# Should you consider land bought in past while calculating FCFE

Hello friends,

I came across this query while reading FCFE & FCFF. I was curious on how a land that is bought in the past and used for the current project to be treated while calculating FCFE and FCFF.

For instance, a company has a land on its balance sheet bought in 2008 and now the company is considering using that very same land for the future project. So the cash flows dervied from the project shall cover the value of the land?

Any help will be appreciated

as far as i know past purchases that are costs regardless of the current project are deemed “sunk” costs and should not be included.

anyone else?

You have to include it at current market value to reflect the true economic cost of the project

Not to scare anyone, but read this entire post: http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91269215

Thank you very much for the link.

I read the post on it. One of them mentions that after calculating the FCFF and FCFE one has to add back the present value of non operating asset to derive the value of the company. I get that. However my question is if that asset is used in operations, how do we account that.

The land that I mentioned was bought 3 years back and would be used for the project, so while calculating FCFF or FCFE, how should I treat the land, should I treat it as an outflow in year 0 but I think that would not be fair as the outflow has happened three years prior.

Can you please post the question?

Suppose you have been hired as a financial consultant to DUDE, Inc. The company is looking at setting up a manufacturing plant overseas to produce a new line of low priced products. This will be a five-year project. The company bought some land three years ago for \$5 million. The land was appraised last week for \$7.15 million. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost \$10.6 million to build.

Market:

8.5 percent expected market risk premium; 5.0 percent risk-free rate.

Debt:

15,000 8 percent coupon bonds outstanding, 15 years to maturity, selling for 90 percent of par; the bonds have a \$1,000 par value each and make semiannual payments.

Common stock:

315,000 shares outstanding, selling for \$60 per share; the beta is 1.3.

The plant has 8 year life. Annual fixed cost is \$290,000 and it produces 8,000 units per year and sell them at \$8000 with VC of \$6000 per unit.

What is the FCFF & FCFE of the company?

After tax cost of debt is 6.01% and cost of equity is 16.05%. My question is how should I treat the value of land? Should I ignore it? Should I use its present value? What will be the value of this project?

What if instead of a factory you were just placing a hot dog stand with after taxes profits of thousand dollars per year. Hotdog stand is using a piece of land(bought 3 years ago) with current MV of 7.5M and you forecast it to be at 7.8M in 3 years. Rf=5%

Hotdog stand without accounting for land - positive npv

Hotdog stand accounting for cost of land - negative

It seems like the problem’s not complete or you haven’t posted all the information (growth rate, tax rate, working capital, initial WC outlay, etc.). Here’s what I have:

======================

WACC Calculations:

Market value of debt = 15,000 * 1,000 = 15,000,000

Market value of equity = 315,000 * 60 = 18,900,000

Weight of debt = 15 / (15 + 18.9) = 0.44; weight of equity = 0.56

WACC = 11.61%

======================

Yield on the Bonds:

FV = 1,000; PMT = 40; PV = -900; N = 30. CPT I/Y = 4.62. Implies annual yield = 9.25%.

======================

Bond Amortization Assuming Straight Line Depreciation:

Par 15,000,000 selling @ 90% =13,500,000. Which means you amortize the remaining 1,500,000 over 15 years using SL. Amortization = 100,000/year.

======================

Interest Expense:

(600,000 x 2) coupon payment + 100,000 amortization = 1,300,000

======================

Net Income Breakdown (in millions):

Sales = 64

VC = (48)

FC = (0.29)

Depreciation = (10.6/8) = (1.325)

EBIT = 14.385

Int. Exp. = (1.3)

EBT = 13.085

Taxes (assuming 35%) = 4.58

NI = 8.51

======================

Yearly FCFF (in millions) = 8.51 + 1.3*(0.65) + 0.1 (bond amortization) + 1.325 - 0.29 (assuming fixed costs are like CapEx) = 10.39.

======================

CF0 = (10.6); CF1-CF8 = 10.39; NPV @ 11.61% = 41.72.

======================

Since land is being used, and is not held for investment, your NPV stays at 41.72. If land was held for investment, its FV would be added to the NPV.

I would not include the land for FCF in this example. In the basic view of FCFF = CFO - CAPEX, land bought for future use is not considered an operating asset and there is no CAPEX (in the current time period) or depreciation associated with it like there would be for plant and equipment. It would have no effect on the the calculations for FCF.

As stated in the text if you are valuing the firm, you would add back any of the nonoperating assets and land at the estimated current value would be captured there. Reference page 237. I would not personally read into it any further and make it more complicated.

This is what I think based on my reading. What is the answer to your posted question? How did you derive your 6% after-tax cost of debt with the given information? I see no tax-rate given.

If you go by the FCFF = EBITDA(1-Tax Rate) + Depr(Tax Rate) - FCInc - WCInv or some variation, I see no way to derive the tax rate unless I miss it.

Edit: I crossed with Aether’s post who went into much more detail.

Edit: After reading JACT’s post, I realized that the original question says land is held for use, NOT for investment. So you don’t add the FV of land back to the NPV. So the NPV = 42.3, NOT 49.45. Edited my original post to reflect this.

Aether, how did you get the coupon payment of 600,000? I got 15,000 bonds x 1,000 FV x 8% = 1,200,000

I would have missed adding back the bond amortization piece but am a little confused on your treatment of it. You include it in Int Exp, and back it out of EBIT, but when you add it back to FCFF you still have the .7 (coupon + amortization), and then add it alone without the tax rate? or did you just fumble that when you wrote it?

Also, why didn’t you back out the WCInv piece of \$48mil here?

Yearly FCFF (in millions) = 8.9 + 0.7*(0.65) + 0.1 (bond amortization) + 1.325 - 0.29 (assuming fixed costs are like CapEx) = 10.5.

I would have thought, based on the above and the way I think you are treating the amortization that:

FCFF = NI + Int Exp(1-tax rate) + ncc - FCInv - WCInv

FCFF = 8.5 + 1.2*(0.65) + 0.1 + 1.325 - 0.29 - 48 = -37.585

or is this not it? Not trying to be nitpicky, but I’m not sure if you did what you did for a reason because I don’t have full confidence either.

Also, I didn’t mean to imply in previous post that Land for future use is treated differently from Land for Investments. If I were valuing the firm, I would include it becuase it is an asset of the firm but it just is being left out of the operating calculations.

Don’t worry about nitpicking… made the post without verifying so I expected errors. Feel free to chime in. Looks like an interesting problem. Would be nice to look at the final solution to see if we were close :).

Anyway, I messed up the coupon payments. I was looking at the “semiannual payments” bit, and forgot to double down the payment calculation. As you stated, it should be \$1.2M, NOT \$600K.

I think you were too quick to jump on my post. Right after I posted, I did realize that the (Coupon Payment + Amortization) = Interest Expense, and this must be added back after taxes. I am pretty sure I made the change while you were verifying my old post.

You’re confusing WCInv for FCInv. You can’t randomly categorize your VC and FC as WC. Remember, WC is investment in operating assets, so FC and VC have nothing to do with WCInv. I subtracted FC from the original calculation because you can deem it a part of CapEx/FCInv. I’m not sure if VC is part of CapEx… would be nice for someone to confirm this. Also, in my original post, I did mention that the OP hasn’t supplied us with a WCInv number, so that portion doesn’t even appear in the calculation.

Regarding land, CFAI text clearly states that land held for investment must be added back. If land’s held for use, I wouldn’t add it.

I have updated my original calculations to reflect the coupon payments of \$1.2M. Feel free to nitpick further.

On a related note, note that this is a discount bond. Hence, we’re adding the amortization to the FCFF calculation. If this were a premium bond, we’d be subtracting the amortization from the FCFF formula.

Hey friends,

Sorry for being a dumbledore and not posting the entire problem, I just wanted to know the treatment for land bought in past and held for use for a future project.

As aether puts it ‘CFAI text clearly states that land held for investment must be added back. If land’s held for use, I wouldn’t add it’

So I think the land treatment shall be to this effect

Land bought in 2008 for a project to initiate in 2013 - 5 mn

Held for use: Ignore the value of land

Whle calculating cash flow: Land will be excluded from CAPEX and year 0 will only have plant and equipment as an outflow.

I am posting below the entire problem

Suppose you have been hired as a financial consultant to DUDE, Inc. The company is looking at setting up a manufacturing plant overseas to produce a new line of low priced products. This will be a five-year project. The company bought some land three years ago for \$5 million. The land was appraised last week for \$7.15 million. In five years, the after tax value of the land will be \$7.35 million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost \$10.6 million to build. The following market data on DUDE’s securities are current:

Debt:

15,000 8 percent coupon bonds outstanding, 15 years to maturity, selling for 90 percent of par; the bonds have a \$1,000 par value each and make semiannual payments.

Common stock:

315,000 shares outstanding, selling for \$60 per share; the beta is 1.3.

Preferred stock:

15,000 shares of 6 percent preferred stock outstanding, selling for \$48 per share.

Market:

8.5 percent expected market risk premium; 5.0 percent risk-free rate.

DUDE’s tax rate is 35 percent. The project requires \$550,000 in initial net working capital investment to get operational. Assume your company raises for new projects externally using current capital structure and paid 5% floatation cost to the consulting firm.

1. What is the market value of the company? What is the amount raised to run the project? What is the WACC?

2. What is the project’s initial cash flow considering all side effects?

3. The new product is riskier and needs +3% adjustments. What should be the appropriate discount rate to evaluate this project?

4. The plant has 8 year life. Under straight line depreciation, show how much is the after tax salvage value if the plant can be scrapped at the end of the life for \$3.5 million.

5. What is the annual operating cash flow if annual fixed cost is \$290,000 and it produces 8,000 units per year and sell them at \$8000 with VC of \$6000.

6. What are the Accounting break even Q? Cash Break even Q.

7. What is the NPV and IRR of the project?

Question 6 is baloney, so didn’t address it. genuinecfa - can you please post the answers? Thanks.

Aether, I just have the question, dont have the answer to it.

The NPV as per my calculation comes to 36.9 mn and IRR is 81%. I have done the solution in an excel. If you post your e-mail add. I can send it to you.