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    Table of ContentsC1_THE ROLE OF FINANCIAL MANAGEMENT

    C2_ THE TAX ENVIRONMENT

    C11_ CAPITAL BUDGETING: CONCEPTS AND METHODS

    C13_RISK IN CAPITAL BUDGETING

    C4_THE TIME VALUE OF MONEY

    C9_RISK AND RATES OF RETURN

    C14_COST OF CAPITAL

    C16_CAPITAL-STRUCTURE POLICY

    C17_DIVIDEND POLICY AND INTERNAL FINANCING

    C19_SHARES AND CONVERTIBLE SECURITIES

    Texas instruments financial calculator, BA II Plus_ $53.66 on www.fishbond.com.au

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    C1_THE ROLE OF FINANCIAL MANAGEMENTWhat is financial management?

    1. Long-term investments that the firm undertaken is capital budgeting.2. The firm raises money to fund these investments referring to as capital structure.3. The firm best manage its cash flow as they arise in its day to day operations referring to

    as working-capital management.

    The goal of the financial manager

    Making investment decisions (capital budgeting decisions)

    Board of Directors

    Marketing Manager

    Chief Financial Officer (CFO)

    - Oversee financial planning;

    - Company strategic planning;

    - Control company cash flow.

    Operations Manager

    Chief executive Officer (CEO)

    Treasurer

    Cash management

    Credit management

    Capital expenditures

    Raising capital

    Financial planning

    Management of foreign

    currencies

    Financial Controller

    Taxes

    Financial statements

    Cost accounting

    Data processing

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    Making decisions on how to finance these investments (capital structure decisions) Managing funding for the companys day to day operations working-capital

    management)

    C2_ THE TAX ENVIRONMENTTaxable income = assessable income allowable deductions2.1 Calculation of taxable income: individual Jane Piper

    $ $

    Assessable income

    Gross wages 45000

    Less: Allowable deductions

    Purchase clothing and boots 250

    Replacement of tools 250 500

    Taxable income Jane Piper $44500

    2.2 Calculation of taxable income: business J & S Plumbing$ $ $

    Assessable income

    Sales $600000

    Less: Allowable deductions

    Cost of materials used 230000

    Operating expenses

    Apprentice wages 45000

    Machinery and vehicle depreciation 15000

    Other expenses 40000 100000

    Financial expenses

    Interest 20000 $350000

    Taxable income J & s plumbing $250000

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    2.3 Calculation of income tax payable for an individual taxpayer: Jan Piper

    Taxable income Tax to be paid on$

    Tax rate % Tax payable $ After tax income$0 6000 6000 0 Nil6001 37000 31000 15 465037001 44500 7500 30 2250Total $44500 ($6900) $37600

    Australian income-tax rates for resident taxpayersEach dollar of taxable income in range Taxed at

    0 6000 0%6001 37000 15%37001 80000 30%80001 180000 37%180001 and above 45%

    2.4 Calculation of income tax payable for a business partnership: J & S Plumping

    John: Taxable income $225000

    Taxable income Tax to be paid on$ Tax rate % Tax payable $ After tax income$0 180000 180000 Various (30) 54550180001 225000 45000 45 20250Total 225000 (74800) $150200

    Sue: Taxable income $25000

    Taxable income Tax to be paid on$ Tax rate % Tax payable $ After tax income$0 6000 6000 0 Nil6001 25000 19000 15 2850Total $25000 (2850) $221502.5 Calculation of income tax payable for a company: J & S Plumbing Limited

    $Taxable income 250000- Company tax @ 30% (75000)Net income after tax 175000

    Tax saving = charge in taxable income x marginal tax rate

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    2.6 Income tax payable under classical tax system

    J & S Plumping Limited net income after tax: $250000 - $75000 = $175000

    John: 90% $157500

    Sue: 10% $17500

    Total 100% $175000

    John Sue TotalDividend income 157500 17500 175000Income tax (46225) (1725) (47950)After tax income 111275 15775 127050

    Dividend imputation system refers to the tax system applying a company andshareholders that net income of the company is accounted for the shareholders andtaxed at the marginal rate. This is because the company income is taxed twice, so the

    shareholders are considered as credit for the income tax paid by the company.

    Franking (imputation) creditsoFully franked: an amount of income tax paid by the company that is credited to

    shareholders when they receive the company dividends.

    oUnfranked: no income tax is paid by the companyoPartially franked

    Imputation credit = (fully franked dividend x company tax rate)/(1- company tax rate)[each shareholder]

    Grossed-up dividend amount = dividend + imputation creditOr

    Grossed-up fully franked dividend = fully franked dividend amount/ (1 company taxrate)

    2.7 Calculation of individual tax payable on fully franked dividends

    SHARHOLDER JOHN SHAREHOLDER SUETax Calculate Income Tax Calculate Income

    Franked dividendreceived $157 500 $17 500Grossed-upfranked dividendamount$225 000 $25 000

    Taxable income 225 000 25 000Tax on taxableincome * (74 800) (2850)Less: Imputationcredit 67 500 7 500Tax(payable)/refund (7 300) 4 650**After tax income 150 200 22 150*: calculated at marginal tax rate

    **: surplus imputation (franking) credit

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    2.8 Unfranked dividend amounts

    J & S Plumbing LimitedPrevious taxable income $250 000

    - Investment allowance deduction ($250 000)= Taxable income 0Tax payable @ 30% 0Company net income after tax $250 000Unfranked dividend paid to:John; 90% $225 000Sue: 10% $ 25 000Total $ 250 0002.9 Calculation of individual tax payable on unfranked dividends

    SHAREHOLDER JOHN SHAREHOLDER SUETAX CAL. INCOME TAX CAL. INCOME

    Dividendreceived $225000 $25000Gross-upfrankeddividendamount

    $225000 $25000

    Taxable income $225000 $25000Tax on taxableincome ($74800) ($2850)Less:Imputationcredit0 0

    Tax payable ($74800) (2850)After taxincome

    $150 200 $22150

    2.10 Partially franked dividend amounts

    The companys net income before tax: $250000An investment allowance tax deduction: $100000

    Therefore, the companys tax income: $150000Income taxes: $45000 ($150000 x 30%)

    Net income after tax: $205000 ($250000 - $45000)

    DIVIDEND + IMPUTATIONCREDIT = GROSS-UPDIVIDEND AMOUNTJohn: 90% $184500 $40500 $225000Sue: 10% $20500 $4500 $25000Total 205000 $45000 $2500002.11 Calculation of individual tax payable on partially franked dividends

    SHAREHOLDER JOHN SHAREHOLDER SUETAX CALC. INCOME TAX CALCUL. INCOMEDividend received $184500 $20500Gross-up frankeddividend amount $225000 $25000Taxable income $225000 $25000

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    - Individual taxlevied (74800) (2850)Less: Imputationcredit

    40500 4500

    Individual tax(payable)/refund ($34300) 1650After tax incoome $150200 22150 Integration of the dividend imputation system

    John Smith: Summary of net income after tax

    PARNERSHIP2.4 FULLY FRANKEDDIVIDEND 2.7 UNFRANKEDDIVIDEND 2.9 PARTIALLYFRANKEDDIVIDEND 2.11J & S PlumbingbusinessBusiness netincome

    $250000 $250000 $250000 $250000

    -Tax paid bybusiness(company

    0 ($75000) 0 ($45000)

    =business netincome after tax

    $250000 $175000 $250000 $250000

    John SmithReceive 90%share of businessnet income aftertax

    $225000 157500 225000 184500

    -Tax paid byJohn

    ($74800) ($7300) ($74800) ($34300)

    Net income after

    tax

    $150200 $150200 $150200 $150200

    Taxation category 1Companies with shareholders that are fully or substantially integrated by the dividendimputation system (prepaid personal tax - franking credits) _ companies

    - The amount of income tax paid by the company on its net income is largely irrelevanttothe amount of net income after tax of its shareholders.

    - Investment and financing decisions should focus on maximising companyspre-taxnetincome and cash flows. This is because reducing the amount of income tax paid by the

    company will not increase the net income after tax of shareholders.

    Taxation category 2a) Sole traderb) Partnershipc) Companies with shareholders that are not integrated by the dividend imputation

    system- The amount of income tax paid by the company on its net income is largely relevantto

    the amount of net income after tax of its shareholders.

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    - Investment and financing decisions should focus on maximising companys after-taxnetincome and cash flows. Reducing the amount of company income tax paid maximise the

    after-tax net income and cash flows that can be paid to shareholders as a dividend.

    Taxation category 3The in-between case companies with shareholders that are part integrated by thedividend imputation system

    - The amount of income tax paid by the company has some effecton the after-tax wealthof its shareholders.

    - Investment and financing decisions should focus on maximising business after-effective-taxincome and cash flows.

    Teff= T(1-u)

    Where T = the nominal or statutory company income tax rate

    u=the proportion of the income tax paid by the company that shareholders are

    effectively able to use to offset their individual income-tax liabilities.

    Teff= 0.3(1-0.7) = 0.9 (9%)

    70% of imputation credits

    The statutory company income tax rate (T) = 30%

    Capital gain: the difference b/w the sale value of the asset and its purchase valueCapital loss: the sale value of the asset < its purchase value

    Concessional discount sets apart a proportion of the net assessable capital gain

    2.12 Calculation of capital-gains tax payable by an individual taxpayer

    Shares: $50000

    Shares purchased: $30000

    Capital gain: $20000Concessional discount: 50% => $10000 of the capital gain

    Marginal tax rate: 45% => $10000 x 0.45 = $4500

    The average tax rate on the capital gain ($20000): $4500/$20000 = 22.5%

    The return that shareholders may obtain from their share investment has two taxaspects:

    - Taxation of any dividend received- Taxation of any capital gain when the shares are sold Shareholders should know:- The amount of the dividend they received- The amount of the imputation credit associated with the dividend- The amount of the other net income- The marginal tax rate- Whether they had any capital losses available to offset any assessable capital gain.

    2.13 Calculation of after-tax rates of return

    TAX CALC. INCOMEFully franked dividendreceived

    $2000

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    Gross-up franked dividend $2857Capital gain received $20000Assessable capital gain $10000

    Incremental taxable income $12957Incremental individual taxlevied

    ($5786)

    Less: Imputation credit $857Individual tax(payable)/refund

    ($4929)

    After tax return $17071

    The grossed-up value fully franked dividend = dividend amount/(1-company tax rate)

    = $2000/(1-0.3) = $2857. Imputation credit = $857

    Assessable capital gain = $20000 x 50% = $10000

    Johns marginal tax rate: 45%The original investment in shares: $30000

    The after-tax rate of return = $17071/$30000 = 57% p.a.

    C11_ CAPITAL BUDGETING: CONCEPTS ANDMETHODSLesson 1: Capital-budgeting decisions are critical in defining a companys business.Lesson 2: Very large investments are frequently the result of many smaller investment

    decisions that define a business strategy.

    Lesson 3: Successful investment choices lead to the development of managerial

    expertise and capacities that influence the firms choice of future investments.

    The sources of profitable projects- Product differentiation insulates a product from competition, thereby allowing a

    company to charge a premium price. The source of differentiation can be due to

    advertising, patents, service or quality. The greater proportion of product differentiation

    creates more profits and cash flows, as well as owners value.- Cost advantage:

    Economics of scale arises from extending fixed costs over a larger volume of output, thusreducing the average fixed cost per unit.

    Economics of scope refers to widening the range of scope of services or products that anorganisation can market profitably to the same customer base.

    - Introduce existing product in a new market Types of capital investment projects- Revenue enhancing projects: expanding existing business or introducing new products- Cost-reduction projects: reducing the cost of doing business- Mandated investment projects: companies frequently make capital investment to meet

    safety and environmental regulations.

    The typical capital budgeting process- Phase 1: the firms management identifies promising investment opportunities.- Phase 2: once the investment opportunity has been identified, its value-generating

    potentially thoroughly evaluated.

    Principle for selecting capital-budgeting criteria

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    - Rely on cash flows rather than accounting profits to measure a projects costs andbenefits.

    - Be consistent with the goal of maximising shareholders wealth.- Allow for the time value of money.- Be able to account for the risks of projects.

    11.1 Operating cash flows in the presence of depreciation

    Asset cost: $1 million

    EXPECTED ACCOUNTING PROFIT EXPECTED CASH FLOWYear 1 to 4 Year 1 to 4Cash revenues $500000 Cash revenues $500000Less: Cash expenses $100000 Less: Cash expenses $100000

    Depreciation 250000Net profit 150000 Net cash flows 400000

    Interest expensesCost of funds is known as the cost of capital

    and it will be used as the discount rate

    when you discount future cash flows back to the present. The interest expense should

    not be subtracted from the cash flows when doing cash-flow projections; interest has

    been accounted for in the discount rate.

    Changes in net working capital Changes in capital spending

    11.2 Capital budgeting and wealth maximisation

    Organic kitchen will expand and diversify its operations.

    Various costs: $2 million

    Regain (recoup) net cash flows: $150000 in the first year

    Outlet sold: $2.45 million

    Rate of return: 20%

    Expected cash returns: $2.6 million ($0.5 million + 2.45 million)

    PV = $2600000/ (1+0.2) = $2167000

    Net present value = the present value of the future cash flows returned by the projectthe initial investment = $2167000 - $2000000 = $167000 (or present value surplus)

    Allowing for the time value of money Discounted-cash flow capital-budgeting criteria

    The three capital-budgeting techniques are net present value, profitability index andinternal rate of return.1. NET PRESENT VALUE

    Net present value = the present value of the future cash flows returned by theproject the initial investment

    P C 1 k

    IWhere ACF = expected annual cash flow in year t

    k= the appropriate discount rate or required rate of return

    IO= the initial outlay or the investment amount

    n the projects expected lifeP 0 ccept the projectNPV< 0 Reject the project

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    Advs:

    a) uses cash flows

    b) recognises the time value of

    moneyc is consistent with the firms goalof wealth maximisation

    Disadvs:

    Requires detailed long term forecasts of the

    incremental benefits and costs.

    11.3 Calculating net present value

    $40000 investment in new equipment, 12% required rate of return with expected cash

    flows are:

    CASH FLOWInitial outlay -$40000Year 1 $15000Year 2 $14000Year 3 $13000Year 4 $12000Year 5 $11000

    The net present value of the project can be calculated as:

    NPV =.

    .

    .

    .

    . 0000

    = 13393 + 11161 + 9253 +7626 + 6242 40000= 47675 40000= 7675

    Since net present value (NVP) of this project is greater than zero, the net present value

    criterion indicates that the project should be accepted.

    Otherwise, a financer uses financial table of each period.

    11.4 Calculating net present value

    Initial cost $30000

    The future cash inflows from this project are $15000 annually for three years

    The required rate of return is 10%

    Since the cash flow from year 1 to year 3 is identical, this particular stream of cash flow

    resembles an annuity.

    2. PROFITABILITY INDEX (PI)

    1

    Where ACF = expected annual cash flow in year t

    k= the appropriate discount rate or required rate of return

    IO= the initial outlay or the investment amount

    n the projects expected life

    PI 1 ccept

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    PI< 1 Reject

    Advs:

    a) Uses cash flows.b) Recognises the time value.c) Is consistent with the firms goal

    of wealth maximisation.

    Disadvs:

    Requires detailed, long-term

    forecasts of the incremental benefits

    and costs.

    11.5 Calculating the profitability index

    The present value of future cash flows is $47675

    PI = = 1.19

    The PI > 1, accepting the project

    NPV and PI is same function but NPV is superior in which it indicate the value increment

    as the result of under taking the project.

    3. INTERNAL RATE OF RETURN (IRR) 1

    Where ACFt = expected annual cash flow in year t

    IO = the initial outlay or the investment amount

    n the projects expected lifeIRR the projects internal rate of return

    IRR required rate of return; cceptIRR< required rate of return; Reject

    Advs:

    a) Uses cash flows.b) Recognises the time value.c) Is consistent with the firms goal

    of wealth maximisation.

    Disadvs:

    a) Requires detailed, long-term

    forecasts of the incremental benefits

    and costs.

    b) Can involve tedious calculations.

    c) Possibility of multiple IRRs.

    11.7 Computing IRR for even cash flows

    A required rate of return of 20% of proposals A and B. The cash flow of these projects is:

    PROJECT A PROJECT BInitial outlay $3817 $3817Year 1 0 1784Year 2 0 1784Year 3 6271 1784

    Management plans to calculate the internal rate of return for each project and determinewhich project should be accepted.

    Project s pay off is a single amount in three years time, so its IRR can be found by theuse of the PVIFi,n table.

    $3817 =$6271(PVIFi,3)

    PVIFi,3 = $3817/$6271 = 0.609

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    Looking at the n =3, the table value of 0.609 corresponds with to an interest rate, i equal

    to 18%. In other words, project A has an IRR of 18% and, since this is less than required

    the rate of 20%, the project should be rejected.

    Project Bs cash inflows represent an annuity of $178 per annum. The relationshipbetween this annuity and its present value of $3817 is given by:

    $3817 = $1784(PVIFAi,3)

    PVIFAi,3 = $3817/$1784 = 2.140

    Examining three period row, the table value of 2.140 corresponds to an interest rate, i,

    equal to 19%; this is project Bs IRR, which is less than the required rate of 20%, so thisproject should not be accepted.

    11.8 Computing IRR for uneven cash flows

    Using trial and error;

    Step 1: Pick an arbitrary rate, and use it to determine the present value of the outflows.Try i= 15%:

    Inflow year NET CASH FLOW PRESENT-VALUEFACTOR AT 15% PRESENT VALUE1 $1000 0.870 $8702 2000 0.756 15123 3000 0.658 1974Present value ofinflows 4356Initial outlay (3817)Step 2: Comparing the above present value of the inflows with the initial outlay; if they

    are not equal, pick another interest rate.

    Since the previous PV of inflows is greater than the initial outlay, we must try agreater interest rate so as to lower the PV. Try I =20%

    Inflow year NET CASH FLOW PRESENT-VALUEFACTOR AT 15% PRESENT VALUE1 $1000 0.833 $8332 2000 0.694 $13883 3000 0.579 $1737Present value ofinflows 3958Initial outlay (3817)Step 3: Again compare the present value with the outlay and repeat the step 2. Since the

    previous PV of inflows is still greater than the initial outlay, we must try an interest rate that is

    greater again. Try I =23%

    Inflow year NET CASH FLOW PRESENT-VALUEFACTOR AT 15% PRESENT VALUE1 $1000 0.813 $8132 2000 0.661 $13223 3000 0.537 $1611Present value of 3746

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    inflowsInitial outlay (3817)Step 4: Again compare the present value with the outlay and repeat step 2. This time the

    PV is less than the initial outlay, meaning that the IRR is less than 23%. If it is necessary to carryout further interactions, this should proceed. However, in our example we are now reasonably

    close and we know that the IRR lies between 20% and 23%. We can therefore use interpolation,

    to move towards a solution.

    By inspection of the interpolation table we can see that unknown IRR, i%, is equal to 20% plus

    the distance d1. d1 = d2 x d3/d4; that is, d1 =1.995%, or (3%) we try 22% in the above present-

    value computations, it yields the desired $3817 present value of inflows.

    Modified internal rate of return (MIRR)Three disadvantage of IRR:

    1) the IRRs assumption that a projects future cash inflows are reinvested at the IRR; 2) the prospect of multiple IRRs when future cash flows switch between positive and

    negative;

    3) thedifficulty of calculating a projects IRR without the aid of a financial calculator orspreadsheet software.

    1where n = project life in years

    MIRR required rate of return: AcceptMIRR < required rate of return: Reject

    Non-discounted-cash-flow capital-budgeting criteriaPAYBACK PERIOD: the number of year needed to recover the initial cash outlay.

    Accept if payback maximum acceptable payback periodReject if payback > maximum acceptable payback period

    Disadvs:

    - The payback period calculation ignores the time value of money. Cash flows at differentpoints in time are treated equally.

    - The payback period ignored cash flows that are generated by the project beyond the endof the payback period.

    d2=3%

    20%

    i%

    23%

    3958

    3817

    3746 d4=$212

    d1=? d3=$141

    I IRR PV

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    - There is no clear-cut way to define the cut-off criterion for the payback period that istied to the value-creation potential of the investment.

    DISCOUNTED PAYBACK PERIOD: the number of years needed to recover the initialcash outlay from the discounted cash flows.

    Comparing the discounted payback period with the desired payback period makes

    the accept-reject decision.

    Accounting rate of return (AROR)AROR compares the average profits with the average dollar size of the investment.

    2

    Where Apt = accounting profit in year t

    IO = the initial outlay

    SV = the expected salvage value of the project

    n = the expected life of the project

    AROR a minimum accepted AROR: AcceptAROR < a minimum accepted AROR: Reject

    Disadvs:

    a) Ignore time value of money.

    b) Uses accounting profits rather than cash flows.

    11.9 Calculating accounting rate of return

    Initial outlay $20000

    Expected salvage value: 0

    Profit annually/5 years: $800

    8005

    5200000

    2 80010000 0. 08 8%

    The disadvantage of AROR:

    - Its limitations of discriminating capital-budgeting criterion in which AROR techniquegives equal weight to all returns within the projects life without any regard for the timevalue of money.

    - It deals with accounting profit figures rather than cash flows; hence it does not reflectthe proper timing of the benefits.

    The role of taxation in capital budgeting

    C13_RISK IN CAPITAL BUDGETING Three measure of projects risk

    Projects stand alone risk: ignores diversification within the firm and within theshareholders portfolio.Project is combined with firms other projects and assets

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    Projects contribution to firm risk project form the companys perspective: ignoresdiversification within the shareholders portfolio, but allows for diversification withinthe firm (securities are combined to form diversified portfolios).

    Systematic riskProject from the shareholders perspective: allows for diversificationwithin the firm and within shareholders porfolio. Risk-adjusted discount rates

    1

    where ACFt= expected annual cash flow in year t

    k*= the risk-adjusted discount rate

    IO = the initial outlay or the investment amount

    n the projects expected life

    13.1 Risk-adjusted discount rateAn expected life: 5 years

    Normal required rate of return: 10%

    The minimally accepted rate of return: 15%

    Initial outlay = $110000

    The expected cash flow annually: $30000

    Required rate of return for projects with different levels of riskPROJECT REQUIRED RATE OF RETURN (%)Replacement decision 12Modification or expansion of existing productline

    15

    Project unrelated to current operations 18

    Research and development operations 25

    Certainty-equivalent approach

    The lower the risk, the higher the certain cash flow and thus the larger the value of

    alpha.

    (1 )

    Where ACFt = expected annual cash flow in year t= the certainty-equivalent coefficient in year tkrf =the risk-free rate of returnIO = the initial outlay or the investment amountn the projects expected life13.2 Certainty equivalentThe 100 BHP-Billiton shares worth $20 each, you accept $1700 for sure instead of thechance of receiving $2000. Your certainty equivalent ( $1700$2000= 0.85Certain cash flow t =

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    13.3 Certainty equivalents in capital budgeting10% required rate of returnExpected life of 5 yearsInitial outlay: $120000The expected cash inflows and certainty-equivalent coefficients are:

    Year, t EXPECTED CASH FLOW, CERTAINTY-EQUIVALENTCOEFFICIENT,

    1 $10000 0.952 20000 0.903 40000 0.854 80000 0.755 80000 0.65The risk-free rate of interest: 6%. What is the projects net present value?

    Solution:Using the certainty-equivalent approach, we must remove the risk from the future cashflows.

    EXPECTED CASH FLOW, CERTAINTY-EQUIVALENTCOEFFICIENT,

    10000 0.95 950020000 0.90 1800040000 0.85 3400080000 0.75 6000080000 0.65 52000Year, t EQUIVALENT

    RISKLESS CASHFLOW

    DISCOUNT FACTOEAT 6%

    PRESENT VALUE

    1 9500 0.943 8958.502 18000 0.890 16020.003 34000 0.840 28560.004 60000 0.792 47520.005 52000 0.747 38844.00Total present value ofinflows 139902.50Less: Initial outlay 120000.00Net present value 19902.50

    The project should be accepted, as its present value is greater than zero.

    Sensitivity analysis: the distribution of possible net present values or internal rate ofreturn for a particular project is affected by a change in one particular input variable.

    13.5 Sensitivity anlalysis

    Initial cost of equipment $1500000Expected life of equipment 5 yearsSalvage value of equipment $250000Working capital requirement $500000Depreciation method Straight line method

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    Annual depreciation expense $250000Variable cost per unit $20Fixed cost per year $400000

    Discount rate 12%Corporate tax rate 30%

    Scenario analysis: changing only one input variable at a time and analysing its effect onthe investment NPV.

    13.6

    Simulation analysis: generating thousands of estimates of NPV that are built uponthousands of values for each of the investments key variables.

    Probability tree

    Real options in capital budgeting- Timing opinion: the option of delay a project until estimated future cash flows are more

    favourable

    - Expansion option: the option to increase the scale or scope of an investment in responseto realised demand.

    - Contract, shut down and abandonment options: the options to slow down production,halt production temporarily, or stop production permanently (abandonment).

    13.7 The option to expand a project

    the initial outlay on this new restaurant: $2.4 million

    the present value of the free cash flows (excluding the initial outlay): $2 million

    a negative NPV: -$400000

    Probability of new restaurant received 50% with annual cash flows: $320000/year

    Probability of new restaurant received 50% with annual cash flows: $80000/year

    The discount rate of return: 10%

    If the new restaurant is favourably received, the PV of perpetual cash flows: $320000/0.1 =

    3200000

    NPV= 3200000 2400000 =$800000If the new restaurant is unfavourably received, the PV of perpetual cash flows: $80000/0.1

    =$800000

    NPV =800000 240000 = -$1600000If the restaurant is succeeding, you will build more restaurants.

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