Finance & Accounting Department

Advanced Corporate Finance S07 23/24

Exercises Book

2023-2024
Chapter 1: Selecting Investments in a situation of certainty
Chapter 2: Selecting Investments in a situation of uncertainty
Chapter 3: Long-term Financing Methods
Chapter 4: Criteria for choosing types of financing
Chapter 5: Cost of Capital
Chapter 6: Financing Plan

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 CHAPTER 1
Exercise 1.

CASE N° 1: P1 – P2

Two mutually exclusive projects (P1) and (P2).

Each project requires an investment of 5,000 K€ originally, depreciated linearly over 5 years,
and has an economic duration of 5 years. Tax rate is 33.33%.

Economic and commercial studies calculated the following EBITDA for the five years:

EBITDA in K€ (P1) (P2)

1 1,000 2,000
2 1,000 2,800
3 1,000 3,400
4 3,000 1,800
5 8,410 1,400

WCR will be neglected, as well as a potential resale value of the investment after 5 years.

The discount rate / WACC for the company is 8% (minimum required return by the
investors).

Questions:

1) Are these projects profitable? (Calculate cash-flows, IRR and NPV)

2) What are their Payback periods?
3) What can we conclude about the value these projects provide to the company?

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Answers:
An investor deciding on a project with variable cash-flows, interest / discount rates and time /
period, may select the most relevant decision criterion to accept or reject the investment.
This criterion becomes the most important element of the decision making:
• The rate of return is the most important and the investor decides by comparing to
his cost of capital or minimum required return (IRR);
• The investor with less visibility i.e., more uncertainty about the future, may decide
according to the payback period (PP);
• The investor seeking the highest value by the project may decide according to the
Net Present Value (NPV).

I Internal Rate of Return: IRR

A. Definition
The Internal Rate of Return is the discount rate at which the cash-flows generated
from the project have the same Present Value as the necessary initial investment.
A project with an IRR lower than the minimum required return by the investor(s) will be
rejected. With two acceptable projects, we select the project with the highest IRR.

B. Cash-Flows of Project P1:

Taxes Cash-flow =
(P1) EBITDA - Depreciation
(33.33%) Net Earnings + Reversal of Depreciation
1 1,000 – 1,000 = 0 0 0 + 1,000 = 1,000
2 1,000 – 1,000 = 0 0 0 + 1,000 = 1,000
3 1,000 – 1,000 = 0 0 0 + 1,000 = 1,000
4 3,000 – 1,000 = 2,000 667 1,333 + 1,000 = 2,333
5 8,410 – 1,000 = 7,410 2,470 4,940 + 1,000 = 5,940

So:

The IRR (P1) comes from the equation:

5,000 = 1,000 (1 + IRR)–1 + 1,000 (1 + IRR)–2 + 1,000 (1 + IRR)–3 + 2,333 (1 + IRR)–4 + 5,940
(1 + IRR)–5 .

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We can calculate by iteration (trial and error, with a guess starting value) or with Excel.
1. By iteration first:

If we start with 25% as a guess, the Present Value of the Cash-flows to be compared
5
→∑ CFi ( 1 , 25 ) =4 853 K €
−i

with the initial investment of 5,000 K€ calculates as: i=1 .

5
→∑ CFi ( 1 , 23 ) =5 140 K €
−i

Using 23% i=1 .

So, the answer lies between 23% and 25%. Let us try to find the IRR by linear
interpolation:

When the IRR decreases by 2 points, the PV increases by 287 K€.

2×140
=0 . 97
In order to find the target value of 5,000 K€, we calculate287 or the IRR
for (P1) = 23.97%;

2. Excel obviously gives us the same answer immediately.

B. Cash-Flows of Project P2:

Taxes Cash-flow =
(P2) EBITDA -Depreciation
(33.33%) Net Earnings + Reversal of Depreciation
1 2,000 – 1,000 = 1,000 333 667 + 1,000 = 1,667
2 2,800 – 1,000 = 1,800 600 1,200 + 1,000 = 2,200
3 3,400 – 1,000 = 2,400 800 1,600 + 1,000 = 2,600
4 1,800 – 1,000 = 800 267 533 + 1,000 = 1,533
5 1,400 – 1,000 = 400 133 267 + 1,000 = 1,267

The IRR (P2) comes from the equation:

5,000 = 1,667 (1 + IRR)–1 + 2,200 (1 + IRR)–2 + 2,600 (1 + IRR)–3 + 1,533 (1 + IRR)–4 + 1,267
(1 + IRR)–5.
Since we are comparing (P2) to (P1), let us try an IRR of 24%:
8 8
→∑ CFi ( 1 , 24 ) =5 219 K € →∑ CFi ( 1 , 25 ) =5 115 K €
−i −i

i=1 i=1
. An IRR of 25% .
8
→∑ CFi ( 1 , 27 )−i =4 918 K €
i=1
An IRR of 27%
When the IRR increases by 2 points, the Present Value decreases by 197 K€.
2×115
=1.17
Interpolation then gives us 197 and so the IRR for (P2) = 26.17 %.

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Conclusion: Using an IRR, we select project (P2).

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C. Analysis
C.1. What does the IRR mean?
Project 2’s IRR of 26.17% suggests that the initially invested 5,000 K€ returns 26.17%
exactly. But this is assuming that all capital remains invested fully in the project during its
economic life. This is not the case!
Looking at the amounts of capital invested (rounded at K€):

Capital invested at
Annual Return on capital Free-up of capital
(P2) the begin of the
Cash-flows invested at 26.17% invested
period
1 5,000 1,667 1,308 359
2 4,641 2,200 1,214 986
3 3,655 2,600 956 1,644
4 2,011 1,533 526 1,007
5 1,004 1,267 263 1,004
9,267 4,267 5,000

The IRR represents the return on 5,000 K€ during the first year, on 4,641 K€ during the 2nd
year, etc., and the return on 1,004 K€ during the last year.
Each year of cash-flows allows for:
• Return on capital that remains invested in the project, plus
• Freed-up capital from the project.
This means that actual cash-flows are higher than the return on capital invested.
There is an analogy with repaying a bank loan. It is as if the company has lent 5,000 K€ to the
project, which in return pays interest of 26.17% and reimburses principal of the loan.

C.2. Underlying hypothesis under the model

Our approach suggests that all resulting cash-flows from the project are being re-invested and
included in the IRR. However, the model ignores that part of the cash is used elsewhere.
For example, in project (P2), what would the investor do with the cash-flow of 1,667 K€ at the
end of year 1? This 1,667 K€ does not remain idle:
• If this cash-flow is re-invested at a rate > IRR, we need to consider the incremental
return / cash-flow, which the model does not;
• The same issue arises when the cash-flow is re-invested at a rate < IRR;
• Using an IRR of 26.17% ignores that different returns on cash-flows actually
happen, or likewise, we assume that these are re-invested at the same rate of
26.17%.

Our hypothesis that the IRR remain constant over the life of the project is unrealistic.
It is hardly imaginable that the company finds re-investments for the project’s cash-flows at
exactly the same rate.
If the IRR is high, this leads to an overestimation of the return on the project (and vice versa).

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We need to beware that project (P2)’s return is actually lower than 26.17%.

II Payback Period: PP

A. Definition
This criterion selects investments or projects with rapid returns of capital invested, preferring
less risk.
An investor would refuse to commit funds for a too long period, preferring projects with large
cash-flows in the beginning of the project.
The PP equals the waiting time until the moment when the accumulated cash-flows from
the project equal the amount of capital invested.
Consequently, those projects with longer payback periods are rejected.
Between two acceptable projects, the one with the lowest PP is selected.
Remark:
In reality, we often see PPs calculated on cash-flows which are not updated in time, during the
project, which makes PP a static tool. In addition, in using the PP, we add up cash-flows
at different points in time, which ignores time value of money.

B. Calculation of PP for project P1:

Present
Annual Value of Accumulated
(P1) Accumulated
Cash-flows Cash-flows at PVs
Cash-flows
8%
1 1,000 1,000 926 926
2 1,000 2,000 857 1,783
3 1,000 3,000 794 2,577
4 2,333 5,333 1,715 4,292
5 5,940 11,273 4,042 8,334

Based on actual cash-flows, we need between 4 to 5 years to recover the initial investment of
5 000 K€. By linear interpolation we find:
Present Value of Cash-flow in year 5 = 4,042 K€.

( 5 000−4 292 )
×12=2. 1
Time necessary during year 5 to reach 5,000 K€ = 4042 months.

PP of Project (P1) = 4 years and 2.1 months.

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Similarly, for Project (P2):

Accumulated Present Value of

(P2) Annual Cash-flows Accumulated PVs
Cash-flows Cash-flows at 8%
1 1,667 1,667 1,543 1,543
2 2,200 3,867 1,885 3,428
3 2,600 6,467 2,064 5,492
4 1,533 8,000 1,127 6,619
5 1,267 9,267 863 7,482

Project P2 needs 2 to 3 years to recover the initial investment. By linear interpolation we find:
Present Value of Cash-flows after year 3 = 2 064 K€.

( 5 000−3 428 )
×12=9.14
Necessary time during year 3 to reach 5,000 K€= 2 064 months.
PP of Project (P2) = 2 years and 9.1 months.

Conclusion:
Using the criterion of Payback Period, (P2) is preferable to Project (P1), as the investor has to
wait less time to recover her/his initial investment.

C. Analysis
• The PP method is obviously only feasible for two projects with equal economic life;
• The PP method ignores cash-flows after the moment that the initial investment is
recovered. It is a method of cash management and does not analyse return.

PP is a useful method, but only in combination with other selection criteria.

We see this also in the fact that project (P1) generates higher accumulated cash-flows than
Project (P2).

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III Net Present Value: NPV

A. Definition
The Net Present Value represents value creation by the company from its investment,
the difference between the Present Value of cash-flows from the project and capital
invested.
Cash-flows are discounted by the company’s r = WACC:
n
∑ CFi ( 1+r )−i −I 0
NPV = i=1 if there is only one, single initial investment I0 at date 0,
Or more in general:
n
∑ A i ( 1+r )−i
NPV =i=0 in which Ai = net cash-flows from operations minus investments.
A project with a negative NPV is rejected.
We select between two acceptable projects, the one with the highest NPV.

B. Calculation of NPVs:
NPV (P1) = 8,334 – 5,000 = 3,334 K€,
NPV (P2) = 7,482 – 5,000 = 2,482 K€.
Project (P1) is the most interesting project according to its NPV.

C. Analysis

C.1. The IRR is the rate of return at which NPV = 0

Finding a positive NPV for both projects is not surprising, since both IRRs are > 8%.
A positive NPV means that the rate of return on the project is higher than the required WACC
of the company (here 8%).
This does not automatically mean that we will select the project with the highest NPV.
Projects with positive NPVs need to be examined according to the other criteria (PP, non-
financial considerations) for a final decision.
A positive NPV is a necessary but not sufficient financial criterion to accept a project or
investment.

C.2. What do we do in case of conflicting signals from the IRR and NPV?
From time to time the two methods give conflicting results.
In our example:

(P1) (P2) Conclusion?

IRR 23.97% 26.17% Select Project (P2)

NPV (8%) 3,334 2,482 Select Project (P1)

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In this situation, a rate of return exists at which the two NPVs are equal.
This rate of return calculates as:
– 5 ,000 + 1,000 (1 + r)–1 +1,000 (1 + r)–2 + 1,000 (1 + r)–3 + 2,333 (1 + r)–4 + 5,940 (1 + r)–5 =
– 5,000 + 1,667 (1 + r)–1 + 2,200 (1 + r)–2 + 2,600 (1 + r)–3 + 1,533 (1 + r)–4 + 1,267 (1 + r)–5
Arriving at:
– 667 – 1,200 (1 + r)–1 – 1,600 (1 + r)–2 + 800 (1 + r)–3 + 4,673 (1 + r)–4 = 0.
We find r~¿ 19%.
Visualised below:

Summarising:
• Using the IRR Project (P2) is the best;
• Using the NPV:
– at a rate >19% Project (P2) delivers more value than Project (P1),
– at a rate <19% Project (P1) delivers more value than Project (P2).

Which criterion to use?

The NPV-method is based on a hypothesis of re-investment of cash-flows at a rate of
return equal to the WACC of the company. For the IRR, the implicit hypothesis is that the
re-investment of cash-flows is done at the same IRR during the life of the project.
If the company’s financial policy is coherent, cash-flows are re-invested at a rate >= WACC,
which is more realistic. For this reason, and out of prudence, we consider the NPV better
adapted to capital budgeting decisions than the IRR.
Finally, using IRRs as selection criterion, prioritises projects with important cash-flows in the
first years of a project. This of course has a positive side. In our case, Project (P2) returns
large cash-flows in the first years. This explains why its return rate is higher than 19% (at
which rate both projects had equal value), but – let’s not forget! - indicates also a higher risk

11
if we select Project (P2) above Project (P1).
Exercise 2.

At the beginning of the year N, the company ROANNE is largely profitable and plans to
replace a machine, which has been in service since the beginning of the year N-3. This
machine had been acquired at €400,000 and is depreciable linearly over 8 years. The current
machine can still be used for 5 years for a maintenance fee of €15,000 per year.

The purchase price of the new machine is €600,000. The new machine would be depreciated
over 5 years, also according to the linear method. The maintenance costs amount to €9,000
per year, over a period of use of 5 years. It is estimated that at the end of 5 years the new
machine can be resold for €4,500 (price net of tax on capital gains on sale).

The new machine, more efficient and more economical, would allow:
 To increase production and sales, currently 10,000 units, by 50%. The selling price is
€50 per unit;
 To reduce fixed unit costs from €12 to €9;
 To reduce the Working Capital Requirement of €5,000 in the first year of operation.

The variable cost marginal rate would remain at the current level of 40% of sales/turnover.

The seller of the new machine offers to repurchase the old machine now for €260,000 (price
net of tax on the capital gains on sale). If we continue using the old machine, it can be resold
after 5 years for €3,000 (price net of tax on the capital gains on disposal).

Note: The transfer prices of Fixed Assets are the sale of the asset, net of capital gains tax.
The corporate tax rate is 33.33%. The Cost of Capital is 8%.
The basis for calculating Depreciation is the acquisition value.

Assignment:
Using the NPV and IRR methods, conclude on the proposed project:

 Determine the Initial investment amount in the new machine;

 You calculate the cash-flows for the old machine, for the years N, …, N+4;
 You calculate the cash-flows for the new machine, for the same 5 years;
 Take the difference, the incremental cash-flows which result from the investment in
the new machine;
 Discount the 5 incremental cash-flows at the Cost of Capital and compare these with
the investment in the new machine. Now, compute the NPV and IRR of the project.

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 Answers:
To study the project of replacing the old machine, we should compare the new machine’s incremental
cash-flows with the old cash-flows.
So, we will calculate:
 Cash-flows of the old machine;
 Cash-flows of the new machine and the old one is sold;
 The difference between the two, i.e., the incremental cash-flows.

See spreadsheet
End of End of N+2 End of End of N+4
End of N / N+1 / / N+3 / /
CASH-FLOW Start of N Begin N+1 Begin N+2 Begin N+3 Begin N+4 Begin N+5

Old machine
10 000 *
Turnover 50 500,000 500,000 500,000 500,000 500,000

Margin on Variable expenses 0.4 0.4 0.4 0.4 0.4

200,000 200,000 200,000 200,000 200,000
Variable expenses -300,000 -300,000 -300,000 -300,000 -300,000

10 000 *
Fixed costs 12 -120,000 -120,000 -120,000 -120,000 -120,000
Maintenance fee -15,000 -15,000 -15,000 -15,000 -15,000

EBITDA 65,000 65,000 65,000 65,000 65,000

400 000 /
Depreciation 8 -50,000 -50,000 -50,000 -50,000 -50,000

EBIT 15,000 15,000 15,000 15,000 15,000

Tax 33.33% -5,000 -5,000 -5,000 -5,000 -5,000
Net Earnings 10,000 10,000 10,000 10,000 10,000

Sale of old machine 3,000

Reversal of Depreciation 50,000 50,000 50,000 50,000 50,000

Net Cash-Flow 60,000 60,000 60,000 60,000 63,000

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 For the cash-flows for the new machine, we start by calculating the capital invested, made up
by the acquisition of the new machine, its impact on WCR and the sale of the old machine:
See spreadsheet

CASH-FLOW Start of N

New machine

Acquisition 600,000
Reduction of WCR -5,000
Sale of old machine -260,000
Capital to be Invested 335,000

The new machine is expected to increase sales by 50%, from 10,000 to 15,000 units.
Furthermore, fixed charges per unit drop to €9.
See spreadsheet
End of End of N+2 End of End of N+4
End of N / N+1 / / N+3 / /
Start of
CASH-FLOW N Begin N+1 Begin N+2 Begin N+3 Begin N+4 Begin N+5

New machine

Capital to be
Invested -335,000

Turnover 15 000 * 50 750,000 750,000 750,000 750,000 750,000

Margin on Variable expenses 0.4 0.4 0.4 0.4 0.4

300,000 300,000 300,000 300,000 300,000
Variable expenses -450,000 -450,000 -450,000 -450,000 -450,000

Fixed costs 15 000 * 9 -135,000 -135,000 -135,000 -135,000 -135,000

Maintenance fee -9,000 -9,000 -9,000 -9,000 -9,000

EBITDA 156,000 156,000 156,000 156,000 156,000

Depreciation 600 000 / 5 -120,000 -120,000 -120,000 -120,000 -120,000

EBIT 36,000 36,000 36,000 36,000 36,000

Tax 33.33% -12,000 -12,000 -12,000 -12,000 -12,000
Net Earnings 24,000 24,000 24,000 24,000 24,000

Change in WCR -5,000

Sale of new machine 4,500

Reversal of Depreciation 120,000 120,000 120,000 120,000 120,000

Net Cash-Flow -335,000 144,000 144,000 144,000 144,000 143,500

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 To compare using the old machine with investing in a new machine, we calculate incremental
cash-flows between the 2 scenarios:

See spreadsheet
End of End of N+2 End of End of
CASH-FLOW Start of N End of N / N+1 / / N+3 / N+4 /
Begin N+1 Begin N+2 Begin N+3 Begin N+4 Begin N+5
New machine -/- old
machine

Capital to be Invested -335,000

Turnover 250,000 250,000 250,000 250,000 250,000

Variable expenses -150,000 -150,000 -150,000 -150,000 -150,000

Fixed costs -15,000 -15,000 -15,000 -15,000 -15,000
Maintenance fee 6,000 6,000 6,000 6,000 6,000

EBITDA 91,000 91,000 91,000 91,000 91,000

Depreciation -70,000 -70,000 -70,000 -70,000 -70,000

EBIT 21,000 21,000 21,000 21,000 21,000

Tax -7,000 -7,000 -7,000 -7,000 -7,000
Net Earnings 14,000 14,000 14,000 14,000 14,000

Change in WCR 0 0 0 0 -5,000

Sale of new -/- old machine 0 0 0 0 1,500

Reversal of Depreciation 70,000 70,000 70,000 70,000 70,000

Incremental Cash-Flow -335,000 84,000 84,000 84,000 84,000 80,500

Since the investment is at the Start of N, we have multiplied by 1.08, to calculate PVs at the End of N.

We can now calculate (N)PVs:

See spreadsheet
Incremental NPV 8% -1,994.40 €

PV old machine End of N 241,604.35 €

PV new machine Start of N; corrected 239,609.95 €

Difference Start of N; corrected -1,994.40 €

IRR 7.77%

Profitability Index PI 0.99

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Exercise 3 - DIFFERENT PROJECTS.

The following 3 different projects and the cash-flows they generate during their operation are:

Initial Investment 1 2 3 4 5
P4 -60,000 25,000 30,000 25,000 9,000 7,000
P5 -60,000 35,000 30,000 25,000
P6 -100,000 30,000 30,000 40,000 31,000 40,000

1) Compare P4 and P5 using the criterion NPV (at 13%) and IRR. What do you notice?
How can we correct?
2) Compare P4 and P6 using the criterion NPV (at 13%) and IRR. What do you notice?
Which methods do we have to correct?
3) How can we compare P5 and P6?

Answers:
Using NPVs and IRRs we get:

Projects NPV at 13% IRR

(P4) 12,264 23%
(P5) 11,794 25%

Both projects’ NPVs are positive and their IRRs higher than 13%, which is satisfactory.
But the two criteria do not select the same project. How to explain this contradiction?
The projects have different durations!
We therefore propose 2 methods:
– The method of smallest common multiple of the projects’ durations;
– The method of Annuity-Equal Cash-Flows.

A. Method of Smallest Common Multiple

To equalise the duration of two projects (P 4) and (P5), we assume that these are repeated
several +times, until the total duration of both projects is the same for (P4) and (P5).
So, we take 3 x 5 = 15 years and renew (P4) 3 times and (P5) 5 times.

NPV (P4) = 12 264 + 12 264 (1.13)–5 + 12 264 (1.13)–10 = €22,533.

NPV (P5) = 11 794 + 11 794 (1.13)–3 + 11 794 (1.13)–6 + 11 794 (1.13)–9 + 11 794 (1.13)–12 =
€32,280.

So, from a financial perspective, (P5) is better than (P4).

This method is simple but not so realistic. Re-investments for a 15-year period are not
done at the same rates and are not identical from a technical angle either.

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B. Annuity-Equivalent Cash-Flow method
This method eliminates the impact of “time” and compares average annual returns per project.
We convert each project’s total stream of cash-flows into an equivalent stream of equal
annual cash-flows with the same Present Value as the total cash-flow stream. We prefer the
project with the highest average annual value (AECF).

We calculate AECF as follows: NPV / ADF = NPV / ( (1 – (1+r)n) / r ).

1−1,13−5
=12 264
Or for project P4: NPV (P4) = AECF * 0,13 and we find AECF (P4) = €3,487.
−3
1−1,13
=11 794
And for project P5: NPV (P5) = AECF * 0,13 and we find AECF (P5) = €4,995.
This result confirms our preference of (P5) over (P4).

Remark:
The AECF-method not only eliminates the impact of different durations but also different
sizes of projects.

Comparing projects of similar durations but different sizes

Let us compare project (P4) with project (P6):

NPV (P6) at 13% = €18,488 and IRR (P6) = 20%.

NPV (P4) at 13% = €12,264 and IRR (P4) = 23%.

– The NPV criterion selects project (P6) over (P4). But that does not take into account the
additional investment of €40,000 in project (P6);
It seems upfront that an investment of €100,000 creates a higher value than an
investment of €60,000;
– The IRR criterion selects project (P4). But again, what does this mean? Do we prefer a
return of 23% on €60,000 or 20% on €100,000?
If we have €100,000 to invest, the answer depends on the way we manage the
incremental €40,000.

We need to eliminate the impact of the size of the investment.

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A. Profitability Index PI
The Profitability Index PI measures the return on €1 of capital invested. Its objective is to
maximise the relative value, which eliminates the size of investments in projects.
n

PI
∑ CF i ( 1+WACC )−i
i=1
¿
I0

n
NPV
−I 0 + ∑ CFi ( 1+ t m )−i ( PI ❑) =1+
¿ I 0∨¿ ¿
Since NPV = i=1 , we calculate PI as:

Any project with a PI < 1 is rejected.

Between 2 projects with PIs > 1, we select the project with the highest PI.
Investments that demand too much capital are punished.

12 264
1+ =1.20
In our exercise, we prefer project (P4) as PI (P4) = 60 000 and PI (P6) =
18 488
1+ =1.18
100 000 at a rate of 13%.

The PI-method corrects for the flaw in the NPV-method which assumes that the
incremental investment of €40,000 delivers the same return as project (P4).

B. Incremental cash-flow method

The incremental cash-flow method calculates the difference between cash-flows of different
projects. Then we compute the NPV, IRR etc. of the incremental cash-flow stream.
This method allows for selecting the project with the highest initial investment if its return
criteria are satisfactory.

In our exercise:

Amounts in Initial NPV at

CF1 CF2 CF3 CF4 CF5 IRR PI
€ investment 13%
(P6) 100,000 30,000 30,000 40,000 31,000 40,000 18,488 20% 1.18
(P4) 60,000 25,000 30,000 25,000 9,000 7,000 12,264 23% 1.20
Incremental
cash-flows 40,000 5,000 0 15,000 22,000 33,000 6,224 17.3% 1.15
(P6 – P4)

Our calculations show that the NPV of incremental cash-flows is €6,224, its IRR is 17.3 %and
its PI > 1. The incremental cash-flow method therefore selects project (P6), the one with the
highest initial investment.

This method has the same disadvantage as the NPV-method, i.e., it assumes that
18
incremental cash-flows are re-invested at 13%, which is not always true.

19
We conclude that the selection of the project depends on how incremental cash-flows
can be re-invested:
– If the company can invest the incremental €40,000 in an alternative project that
returns more than the incremental cash-flow, we select the less expensive project
(P4);

– If the firm can investment the €40,000 in an alternative project returning less than
the incremental cash-flows, we prefer investing in project (P6):

Imagine during a period of 5 years, the firm does not have investment
opportunities at a higher return than only 6%. Each year, cash-flows are invested
at a rate inferior to that of the incremental cash-flows above. This leads to
preferring project (P6) and invest €100,000.

C. The AECF-method for projects P4 and P6

We have seen that the AECF-method allows for comparing projects of different sizes
and durations.
r
We calculate AECF as AECF=NPV * −n .
1−( 1+ r )

AECF (P4): AECF=€ 3,487 .

−5
AECF∗1−1 , 13
AECF (P6): NPV ( P6 )= and 18 488=AECF * ( 3,517 ) ⇒ AECF=€ 5,256.
0 , 13

The AECF-method prefers project (P6).

D. The AECF-method for projects P5 and P6

The AECF-method solves 2 problems in one calculation: projects P5 and P6 have different
durations, and different sizes of initial investments.

The AECF of project P5 is €4,995 and for project P6 the AECF is €5,256.
We have now corrected for different durations ànd for different initial investments and select
project P6.

20
 SUMMARY

COMPARISON OF INVESTMENT SELECTION CRITERIA

METHOD OBJECTIVE APPLICABLE FOR ACCEPTED
• same size
Net Present Value (NPV) Maximise value • same duration NPV > 0
• same level of risk, i.e., discount rate
Maximise return
• same duration
Profitability Index (PI) on capital PI > 1
• same level of risk, i.e., discount rate
invested

Internal Rate of Return (IRR) Maximise return • same level of risk, i.e., discount rate IRR > Cost of Capital

Highest possible Incremental NPV > 0

• same duration
Incremental Cash-flow incremental cash- PI > 1
• same level of risk, i.e., discount rate
flows IRR > Cost of Capital
Highest value
• same size
Smallest common multiple over adjusted NPV > 0
• same level of risk, i.e., discount rate
durations
Maximise
Annuity-Equivalent Cash-
average annual • same level of risk, i.e., discount rate AECF > 0
flows (AECF)
value

If we compare projects / investments, we select the project that maximises the criterion used.

21
 CALCULATION FORMULAS

n
NPV=−I 0 + ∑ C Fi ( 1+ t )
−i
Net Present Value (NPV) i=1

∑ CFi ( 1+t )−i NPV

Profitability Index (PI) PI = i =1 =1+
|I 0| |I 0|

n
I 0=∑ C Fi ( 1+ IRR )
−i
Internal Rate of Return (IRR) i=1

So NPV = 0

d
I 0=∑ C Fi ( 1+ t )
−i
Payback period (PP) i=1

STATISTICAL FORMULAS

Mathematic expectation of a random variable x E ( x ) = ∑ pi x 1

i

Arithmetic average of a variable x, with weights f

x=∑ f i x i
i .

Variance and standard deviation 2

VAR ( x )=σ ( x )=E ( x )−[ E ( x ) ] = E[x-E(x)]² / n.
2 2

Standard deviation
σ ( x )= √ VAR ( x ).

22
Exercise 4 - OPTIMUM LIFETIME.

To manufacture a chemical product, you must acquire sophisticated equipment, valued at

€120,000, which can be depreciated over three years (coefficient 1.5) as follows: €60,000 in
the first year, €30,000 in the second year and €30,000 in the 3rd year.

Its resale price after one year of use is €60,000, €40,000 after two years of use, €20,000 after
3 years of use.
Maintenance costs are estimated at €20,000 for the first year, €30,000 for the second year and
€50,000 for the third year.
The annual gross profit margin generated by this product is estimated at €100,000 each year,
before maintenance costs and depreciation.

The corporate tax rate and capital gains tax rate are 33.33%. The discount rate used for this
type of investment is 12%.

Question:
What is the optimal renewal policy for the equipment? Should it be sold at the end of year 1,
end of year 2, or end of year 3?

Answer: See spreadsheet

1 2 3

Gross Profit Margin 100,000 € 100,000 € 100,000 €

Depreciation / amortisation -60,000 € -30,000 € -30,000 €

Maintenance -20,000 € -30,000 € -50,000 €

EBIT 20,000 € 40,000 € 20,000 €

Taxes (1/3rd) -6,667 € -13,333 € -6,667 €

Net Earnings 13,333 € 26,667 € 13,333 €

CF after Reversal of Depreciation 73,333 € 56,667 € 43,333 €

If we sell the machine at the end of year 1:

Re-sale price €60,000 and book value €60,000. No result on the sale.

NPV = -120,000 + (73,333 + 60,000) * (1+12%)-1 = - €951.78.

AECF = NPV / ADF = NPV * r / (1 – (1+r)-n) = -951.78 * 0.12 / (1 – (1.12)-1) = - €1,066.

If we sell the machine at the end of year 2:

Re-sale price €40,000 and book value €30,000. €10,000 capital gains before tax on the sale.
With taxes at 33.33%, capital gains tax = €3,333 and the additional cash-flow at the end of
year 1 is €36,667 (€40,000 - €3,333).

NPV = -120,000 + 73,333 / 1.12 + (56,667 + 36,667) / (1+12%)2 = €19,882.

AECF = NPV / ADF = NPV * r / (1 – (1+r)-n) = 19,882 * 0.12 / (1 – (1.12)-2) = €11,765.

23
If we sell the machine at the end of year 3:
Re-sale price €20,000 and book value €0. €20,000 capital gains before tax on the sale. With
taxes at 33.33%, capital gains tax = €6,667 and additional cash-flow at the end of year 3 is
€13,333 (€20,000 - €6,667).

NPV = -120,000 + 73,333 / 1.12 + 56,667 / 1.122 + (43,333 + 13,333) * (1+12%)-3 = €30,987.

AECF = NPV / ADF = NPV * r / (1 – (1+r)-n) = 30,987 * 0.12 / (1 – (1.12)-3) = €12,901.

So, the optimal renewal policy is after 3 years, because it has the highest (positive!)
AECF.

24
 CHAPTER 2

Selection of projects under uncertainty

Under uncertainty, there are for each projects many possible outcomes that we need to
consider. Each different situation has a different possible cash-flow to be determined.

If we use the NPV-method, we obtain a multiple of possible cash-flow calculations:

If we could add probabilities to each different, future outcome, we obtain a probabilistic

distribution for our cash-flows.
Assigning probabilities to future events is difficult. It would be helpful if the company
collected enough historical data (for example, claims information by general insurance
companies or actuarial data by life insurers).

Reminder of statistical formulas:

E ( x ) = ∑ pi x 1
Mathematic expectation: i .
x=∑ f i x i
Arithmetic average: i .
Variance and standard deviation:

σ ( X )=√ VAR ( X ) .
2
VAR ( X )=σ 2 ( X )=E ( X 2 )−[ E ( X ) ] = E[x-E(x)]² / n.

We calculate the Expected NPV, standard deviation (NPV) and Coefficient of Variation v.

Expected CF = Σ (pi × Scenarioi CF).

−n
1−( 1+r )
Expected NPV = Σ (pi × Scenarioi NPV) or – I0 + E(CF) .
r
N.B. We can use the PV of an Ordinary Annuity here of the cash-flows are equal for each
year. Otherwise, we need to discount each cash-flow.

Variance of CF = Σ (pi * ( Scenarioi CF – E(CF) )2).

Variance of NPV = Σ ( VAR (CFj) / (1+r)2j) (for year j) or
= [ Expected (NPV2) – (Expected NPV)2 ] /n

25
= [ Σ (Scenario NPV)2 – (Expected NPV)2 ] /n, with n being the duration of the project.
Exercise 1

A company is considering two projects. Each of the two projects has a life of 3 years. The
following cash-flows are forecasted from the projects:

Project Max Project Delta

Year 1
Cash-flow Probability Cash-flow Probability
1,000 0.4 2,000 0.4
2,000 0.5 3,000 0.3
4,000 0.1 5,000 0.3
Year 2
Cash-flow Probability Cash-flow Probability
1,500 0.3 800 0.2
2,000 0.6 6,000 0.3
6,000 0.1 5,000 0.5
Year 3
Cash-flow Probability Cash-flow Probability
3,000 0.2 4,000 0.4
3,000 0.4 3,000 0.2
5,000 0.4 9,000 0.4

The initial investment is 4,000K€ for both projects. The cost of capital of the project is
10%. It is assumed that the flows are independent in time.

Question:
According to the criteria expectancy / variance, which is the most interesting project to
execute?

26
Answer:
Project Max:
E(NPV)

E(CF1) = 1,000*0.4 + 2,000*0.5 + 4,000*0.1= 1,800.

E(CF2) = 1,500*0.3 + 2,000*0.6 + 6,000*0.1 = 2,250.
E(CF3) = 3,000*0.2 + 3,000*0.4 + 5,000*0.4 = 3,800.

E(NPV) = -4,000 + 1,800/1.1 + 2,250/1.12 + 3,800/ 1.13 = 2,350.86

Project Delta:
E(NPV):

E(CF1) = 2,000*0.4 + 3,000*0.3 + 5,000*0.3 = 3,200.

E(CF2) = 800*0.2 + 6,000*0.3 + 5,000*0.5 = 4,460.
E(CF3) = 4,000*0.4 + 3,000*0.2 + 9,000*0.4 = 5,800.

E(NPV) = -4,000 + 3,200/1.1 + 4,460/1.12 + 5,800/ 1.13 = 6,952,67.

Variance of NPV = Σ ( VAR (CFi) / (1+r)2i) or [ Expected (NPV2) – (Expected NPV)2 ] / n

= [ Σ (Scenario NPV)2 – (Expected NPV)2 ] / n, with n being 3 years here.

We have calculated project Max’s Var(NPV) as 2,271,353 and Var(NPV) of project Delta is
7,633,403. Now, let us calculate the standard deviation and coefficient of variation:

Max: σ = √ 2,271,353 = 1,507.10

Delta: σ = √ 7,633,403 = 2,762.86

Project MAX’s Coefficient of variation = σ (NPV) / E(NPV) = 1,507.10 / 2,350.86 = 0.64.

Project DELTA’s Coefficient of variation = σ (NPV) / E(NPV) = 2,762.86/6,952.67 = 0.40.

The company will select project DELTA, since it has the lowest relative risk.

27
Exercise 2

Given the success of one of its products, company X is considering a new investment. The
continued growth of its sales, however, depends on economic conditions:
In the first year, there is a 65% probability that demand will be high; if so, there is a 75%
probability that it will remain so in subsequent years;
On the other hand, if initial demand is weak, it remains low thereafter in 60% of the following
years.

The firm is studying two possibilities:

· The first solution is to build a high-capacity plant that would require an
investment of €750,000. The production capacity would be largely sufficient
to meet the demand of the next 10 years;
· The second solution is constructing a small capacity plant, costing only
€250,000. It does not, however, meet demand if economic conditions are
very good. In that case, executives believe if demand is strong, they have
the option to build an extension at the end of the first year for €180,000.

The WACC or discount rate is 7%.

The cash-flows are as follows (in K€):

Table I: First year's cash-flow:

Demand High (65%) Low (35%)

Large plant 800 - 150
Small plant 230 20

Table II: Cash-flows at the end of the 2nd year (dependant on scenario; for years 2 to 10):

Demand High / High High / Low Low / High Low / Low

Large plant 1,700 150 1,100 - 1,000
Small (no extension) 740 400 680 30
Small (with extension) 1,400 210

Assignments:
1) Present the Decision Tree corresponding to the decisions to be made by the company,
only for the first 2 years?

2) Indicate the optimal decision for the company?

28
Answer:
1. Decision Tree (cash-flows in K€):
(0.75)
1,700
(0.65)
800

(0.25) 150
-750

(0.35) (0.4)
1,100
-150
(0.6)
-1,000

(0.75)

Extension 1,400
(0.65) -180
230

(0.25) 210
(0.75) 740

Without
-250 extension

(0.25) 400

(0.35) (0.4) 680

20
(0.6) 30

2. First calculate: Extension or not

If Extension:
E(NPV) = -180 + 75% * 1,400/(1+7%) + 25% * 210/(1+7%) = €850.37.
Without Extension:
E(NPV) = 75% * 740/(1+7%) + 25% * 400/(1+7%) = €612.
So, the Extension gives a higher value and the company will invest in it.

3. Now analyse the capacity decision: Large capacity or Small capacity

Large capacity:
E(NPV) = -750 + 65% * [800/1.07 + (75% *1,700 + 25% *150)/1.072] + 35% * [(-
150)/1.07 + (1,100 * 40% -1,000 * 60%)/1.072] = €383.

Small capacity (including Extension, as per point 2 above):

E(NPV) = -250 + 65% * [230/1.07 + 850.37/1.07] + 35% * [20/1.07 + (680 * 40% +
30 * 60%)/1.072] = €501.50.

 So, the optimal decision is producing at Small capacity with Extension.

29
 Case study – MAXLU – Extending an investment under absolute uncertainty

MAXLU
Associated knowledge
Investment, Real options approach

1) The company MAXLU makes alarm systems for swimming pools.

The firm wishes to diversify and produce and market temporary dyes for swimming pools. At
the moment, no other company has a product like this on the market. This quasi-monopoly
position would allow MAXLU to make a strategic head-start in the market of dyes for pools
and jacuzzis.
The production department requires a new machine to manufacture the dyes – at a cost of
€480,000 (linear depreciation over 5 years).

The projected revenues (€) are as follows:

N+1 N+2 N+3 N+4 N+5
400,000 450,000 500,000 600,000 700,000

Variable expenses represent 57.25% of revenues.

Fixed charges (excluding depreciation) amount to €75,000 per year.
Corporate tax rate is 33.33%. The company’s WACC is 13%.

Assignment
1) Determine the NPV of the project?

Answer 1:

CASH-FLOW Begin N + 1 End N + 1 End N + 2 End N + 3 End N + 4 End N + 5

Acquisition new machine -480,000

Turnover 400,000 450,000 500,000 600,000 700,000

Variable expenses -229,000 -257,625 -286,250 -343,500 -400,750
Gross Margin 171,000 192,375 213,750 256,500 299,250
Fixed costs -75,000 -75,000 -75,000 -75,000 -75,000
Depreciation -96,000 -96,000 -96,000 -96,000 -96,000
EBIT 0 21,375 42,750 85,500 128,250
Tax 0 -7,125 -14,250 -28,500 -42,750
Net Earnings 0 14,250 28,500 57,000 85,500

Reversal of Depreciation 96,000 96,000 96,000 96,000 96,000

Net Cash-Flow -480,000 96,000 110,250 124,500 153,000 181,500

NPV -30,068.89 € IRR = 10.66%

The NPV of the project is negative and we should not execute the project.
However, if MAXLU does not invest now, it may miss the market. Fortunately, there is a
2nd investing opportunity €1,000,000 later at year N+5, which may help the 1st, negative
NPV. So, we need to consider the 2nd option for future growth, by extending the project.
Case study – MAXLU (continued)
30
 2) MAXLU’s objective is to develop, over time, machines for pools that are pre-
equipped with dyes and glitter – to be used in private pools and jacuzzis. To pursue
this option, MAXLU has acquired shares in the firm Aquazur, specialised in this type
of machines. Production cannot begin until N+5.

If MAXLU does not seize the opportunity to begin production of dyes on 01/01/N+1, their
competitors will get a foothold on the market, making it impossible to start the planned
operation in N+5. So, let us consider doing the 1st investment and using the 2nd opportunity as
well:

The amount to invest on 01/01/N+5 is an additional €1,000,000 (depreciation over 5 years).

Projected revenues (€) over five years as follows:

N+5 N+6 N+7 N+8 N+9
900,000 1,100,000 1,600,000 2,000,000 2,500,000

Variable expenses represent 65% of turnover.

Fixed charges (excluding depreciation) amount to €100,000 per year.
Corporate tax rate is 33.33%
The discount rate of these cash flows is 15%.
The risk-free interest rate is 4.25%.
τ, the waiting time until the 2nd project starts, is 4 years later (N+5 – N+1).

The cash-flow values are uncertain – corresponding to uncertainty of the share price of the
company’s shares in Aquazur. The standard deviation for Aquazur’s share price is 30%.

To decide, it seems wise to calculate the impact of the second project on value creation.
The decision to begin the second project will only be taken after consideration of MAXLU’s
situation on 01/01/N+5.
The opportunity to realise the project in N+5 is a call-option on future cash-flows of the
investment in the second project.

On 01/01/N+1, we calculate the present value of the cash-flows provided by the investment in
the machines (discounted at the risk-free rate). The exercise or “strike” price of the call-option
is the cost of the investment. If the PV of those future cash-flows exceeds the 2nd investment
(of €1,000,000), executing the 2nd investment seems a good idea.

The 1st and 2nd investments will be made if the value of the call-option (answer 2) exceeds
the negative NPV of the 1st project (answer 1).

Assignments:
2) Using the Black-Scholes model and determine the value of the call-option? This represents
the value to expand the project later.
In Excel: [Link].N(value;VRAI) or [Link](value;TRUE).
EXP and LN are functions to be used for the Black-Scholes formula;

3) Conclude on the opportunity to invest in these two associated projects.

31
 Answer 2:

CASH-FLOW Begin N + 5 End N + 5 End N + 6 End N + 7 End N + 8 End N + 9

Acquisition new machine -1,000,000

Turnover 900,000 1,100,000 1,600,000 2,000,000 2,500,000

Variable expenses -585,000 -715,000 -1,040,000 -1,300,000 -1,625,000
Gross Margin 315,000 385,000 560,000 700,000 875,000
Fixed costs -100,000 -100,000 -100,000 -100,000 -100,000
Depreciation -200,000 -200,000 -200,000 -200,000 -200,000
EBIT 15,000 85,000 260,000 400,000 575,000
Tax -5,000 -28,331 -86,658 -133,320 -191,648
Net Earnings 10,000 56,670 173,342 266,680 383,352

Reversal of Depreciation 200,000 200,000 200,000 200,000 200,000

Net Cash-Flow -1,000,000 210,000 256,670 373,342 466,680 583,352

Present Value of cash-flows 1,179,022

15% IRR = 21.09%

The NPV for the 2nd project is uncertain. What is the value?

The option for the 2nd project, to invest 1,000,000 at year N+5 can be valued as a call option
with the Black-Scholes model. Its parameters are as follows:
 The risk-free interest rate r calculated with a continuous frequency =
ln(1 + risk-free interest rate) = ln(1.0425) = 0.0416;
 The Present value S0 of cash-flows (calculated at a WACC of 15%) from
the 2nd project must be calculated at decision time, N+1, so S0 =
€1,179,022 * e-rT = €1,179,022 * e-0.0416*4= €998,200;
 Time τ = 4 until the start of the 2nd project, is the time until exercising
the call option, here (N + 5 – N + 1);
 Standard deviation or uncertainty of the cash-flows  was given as
30%;
 The amount to invest K is €1,000,000.

The value of the call option is S0 * N(d1) – K * e-rT * N(d2).

d1 = [ ln(S0 / K) + (r + 2 / 2) * T ] / ( * √T)
d2 = d1 -  * √T

Calculations give d1 = 0.5745 and d2 = -0.0255.

Using the normal distribution table on the next page gives:

N(d1) = 0.7172 and N(d2) = 1 – N(0.0255) = 0.4898.

The value of the call option computes at €301,189.

32
Answer 3:
The value of the option to expand the project later, changes our decision. In fact,
its total value is -€30,069 + €301,189 = €271,120. It is ok to make the 1st
investment, in combination with expanding in the market at N+5.

Annex to Case MAXLU: Normal Distribution table

33
 CHAPTER 3

Exercise 1.

A company’s Shareholders’ Equity is €5m, divided into 50,000 shares of nominal value equal
to €[Link] market value of the share is €[Link] company must cover financing needs
amounting to €2,200,000. It carries out a capital increase at an issue price of €220.

Questions:
1) What is the issue premium?

2) What is the subscription parity (# of new shares per existing shares)?

Answers:
The issue premium is €220 - €100 = €120 per share. The number of new shares is
€2,200,000 / €220 = 10,000.
Subscription parity is determined as 10,000 new shares: 50,000 existing = 1:5.
1 new for 5 existing shares.

Exercise 2.

Using the previous exercise, please calculate:

1) The new market value of the share after the capital increase;

2) The value of the preferential subscription right PSR;

3) The situation (before and after capital increase) of the shareholder with 10 shares.

Answers:
The new share price is (50,000 * €300 + 10,000 * €220) / 60,000 = €286.66 per share.

The value of the preferential subscription right PSR = €300 - €286.66 = €13.34.

The situation of an existing shareholder with 10 shares before and after the new issue is:

Before the new issue 10 * €300 = €3,000

After the new issue: Subscribes to 2 new shares for the 10 Does not subscribe to new
existing shares (parity 5:1) shares

The situation of an existing Value of shares after the issue = Existing shares =
shareholder remains the 12 * €286.66 = €3,439.92. 10 * €286.66 = €2,866.60.
same, whether (s)he
participates to the new issue Buys 2 new shares = Sale of 10 PSRs = 10 *
or not. 2 * (€286.66 – 5 * €13.34) = 2 * €220 €13.34 = €133.40 cash in.
= -€439.92 cash out.

New wealth = €3,000. Total wealth = €3,000.

34
 CHAPTER 4
Exercise 1.
SA Tach is about to make an investment in a machine of €300,000. Amortisation of
investment: in equal amounts, linearly over 6 years.
To finance it, she hesitates between a lease and a bank loan repayable in full at maturity (only
interest payments for years 1-5; interest + reimbursement in year 6), at a rate of 6%.
Alternatively, SA Tach can use a leasing arrangement, with the following conditions:
- Annual rents in case of leasing: €60,000 payable at the end of the year:
- Purchase of the machine expected at the end of year 5, at a price of €30,000. Once the
machine is purchased, it will be depreciated over 1 year.
Corporate tax rate: 33.333%. Discount rate required: 5%.

Assignments:
1) Present, in the form of a Table, the actual payments for each mode of financing? Use
rents and tax savings on the lease and check slide 188 for structure;
2) Calculate the Present Values of the cash-outflows. Conclusion, lease or bank loan?

Answer:
CASH-FLOW 1 2 3 4 5 6
Lease
Rent on the lease -60 000 -60 000 -60 000 -60 000 -60 000
Tax savings on the rent 20 000 20 000 20 000 20 000 20 000
Purchase of the machine -30 000

Depreciation after purchase 30 000

Tax savings on the depreciation 10 000

Net Cash-Flow -40 000 -40 000 -40 000 -40 000 -70 000 10 000

PV 5% -189 224 €
CASH-FLOW 1 2 3 4 5 6
BANK LOAN
Depreciation -50,000 -50,000 -50,000 -50,000 -50,000 -50,000

Year Remaining capital Interest paid Reimbursement Total payments Tax savings Tax savings Cash-flow
begin of the year on interest on depreciation
1 300,000 -18,000 0 -18,000 6,000 16,667 4,667
2 300,000 -18,000 0 -18,000 6,000 16,667 4,667
3 300,000 -18,000 0 -18,000 6,000 16,667 4,667
4 300,000 -18,000 0 -18,000 6,000 16,667 4,667
5 300,000 -18,000 0 -18,000 6,000 16,667 4,667
6 300,000 -18,000 -300,000 -318,000 6,000 16,667 -295,333

PV 5% -200,178 €
The Lease has the least negative present value of cash-outflows. If we select financing only
on the cost, we select the Lease. In addition, Leasing has other advantages (see course slides).

35
 Exercise 2.

The company SADAL plans to finance a machine tool by leasing. The value of the rented
machine tool is €500,000. The economic life is 5 years. Its depreciation is constant. The
annual fee (“rent”) is paid at the beginning of the period: the amount is €140,000.
The lease term is 4 years. The option to purchase the machine tool at the end of the lease is
€50,000. The machine will be depreciated over one additional year after the option is
exercised, i.e., if the machine is indeed bought at the end of the lease. Tax rate: 33.33%.
Assignment:
1) Make the table with cash-outs as in the previous Exercise 1. Then add the opportunity loss
of Tax savings on Depreciation, had SADAL bought the machine instead of leasing it.
Now, calculate the gross actuarial rate of the lease, as the IRR of the cash-flows?
N.B. This is a method of opportunity costs. Include not only Tax savings on the lease but
also the loss of tax savings (negative, opportunity costs) on depreciation (if the machine
instead was bought);
2) The banker offers financing of the machine tool with a loan repayable in full at a rate of
9% over 4 years.
What type of financing should be selected based on the real cost (gross actuarial rate)?

Answer:

CASH-FLOW 0 1 2 3 4 5

Rent on the lease -140 000 -140 000 -140 000 -140 000
Tax savings on the rent 46 667 46 667 46 667 46 667

Option of purchase -50 000

Tax savings on depreciation 16 667

Value of the machine tool 500 000

Depreciation machine tool 100 000 100 000 100 000 100 000 100 000
Loss of tax savings on depreciation -33 333 -33 333 -33 333 -33 333 -33 333
had it been acquired instead of leased

Net Cash-Flow 360 000 -126 667 -126 667 -126 667 -36 666 -16 666

Gross actuarial rate 8.64%

360,000 = -126,667 *(1- (1+r)-3/r) -36,666/(1+r)4 -16,666/(1+r)5 r = 8.64%.

The bank charges 9% for the loan, which is tax deductible. Net of tax, the
interest on the loan is 6%, so the bank loan is cheaper for the company.

36
 Exercise 3.

The company OWEIS plans to finance a machine whose value is €800,000 and which has a
linear amortisation over 4 years. Two types of financing are possible:
 A loan of €800,000 by constant amortisation at the rate of 8% over 4 years, or
 Leasing: annual payments of €250,000. The lease term is 4 years (without option to buy).
The company is subject to corporate tax (33.33%). The discount rate is 6%.

Questions:
1) Calculate the actual repayments, induced by the loan?
2) Which financing method should be chosen based on previous calculations?

Answer 1: Loan amortisation

Loan Reimbursement Interest Tax savings on Tax savings on
outstanding of the loan interest depreciation Cash-out
800,000 -200,000 -64,000 +21,333.33 +66,666.67 -176,000
600,000 -200,000 -48,000 +16,000 +66,666.67 -165,333.33
400,000 -200,000 -32,000 +10,666.67 +66,666.67 -154,666.67
200,000 -200,000 -16,000 +5,333.33 +66,666.67 -144,000

PV of cash-flows of bank loan @WACC = - €557,107.

Answer 2:
Annual lease payments net of tax: €250,000 * (1 – 33.33%) = €166,666.67.
PV of an annuity @€166,666.67, 4, WACC = - €577,518.

Financing by a bank loan is cheaper, but Leasing has other advantages (see course
slides). So, the selection of the financing method depends on what is more important to
the company, costs only, or also flexibility and technological risk insurance.

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 CHAPTER 5

Exercise.
A company Z seeks to finance an industrial material of €1,800,000 in straight line
depreciation over 5 years. The economic life of the industrial material is 5 years. Its
depreciation is constant, repayable over 5 years by constant annuity.
Corporate tax rate is 33.33%.
It has two funding opportunities:

 Option 1:
Fund the equipment entirely with own funds;

 Option 2:
Borrow 1/3rd of the amount at an interest rate of 10% and finance the rest by own
funds. The bank loan is also offered for 5 years.

Questions:
1) Knowing that the market forecasts are as follows:
The market rate of return (Rm) is 9%, the risk-free rate (Rf) is 7%, the systematic risk
of the company (βe) is 1.2.
Calculate the Cost of Equity?

2) Bearing in mind that the one-off cost of issuing debt amounts to 1% of the amount
borrowed, calculate the Effective Cost of Debt?
Set up the loan amortisation table (with the Total Payment method);

3) Calculate the weighted average cost of capital (WACC) for the second financing
option?

4) Why do we consider the Cost of Capital in the investment decision?

38
 Answer 1:
We are using as parameters:
Market return Rm is 9%, risk-free rate Rf of 7%, systemic risk βe is 1.2:
Cost of Equity RE= Rf + βe (Rm- Rf) = 7% + 1.2 * (9% - 7%) = 9.4%.

Answer 2:
Debt is: Borrowed = 1,800,000 / 3 = €600,000.
D.i 600 0000∗10 %
The constant annuity is AECF= −n = −5 = €158,278.49.
1−(1+i) 1−( 1+10 % )

Period Annuity Interest Repayment Interest net of tax Remaining loan

1 €158,278.49 €60,000 €98,278.49 €40,000.00 €501,721.51
2 €158,278.49 €50,172.15 €108,106.34 €33,448.10 €393,615.17
3 €158,278.49 €39,361.52 €118,916.97 €26,241.01 €274,698.20
4 €158,278.49 €27,469.82 €130,808.67 €18,313.21 €143,889.53
5 €158,278.49 €14,388.95 €143,889.53 €9,592.64 €0

One-off transaction cost of issuing debt is 1% of the borrowed amount, which we include in
our calculations by deriving the Effective Cost of Debt from the following equation:

600,000-1%*600,000 = (98,278.49+40,000)/(1+i) + (108,106.34+33,448.10)/(1+i)2 +

(118,916.97+26,241.01)/(1+i)3+ (130,808.67+18,313.21)/(1+i)4+
(143,889.53+9,592.64)/(1+i)5.

By using the IRR function in Excel, the Effective cost of Debt computes at 7.03% after tax.

Answer 3:
The WACC for the 2nd financing option is 9.4% * 2/3 + 7.03% *1/3 = 8.61%. This is lower
than the cost of the 1st financing option, so we prefer financing the project by a mix of internal
funds and the bank loan.

Answer 4:
Why do we calculate the WACC?

The cost of financing the project is the minimum return required by investors to finance the
project.

39
 CHAPTER 6

Case study AROLA Ltd.

Part 1 - Establishment of the Financing Plan

The company AROLA plans to install a new site with several production units operational
from year N. Preliminary financial studies showed that the project, on the one hand,
corresponded to the company's standards and on the other hand that it proved to be more
interesting than the other options.

The amount of the initial total investment assumed at the beginning of year N amounts to
4,000 K€, of which:

- Land : 500 K€
- Construction : 1,000 K€ (lifetime: 20 years)
- Other Fixed Assets : 2,500 K€ (lifetime: 10 years)
________
Total Fixed Assets 4,000 K€

This investment is expected to generate incremental revenues as follows:

- Increase year N/N-1 : +3,000 K€
- Increase year N+1/N : +7,000 K€
- Increase year N+2/N+1 : +5,000 K€
- Increase year N+3N+2 : +5,000 K€
- Increase year N+4/N+3 : +10,000 K€

Working Capital is at its desirable level at the beginning of the year N and must represent on
average 10% of Revenues to cover the need for financing the operation. So, the change in
WCR = 10% * incremental revenues.

The company will have to face replacement investment on its Fixed Assets:
- Year N : 0 K€
- Year N+1 : 300 K€
- Year N+2 : 300 K€
- Year N+3 : 300 K€
- Year N+4 : 400 K€

Depreciation charges on existing Production units and their maintenance costs can be
estimated at 500 K€ per year.

Cash position is €0 at the beginning of year N.

AROLA has planned the following dividend payments to its shareholders:

- To be paid year in N: 100 K€
- To be paid in year N+1: 100 K€
- To be paid in year N+2: 200 K€
- To be paid in year N+3: 200 K€
- To be paid in year N+4: 200 K€

Currently, the following financing is planned: a Capital increase n° 1, by issuing new shares
of 1,200 K€ at the beginning of year N.

40
Medium and long-term financing is in place is as follows:
 Bank Loan: 1,500 K€, received by AROLA the year N-1;
 Repayment term 5 years, equals 300 K€ per year;
 No repayments have been made at 31/12 / N-1.

The following forecasts are also given for Net Income before Tax:
(in K€) N N+1 N+2 N+3 N+4
Net Income 0 1,800 3,300 3,300 3,300
before Tax

Assignment:
Build AROLA's Financing Plan for years N to N+4, knowing that the company will be able to
borrow for 5 years at 5% with constant repayment and a possible deferral for the repayment of
the loan to the end of year 5. Banking costs for taking a new loan are 5% before tax or 5% *
(1 - tax rate) after tax, payable upfront. The corporate tax rate is 33.33%.

Answer:

Calculation of the changes in WCR:

Years N N+1 N+2 N+3 N+4

Incremental revenues 3,000 7,000 5,000 5,000 10,000
(in K€)
Change in WCR
(10% of revenues) 300 700 500 500 1,000

Self-financing potential is therefore:

K€ N N+1 N+2 N+3 N+4

Net Income before Tax 0 1,800 3,300 3,300 3,300

Tax at 33.33% 0 -600 -1,100 -1,100 -1,100

Net Earnings 0 1,200 2,200 2,200 2,200

Reversal of Depreciation
of Fixed Assets *) 300 300 300 300 300
Reversal of Depreciation
of Existing production 500 500 500 500 500
units and maintenance
costs
Operating
Cash-flows 800 2,000 3,000 3,000 3,000

*) Construction = 1,000 / 20 + Other Fixed Assets = 2,500 / 10 = 300

41
Dividends and Retained Earnings:

(in K€) N N+1 N+2 N+3 N+4

Net Earnings 0 1,200 2,200 2,200 2,200

Dividends paid -100 -100 -200 -200 -200

Added to Retained (100) 1,100 2,000 2,000 2,000
Earnings

42
 PRELIMINARY FINANCING PLAN (in K€)
YEARS
N N+1 N+2 N+3 N+4
REQUIREMENTS
Investments
- Initial investments 4,000
- Replacement 300 300 300 400

Related to Operations
- Change in WCR 300 700 500 500 1,000

Related to Financing
- Repayment of previous loans 300 300 300 300 300
- Repayment of new loans
- Dividends 100 100 200 200 200

TOTAL FINANCING NEEDS (N) 4,700 1,400 1,300 1,300 1,900

RESOURCES
Internal Resources
- Self-financing / Cash-flows 800 2,000 3,000 3,000 3,000

External Resources
- Capital increase by new issue n° 1 1,200
- New Loan

TOTAL RESOURCES (R) 2,000 2,000 3,000 3,000 3,000

(R) - (N) -2,700 600 1,700 1,700 1,100
Begin Cash position 0 -2,700 -2,100 -400 1,300
End Cash position -2,700 -2,100 -400 1,300 2,400

There is a Cash deficit of €2,700 in year N. The company needs to secure a Loan, equal to the
net financing needs, including banking costs.

What should be the minimum amount of the New Loan?

Since the company has insufficient cash in the beginning, suppose that the company can
negotiate with the bank that a repayment of the loan is suspended / deferred for two years and
begins in year N+2.
Draft the Loan amortisation table.

43
New Loan = 2,700 + New Loan * 5% * (1 – tax rate)  New Loan = 2,793 K€.

Since the company has insufficient cash in the beginning, suppose that the company can
negotiate with the bank that a repayment of the loan is suspended / deferred for two years and
begins in year N+2.

Using constant repayment of the new loan, the amortisation table is:

Years Outstanding Interest Repayment of Loan Cash-out

balance (5%)

N 2,793 140 0 140

N+1 2,793 140 0 140

N+2 2,793 140 931 1,071

N+3 1,862 93 931 1,024

N+4 931 47 931 978

The New Loan is generating tax savings and the Cash-flows are adapted accordingly:

Years N N+1 N+2 N+3 N+4

Cash-flows before 800 2,000 3,000 3,000 3,000
New Loan
Interest on new loan -140 -140 -140 -93 -47

Tax savings on 47 47 47 31 16
interest on new loan at
33.33%

Self-financing 707 1,907 2,907 2,938 2,969

capacity

We update the Preliminary Financing Plan.

44
 NEW FINANCING PLAN

YEARS
N N+1 N+2 N+3 N+4
REQUIREMENTS
Investments
- Initial investments 4,000
- Replacement 300 300 300 400

Related to Operations
- Change in WCR 300 700 500 500 1,000

Related to Financing
- Repayment of previous loans 300 300 300 300 300
- Repayment of new loans 931 931 931
- Dividends 100 100 200 200 200

TOTAL FINANCING NEEDS (N) 4,700 1,400 2,231 2,231 2,831

RESOURCES
Internal Resources
- Self-financing / FCFE 707 1,907 2,907 2,938 2,969

External Resources
- Capital increase by new issue n° 1 1,200
- New Loan 2,793

TOTAL RESOURCES (R) 4,700 1,907 2,907 2,938 2,969

(R) - (N) 0 507 676 707 138

Ending Cash position 0 507 1,183 1,890 2,028

45
Case study AROLA Ltd. (continued)

Part 2 – Financial Standards

The AROLA company has just received clarification from its bank about the bank loan it is
considering. The firm realises that the following criteria must be respected:

FINANCIAL AUTONOMY RATIO:

Shareholders’ Equity >= 1
LONG-TERM DEBT

REPAYMENT CAPACITY RATIO:

LONG-TERM DEBT < 4 YEARS
FCFE

Which consequences can these constraints have on the Financing Plan and on the capital
structure of the company, knowing that the amount of its Shareholders' Equity is 500 K€ at
31.12.N-1 and that the shareholders request a remuneration on their capital of at least 15% on
a new issue?
Consider that these new dividends will be paid as of year N+1.

N.B. 1) The dividends provided for in the updated Financing Plan correspond to the existing
Shareholders' Equity before year N (i.e., 500 K€), plus to those shareholders whose
contribution is expected in year N (who are funding the capital increase of 1,200 K€);
2) Retained Earnings (Net Income - Dividends) should be added to Shareholders’
Equity, each year.

To determine which constraints the two criteria have on the Financing Plan, you can follow
the following pattern:

1) Check whether the banking criteria are respected or not?

2) Calculate, considering the situation in year N, the amount of a possible increase of
capital? Target both Capital structure ratios;
3) Find the amount of the loan to be negotiated;
4) Construct the final Financing Plan (using the following table).

46
 Answer Case study AROLA Ltd – Part 2

Below a table, summarising AROLA’s Capital Structure, using the Updated Financing Plan:

Years N N+1 N+2 N+3 N+4

Shareholder’s Equity, begin of the year 500 + 1,200 1,600 2,700 4,700 6,700
Retained Earnings -100 1,100 2,000 2,000 2,000
Shareholders’ Equity, end of the year 1,600 2,700 4,700 6,700 8,700
Debt, begin of the year 1,500 3,993 3,693 2,461 1,231
New Loan 2,793 0 0 0 0
Repayment of old + new loan -300 -300 -1,231 -1,231 -1,231
Debt, end of the year 3,993 3,693 2,462 1,231 0
Financial Autonomy Ratio: 0.40 0.73 1.90 5.44
Shareholders’ Equity / Debt
(Target: >= 1)
Self-financing 707 1,907 2,907 2,938 2,969
Repayment Capacity Ratio: Debt / FCFE 5.64 1.93 0.84 0.42 0
(Target: < 4)

Financial Autonomy Ratio should be >= 1, which is not the case until the year N+2.

Repayment Capacity Ratio should be <4, which is not the case at begin of year N.

AROLA needs to raise additional capital again and re-calculate the new loan, as follows:

C, increase of capital (“new issue 2”)

L’, new loan re-calculated
E, Shareholders’ Equity at the end of year N, before capital restructuring
D, Debt at the end of year N before capital restructuring.

Several constraints need to be respected:

(1) Financial Autonomy Ratio: E + C > D + L’

1,600+C
> ¿1  C = 1,196. The 2nd capital increase must be at least 1,200 K€.
3,993−C

After new issue n° 2, the net cash deficit decreases to -1,500 K€ from -2,700 K€ in the
Updated Financial Plan at the end of year N and this needs to be financed by the new loan re-
calculated.

(2) L' =1,500+ L'∗5 %∗(1−tax rate)

The Re-calculated New Loan is re-calculated at L’ 1,551 K€.

47
Re-calculate the amortisation table and Cash-flows for new loan L’:

Years Outstanding balance Interest (5%) Repayment of Loan

N 1,551 77 0
N+1 1,551 77 0
N+2 1,551 77 517
N+3 1,034 52 517
N+4 517 26 517

Years N N+1 N+2 N+3 N+4

Cash-flows before New Loan 800 2,000 3,000 3,000 3,000
Interest on Re-calculated Loan -77 -77 -77 -52 -26
Tax savings on interest on new 26 26 26 17 8
loan at 33.33%

Self-financing capacity 749 1,949 2,949 2,965 2,982

Retained Earnings and Dividends being re-calculated as well:

(in K€) N N+1 N+2 N+3 N+4

Net Income before Tax 0 1,800 3,300 3,300 3,300

(before new loan)
Interest on new loan -77 -77 -77 -52 -26
Net Income before Tax -77 1,723 3,223 3,248 3,274
(after new loan L’)
Tax at 33.33% 26 574 1,074 1,083 1,091
Net Earnings (51) 1,149 2,149 2,165 2,183
Dividends on existing shares paid 100 100 200 200 200
Dividends on new shares (15%) 180 180 180 180
Retained Earnings (151) 869 1,769 1,785 1,803

The Capital Structure table re-calculated:

Years N N+1
Shareholder’s Equity, begin of the year 500 + 2,400 2,749
Retained Earnings -151 869
Shareholders’ Equity, end of the year 2,749 3,618
Debt, begin of the year 1,500 2,751
Re-calculated New Loan L’ 1,551 0
Debt, end of the year 2,751 2,451
Financial Autonomy Ratio: 0.99 1.48
Shareholders’ Equity / Debt (Target >= 1)
Self-financing 749 1,949
Repayment Capacity Ratio: 3.67 1.25
LT Debt / FCFE (Target < 4)

48
 FINAL FINANCING PLAN

YEARS
N N+1 N+2 N+3 N+4
REQUIREMENTS
Investments
- Initial investments 4,000
- Replacement 300 300 300 400

Related to Operations
- Change in WCR 300 700 500 500 1,000

Related to Financing
- Repayment of previous loans 300 300 300 300 300
- Repayment of Re-calculated new loan 517 517 517
- Dividends 100 280 380 380 380

TOTAL FINANCING NEEDS (N) 4,700 1,580 1,997 1,997 2,597

RESOURCES
Internal Resources
- Self-financing / FCFE 749 1,949 2,949 2,965 2,982

External Resources
- Capital increase by new issue 2,400
- Re-calculated New Loan 1,551

TOTAL RESOURCES (R) 4,700 1,949 2,949 2,965 2,982

(R) - (N) 0 369 952 968 385

Ending Cash position 0 369 1,321 2,289 2,674

49