Capital Budgeting Question problems, examples, economic, 2011, 2010

ruchita

Hi folks,

I'm really getting caught up in one of the (ongoing) examples. I'm using the 2010 L2 book, but I figure things are going to be pretty identical in the 2011 book.

This has to do with Capital Budgeting, and specifically economic income. I'm having problems with one of the examples they have provided - it is "Table 30: Condensed Financial Statements for Granite Corporation." I am having a lot of trouble trying to figure out how the CFAI came up with their "Financing Cash Flows."

In the table, Financing cash flows are as follows:
Debt repayment : -11,525
Dividends/repurchases: -27,987

I cannot figure out how they came up with the debt repayment figure. I understand the total loan liability in the example is 109,747 (all of this is for year 1). Under "interest expense", I can correctly come up with the $9,146 value. However, I can't get the $11,525 repayment. If I amortize the loan, I get the correct interest expense but the principal amortization portion is $18,583. I'm using an interest rate of 8.333333 %.

Have I made this example clear? What am I missing?

Its frustrating as I'm running into the same issue when it comes to the problems (Questions 33-38). They provide the balance sheet and income statements, even providing the cash flows. But it bugs me that I cannot come up with these debt repayment numbers under "financing cash flows" for the life of me

luda002

cgeorgan,

A bit tricky, but: the text notes that the company is borrowing 50% of the beginning market value of the company (project , but in this case Granite is purely the five year project). The beginning market value is the present value of future cash flows (ignores the initial capital outlay).

Since the beginning MV is 219,492, the company borrows 109,746.

Now the tricky part:
a) the text also says the company will *maintain* the 50% ratio.
b) the company is winding down in five years so is distributing all cash flows to bond and equity holders

The beginning MV at the start of year two is the same as the ending MV for year one = 196,441.

212,492 - 196,441 = 23,051. In other words, the value of the company (project) declined 23,051. To maintain the 50% debt/value ratio, the company needs to pay back half that amount to bond holders. Half of 23,051 = 11,525.

Since total operating cash flow from year one was 39,513, and we paid 11,525 to bond holders, (39,513 - 11,525) = 27,988 is paid as dividends to equity holders. (Figures have been rounded, so might not add up exactly).

Hope this helps,

BES

-------------------------------------------------------------------
If you think hiring a professional is expensive...
wait until you've hired an amateur.

smuggycfa

blue-eyed-samurai,

Thanks for this well-reasoned response. I can only pray I'm not asked to reproduce that math on the test...ugh.

c