Capital Budgeting

Real Options in Capital Budgeting

The usual capital spending or budgeting techniques guide financial managers of companies in making accept or reject decisions about specific projects and assets. They do not guide these managers in areas related to the project after it has been initiated. The managers using only these techniques would not be able to change their decisions when the project has started. One assumption of capital budgeting is that if a project is accepted it will continue without any consideration of actual cash flows. Real options play a vital role for managers in this area. The managers have options through which they can adjust projects according to the changing trends of the market. These options are often referred to as real options, managerial options or strategic options. The managers can adjust projects according to change in economical conditions, market competition and varying growth trends using real options. The managers have to recognize the options available in a project and generate newer options for each project. The various real options available in a project include investment timing options, abandonment options, growth options and flexibility options (Brigham & Ehrhardt, 2001). The capital budgeting techniques offer two alternatives for management either to accept the project or reject it.

There is another option available with these two alternatives which is investment timing, where the investment in a project can be delayed to a future date. For example suppose IBM plans to manufacture computers based on advanced technology, Microsoft has the option to immediately start creating the software that would be required for the new computers or delay the development to a later stage when IBM is ready to launch its computers in the market. This option is viable only if the delay compensates for any loss in market share of the software. The second option available to managers during a project is the abandonment option which enables them to abandon or discard any project before its life when it starts to have an adverse affect on the project’s cash flows. The abandonment option is used when the cash flows of a project are affected adversely by changing environments. For example a project which had a positive NPV is started but after two years due to severe economic conditions the projects cash flows become negative then the managers can decide to abandon the project at this point if the option is available. The growth option enables managers to enhance projects with growth in demand and sales. The managers can decide to add more components to a project or make it more geographically diversified to meet the increase in demands and benefit from new geographical markets.

The flexibility option makes projects more flexible to changing trends and market conditions. Suppose a company is planning to setup a manufacturing plant for shoes which would produce sports shoes for various age groups. Though the NPV of the future cash flows is positive, the management has an option to establish a plant with some extra capital spending to make it flexible to shifts in demand of shoes. If the demand for sports shoes declines and that for formal shoes rises, the company would be able to cope with this shift in demand by increasing the production of formal shoes and decreasing sports shoes production. The real options available to managers can be evaluated by various methods which include the following: Using the traditional capital budgeting techniques and assuming the values of real options to be zero, Second valuation technique is to use the same traditional approach and include a qualitative identification of real options, Third techniques is to use decision trees, and the last technique is to adapt the financial option model and value real options specific to various projects. The most common technique for valuing and analyzing real options is to apply the Black-Scholes model for call and put options (Brach, 2003). The management of the company can diversify the capital spending structure by applying any one of the real options in various scenarios.

References
Brach, A. M. (2003). Real Options in Practice. New Jersey: John Wiley & Sons, Inc.

Brigham, E., & Ehrhardt, M. (2001). Financial Management: Theory and Practice 11th Edition. Florence: South-Western Educational Publishing.

Brief Introduction

The framework for a judicious capital budgeting of a local government unit responds to the specific needs of people in a community. It also manifests the vital role of the Mayor, or the local chief executive, who executes sound policies and fosters strong partnerships with thee Council Members, members of the local legislative body. Thus, good governance emanates from the synergy of a local government unit that focuses on fiscal and public management.

The conscious effort for judicious capital budgeting is said to have an efficient work and financial plan. Qualitative and objective budgeting policies shall make effective the efficient performance of a local government unit responding to varied needs of local governance in a community.

This paper will discuss and examine the formulation and framework of budget policies which are key executor guidelines to the devolution of power in local governments. The monographs from the local governments of Peachtree City in Georgia, Village of Hanover Park in Illinois and Mecklenburg County of North Carolina will be used as literature review in budgeting policies.

What is budget policy?

In layman’s term, ‘budget policy’ is an implementing guideline that shall regulate and control the utilization of government resources. The technical term “to enact fiscal management of the State” refers to the same purpose of budgetary controlling. Thus, to cite the purpose of budget policy is to allocate the resources in the aspect of spending in accordance to prioritization, transparent accountability and orderliness (US Office of Management and Budget, 2008).

The City of Peachtree, Georgia

Inclusion of funds in the operating budget

As cited from the document, ‘Annual Budget for Fiscal Year Ending September 30^th 2008 of Peachtree City of Georgia’, the local government has enacted the budget policies as  basis for the City’s routine financial practices associated with preparation, adoption, and the execution of operating capital budgets in which  the primary objective is to provide a standard of budgetary performance which both staff and council have endorsed and to provide budgetary decision making with greater continuity, reinforcing the City’s core financial values and preserving them for successive staff and Council (McMullen, B.J., Salvatore, P.J. and Camburn, J.I., 2007).

Further to cite, the operating and capital budget policies have included [under “Policy 1”] the scope of budget, such as (1) General Fund, (2) Special Revenue Funds, (3) Capital Projects Funds, and (4) Debt Service Funds. Moreover, the Public Improvement Program (PIP) budget has been organized parallel with the annual operating budget and funding of PIP projects (together with on-going operating expenses), an integral part of the operating budget, which is covered under “Policy 2”.

The baseline funding level: how is it used in the budget process?

According to the Peachtree Annual Budget of FY 2008, the “Policy 3” states that: baseline and service level funding refers to a condition or situation wherein the City’s top program priority is in the maintenance of existing service levels in all divisions and departments in the absence of a fiscal crisis. The procedures on the budget should consist of the computation of “baseline funding levels” for all section of the local government unit; representing the present manpower and cost of supplies. The “baseline funding level” shall be the “terms of reference” in providing additional manpower or facilities in effect of agreements to budget allocation or appropriation.

Entities for annual budget preparation and submission

To cite, the responsible entity in the budget preparation and submittal is stipulated under “Policy 9” by virtue and in compliance with the Peachtree City Ordinance that refers to the City Manager being responsible for the preparation and submission of the City’s annual budget. Moreover, based on the provision, the City’s Manager shall have the authority to standardize budget documentation, such as (1) to prepare the budget calendar, (2) review departmental budget requests for accuracy and conformity to budget guidelines, and (3) also review all revenue forecasts prepared during the budget process.  In view of the function of the City’s Manager, the Financial Services Division shall assist in the preparation and drafting of the budget proposal.

The Village of Hanover Park in Illinois

Established in 1958, the Village of Hanover Park is under a “Manager Form of Government” with presently populated communities situated at the North-Western tip of Chicago business district.

Percentage of budget requirement to the General Fund

Generally, the Village of Hanover Park’s financial policies has been created to enable a sustainable financial security. The primary objectives embark on financial policies that will support the management’s budgetary resolution essential to uphold or maintain the Village’s financial capacity.  Thus, to cite, the “Exhibit B” of the Financial Policy stipulates that the General Fund (unreserved fund balance) should be sustained at a “minimum of 25% “ of the General Fund total budgeted annual spending to provide financing for unexpected spending and revenue deficit.

Conditions required for amending the Village’s budget

The conditions for amending the Village budget may be cited from the provisions of the “Village of Hanover Park Municipal Code section 24-6”, which states that: “the budget may be amended after its adoption by virtue of the authority vested upon the Village Manager to revise the budget within any separate fund as may be required by a vote of 2/3 of the incumbent membership who has likewise vested with the authority to amend the budget by transferring monies from one fund to another or adding to any fund, however, no revision of the annual budget shall be made increasing the budget in the event monies are not available” (Exhibit D: Budget Process, p.32; in Hanover Annual Budget, 2008).

The Mecklenburg County of North Carolina

The ‘Mecklenburg County of North Carolina’s Fiscal Year 2008-2010 Strategic Business Plan and Adopted Budget for Fiscal Year 2007-2008’ focuses on the characteristics and values of people and partnership in the community.  In effect, it envisions to achieving the “short-term” and “long-term” objectives wherein the strategic business plan has been aligned in the corporate-community partnership.

Procedures in reviewing and selecting capital projects

Based on Mecklenburg County’s financial management policies, the budget is being earmarked for “capital projects” consistent by virtue of ordinances of the Local Government Budget and Fiscal Control Act (NCGS159-13.2). To cite, the procedures in reviewing and selecting capital projects would be, such as: (1) participation in joint capital planning process to ensure that coordinated planning and exploration of joint use of sites and facilities will occur, (2) Any capital project financed through the issuance of bonds will be financed for a period not to exceed the expected life of the project, (3) pursue a process for building linkages between the City and County capital programs to ensure that both governing boards have a perspective on communitywide needs and priorities and the community’s overall financial capacity, (4) All capital projects will be reviewed by the Citizen’s Capital Budget Advisory Committee to prioritize projects within the total dollar amount the community can afford.

Policy on the lapse of budget authority for year-end encumbrance

The adoption of a “budgetary control” is being envisioned and outlined in the financial management systems, specifically on capital project outlays.  The designing of such budgetary control will provide monitoring in expense which meant to regulate the spending of the budget appropriations of the Board of County Commissioners.

To cite, a project duration or time-frame in the financial plan shall be adopted for the capital projects outlay that form part of the leveling of budgetary control in which expenditures minimizes to go the appropriated amount as earmarked from the General Fund. On the other hand, an “encumbrance recording system” shall also be established as a method or technique in achieving budgetary control. Moreover, to cite, encumbered amounts lapse, at year-end in the General Fund but not in the “Capital Projects Fund” and “Special Revenue Funds”.

Conclusion

It appears that the budget policies herein discussed are consistent with the safety net procedures of capital budgeting. The local governments have realized the decentralized function of fiscal and public management in a way that the resources judiciously focus on the divestment and sustainable cycle processes of spending.

From the review and discussion of the literatures, the sensibility in capital budgeting is characterized by a strong leadership in community which essentially reflects the political will in community governance; that the politico-persona of the local chief executive has transformed into the role of an area manager.

It may also be perceived that the characteristic of the local executives [depicted in this paper] could be an encouraging factor for other local government units to supplant their function as area manager from the political personality. What has been reflective of a dynamic and consistent budget policy depicts the essence of good governance wherein the devolution of power in the local government may achieve sustainable democracies.

References

  Local Government of Village of Hanover Park, Illinois (2007). ‘Annual Budget 2008 –

            2009’. Retrieved 22 April 2008 from

            http://hanoverparkillinois.org/Services/Finance/AnnualBudget.htm.

McMullen, B.J., Salvatore, P.J. and Camburn, J.I. (2007). ‘City of Peachtree City of Georgia

            Annual Budget for Fiscal Year Ending September 30^th 2008’. Retrieved 22 April 2008

            from http://www.peachtree-city.org/DocumentCenterii.asp?FID=11.

Mecklenburg County North Carolina (2008). ‘Fiscal Year 2008-2010 Strategic Business

            Plan and Fiscal Year 2008 Adopted Budget’. Retrieved 22 April 2008 from

http://www.charmeck.org/Departments/County+Managers+Office/Business+Management/Ho me.htm.

US Office of Management and Budget (2008). ‘Analytical Perspective: Budget of the United

            States Government, Fiscal Year 2009’. Retrieved 22 April 2008 from

            http://www.whitehouse.gov/omb/budget/fy2005/pdf/spec.pdf.

Instructions: HW Assignments will be uploaded to Kean Blackboard and must be accessed from there. You must work in groups that were assigned (or independently if not assigned to groups) on homework assignments. Points are noted against each question. You are required to submit Home Work assignments electronically on Kean Blackboard using MS-Office or other text editors. You are required to complete your assignments as per the due date indicated by the Professor.

Total Points in Assignment: 100 (Points scored will be scaled down to a maximum of 15 towards the final grade)

Assignment:

Part I: Cost of Capital

During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that has been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice-president. Your first task is to estimate Harry Davis’s cost of capital.

Jones has provided you with the following data, which she believes may be relevant to your task:

a) The firm’s tax rate is 40%.

b) The current price of Harry Davis’s 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153. 72. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

c) The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116. 95. Harry Davis would incur flotation costs equal to 5% of the proceeds on a new issue.

d) Harry Davis’s common stock is currently selling at $50 per share. Its last dividend (D0) was $3. 12, and dividends are expected to grow at a constant rate of 5. 8% in the foreseeable future. Harry Davis’s beta is 1. 2; the yield on T-bonds is 5. 6%; and the market risk premium is estimated to be 6%. For the over-own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 3. 2%judgmental risk premium.

e) Harry Davis’s target capital structure is 30% long-term debt, 10% preferred stock, and 60%common equity. To help you structure the task, Leigh Jones has asked you to answer the following questions.

1. What sources of capital should be included when you estimate Harry Davis’s weighted average cost of capital (WACC)? Should the component costs be figured on a before-tax or an after-tax basis? Should the costs be historical (embedded) costs or new (marginal) costs? (5 points)

Sources of capital to be included to estimate WACC are

* Long term debt – to be considered after-tax

* Preferred stock – to be considered before tax ( preferred stock is not tax-deductible)

* Common equity – to be considered before tax When it comes to corporate financing, most firms incorporate tax effects in the cost of capital.

For this reason, component costs should be calculated on an after-tax basis. In financial management, the WACC is used primarily to make investment decisions and these decisions hinge on projects expected future returns versus the cost of new or marginal capital that will be used to finance these projects. Thus the relevant cost its marginal cost of new debt to be raised during the planning period

2. What is the market interest rate on Harry Davis’s debt, and what is the component cost of this debt for WACC purposes? (3 points)

Pre -Tax cost of Debt is the YTM in the case of a Bond.

The current price of Harry Davis’s 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153. 72.

We used the RATE function in Excel to calculate the YTM:

=RATE(30,60,-1153. 72,1000) = 5%

Since this is a semiannual rate, we multiplied by 2 to find the annual rate, which is the pre-tax cost of debt. 5% x 2 = 10% = rd

After tax component cost of debt = Interest Rate – Tax Savings = rd – rdT

We calculated that the rd is 10%, and it is stated above that the tax rate is 40%. rd(1 – T) = 10. %(1 – 0. 40) = 10. 0%(0. 60) = 6. 0 = 6% component cost of debt, which is the after-tax cost of debt.

3. What is the firm’s cost of preferred stock? (3 points)

The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116. 95. Harry Davis would incur flotation costs equal to 5% of the proceeds on a new issue. The cost of preferred stock is simply the preferred dividend divided by the price the company will receive if it issues new preferred stock. No tax adjustment is necessary, as preferred dividends are not tax-deductible.

Dps is the Preferred dividend = 0. 10($100) = $10

Pps is the preferred stock price = $116. 95

F is the flotation cost as a percentage of proceeds = 5% rps = Dps / Pps(1-F) = $10 / 111. 10 = 0. 09 = 9% cost of preferred stock

4. Would you expect Harry Davis’s preferred stock to be riskier or less risky to investors than its debt? Compare the preferred stock yield to the yield to maturity on the debt and explain the risk/return trade-off between preferred stock and debt from an investor’s point of view. (3 points)

Preferred stocks are riskier to investors than debt. Corporations own the most preferred stock because 70% of preferred dividends are non-taxable to corporations. Therefore, the preferred stock often has a lower before-tax yield than the before-tax yield on debt. But, the after-tax costs to the issuer are higher on preferred stock than debt. This is consistent with the higher risks of preferred stock.

5. Harry Davis doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis’s estimated cost of equity? (2 points)

Harry Davis’s beta is 1. 2; the yield on T-bonds is 5. 6%, and the market risk premium is estimated to be 6%.

Risk-free rate: 5. 6%

Market risk premium: 6%

Beta: 1. 2 rs = Risk-free rate + (Market risk premium) (Beta) rs = rRF + (RPM) bi rs = . 056 + (. 06)(1. 2) = 0. 128 = 12. 8% estimated cost of equity using CAPM approach

6. What is the estimated cost of equity using the discounted cash flow (DCF) approach? (2 points)

Harry Davis’s common stock is currently selling at $50 per share. Its last dividend (D0) was $3. 12, and dividends are expected to grow at a constant rate of 5. 8% in the foreseeable future. P0 = $50 D0 = $3. 12 g = 5. 8% D1 = $3. 30 rs = D1/P0 + g D1= D0(1+g)= $3. 12(1+. 058) = $3. 30 s = ($3. 30/$50)+5. 8% = 6. 6% +5. 8% = 12. 4% estimated cost of equity using DCF approach

7. Suppose the firm has historically earned 15% on equity (ROE) and retained 62% of earnings, and investors expect this situation to continue in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this consistent with the 5. 8% growth rate provided by Jones? (2 points)

Payout rate = 100% – 62% = 38% ROE = 15% Growth from earnings retention model:

g = (Retention rate)(ROE) g = (1 – Payout rate)(ROE) g = (1 – 0. 38)(15%) = 9. %.

Using the Earnings Retention Model, the estimated future dividend growth rate is 9. 3%, which is almost twice the growth rate provided by Jones, and hence inconsistent. Note that the earning retention model assumes the retention and payout rate will remain constant, as will the ROE on new investments. Under these assumptions, the earnings growth and dividend growth rate will also be constant.

8. What is the cost of equity-based on the bond-yield-plus-judgmental-risk-premium method? (2 points)

For the over-own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 3. %judgmental risk premium. We calculated earlier that the company’s bond yield is 10%. rs= rd + Judgmental risk premium rs= 10. 0% + 3. 2% = 13. 2% cost of equity-based on bond-yield-plus-judgmental-risk-premium method

9. What is your final estimate for the cost of equity, rs? (2 points)

CAPMrs = 12. 8% DCF rs= 12. 4% Bond-yield-plus-judgmental-risk-premium risk rs = 13. 2% Average rs= 12. 8% Final estimate for the cost of equity, rs = 12. 8%

10. What is Harry Davis’s weighted average cost of capital (WACC)? (2 points)

The firm’s tax rate is 40%.

Harry Davis’s target capital structure is 30% long-term debt, 10% preferred stock, and 60%common equity. We calculated earlier that the pre-tax cost of debt, rd is 10%, the cost of preferred stock, rps is 9% and the cost of equity, rs is 12. 8%. Wd = 30% rd = 10% T = 40% Wps = 10% rps = 9% Ws = 60% rs = 12. 8% WACC= wdrd(1 – T) + wpsrps + wsrs WACC= 0. 30(. 10)(1 ? 0. 40) + 0. 10(. 09) + 0. 60(. 128) = . 1038 = 10. 38% weighted average cost of capital

11. What four common mistakes in estimating the WACC should Harry Davis avoid? (2 points)

Four common mistakes that are to be avoided are

1. Using current cost of debt (instead of the historical cost of debt)
2. Mixing current and historical measures to calculate MRP
3. Using book weights to estimate the weight for capital structure (instead of market weights) 4. Misidentifying the capital component sources

Part II: Capital Budgeting

You have just graduated from the MBA program at a large university, and one of your favorite courses was “Today’s Entrepreneurs. ” In fact, you enjoyed it so much you have decided you want to “be your own boss. ” While you were in the master’s program, your grandfather died and left you $1 million to do with as you please.

You are not an inventor and you do not have a trade skill that you can market; however, you have decided that you would like to purchase at least one established franchise in the fast-foods area, maybe two (if profitable). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is three years. After three years you will sell off your investment and go on to something else. You have narrowed your selection down to two choices; (1) Franchise L, Lisa’s Soups, Salads; Stuff and (2) Franchise S, Sam’s Fabulous Fried Chicken.

The net cash flows shown below include the price you would receive for selling the franchise in Year 3 and the forecast of how each franchise will do over the three-year period. Franchise L’s cash flows will start off slowly but will increase rather quickly as people become more health-conscious, while Franchise S’s cash flows will start off high but will trail off as other chicken competitors enter the marketplace and as people become more health-conscious and avoid fried foods. Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for you to invest in both franchises.

You see these franchises as perfect complements to one another: You could attract both the lunch and dinner crowds and the health-conscious and not so health-conscious crowds without the franchises directly competing against one another. Here are the net cash flows (in thousands of dollars): Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. You also have made subjective risk assessments of each franchise and concluded that both franchises have risk characteristics that require a return of 10%. You must now determine whether one or both of the franchises should be accepted.

1. What is the difference between independent and mutually exclusive projects? (2 points) Independent projects are those projects whose cash flows are not affected by other projects. If Costco is considering opening a new store in Los Angeles and another one in New York, they would be independent. Mutually exclusive projects are two different methods of attaining the same result. If one is accepted the other would be rejected. If Costco were considering relocating its corporate headquarters to Los Angeles or New York, only one of the 2 locations will be selected thus rejecting the alternate location.

When projects are mutually exclusive, it means they do the same job or have the same purpose.

2. Define the term net present value (NPV). What is each franchise’s NPV? (4 points) Net Present Value is defined as the present value of the project’s cash inflows minus the present value of its costs. It tells us how the project contributes to shareholder wealth. The larger the NPV the more value the project adds and thus the higher the stock price.

NPV = CF0 + CF1/ (1+r)1 + CF2/(1+r)2 + CF3/(1+r)3….. + CFN/(1+r)N r = 10%

Franchise L CF0L = -100 CF1L = 10 CF2L = 60 CF3L = 80

NPVL= CF0L + CF1L/ (1+r)1 + CF2L/(1+r)2 + CF3L/(1+r)3 = -100 +10/(1+. 10)1 + 60/(1. 10)2 + 80/(1. 10)3 = -100 + 9. 09 + 49. 59 + 60. 11 = $18. 79

Franchise S

CF0S = -100

CF1S = 70

CF2S = 50

CF3S = 20

NPVS= CF0S + CF1S/ (1+r)1 + CF2S/(1+r)2 + CF3S/(1+r)3 = -100 +70/(1+. 10)1 + 50/(1. 10)2 + 20/(1. 10)3 = -100 + 63. 64 + 41. 32 + 15. 03 = $19. 99

3. What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive? How would the NPVs change if the cost of capital changed? (4 points)

NPV is generally regarded as the best single screening criterion, primarily because it is directly related to the firm’s central goal of maximizing the stock’s intrinsic value. NPV tells us how the project contributes to shareholder wealth. The larger the NPV the more value the project adds and thus the higher the stock price. A negative NPV indicates sufficient cash is not being generated from the project to meet the cost associated with the project. Zero NPV indicates that cash generated is only sufficient to cover costs. Positive NPV on the other hand indicates that the inflow of cash is larger than the outflow.

NPV rules dictate that if projects are independent, both projects should be accepted as long as they have a positive NPV. In this case both Franchise S; L have positive NPV’s and should be accepted. If projects are mutually exclusive, then the project with the larger NPV should be selected. In this case, Franchise S has a higher NPV indicating that the returns from investing in Franchise S are larger and thus Franchise S should be selected.

4. Define the term internal rate of return (IRR). What is each franchise’s IRR? (4 points)

IRR is the discount rate that forces the PV of the inflow of a project to equal the initial cost.

In other words, it forces the NPV to be zero. IRR is an estimate of the project’s rate of return and it is comparable to the YTM on a bond.

NPV = CF0 + CF1/ (1+IRR)1 + CF2/(1+IRR)2 + CF3/(1+IRR)3….. + CFN/(1+IRR)N = 0

Using Excel function IRR

IRRL = 18. 13%

IRRS = 23. 56%

5. What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive? How would the IRRs change if the cost of capital changed? (4 points)

IRR is an estimate of a project’s rate of return. If the return exceeds the cost of funds used to finance the project, then the difference is a bonus that goes to the firm’s stockholders and causes the stock price to rise. So if the WACC/hurdle rate(r) is less than the estimated return IRR, it indicates the project will be profitable. As in NPV where zero is the threshold above which the project is considered profitable, r is the threshold above which IRR is considered profitable In the condition where Franchise S and L are independent, both franchises have positive IRR’s and thus both franchises should be accepted.

However, when both franchises are mutually exclusive, the franchise with the larger IRR has to be selected, which in this case Franchise S.

6. Construct NPV profiles for Franchises L and S. At what discount rate do the profiles cross? From the NPV profile which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain. (6 points)

NPV Profile for Franchise S; L

Cost of Capital = 10%

On this plot, the X-Axis is the cost of capital and the Y-axis is the NPV. IRR is the discount rate at which the profile line crosses the X-axis. Profiles crossover at an 8. 68% cost of capital. Based on the plot, the NPV for both Franchise S and Franchise L have NPV’s above the cost of capital indicating cash inflow is larger than the costs and thus both projects should be selected if they are independent of each other.

On the other hand, if the projects are mutually exclusive, the project with the larger x-intercept (higher IRR), which is Franchise S, should be accepted.

7. What is the underlying cause of ranking conflicts between NPV and IRR? (3 points)

Ranking conflicts occur when the cost of capital is higher than the crossover rate which causes NPV and IRR to point in different directions. The two basic conditions that cause these conflicts are * Timing difference: When one project receives the majority of the cash early while the other receives it later.

This is the reason for conflict between Franchise S; Franchise L * Project size (scale) difference: Significant difference in invested amount can cause a conflict When either timing or size differences occur, the firm will have different amounts of funds to invest in other projects depending on which of the two mutually exclusive projects it chooses. Given this situation, the rate of return at which differential cash flows can be reinvested is a critical issue. Therefore, whenever conflict exists between mutually exclusive projects, NPV method is better to use.

8. What is the “reinvestment rate assumption,” and how does it affect the NPV versus IRR conflict? (3 points)

NPV calculation is based on the assumption that cash inflows can be reinvested at the project’s risk-adjusted WACC, whereas the IRR calculation is based on the assumption that cash inflows can be reinvested at the IRR itself. Since NPV assumes reinvestment at cost of capital which is more realistic and is typically lower than the IRR (cash flows generally cannot be reinvested at heir IRR), so NPV is the more reasonable method. NPV should be used to choose between mutually exclusive projects.

9. Define the term modified IRR (MIRR). Find the MIRRs for Franchises L and S. (4 points)

IRR overstates the expected rate of return for accepted projects because cash flows cannot be reinvested at the IRR. The modified IRR (MIRR) rectifies this problem by assuming reinvestment at the WACC or any other reasonable rate. Using excel function MIRR, we calculated the MIRR for Franchise L and S.

10. What are the MIRR’s advantages and disadvantages vis-a-vis the regular IRR? What are the MIRR’s advantages and disadvantages vis-a-vis the NPV? (4 points)

MIRR has two significant advantages over IRR. First, MIRR assumes reinvestments at cost of capital rather than an investment at IRR which is generally not correct. Thus, MIRR is usually a better indicator of profitability. In addition, the MIRR eliminates the multiple IRR problem because there can never be more than one MIRR, and it can be compared with the cost of capital when deciding on accepting or rejecting projects.

MIRR does not always lead to the same decision as NPV in the case of mutually exclusive projects where the difference in size and timing can give rise to conflicts. In these considerations, NPV is a better indicator as it selects the project that maximizes value. However, MIRR is superior to the regular IRR as an indicator of a project’s “true” rate of return.

Part III: Forecasting Financial Statements

Matthews Industries’ most recent financial statements are available in the attached Excel worksheet and also in the partial model file, Ch12 P11 Build a Model. xls from the textbook’s web site.

Matthews Industries’ financial planners must forecast the company’s financial results for the coming year. The forecast will be based on the forecasted financial statements method, and any additional funds needed will be obtained by using notes payable. Complete the partial model and answer the following questions.

1. Assume that the firm’s 2010 profit margin, payout ratio, capital intensity ratio, and spontaneous liabilities to sales ratio remain constant. If sales grow by 10% in 2011, what is the required external capital the firm will need in 2011 as calculated by the AFN equation? (10 points)

The required external capital for 2011 as calculated by AFN is 327. 27 Million.

2. If 2010 ratios remain constant, what is Matthews’ self-supporting growth rate?

How will the self-supporting growth rate change if each of the following changes occur:

(1) the profit margin declines,

(2) the payout ratio increases, or

(3) the capital intensity ratio declines? (10 points)

Self-supporting g =(PM(1 – POR)(S0))/(A0* – L0* – PM(1 – POR)S0)=$234. 30/ $5,615. 70= 4. 17%

Mathew’s self-supporting growth is calculated to be 4. 17%. Effect on Self-Supporting growth when all ratios are kept constant except one ratio is changed as follows 1) When the profit margin declines, the self-supporting growth percentage drops.

Assuming that everything else is constant and M falls to 2. 55%, self-supporting growth g would fall to 2. 96% 2) When Payout-ratio increases, self-supporting growth percentage drops. Assuming that everything else is constant and POR increases to 55%, self-supporting growth g would fall to 3. 39% 3) When capital intensity ratio (A0*/S0) declines, it does not change the self-supporting growth

3. Matthews’ management has reviewed its financial statements and arrived at two possible scenarios for 2011.

The first scenario assumes a steady-state while the second scenario, the target scenario, shows some improvement in ratios toward industry-average values. Forecasted values for the scenarios are shown in the partially completed file Ch12 P11 Build a Model. xls. If Matthews assumes that external financing is achieved through notes payable and financing feedbacks are not considered because the new notes payable are added at the end of the year, what are the firm’s forecasted AFN, EPS, DPS, and year-end stock price under each scenario? (14 points)

Using the file Chapter 12P11 Build a Model. ls, forecasted values for scenarios are as follows:

See excel file submitted separately for detailed calculations on Part III.

Scoring Sheet:

Chapter 7 Fundamentals of Capital Budgeting

7-1. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $20 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 40% will come from customers who switch to the new, healthier pizza instead of buying the original version. a. b. Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new pizza?

Suppose that 50% of the customers who will switch from Pisa Pizza’s original pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this case? Sales of new pizza – lost sales of original = 20 – 0. 40(20) = $12 million Sales of new pizza – lost sales of original pizza from customers who would not have switched brands = 20 – 0. 50(0. 40)(20) = $16 million a. b. 7-2. Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi Munch.

Kokomochi plans to spend $5 million on TV, radio, and print advertising this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9 million this year and by $7 million next year. In addition, the company expects that new consumers who try the Mini Mochi Munch will be more likely to try Kokomochi’s other products. As a result, sales of other products are expected to rise by $2 million each year. Kokomochi’s gross profit margin for the Mini Mochi Munch is 35%, and its gross profit margin averages 25% for all other products.

The company’s marginal corporate tax rate is 35% both this year and next year. What are the incremental earnings associated with the advertising campaign? A B C 1 Year 2 Incremental Earnings Forecast ($000s) 3 1 Sales of Mini Mochi Munch 4 2 Other Sales 5 3 Cost of Goods Sold 6 4 Gross Profit 7 5 Selling, General & Admin. 8 6 Depreciation 9 7 EBIT 10 8 Income tax at 35% 11 9 Unlevered Net Income D 1 9,000 2,000 (7,350) 3,650 (5,000) (1,350) 473 (878) $300 E 2 7,000 2,000 (6,050) 2,950 2,950 (1,033) 1,918 $250 ©2011 Pearson Education, Inc. Publishing as Prentice Hall $200 70 80 90 100 110 120 130 140 150 90

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• Corporate Finance, Second Edition 7-3. Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store.

Which of the following should be included as part of the incremental earnings for the proposed new retail store? a. b. c. d. e. f. g. a. b. c. d. e. f. The cost of the land where the store will be located. The cost of demolishing the abandoned warehouse and clearing the lot. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead. The $10,000 in market research spent to evaluate customer demand. Construction costs for the new store. The value of the land if sold. Interest expense on the debt borrowed to pay the construction costs.

No, this is a sunk cost and will not be included directly. (But see (f) below. ) Yes, this is a cost of opening the new store. Yes, this loss of sales at the existing store should be deducted from the sales at the new store to determine the incremental increase in sales that opening the new store will generate for HBS. No, this is a sunk cost. This is a capital expenditure associated with opening the new store. These costs will, therefore, increase HBS’s depreciation expenses. Yes, this is an opportunity cost of opening the new store. (By opening the new store, HBS forgoes the after-tax proceeds it could have earned by selling the property.

This loss is equal to the sale price less the taxes owed on the capital gain from the sale, which is the difference between the sale price and the book value of the property. The book value equals the initial cost of the property less accumulated depreciation. ) While these financing costs will affect HBS’s actual earnings, for capital budgeting purposes we calculate the incremental earnings without including financing costs to determine the project’s unlevered net income. g. 7-4. Hyperion, Inc. currently sells its latest high-speed color printer, the Hyper 500, for $350. It plans to lower the price to $300 next year.

Its cost of goods sold for the Hyper 500 is $200 per unit, and this year’s sales are expected to be 20,000 units. a. Suppose that if Hyperion drops the price to $300 immediately, it can increase this year’s sales by 25% to 25,000 units. What would be the incremental impact on this year’s EBIT of such a price drop? Suppose that for each printer sold, Hyperion expects additional sales of $75 per year on ink cartridges for the next three years, and Hyperion has a gross profit margin of 70% on ink cartridges. What is the incremental impact on EBIT for the next three years of a price drop this year? b. ©2011 Pearson Education, Inc.

Publishing as Prentice Hall Berk/DeMarzo • Corporate Finance, Second Edition Change in EBIT = Gross profit with price drop – Gross profit without price drop = 25,000 ? (300 – 200) – 20,000 ? (350 – 200) = – $500,000 b. Change in EBIT from Ink Cartridge sales = 25,000 ? $75 ? 0. 70 – 20,000 ? $75 ? 0. 70 = $262,500 Therefore, incremental change in EBIT for the next 3 years is Year 1: Year 2: Year 3: 7-5. $262,500 – 500,000 = -$237,500 $262,500 $262,500 91 a. After looking at the projections of the HomeNet project, you decide that they are not realistic. It is unlikely that sales will be constant over the four-year life of the project.

Furthermore, other companies are likely to offer competing products, so the assumption that the sales price will remain constant is also likely to be optimistic. Finally, as production ramps up, you anticipate lower per unit production costs resulting from economies of scale. Therefore,you decide to redo the projections under the following assumptions: Sales of 50,000 units in year 1 increasing by 50,000 units per year over the life of the project, a year 1 sales price of $260/unit, decreasing by 10% annually and a year 1 cost of $120/unit decreasing by 20% annually.

In addition, new tax laws allow you to depreciate the equipment over three rather than five years using straightline depreciation. a. Keeping the other assumptions that underlie Table 7. 1 the same, recalculate unlevered net income (that is, reproduce Table 7. 1 under the new assumptions, and note that we are ignoring cannibalization and lost rent). Recalculate unlevered net income assuming, in addition, that each year 20% of sales comes from customers who would have purchased an existing Linksys router for $100/unit and that this router costs $60/unit to manufacture. (15,000) (15,000) 6,000 (9,000) 1 13,000 (6,000) 7,000 (2,800) (2,500) 1,700 (680) 1,020 2 23,400 (9,600) 13,800 (2,800) (2,500) 8,500 (3,400) 5,100 3 31,590 (11,520) 20,070 (2,800) (2,500) 14,770 (5,908) 8,862 4 37,908 (12,288) 25,620 (2,800) 22,820 (9,128) 13,692 5 – b. a. Year Incremental Earnings Forecast ($000s) 1 Sales 2 Cost of Goods Sold 3 Gross Profit 4 Selling, General & Admin. 5 Research & Development 6 Depreciation 7 EBIT 8 Income tax at 40% 9 Unlevered Net Income ©2011 Pearson Education, Inc. Publishing as Prentice Hall 92 Berk/DeMarzo • Corporate Finance, Second Edition b.

Year Incremental Earnings Forecast ($000s) 1 Sales 2 Cost of Goods Sold 3 Gross Profit 4 Selling, General & Admin. 5 Research & Development 6 Depreciation 7 EBIT 8 Income tax at 40% 9 Unlevered Net Income 7-6. 0 (15,000) (15,000) 6,000 (9,000) 1 12,000 (5,400) 6,600 (2,800) (2,500) 1,300 (520) 780 2 21,400 (8,400) 13,000 (2,800) (2,500) 7,700 (3,080) 4,620 3 28,590 (9,720) 18,870 (2,800) (2,500) 13,570 (5,428) 8,142 4 33,908 (9,888) 24,020 (2,800) 21,220 (8,488) 12,732 5 – Cellular Access, Inc. is a cellular telephone service provider that reported net income of $250 million for the most recent fiscal year.

The firm had depreciation expenses of $100 million, capital expenditures of $200 million, and no interest expenses. Working capital increased by $10 million. Calculate the free cash flow for Cellular Access for the most recent fiscal year. FCF = Unlevered Net Income + Depreciation – CapEx – Increase in NWC= 250 + 100 – 200 – 10 = $140 million. 7-7. Castle View Games would like to invest in a division to develop software for video games. To evaluate this decision, the firm first attempts to project the working capital needs for this operation.

Its chief financial officer has developed the following estimates (in millions of dollars): Assuming that Castle View currently does not have any working capital invested in this division, calculate the cash flows associated with changes in working capital for the first five years of this investment. Year0 1 2 3 4 5 6 Cash Accounts Receivable Inventory Accounts Payable Net working capital (1+2+3-4) Increase in NWC Year1 6 21 5 18 14 14 Year2 12 22 7 22 19 5 Year3 15 24 10 24 25 6 Year4 15 24 12 25 26 1 Year5 15 24 13 30 22 -4 0 2011 Pearson Education, Inc. Publishing as Prentice Hall Berk/DeMarzo • Corporate Finance, Second Edition 93 7-8. Mersey Chemicals manufactures polypropylene that it ships to its customers via tank car. Currently, it plans to add two additional tank cars to its fleet four years from now. However, a proposed plant expansion will require Mersey’s transport division to add these two additional tank cars in two years’ time rather than in four years. The current cost of a tank car is $2 million, and this cost is expected to remain constant.

Also, while tank cars will last indefinitely, they will be depreciated straight-line over a five-year life for tax purposes. Suppose Mersey’s tax rate is 40%. When evaluating the proposed expansion, what incremental free cash flows should be included to account for the need to accelerate the purchase of the tank cars? initial tank car cost inflation rate depreciable life Year: with expansion CapEx Depreciation Tax Shield FCF without expansion CapEx Depreciation Tax Shield FCF Incremental FCF (with-without) 0 1 4 0% 5 2 -4 0 0 -4 0. 32 0. 32 0. 32 0. 32 0. 2 0. 32 0. 32 0. 32 0. 32 0. 32 0 0 0 3 replace date without expansion replace date with expansion tax rate 4 5 6 7 4 2 40% 8 9 10 -4 0 0 0 0 0 -4 0 0. 32 -4 4. 32 0. 32 0. 32 0 0. 32 0. 32 0 0. 32 0. 32 0 0. 32 0. 32 -0. 32 0. 32 0. 32 -0. 32 0 0 7-9. Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are difficult to estimate, management has projected the following cash flows for the first two years (in millions of dollars): a. b. a. What are the incremental earnings for this project for years 1 and 2?

What are the free cash flows for this project for the first two years? Year Incremental Earnings Forecast ($000s) 1 Sales 2 Costs of good sold and operating expenses other than depreciation 3 Depreciation 4 EBIT 5 Income tax at 35% 6 Unlevered Net Income 1 125. 0 (40. 0) (25. 0) 60. 0 (21. 0) 39. 0 2 160. 0 (60. 0) (36. 0) 64. 0 (22. 4) 41. 6 b. Free Cash Flow ($000s) 7 Plus: Depreciation 8 Less: Capital Expenditures 9 Less: Increases in NWC 10 Free Cash Flow 1 25. 0 (30. 0) (5. 0) 29. 0 2 36. 0 (40. 0) (8. 0) 29. 6 ©2011 Pearson Education, Inc. Publishing as Prentice Hall 94

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• Corporate Finance, Second Edition 7-10. You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office, drops a consultant’s report on your desk, and complains, “We owe these consultants $1 million for this report, and I am not sure their analysis makes sense. Before we spend the $25 million on new equipment needed for this project, look it over and give me your opinion. ” You open the report and find the following estimates (in thousands of dollars): All of the estimates in the report seem correct.

You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year 0), which is what the accounting department recommended. The report concludes that because the project will increase earnings by $4. 875 million per year for 10 years, the project is worth $48. 75 million. You think back to your halcyon days in finance class and realize there is more work to be done! First, you note that the consultants have not factored in the fact that the project will require $10 million in working capital upfront (year 0), which will be fully recovered in year 10.

Next, you see they have attributed $2 million of selling, general and administrative expenses to the project, but you know that $1 million of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that accounting earnings are not the right thing to focus on! a. b. a. Given the available information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed project? If the cost of capital for this project is 14%, what is your estimate of the value of the new project? Free Cash Flows are: 0 = Net income + Overhead (after tax at 35%) + Depreciation – Capex – Inc. n NWC FCF b. 1 4,875 650 2,500 2 4,875 650 2,500 … 9 4,875 650 2,500 10 4,875 650 2,500 –10000 18,025 25,000 10,000 –35,000 8,025 8,025 … 8,025 NPV ? ?35 ? 8. 025 ? 1 ? 1 ? 18. 025 ? 9. 56 ? 1 ? ?? .14 ? 1. 149 ? 1. 1410 ©2011 Pearson Education, Inc. Publishing as Prentice Hall Berk/DeMarzo

• Corporate Finance, Second Edition 95 7-11. Using the assumptions in part a of Problem 5 (assuming there is no cannibalization), a. b. a. Calculate HomeNet’s net working capital requirements (that is, reproduce Table 7. 4 under the assumptions in Problem 5(a)). Calculate HomeNet’s FCF (that is, reproduce Table 7. under the same assumptions as in (a)). 0 1 13,000 (6,000) 7,000 (2,800) (2,500) 1,700 (680) 1,020 2,500 (1,050) 2,470 1 1,950 (900) 1,050 2 23,400 (9,600) 13,800 (2,800) (2,500) 8,500 (3,400) 5,100 2,500 (1,020) 6,580 2 3,510 (1,440) 2,070 3 31,590 (11,520 ) 20,070 (2,800) (2,500) 14,770 (5,908) 8,862 2,500 (941) 10,421 3 4,739 (1,728) 3,011 4 37,908 (12,288 ) 25,620 (2,800) 22,820 (9,128) 13,692 (833) 12,860 4 5,686 (1,843) 3,843 5 3,843 3,843 5 – Year Net Working Capital Forecast ($000s) 1 Cash requirements 2 Inventory 3 Receivables (15% of Sales) 4 Payables (15% of COGS) 5 Net Working Capital b.

Year 0 Incremental Earnings Forecast ($000s) 1 Sales 2 3 4 5 6 7 8 9 Cost of Goods Sold Gross Profit Selling, General & Admin. Research & Development Depreciation EBIT Incometaxat40% Unlevered Net Income (15,000) (15,000) 6,000 (9,000) (7,500) (16,500) Free Cash Flow ($000s) 10 Plus: Depreciation Less: Capital 11 Expenditures 12 Less: Increases in NWC 13 Free Cash Flow 7-12. A bicycle manufacturer currently produces 300,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2 a chain.

The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1. 50 per chain. The necessary machinery would cost $250,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposes using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $50,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $20,000.

If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier? Solution: FCF=EBIT (1-t) + depreciation – CAPX – ? NWC FCF from outside supplier = -$2×300,000 x (1 – . 35) = -$390k per year. ©2011 Pearson Education, Inc. Publishing as Prentice Hall 96 Berk/DeMarzo

• Corporate Finance, Second Edition NPV(outside) ? ?$390, 000 1 ? 1 ? ?1 ? ? 0. 15 ? 1. 1510 ? ? ? $1. 9573M FCF in house: in year 0: – 250 CAPX – 50 NWC= – 300K FCF in years 1-9: ?$1. 50 x 300,000 ? 25,000 -$475,000 cost ? depreciation = incremental EBIT ? tax = (1-t) x EBIT + depreciation = FCF ?$166, 250 -$308,750 +$25,000 -$283,750 FCF in year 10: –$283,750 + (1 – 0. 35) x $20,000 + $50,000 = –$220,750 FCF Note that the book value of the machinery is zero; hence, its scrap proceeds ($20,000) are fully taxed. The NWC ($50,000) is recovered at book value and hence not taxed. NPV (in house): –$300k + annuity of –$283,750 for 9 years + ?$220, 750 1. 1510 $283, 750 ? 1 ? 1 ? 0. 15 ? 1. 159 ? ?$1. 7085M ? ?$300k ? ? $220, 750 ?? 1. 1510 ? Thus, in-house is cheaper, with a cost savings of ($1. 573M – $1. 7085M) = $248. 8K in present value terms. 7-13. One year ago, your company purchased a machine used in manufacturing for $110,000. You have learned that a new machine is available that offers many advantages; you can purchase it for $150,000 today. It will be depreciated on a straight-line basis over 10 years, after which it has no salvage value. You expect that the new machine will produce EBITDA (earning before interest, taxes, depreciation, and amortization) of $40,000 per year for the next 10 years. The current machine is expected to produce EBITDA of $20,000 per year.

The current machine is being depreciated on a straight-line basis over a useful life of 11 years, after which it will have no salvage value, so depreciation expense for the current machine is $10,000 per year. All other expenses of the two machines are identical. The market value today of the current machine is $50,000. Your company’s tax rate is 45%, and the opportunity cost of capital for this type of equipment is 10%. Is it profitable to replace the year-old machine? Replacing the machine increases EBITDA by 40,000 – 20,000 = 20,000. Depreciation expenses rises by $15,000 – $10,000 = $5,000.

Therefore, FCF will increase by (20,000) ? (1-0. 45) + (0. 45)(5,000) = $13,250 in years 1 through 10. In year 0, the initial cost of the machine is $150,000. Because the current machine has a book value of $110,000 – 10,000 (one year of depreciation) = $100,000, selling it for $50,000 generates a capital ©2011 Pearson Education, Inc. Publishing as Prentice Hall Berk/DeMarzo • Corporate Finance, Second Edition 97 gain of 50,000 – 100,000 = –50,000. This loss produces tax savings of 0. 45 ? 50,000 = $22,500, so that the after-tax proceeds from the sales including this tax savings is $72,500.

Thus, the FCF in year 0 from replacement is –150,000 + 72,500 = –$77,500. NPV of replacement = –77,500 + 13,250 ? (1 / . 10)(1 – 1 / 1. 1010) = $3916. There is a small profit from replacing the machine. 7-14. Beryl’s Iced Tea currently rents a bottling machine for $50,000 per year, including all maintenance expenses. It is considering purchasing a machine instead, and is comparing two options: a. b. Purchase the machine it is currently renting for $150,000. This machine will require $20,000 per year in ongoing maintenance expenses. Purchase a new, more advanced machine for $250,000.

This machine will require $15,000 per year in ongoing maintenance expenses and will lower bottling costs by $10,000 per year. Also, $35,000 will be spent upfront in training the new operators of the machine. Suppose the appropriate discount rate is 8% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each year, as is the rental of the machine. Assume also that the machines will be depreciated via the straight-line method over seven years and that they have a 10-year life with a negligible salvage value.

The marginal corporate tax rate is 35%. Should Beryl’s Iced Tea continue to rent, purchase its current machine, or purchase the advanced machine? We can use Eq. 7. 5 to evaluate the free cash flows associated with each alternative. Note that we only need to include the components of free cash flows that vary across each alternative. For example, since NWC is the same for each alternative, we can ignore it. The spreadsheet below computes the relevant FCF from each alternative. Note that each alternative has a negative NPV—this represents the PV of the costs of each alternative.

We should choose the one with the highest NPV (lowest cost), which in this case is purchasing the existing machine. a. b. See spreadsheet See spreadsheet D 0 A B C 5 6 Rent Machine 7 1 Rent 8 2 FCF(rent) 9 3 NPV at 8% 10 Purchase Current Machine 11 4 Maintenance 12 5 Depreciation 13 6 Capital Expenditures 14 7 FCF(purchase current) 15 8 NPV at 8% 16 Purchase Advanced Machine 17 9 Maintenance 18 10 Other Costs 19 11 Depreciation 20 12 Capital Expenditures 21 13 FCF(purchase advanced) 22 14 NPV at 8% E 1 (50,000) (32,500) F 2 (50,000) (32,500) G 3 (50,000) (32,500) H 4 (50,000) (32,500)

I 5 (50,000) (32,500) J 6 (50,000) (32,500) K 7 (50,000) (32,500) L 8 (50,000) (32,500) M 9 (50,000) (32,500) N 10 (50,000) (32,500) (218,078) (20,000) 21,429 (150,000) (150,000) (198,183) (5,500) (20,000) 21,429 (5,500) (20,000) 21,429 (5,500) (20,000) 21,429 (5,500) (20,000) 21,429 (5,500) (20,000) 21,429 (5,500) (20,000) 21,429 (5,500) (20,000) (13,000) (20,000) (13,000) (20,000) (13,000) (35,000) (250,000) (272,750) (229,478) (15,000) 10,000 35,714 9,250 (15,000) 10,000 35,714 9,250 (15,000) 10,000 35,714 9,250 (15,000) 10,000 35,714 9,250 (15,000) 10,000 35,714 9,250 15,000) 10,000 35,714 9,250 (15,000) 10,000 35,714 9,250 (15,000) 10,000 (3,250) (15,000) 10,000 (3,250) (15,000) 10,000 (3,250) 7-15. Markov Manufacturing recently spent $15 million to purchase some equipment used in the manufacture of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 35%. The company plans to use straight-line depreciation. a. b. What is the annual depreciation expense associated with this equipment? What is the annual depreciation tax shield? ©2011 Pearson Education, Inc. Publishing as Prentice Hall 98

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• Corporate Finance, Second Edition c. Rather than straight-line depreciation, suppose Markov will use the MACRS depreciation method for five-year property. Calculate the depreciation tax shield each year for this equipment under this accelerated depreciation schedule. If Markov has a choice between straight-line and MACRS depreciation schedules, and its marginal corporate tax rate is expected to remain constant, which should it choose? Why? How might your answer to part (d) change if Markov anticipates that its marginal corporate tax rate will increase substantially over the next five years? 15 million / 5 years = $3 million per year $3 million ? 35% = $1. 05 million per year Year MACRS Depreciation Equipment Cost MACRS Depreciation Rate Depreciation Expense Depreciation Tax Shield (at 35% tax rate) 0 15,000 20. 00% 3,000 1,050 1 2 3 4 5 d. e. a. b. c. 32. 00% 4,800 1,680 19. 20% 2,880 1,008 11. 52% 1,728 605 11. 52% 1,728 605 5. 76% 864 302 d. In both cases, its total depreciation tax shield is the same. But with MACRS, it receives the depreciation tax shields sooner—thus, MACRS depreciation leads to a higher NPV of Markov’s FCF.

If the tax rate will increase substantially, than Markov may be better off claiming higher depreciation expenses in later years, since the tax benefit at that time will be greater. e. 7-16. Your firm is considering a project that would require purchasing $7. 5 million worth of new equipment. Determine the present value of the depreciation tax shield associated with this equipment if the firm’s tax rate is 40%, the appropriate cost of capital is 8%, and the equipment can be depreciated a. b. c. d. Straight-line over a 10-year period, with the first deduction starting in one year.

Straight-line over a five-year period, with the first deduction starting in one year. Using MACRS depreciation with a five-year recovery period and starting immediately. Fully as an immediate deduction. Equipment Cost Tax Rate Cost of capital 7. 5 40. 00% 8. 00% Year 2 0. 3 0. 6 19. 20% 0. 576 Depreciation Tax Shield (Tc*Dep) Year 3 Year 4 Year 5 Year 6 0. 3 0. 3 0. 3 0. 3 0. 6 0. 6 0. 6 11. 52% 11. 52% 5. 76% 0. 3456 0. 3456 0. 1728 Year 7 0. 3 Year 8 0. 3 Year 9 0. 3 Year 10 0. 3 PV(DTS) a 2. 013 b 2. 396 MACRS table c 2. 629 d 3. 000 Year 0 20% 0. 6 3 Year 1 0. 0. 6 32% 0. 96 7-17. Arnold Inc. is considering a proposal to manufacture high-end protein bars used as food supplements by body builders. The project requires use of an existing warehouse, which the firm acquired three years ago for $1m and which it currently rents out for $120,000. Rental rates are not expected to change going forward. In addition to using the warehouse, the project requires an up-front investment into machines and other equipment of $1. 4m. This investment can be fully depreciated straight-line over the next 10 years for tax purposes.

However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $500,000. Finally, the project requires an initial investment into net working capital equal to ©2011 Pearson Education, Inc. Publishing as Prentice Hall Berk/DeMarzo • Corporate Finance, Second Edition 99 10% of predicted first-year sales. Subsequently, net working capital is 10% of the predicted sales over the following year. Sales of protein bars are expected to be $4. 8m in the first year and to stay constant for eight years.

Total manufacturing costs and operating expenses (excluding depreciation) are 80% of sales, and profits are taxed at 30%. a. b. a. What are the free cash flows of the project? If the cost of capital is 15%, what is the NPV of the project? Assumptions: (1) The warehouse can be rented out again for $120,000 after 8 years. (2) The NWC is fully recovered at book value after 8 years. FCF = EBIT (1 – t) + Depreciation – CAPX – Change in NWC FCF in year 0: – 1. 4m CAPX – 0. 48m Change in NWC = –1. 88m FCF in years 1-7: $4. 8m –$3. 84m $0. 96m –$0. 12m –$0. 14m $0. 70m –$0. 21m $0. 49m $0. 14m $0. 63m

Sales –Cost (80%) =Gross Profit –Lost Rent –Depreciation =EBIT –Tax (30%) = (1 – t) x EBIT +Depreciation = FCF Note that there is no more CAPX nor investment into NWC in years 1–7. FCF in year 8: $0. 63m + [$0. 5m – 0. 30 x ($0. 5m – $0. 28m)] + $0. 48m = $1. 544m Note that the book value of the machinery is still $0. 28m when sold, and only the difference between the sale price ($0. 5m) and the book value is taxed. The NWC ($0. 48m) is recovered at book value and hence its sale is not taxed at all. b. The NPV is the present value of the FCFs in years 0 to 8: NPV= -$1. 88m + an annuity of $0. 63m for 7 years + 1. 544m 1. 158 ? ? $1. 88m ? ? $1. 2458m $0. 63m ? 1 ? $1. 544m ? 1 ? ?? 0. 15 ? 1. 157 ? 1. 158 ©2011 Pearson Education, Inc. Publishing as Prentice Hall 100 Berk/DeMarzo

•  Corporate Finance, Second Edition 7-18. Bay Properties is considering starting a commercial real estate division. It has prepared the following four-year forecast of free cash flows for this division: Assume cash flows after year 4 will grow at 3% per year, forever. If the cost of capital for this division is 14%, what is the continuation value in year 4 for cash flows after year 4? What is the value today of this division?

The expected cash flow in year 5 is 240,000 ? 1. 03 = 247,200. We can value the cash flows in year 5 and beyond as a growing perpetuity: Continuation Value in Year 4 = 247,200/(0. 14 – 0. 03) = $2,247,273 We can then compute the value of the division by discounting the FCF in years 1 through 4, together with the continuation value: NPV ? 7-19. ?185, 000 ? 12, 000 99, 000 240, 000 ? 2, 247, 273 ? ? ? ? $1,367,973 1. 14 1. 142 1. 143 1. 144 Your firm would like to evaluate a proposed new operating division. You have forecasted cash flows for this division for the next five years, and have estimated that the cost of capital is 12%.

You would like to estimate a continuation value. You have made the following forecasts for the last year of your five-year forecasting horizon (in millions of dollars): a. b. You forecast that future free cash flows after year 5 will grow at 2% per year, forever. Estimate the continuation value in year 5, using the perpetuity with growth formula. You have identified several firms in the same industry as your operating division. The average P/E ratio for these firms is 30. Estimate the continuation value assuming the P/E ratio for your division in year 5 will be the same as the average P/E ratio for the comparable firms today.

The average market/book ratio for the comparable firms is 4. 0. Estimate the continuation value using the market/book ratio. FCF in year 6 = 110 ? 1. 02 = 112. 2 Continuation Value in year 5 = 112. 2 / (12% – 2%) = $1,122. c. a. b. We can estimate the continuation value as follows: Continuation Value in year 5 = (Earnings in year 5) ? (P/E ratio in year 5) = $50 ? 30 = $1500. c. We can estimate the continuation value as follows: Continuation Value in year 5 = (Book value in year 5) ? (M/B ratio in year 5) = $400 ? 4 = $1600. ©2011 Pearson Education, Inc. Publishing as Prentice Hall Berk/DeMarzo

• Corporate Finance, Second Edition 01 7-20. In September 2008, the IRS changed tax laws to allow banks to utilize the tax loss carryforwards of banks they acquire to shield their future income from taxes (prior law restricted the ability of acquirers to use these credits). Suppose Fargo Bank acquires Covia Bank and with it acquires $74 billion in tax loss carryforwards. If Fargo Bank is expected to generate taxable income of 10 billion per year in the future, and its tax rate is 30%, what is the present value of these acquired tax loss carryforwards given a cost of capital of 8%? We can shield $10 billion per year for the next 7 years, and $4 billion in year 8.

Given a tax rate of 30%, this represents of tax savings of $3 billion in years 1–7, and $1. 2 billion in year 8. PV = 3 ? 1 ? 1 ? 1. 2 ? $16. 27 B ? 1 ? ?? .08 ? 1. 087 ? 1. 088 7-21. Using the FCF projections in part b of Problem 11, calculate the NPV of the HomeNet project assuming a cost of capital of a. b. c. 10%. 12%. 14%. What is the IRR of the project in this case? a. Year Net Present Value ($000s) 1 2 3 Free Cash Flow Project Cost of Capital Discount Factor (16,500) 10% 1. 000 Year 1 2 3 PV of Free Cash Flow NPV IRR 0 (16,500) 10,182 28. 8% 0. 909 1 2,245 0. 826 2 5,438 0. 751 3 7,830 0. 683 4 8,783 0. 21 5 2,386 2,470 6,580 10,421 12,860 3,843 0 1 2 3 4 5 b. Year Net Present Value ($000s) 1 2 3 Free Cash Flow Project Cost of Capital Discount Factor (16,500) 12% 1. 000 Year 1 2 3 PV of Free Cash Flow NPV IRR 0 (16,500) 8,722 28. 8% 0. 893 1 2,205 0. 797 2 5,246 0. 712 3 7,418 0. 636 4 8,172 0. 567 5 2,181 2,470 6,580 10,421 12,860 3,843 0 1 2 3 4 5 ©2011 Pearson Education, Inc. Publishing as Prentice Hall 102 Berk/DeMarzo • Corporate Finance, Second Edition c. Year Net Present Value ($000s) 1 2 3 Free Cash Flow Project Cost of Capital Discount Factor (16,500) 14% 1. 000 Year 1 2 3 7-22. PV of Free Cash Flow NPV IRR 0 (16,500) 7,374 28. % 0. 877 1 2,167 0. 769 2 5,063 0. 675 3 7,034 0. 592 4 7,614 0. 519 5 1,996 2,470 6,580 10,421 12,860 3,843 0 1 2 3 4 5 For the assumptions in part (a) of Problem 5, assuming a cost of capital of 12%, calculate the following: a. b. a. b. The break-even annual sales price decline. The break-even annual unit sales increase. 28. 5% 25350 7-24. Billingham Packaging is considering expanding its production capacity by purchasing a new machine, the XC-750. The cost of the XC-750 is $2. 75 million. Unfortunately, installing this machine will take several months and will partially disrupt production.

The firm has just completed a $50,000 feasibility study to analyze the decision to buy the XC-750, resulting in the following estimates: ¦ Marketing: Once the XC-750 is operating next year, the extra capacity is expected to generate $10 million per year in additional sales, which will continue for the 10-year life of the machine. Operations: The disruption caused by the installation will decrease sales by $5 million this year. Once the machine is operating next year, the cost of goods for the products produced by the XC-750 is expected to be 70% of their sale price.

The increased production will require additional inventory on hand of $1 million to be added in year 0 and depleted in year 10. Human Resources: The expansion will require additional sales and administrative personnel at a cost of $2 million per year. Accounting: The XC-750 will be depreciated via the straight-line method over the 10-year life of the machine. The firm expects receivables from the new sales to be 15% of revenues and payables to be 10% of the cost of goods sold. Billingham’s marginal corporate tax rate is 35%. Determine the incremental earnings from the purchase of the XC-750.

Determine the free cash flow from the purchase of the XC-750. If the appropriate cost of capital for the expansion is 10%, compute the NPV of the purchase. While the expected new sales will be $10 million per year from the expansion, estimates range from $8 million to $12 million. What is the NPV in the worst case? In the best case? What is the break-even level of new sales from the expansion? What is the break-even level for the cost of goods sold? ¦ ¦ ¦ a. b. c. d. e. ©2011 Pearson Education, Inc. Publishing as Prentice Hall Berk/DeMarzo • Corporate Finance, Second Edition 103 f.

Billingham could instead purchase the XC-900, which offers even greater capacity. The cost of the XC-900 is $4 million. The extra capacity would not be useful in the first two years of operation, but would allow for additional sales in years 3–10. What level of additional sales (above the $10 million expected for the XC-750) per year in those years would justify purchasing the larger machine? See spreadsheet on next page. See spreadsheet on next page. See spreadsheet on next page. See data tables in spreadsheet on next page. See data tables in spreadsheet on next page. See spreadsheet on next page—need additional sales of $11. 84 million in years 3–10 for larger machine to have a higher NPV than XC-750. 0 -5,000 3,500 1 10,000 -7,000 -2,000 -275 725 -254 471 275 -1,200 -454 2 10,000 -7,000 -2,000 -275 725 -254 471 275 0 746 3 10,000 -7,000 -2,000 -275 725 -254 471 275 0 746 4 10,000 -7,000 -2,000 -275 725 -254 471 275 0 746 5 10,000 -7,000 -2,000 -275 725 -254 471 275 0 746 6 10,000 -7,000 -2,000 -275 725 -254 471 275 0 746 7 10,000 -7,000 -2,000 -275 725 -254 471 275 0 746 8 10,000 -7,000 -2,000 -275 725 -254 471 275 0 746 9 10,000 -7,000 -2,000 -275 725 -254 471 275 0 746 10 10,000 -7,000 -2,000 -275 725 -254 471 275 1,000 1,746 . b. c. d. e. f. Incremental Effects (with vs. without XC-750) Year Sales Revenues Cost of Goods Sold S, G & A Expenses Depreciation EBIT Taxes at 35% Unlevered Net Income Depreciation Capital Expenditures Add. To Net Work. Cap. FCF Cost of Capital PV(FCF) NPV Net Working Capital Calculation Year Receivables at 15% Payables at 10% Inventory NWC -1,500 525 -975 -2,750 -600 -4,325 10. 00% -4,325 -164. 6 -413 617 561 510 463 421 383 348 316 673 0 -750 350 1000 600 1 1500 -700 1000 1800 2 1500 -700 1000 1800 3 1500 -700 1000 1800 4 1500 -700 1000 1800 5 1500 -700 1000 1800 6 1500 -700 1000 1800 1500 -700 1000 1800 8 1500 -700 1000 1800 9 1500 -700 1000 1800 10 1500 -700 0 800 New Sales (000s) NPV 8 -2472 Sensitivity Analysis: New Sales 9 10 10. 143 -1318 -165 0 11 989 12 2142 COGS 67% Sensitivity Analysis: Cost of Goods Sold 68% 69. 545% 69% 70% 71% ©2011 Pearson Education, Inc. Publishing as Prentice Hall 104 Berk/DeMarzo

• Corporate Finance, Second Edition Incremental Effects (with vs. without XC-900) Year Sales Revenues Cost of Goods Sold S, G & A Expenses Depreciation EBIT Taxes at 35% Unlevered Net Income Depreciation Capital Expenditures Add. To Net Work. Cap.

FCF Cost of Capital PV(FCF) NPV Net Working Capital Calculation Year Receivables at 15% Payables at 10% Inventory NWC 0 -5,000 3,500 1 10,000 -7,000 -2,000 -400 600 -210 390 400 -1,200 -410 2 10,000 -7,000 -2,000 -400 600 -210 390 400 0 790 3 11,384 -7,969 -2,000 -400 1,015 -355 660 400 -111 949 4 11,384 -7,969 -2,000 -400 1,015 -355 660 400 0 1,060 5 11,384 -7,969 -2,000 -400 1,015 -355 660 400 0 1,060 6 11,384 -7,969 -2,000 -400 1,015 -355 660 400 0 1,060 7 11,384 -7,969 -2,000 -400 1,015 -355 660 400 0 1,060 8 11,384 -7,969 -2,000 -400 1,015 -355 660 400 0 1,060 9 11,384 -7,969 -2,000 -400 1,015 -355 660 400 0 1,060 10 11,384 -7,969 -2,000 -400 1,015 -355 660 400 1,000 2,060 -1,500 525 -975 -4,000 -600 -5,575 10. 00% -5,575 0. 0 -373 653 713 724 658 598 544 494 450 794 0 -750 350 1000 600 1 1500 -700 1000 1800 2 1500 -700 1000 1800 3 1708 -797 1000 1911 4 1708 -797 1000 1911 5 1708 -797 1000 1911 6 1708 -797 1000 1911 7 1708 -797 1000 1911 8 1708 -797 1000 1911 9 1708 -797 1000 1911 10 1708 -797 0 911 s ©2011 Pearson Education, Inc. Publishing as Prentice Hall

A major impact on both financial theory and the practice of financial decision making has been the economic instability, especially in prices, evidenced in the U. S. economy since the mid 1960’s. Inflation in the past few years has not been a major macro economic problem, but its spectere, as demonstrated by the Fed’s recent increases in interest rates, is never for the agendas of financial decision makers. Macro economic instability has necessitated that expectations about the future rate of inflation be taken into consideration in making decision(s) about which capital projects will be undertaken by a firm.

Nominal cash flows determine its degree of profitability. However, in making the capital budgeting decision both real and nominal concepts must be considered. The purpose of this paper is to continue the discussion of the role of inflation in capital budgeting, and to focus on the individual components of the process to draw specific conclusions with respect to the interaction between the cost of capital, inflation, and the cash flow variables within a DCF – IRR framework.

Much research has been published examining the impact of inflation on the capital budgeting decision making process, and, although inflation is not currently a serious problem, bitter lessons from the 1975-1985 period of rapid price increases, coupled with the potential of future inflation, argue for continued research in this field. In a famous article, Rappaport and Taggart examined various methods for incorporating the effect of inflation into capital budgeting.

They provided an analysis which showed the differential impact of using a gross profit per unit approach, a nominal cash flow approach (where individual forecasts are incorporated into each component of cash flow) and a real cash flow approach in which a general price deflator is used to deflate nominal cash flows. In another early article dealing with the subject, Van Horne showed that to be consistent, inflation in forecasting cash flows must also be reflected in a discount rate containing inflation; that is, a bias was introduced if nominal cash flows were discounted at the real and not nominal cost of capital.

Cooley, Roenfeldt and Chew revealed the mechanics by which inflation adjustments can be incorporated into the capital budgeting process. At the same time, Nelson demonstrated the theoretical impact of inflation on capital budgeting and showed how inflation would shift the entire NPV schedule of a capital budget downward for a set or projects. Bailey and Jensen have analyzed how price level adjustments affect the process in detail and specifically how various price level adjustments might change the ranking of projects.

Rappaport and Taggart attempt to combine the simplicity of a gross profit per unit methodology of adjusting for inflation with the more realistic nominal case flow and real cash flow approaches. A gross profit per unit focus on Revenues – Cost of Sales divided by units, and can treat inflation by simply inflating this gross profit per unit as opposed to measuring inflation for both revenues and cost of sales. This is done by making the simplifying assumption that gross margin as a percent of sales is constant over time, which they point out is the same as assuming that EBIT is a constant percentage of sales over time, or that revenues and costs increase at the same rate. In this paper we examine a number of issues raised by Rappaport and Taggart in the area of inflation and capital spending.

Specifically, we will analyze the following areas:

• What is the relationship between the cost of capital and inflation?
• What is the relationship between inflation in the aggregate and the price a firm places on its specific product that results from a capital budgeting decision?
• Assuming costs rise at the aggregate or average rate of inflation, what can we say about expectations of the price of output of the firm?
• What role do depreciable and non-depreciable assets play in the interaction of the variables? How does the presence of plant and equipment as a depreciable asset and the presence of net working capital as a nondepreciable asset impact on the role of inflation in the capital budgeting process?

Universities are institutions where students pursue higher levels of education. This institution enables the students to  study and to conduct research work in various academic fields and after completing and qualifying in their studies  they are awarded academic degrees such as the bachelors degree, master degree and the doctorate degree.

The institution is headed by a board of trustees who ensure that the operations of the institution are carried out effectively.  The chancellor is usually appointed to run the institution.  The institution has many departments which are headed by various deans who ensure that the students’ affairs  and the learning affairs of the institution are run effectively and efficiently.

In case of public universities they are managed by the government through the  Higher  Education Boards which  review their financial needs and  their budget proposals and then they allocate appropriate fund according to the demand of the institutions departments expenses.  The private universities are usually sponsored by private persons thus their operations are not affected by the government since they carry out their activities independently.

A budget is a plan of how an organization would like to achieve its goals in the future.  It consists of estimates that the management with its personnel sets so that the operations of the institution can   run effectively.  A budget process is the procedure that is followed by an organization or a government on how to create and to approve a budget.

The administrator of an organization organizes  a meeting in order to ensure that all members of the organization participate in the preparation of the budget so that the following year’s activities are adequately addressed and then the financial managers ensure that appropriate funds are allocated against the activities of the organization.  The chief executive officers reviews and approves the budgets so that they can make appropriate amendments if need be.

The allocation of resources of a university in the budget process is usually made in compliance  with the university’s strategic plans .  The deans and the directors of the university develop the budget using the proposals for the university faculty.  They consult department chairmen and unit heads so that they can provide a comprehensive budget which is helpful to the particular faculty concerned.  The university vice chancellor is the last person who approves the budget so that it can be made effective and hence he or she directs on how the budget is to implemented by various personnel in the institution..

The expenditures of a university are forecasted, monitored and controlled using the following procedure.  The finance officer creates a valid account that relates to the activities that the university would like to achieve then an account number is created to those accounts .  The account is monitored by carrying one monthly reconciliations of revenues and expenditures and then comparing actual revenues and expenditures to the budget so as to determine the variance so that corrective measures can be carried out. For example for the contracts and clinical activities   they are prepared using invoices which are used to monitor that the terms and conditions of a company are properly followed.

In case there are deficit balances on the allocated accounts they are regulated using the accounts that are associated with them .A comprehensive budget for the institution is necessary  because  there are many activities that are carried out in the institution thus  it is important to  correct the deficits that an organisation has so as to enable the institution to carry out its activities effectively  and to  enable it to achieve its  goals in the future.  The management of the university carries out internal controls when preparing the budget.  An auditor is usually appointed  carries out an  audit in  books of account  so as to ensure that the financial statements portray a true view and also ensure that the books of accounts are accurately and properly kept.  The budget can be forecast using the current years performance and the resources that are available in  the university.

The manager of the institution can encourage people to share responsibility by involving them in the decision making process.  This can enable the employees of the institution to contribute their views, ideas about how to run the activities and this can help them to appreciate the operations of the company and they can enhance the implementation the ideas of an organisation.

The managers of the institution can manage non-financial resources by employing qualified personnel to handle and oversee their operation since in one way or another they contribute to the success of the business. The management of the institution can also manage the non-financial resources by preparing strategic budgeting approaches which can help them to align the necessary resources so as to enhance proper strategic plans for the institution.

The approaches that are used in monitoring and controlling non-financial resources are :activity based costing it is an approach that is used in the measuring the  costs of activities of an organisation this approach enables a manager not to over or under estimate his costs because since either of the two can lead the managers to not to prepare their budget properly since specific funds are allocated to particular projects of a company and this enables the activities of the institution to be carried out effectively.

The other approach that can be used in monitoring and controlling the non-financial resources are the use of the balanced scorecard it is an approach that is used in evaluating the performance of the employees of the institution. It enables the management to assess themselves whether they are performing their activities as expected of them ,in case they don’t perform as expected of them they can take measures of preventing the  bad outcomes from happening in the future.

The advantages of using this approaches is that they enable the management of the organisation to perform their activities effectively and once they adhere to what they  are expected to do  this  can enable the organisation to achieve its  goals and hence they enable it to have greater returns for the institution . The disadvantages of using this approaches is that they may be very costly for the organisation to implement because of inadequacy of resources to implement the projects , some people in the institution may  oppose the idea of implementing the project  because either they may  biased or they would  not like to accept changes in their institutions..

People spend money for various reasons one is to satisfy their basic needs such as to purchase food, clothing and shelter . In case of   the universities the management  spends money in order to meet their current budgets of what they would like to accomplish in a given financial year, thus in their budget they allocate specific funds for specific projects that they would like to set up in the future .

The institution may plan in its budget to build more lecture rooms in order to accommodate the increasing of students that are enrolling in the institutions, since these can be a good investment since in the long run it can generate returns for the institution since the students can enroll in it due to the availability of resources that enhance learning to take place effectively.

In case of universities they prepare capital budget since their expenditure is mostly associated with the purchase of infrastructure that is most preferable for the organization.  The management of the institution can be able to select a type of investment for their institution based on the risk that is involved in setting up the project and also with regard to how the plans of setting up the project have been designed so that enough resources are allocated so that the project can be effectively implemented.  An investment can be evaluated by using the following capital budgeting techniques.  One of them is the net present value technique, internal rate of return and the pay back technique.

The capital budgeting technique that is called net present value can assist the management of an institution to make a decision on whether to accept an investment or not.  If an investment has a positive net present value then it means that an investor can invest in that project.  The rate of return of the investment should be selected depending on the riskiness of the project.  The riskiness of a project is determined by how the case  is  flowing in the institution, if the cash inflow is higher than the cash outflow then it is important to invest in the project since the returns of the project are high.

The internal rate of return is a capital budgeting technique that is used in measuring the efficiency of a project.  It is a discount rate that gives the same result as the net present value. If the internal rate of return is higher than the hurdle rate then an investment  can be implemented  using the rate.

The financial tools can be used by the institution in carrying out its activities .The financial tools consist of financial ratios the enable an institution to compare its performance in its previous years performance so that they can take corrective measures if need be since the ratios are prepared using variables in the financial statements thus comparing their performance can be easy since the financial statements of a company are usually prepared annually.

It is important to manage the resources of an institution because they enable it to achieve goals and objectives in the future .If the resources are properly managed  the an institution can be able to earn greater returns and hence it can continue to progress in the future.