Module 3

1. Module 3 Uses of Funds

2. Framework

3. Framework

4. Capital Budgeting • The process in which the firm renews and reinvents itself • Includes decision such as: opening a new plant, introducing a new product line, closing operations, selling a business, etc. • Answers the question: should the proposed project be accepted or rejected

5. Capital budgeting decision criteria • Payback period • Discounted payback period • Net present value • Profitability Index • Internal rate of return (IRR)

6. Payback period • Number of years needed to recover the initial cash outlay of the project • Example: if the firm’s maximum desired payback period is 3 years and an investment proposal requires an initial cash outlay of $10,000 and yields the following set of annual free cash flows, what is the payback period? Should the project be accepted? • Decision: • ACCEPT if payback period ≤ maximum acceptable payback period • REJECT if payback period ≥ maximum acceptable payback period

7. Payback Period: Pros and Cons • Advantages • Uses free cash flows • Easy to calculate and understand • May be used as a rough screening devise • Disadvantages • Ignores the time value of money • Ignores free cash flows occurring after the payback period • Selection of the maximum acceptable payment period is arbitrary

8. Discounted Payback Period • Number of years needed to recover the initial cash outlay from the discounted free cash flow. • Given the following after tax free cash flows, compute for the discounted payback period. The required rate of return is 17% p.a. • Decision: • ACCEPT if discounted payback period ≤ maximum acceptable payback period • REJECT if discounted payback period ≥ maximum acceptable payback period

9. DPP: Pros and Cons • Advantages • Uses free cash flows • Easy to calculate and understand • Considers time value of money • Disadvantages • Ignores free cash flows occurring after the payback period • Selection of the maximum acceptable payment period is arbitrary

10. Net Present Value (NPV) • Present value of the free cash flows less the investment’s initial outlay. • Gives a measurement of the net value of an investment proposal in terms of today’s dollars. • If NPV is zero, it returns the required rate of return and should be accepted. Where: IO = initial cash outlay FCF = free cash flow n = project’s expected life • Decision: • ACCEPT if NPV ≥ 0 • REJECT if NPV ≤ 0

11. NPV: An Example • J&J is considering new machinery that would reduce manufacturing costs associated with making Johnson’s baby cologne. If the firm has a 12% required rate of return, should the project be accepted?

12. NPV: Pros and Cons • Advantages • Uses free cash flows • Considers time value of money • Consistent with the firm’s goals of shareholder and wealth maximization • Disadvantages • Requires detailed long term forecasts of a project’s free cash flows • Sensitivity to the choice of the discount rate

13. Profitability Index • Benefit/cost ratio • The ratio of the future free cash flows to the initial cash outlay • If NPV provides a measure of the absolute dollar desirability of a project, the PI produces a relative measure of an investment proposals desirability Where: IO = initial cash outlay FCF = free cash flow n = project’s expected life • Decision: • ACCEPT if PI ≥ 1 • REJECT if PI ≤ 1

14. PI: Pros and Cons • Advantages • Uses free cash flows • Considers time value of money • Consistent with the firm’s goals of shareholder and wealth maximization • Disadvantages • Requires detailed long term forecasts of a project’s free cash flows

15. Internal Rate of Return (IRR) • Answers the question: what rate of return does this project earn? • IRR: discount rate that equates the present value of the project’s future net cash flows with the project’s initial cash outlay. You have to solve for IRR. Where: IO = initial cash outlay FCF = free cash flow n = project’s expected life Decision: ACCEPT if IRR ≥ required rate of return REJECT if IRR ≤ required rate of return

16. IRR: Pros and Cons • Advantages • Uses free cash flows • Considers time value of money • Is in general consistent with the firm’s goals of shareholder and wealth maximization • Disadvantages • Requires detailed long term forecasts of a project’s free cash flows • Possibility of multiple IRR’s • Assumes cash flows over the life of the project are reinvested at the IRR

17. Seatwork You are considering a project that will require an initial outlay of $54,200. This project has an expected life of 5 years and will generate after-tax cash flows to the company as a whole of $20,608 at the end of each year over its five-year life. In addition to the $20,608 free cash flow from operations during the 5th and final year, there will be an additional cash inflow of $13,200 at the end of the 5th year associated with the salvage value of a machine, making the cash flow in year 5 equal to $33,308. Given a required rate of return of 15%, calculate the following. Should the project be accepted? Minimum acceptable no of years for PP and DPP is 3 years. • Payback period • Discounted payback period • Net Present Value • Profitability Index • IRR

18. Assignment • You are considering 2 independent projects, project A and project B. the initial cash outlay associated with project A is $45,000, whereas the initial cash outlay associated with project B is $70,000. The required rate of return on both projects is 12%. The expected annual free cash inflows from each project are as follows: Calculate the payback period, discounted payback period, NPV, and PI for each project and indicate if the project should be accepted. Min acceptable years for PP and DPP is 3 years

19. Assignment • Artie’s Soccer Stuff is considering building a new plant. This plant would require an initial cash outlay of $8 million and will generate annual free cash inflows of $2 million per year for eight years. Calculate the project’s payback period, discounted payback period (min acceptable payback period is 4.5 years), NPV and Profitability Index given a required rate of return of 12%. Will you accept or reject the project?

20. Framework

21. Working Capital Management • Working capital is the difference in the firm’s current assets and is current liabilities • WC = Current Assets – Current Liabilities • Can give rise to short-term financing problems

22. Appropriate level of working capital • Hedging principle, or principle of self-liquidating debt • Matching the cash-flow generating characteristics of an asset with the maturity of the source of financing used to finance its acquisition • E.g. a seasonal expansion in inventories should be financed with short-term credit or current liability

23. Sources of financing • Temporary sources of financing • Unsecured bank loans, commercial paper, loans secured by accounts receivable and inventories • Permanent sources of financing • Intermediate term loans, long-term debt, preferred stock, common equity • Spontaneous sources of financing • Trade credit, wages payable, accrued interest, accrued taxes

24. Measuring WC efficiency • Minimize working capital by: • Speeding up collection of cash • Increasing inventory turns • Slowing down disbursement of cash • CASH CONVERSION CYCLE

25. Cash Conversion Cycle

26. Estimating the cost of short-term credit (APR) • APR = interest/ (principal x time) • Example: SKK Corporation plans to borrow $1,000 for a 90-day period. At maturity, the firm will repay the $1,000 principal amount plus $30 interest. What is the effective annual rate of interest for the loan? Interest = Principal x Rate x Time

27. Estimating the cost of short-term credit (APY) • To account for the influence of compounding • Example: SKK Corporation plans to borrow $1,000 for a 90-day period. At maturity, the firm will repay the $1,000 principal amount plus $30 interest. What is the APY of the loan? Where: m = number of compounding periods i = nominal rate of interest per year

28. Trade Credit Credit terms and cash discount Stretching of trade credit Bank credit Line of credit Credit terms Transaction loans Commercial paper Accounts receivable loans Factoring accounts receivables Inventory loans Sources of short-term credit

29. Framework

30. Motives for holding cash Transactions motive • Allow the firm to meet cash needs that arise in the ordinary course of doing business Precautionary motive • Buffer stock of liquid assets. • To be used to satisfy possible, but indefinite needs Speculative motive • To take advantage of potential profit-making situations

31. Cash Management Decisions • What can be done to speed up cash collections? • Manage the cash inflow and cash outflows • What should be the composition of a marketable securities portfolio?

32. Cash Gathering System Step 1: Customer writes check and places it in the mail Step 2: Mail is delivered to firm’s headquarters Step 3: checks are processes and deposited in bank Step 4: checks are forwarded to the clearing system Step 5: checks are passed on to customer’s bank Step 6: Customer’s funds are declared good Step 7: Firm receives notice that checks have cleared Day 1 Mail float Day 2-3 Processing float Day 4-5 Transit float Day 6 Day 7

33. Managing cash inflows • Lock-box arrangements • Firms mail their checks not to the company but into a numbered post office box, which will be opened by the bank • Pre-authorized checks • Resembles an ordinary check, but it does not contain nor require the signature of the person whose account is being drawn • Concentration banking and wire transfers

34. Managing cash outflows • Zero-balance accounts • Permit centralized control over cash outflows • Payable –through drafts • With the appearance of ordinary checks but are not drawn on a bank. It is drawn against the issuing firm and is presented to the issuing firm’s bank • Electronic funds transfer

35. Marketable Securities • General selection criteria • Financial risk: possible changes in financial capacity of the security issuer to make future payments • Interest rate risk: changes in interest rate • Liquidity: ability to transform the security into cash • Taxability: tax treatment of the income a firm receives • Yields: return; influenced by financial risk, interest rate risk, liquidity and taxability

36. Marketable Securities Alternatives • Treasury bills • Banker’s acceptances • Negotiable certificates of deposit • Commercial paper • Repurchase agreements • Money market mutual funds