CF-E4

FIN 6301, Corporate Finance 1

Course Learning Outcomes for Unit IV Upon completion of this unit, students should be able to:

3. Apply the valuation principle. 3.1 Describe the relationship between risk and return. 3.2 Explain how to calculate the weighted average cost of capital (WACC).

8. Analyze the risk and return of a financial decision.

8.1 Describe how to estimate the discount rate for individual projects.

Course/Unit Learning Outcomes

Learning Activity

3.1

Unit Lesson Chapter 9, pp. 373-388, 393–395 Chapter 10, pp. 411-432 Unit IV Essay

3.2

Unit Lesson Chapter 9, pp. 373-388, 393–395 Chapter 10, pp. 411-432 Article: “Understanding a Company’s Cost of Capital Valuable; Knowledge of

Finance Can Help Risk Managers Get Boards’ Attention” Unit IV Essay

8.1

Unit Lesson Chapter 9, pp. 373-388, 393–395 Chapter 10, pp. 411-432 Unit IV Essay

Required Unit Resources Chapter 9: The Cost of Capital, pp. 373-388, 393–395 Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows, pp. 411–432 In order to access the following resource, click the link below. Wojcik, J. (2002, May 6). Understanding a company's cost of capital valuable; Knowledge of finance can help

risk managers get boards' attention. Business Insurance, 36, 13. http://link.galegroup.com.libraryresources.columbiasouthern.edu/apps/doc/A85673848/PPSB?u=oran 95108&sid=PPSB&xid=6b469e6c

Unit Lesson

Types of Projects Engaging in projects is a good way for companies to utilize and maximize excess cash/profits. In many cases, companies are looking at ways to reduce costs and/or increase revenues. We will discuss below the two types of projects and how these can play a role in decision-making. There are generally two types of projects—expansion projects and replacement projects. Expansion projects are those projects that are intended to expand the earnings of a business. Replacement projects, on the other

UNIT IV STUDY GUIDE

Projects and Their Valuation

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hand, are those projects that are intended to replace older assets in order to increase efficiency. Undertaking these types of projects can lead to more income for companies by streamlining processes, reducing costs, and increasing revenue. Here is an example of how companies might engage in an expansion project. Company Y had a surplus of money, and the chief executive officer (CEO) was exploring ways to better maximize this excess cash. The CEO wanted to use that capital in a financially productive way to generate significantly more income. The CEO eventually decided to engage in an expansion project by increasing the production capacity of the company. Then, 50 more machines were purchased and installed within the company, leading to the hiring of more employees and the construction of additional area for workspace. As a result of the expansion project, capacity was greatly increased, and the company significantly increased their profits due. Here is an example that can demonstrate why companies would engage in a replacement project. Company Z had been operating with the same infrastructure for 10 years. Even though the machines used in the company are still operational, they are already showing signs of wear and tear based on the decreased output and the amount of time needed to handle and maintain the equipment on a regular basis. The leader of the company decided that it would be best to replace the machines one by one in order to increase productivity and efficiency by eventually cutting down on the high operational cost. Eventually, all of the old machines were replaced with more cost-efficient machines, leading to more productive and efficient operations.

Cash Flow In order to finance different projects, company decision makers need to understand cash flow (both inflow and outflow). Cash inflow refers to the money received by an organization as a result of financing, operating, and investing activities. Cash outflow refers to the money paid out by the organization for these same activities (i.e., their expenses). Estimation of this cash flow is necessary before conducting capital budgeting analysis to determine whether the anticipated benefits outweigh the costs. The following components are segments of cash flow for a project.

• Initial investment outlay refers to the cost associated with starting a project such as installation, equipment, and labor.

• Operating cash flow over a project’s life pertains to the additional cash flow needed during the course of a project. For instance, when the current liabilities exceed the current assets, the working capital decreases, representing a cash inflow.

• Terminal year cash flow refers to the final cash flow that encompasses the inflows and outflows of the termination of a project, including the potential salvage value of a machine used in that project.

To demonstrate how cash flow works within an actual expansion project, consider the following example. The company, Solvent, a washing machine business, is in the process of engaging in an expansion project. Before engaging in the expansion, the chief financial officer (CFO) of Solvent, Pat, analyzed the cash flows needed for this project. For the initial investment outlay, Pat estimated the cost needed to rent more space; buy and install more washing machines; and pay for electricity, water supply, and labor costs. For operating cash flow over a project’s life (i.e., the working capital), Pat estimated the interplay between assets and liabilities during the different phases of the project. Finally, considering the terminal year cash flow, Pat estimated the final cash flow that encompasses the inflows and outflows of the termination of the expansion. When all of these cash flow segments have been analyzed, a more realistic estimation of the capital needed for this expansion project will be possible.

Capital Budgeting Capital budgeting is the process of determining and evaluating the potential expenses and investments involved in a project. According to Schlegel, Frank, and Britzelmaier (2016), larger companies are more likely to use the more complex capital budgeting methods, whereas small companies tend to use the simpler methods. The three most popular methods used to determine and evaluate which project should be prioritized over others are throughput analysis, discounted cash flow analysis, and payback period analysis. According to Chittenden and Derregia (2015), most companies continue to use simple capital budgeting methods, such as payback period analysis, even though they are theoretically less accurate. However, given

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that throughput analysis is considered the most accurate, consider how this method can be effectively utilized to determine if a project is worth pursuing. Consider the following scenario. A planned expansion project is anticipated to increase throughput by increasing the capacity of production (i.e., more goods can be produced). The incremental reduction in operating expenses is not expected to be significant because the current operational expenses are already considered very low. However, there is an expected incremental increase in the return on investment (ROI) based on the projected increase in production capacity. If a throughput analysis for this project were conducted, it is likely that the results would indicate that the project is worth pursuing. Consider the rationale—in order to pursue a project based on throughput analysis, at least one of the following criteria should be met.

• Is there an incremental increase in throughput?

• Is there an incremental decrease in operating cost?

• Is there an incremental increase in ROI? At least one criterion should be fulfilled in order to proceed with a project. A decrease in operating cost is the least important criterion because operating cost can reach the level of zero, whereas production capacity and ROI are practically endless. For the scenario above, two out of the three criteria were fulfilled.

Project Valuation Valuation analysis is the evaluation of the potential merits of an investment or the objective assessment of the value of a business or asset. This means that the analysis can be both based on projections regarding the future (i.e., potential value) or current data (i.e., current value). Valuation analysis is one of the most important tasks that investors engage in because it provides information about whether an investment is worth pursuing. Valuation analysis answers the main question: What is the worth of something? Scenario analysis involves the calculation of the expected value of a project, which would often lead to the best-case scenario and the worst-case scenario and the corresponding probabilities of occurrence. This calculation depends on various factors such as historical performance data, average cost of capital, projected cash inflows, and annual expenditures. The major drawback of scenario analysis is that the probability analyses are often targeted toward extreme positive and negative events. But low probabilities still could happen, and risk analysis can determine whether investors can tolerate the level of risk assessed within a given project. Break-even analysis involves the calculation of the point at which the received revenue is equal to the associated cost. This is usually considered the first step toward profitability because once break-even is achieved, profits can now be accrued. As a supply side form of analysis, break-even analysis does not take into consideration the possible effect of demand on the price. For example, if a toy costs $50 to make with a fixed cost of $1,000, the break-even point for a selling price of $100 is 20 toys. Selling beyond these 20 toys would result in profits.

Conclusion The purpose of capital budgeting is to assess whether potential returns are sufficient based on target benchmarks (i.e., investment appraisal). Because capital often has limitations, companies need to assess which project would bring the most financial return within a given period of time. Project valuation is vital for investors to ensure that an investment is worth pursuing.

References Chittenden, F., & Derregia, M. (2015). Uncertainty, irreversibility and the use of ‘rules of thumb’ in capital

budgeting. The British Accounting Review, 47(3), 225–236. Schlegel, D., Frank, F., & Britzelmaier, B. (2016). Investment decisions and capital budgeting practices in

German manufacturing companies. International Journal of Business and Globalisation, 16(1), 66–78.