgeting process

primarily through the use of the appropriate required return used to evaluate a
project. This required return the risk‐adjusted discount rate considers the
returns opportunities that are available on other projects of equivalent risk.

Problem 1:
The MacCauley Company has sales of $200 million and total expenses (excluding
depreciation) of $130 million. Straight-line depreciation on the company’s assets is $15
million, and the maximum accelerated depreciation allowed by law is $25 million.
Assume that all taxable income is taxed at 40 percent. Assume also that net working
capital remains constant.

a. Calculate the MacCauley Company’s after-tax operating cash flow using both
straight-line and accelerated depreciation.

Straight-line depreciation:
∆ ∆ ∆ 1 ∆
200 130 15 1 0.4 15 $48 million

Accelerated depreciation:
∆ ∆ ∆ 1 ∆
200 130 25 1 0.4 25 $52 million

Problem 2:
Calculate the annual straight-line depreciation for a machine that costs $50,000 and
has installation and shipping costs that total $1,000. The machine will be depreciated
over a period of 10 years. The company’s marginal tax rate is 40 percent.

50,000 1,000
$5,100 . .
10

3
Problem 4:
Johnson Products is considering purchasing a new milling machine that costs
$100,000. The machine’s installation and shipping costs will total $2,500. If accepted,
the milling machine project will require an initial net working capital investment of
$20,000. Johnson plans to depreciate the machine on a straight-line basis over a period
of 8 years. About a year ago, Johnson paid $10,000 to a consulting firm to conduct a
feasibility study of the new milling machine. Johnson’s marginal tax rate is 40 percent.

a. Calculate the project’s net investment (NINV).

Ignore feasibility study as it constitutes a sunk cost, i.e. historic non-incremental cost
100,000 2,500 20,000 $122,500

b. Calculate the annual straight-line depreciation for the project.

Net working capital does not depreciate; all other costs associated with NINV are
depreciable
100,000 2,500
$12,812.50 . .
8

Problem 5:
A new machine costing $100,000 is expected to save the McKaig Brick Company
$15,000 per year for 12 years before depreciation and taxes. The machine will be
depreciated on a straight-line basis for a 12-year period to an estimated salvage value
of $0. The firm’s marginal tax rate is 40 percent. What are the annual net cash flows
associated with the purchase of this machine? Also compute the net investment (NINV)
for this project.

$100,000

100,000
$8,333.33
12
∆ ∆ ∆ 1 ∆
15,000 8,333.33 1 0.4 8,333.33 $12,333.33 . .

Problem 7:
The Taylor Mountain Uranium Company currently has annual cash revenues of $1.2
million and annual cash expenses of $700,000. Depreciation amounts to $200,000 per
year. These figures are expected to remain constant for the foreseeable future (at least
15 years). The firm’s marginal tax rate is 40 percent.

A new high-speed processing unit costing $1.2 million is being considered as a

potential investment designed to increase the firm’s output capacity. This new piece of
equipment will have an estimated useful life of 10 years and a $0 estimated salvage
value. If the processing unit is bought, Taylor’s annual revenues are expected to
increase to $1.6 million and annual expenses (exclusive of depreciation) will increase
to $900,000. Annual depreciation will increase to $320,000. Assume that no increase in
net working capital will be required as a result of this project. Compute the project’s
annual net cash flows for the next 10 years, assuming that the new processing unit is
purchased. Also compute the net investment (NINV) for this project.

4
 $1.2 million

∆ 1.6 1.2 $400,000

∆ 900,000 700,000 $200,000
∆ 320,000 200,000 $120,000

∆ ∆ ∆ 1 ∆
400,000 200,000 120,000 1 0.4 120,000 $168,000

Problem 8:
A firm has an opportunity to invest in a new device that will replace two of the firm’s
older machines. The new device costs $570,000 and requires an additional outlay of
$30,000 to cover installation and shipping. The new device will cause the firm to
increase its net working capital by $20,000. Both the old machines can be sold – the
first for $100,000 (book value equals $95,000) and the second for $150,000 (book value
equals $75,000). The original cost of the first machine was $200,000, and the original
cost of the second machine was $140,000. The firm’s marginal tax bracket is 40
percent. Compute the net investment for this project.

Device #1:
Gain on sale 100,000 95,000 $5,000
Tax payable 5,000 0.4 $2,000
A/tax proceeds on disposal 100,000 2,000 $98,000

Device #2:
Gain on sale 150,000 75,000 $75,000
→ assume capital gains taxed at same rate as ordinary income
Tax payable 75,000 0.4 $30,000
A/tax proceeds on disposal 150,000 30,000 $120,000

570,000 30,000 20,000 98,000 120,000 $402,000

Problem 10:
Nguyen, Inc., is considering the purchase of a new computer system (ICX) for
$130,000. The system will require an additional $30,000 for installation. If the new
computer is purchased, it will replace an old system that has been fully depreciated.
The new system will be depreciated over a period of 10 years using straight-line
depreciation. If the ICX is purchased, the old system will be sold for $20,000. The ICX
system, which has a useful life of 10 years, is expected to increase revenues by $32,000
per year over its useful life. Operating costs are expected to decrease by $2,000 per
year over the life of the system. The firm is taxed at a 40 percent marginal rate.

a. What net investment is required to acquire the ICX system and replace the old
system?

Existing system:
Gain on sale 20,000 0 $20,000
Tax payable 20,000 0.4 $8,000
A/tax proceeds on disposal 20,000 8,000 $12,000

130,000 30,000 12,000 $148,000

5
b. Compute the annual net cash flows associated with the purchase of the ICX
system.

130,000 30,000
∆ 0 $16,000
10
∆ ∆ ∆ 1 ∆
32,000 2,000 16,000 1 0.4 16,000 $26,800

Problem 11:
Two years ago, Agro, Inc., purchased an ACE generator that cost $250,000. Agro had
to pay an additional $50,000 for delivery and installation, and the investment in the
generator required the firm to increase its net working capital position by $25,000. The
generator, which is being depreciated over a period of 5 years using straight-line
depreciation, has a current market value of $79,550. The firm’s marginal tax rate is 40
percent. If the firm liquidates the asset for its current market value, compute the after-
tax proceeds from the sale of the asset.

Firm will recover net working capital investment when asset no longer required (i.e.
liquidated), thereby increasing the after-tax proceeds from sale of the asset

250,000 50,000
Net book value 250,000 50,000 2
5
300,000 120,000 $180,000
Loss on sale 180,000 79,550 $100,450
Tax receivable 100,450 0.4 $40,180
A/tax proceeds on disposal 79,550 40,180 25,000 $144,730

Problem 12:
Benford, Inc., is planning to open a new sporting goods store in a suburban mall.
Benford will lease the needed space in the mall. Equipment and fixtures for the store
will cost $200,000 and be depreciated over a 5-year period on a straight-line basis to
$0. The new store will require Benford to increase its net working capital by $200,000
at time 0. First year sales are expected to be $1 million and to increase at an annual
rate of 8 percent over the expected 10-year life of the store. Operating expenses
(including lease payments and excluding depreciation) are projected to be $700,000
during the first year and increase at a 7 percent annual rate. The salvage value of the
store’s equipment and fixtures is anticipated to be $10,000 at the end of 10 years.
Benford’s marginal tax rate is 40 percent.

a. Compute the net investment required for Benford.

200,000 200,000 $400,000

6
b. Compute the annual net cash flows for the 10-year projected life of the store.
Period ΔR ΔO ΔDep Term CF NCF
1 1,000,000 700,000 40,000 196,000
2 1,080,000 749,000 40,000 214,600
3 1,166,400 801,430 40,000 234,982
4 1,259,712 857,530 40,000 257,309
5 1,360,489 917,557 40,000 281,759
6 1,469,328 981,786 - 292,525
7 1,586,874 1,050,511 - 321,818
8 1,713,824 1,124,047 - 353,866
9 1,850,930 1,202,730 - 388,920
10 1,999,005 1,286,921 - 206,000 633,250

Termination cash flows (after tax):

Recovery net working capital $200,000
Recovery a/tax salvage equipment 10,000 10,000 0.4 $6,000

MMR Chapter 15: Dividend Policy

Question 4:
Explain what is meant by the clientele effect.

The "clientele effect" suggests that investors will tend to be attracted to firms that have
dividend policies consistent with the investors' objectives. High dividend payout
companies will attract investors who want high dividend yields. Growth-oriented
companies, with low (or zero) dividend payouts, will attract investors who prefer earnings
retention and possible price appreciation.

Question 6:
Explain what is meant by the signaling effects of dividend policy.

A change in dividend policy represents an unambiguous signal to investors concerning

management’s assessment of the future prospects (i.e., earnings and cash flows) of the
company. As insiders, management is perceived as having access to more complete
information about the future profitability of the firm than is available to investors outside
the company.

Question7:
In the theoretical world of Miller and Modigliani (dividend irrelevance theory), what role
does dividend policy play in the determination of share values?

In the world of Miller and Modigliani the value of a firm is determined solely by the firm's
investments. Dividend payouts are a mere detail to the firm given an investment policy
and do not directly influence the firm's value. M and M do recognize that dividends may
provide "information content" to investors, indicating to investors what management feels
the future earnings prospects are likely to be.

Question 8:
What role do most practitioners think dividend policy plays in determining share values?

Most practitioners believe that dividends are important because they help to resolve
uncertainty for investors. Furthermore, in the "real" world where the transactions costs
associated with raising new external funds are significant, a policy of retaining a greater
proportion of earnings when the firm has a large number of attractive investment
opportunities is likely to be a wealth maximizing strategy.
7