Other Investment Criteria and Free Cash Flows in Finance

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Other Investment Criteria and Free Cash Flows in
Finance

• Capital Budgeting Decisions

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Todays agenda

• Midterm exam
• Net Present Value (revisit)
• Other two investment rules
• Free cash flows calculation
• A specific example

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Mid-term exam

• The midterm exam score and the solution were
  posted on my website last Friday
  http//online.sfsu.edu/li123456
• Most students have done very well in the first
  midterm exam. If you dont do very well, dont
  worry about it and you can try your best to do
  much better in the second midterm and the final.
• Remember the weight of 0.2 for the midterm with a
  lower score.

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Net Present Value rule (NPV)

• NPV is the present value of a project minus its
  cost
• If NPV is greater than zero, the firm should go
  ahead to invest otherwise forget about this
  project
• A hidden assumption there is no budget
  constraint or money constraint.

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NPV (continue)

• In other words
• Managers can increase shareholders wealth by
  accepting all projects that are worth more than
  they cost.
• Therefore, they should accept all projects with
  a positive net present value if there is no
  budget constraint.

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Net Present Value

• NPV PV - required investment

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Net Present Value

• Example
• You have the opportunity to purchase an office
  building. You have a tenant lined up that will
  generate 16,000 per year in cash flows for
  three years. At the end of three years you
  anticipate selling the building for 450,000.
  How much would you be willing to pay for the
  building?

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Net Present Value
466,000

• Example - continued

450,000
16,000
16,000
16,000
0 1 2
3
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Net Present Value
466,000
450,000

• Example - continued

16,000
16,000
16,000
0 1 2
3
Present Value 14,953 14,953
380,395 409,323
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Net Present Value

• Example - continued
• If the building is being offered for sale at a
  price of 350,000, would you buy the building and
  what is the added value generated by your
  purchase and management of the building?

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Net Present Value

• Example - continued
• If the building is being offered for sale at a
  price of 350,000, would you buy the building and
  what is the added value generated by your
  purchase and management of the building?

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Another example about NPV

• An oil well, if explored, can now produce 100,000
  barrels per year. The well will produce forever,
  but production will decline by 4 per year. Oil
  prices, however, will increase by 2 per year.
  The discount rate is 8. Suppose that the price
  of oil now is 14 for barrel.
• If the cost of oil exploration is 12.8 million,
  do you want to take this project?

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Solution

• Visualize the cash flow patterns
• C01.4, C11.37, C21.34, C31.31
• What is the pattern of the cash flow?
• gC1/C0 -1 -0.0208-2.1
• PV( the project) C0C1/(r-g)15
• NPVPV( the project ) -12.8gt0
• Whats your decision?

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Two other investment rules

• IRR rule
• Payback period rule

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IRR rule

• Internal Rate of Return (IRR) Single discount
  rate at which NPV 0.
• IRR rule - Invest in any project offering a IRR
  that is higher than the opportunity cost of
  capital or the discount rate.

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IRR rule

• Example
• You can purchase a building for 350,000. The
  investment will generate 16,000 in cash flows
  (i.e. rent) during the first three years. At the
  end of three years you will sell the building for
  450,000. What is the IRR on this investment?

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Internal Rate of Return

• Example
• You can purchase a building for 350,000. The
  investment will generate 16,000 in cash flows
  (i.e. rent) during the first three years. At the
  end of three years you will sell the building for
  450,000. What is the IRR on this investment?

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Internal Rate of Return

• Example
• You can purchase a building for 350,000. The
  investment will generate 16,000 in cash flows
  (i.e. rent) during the first three years. At the
  end of three years you will sell the building for
  450,000. What is the IRR on this investment?

IRR 12.96
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Internal Rate of Return
IRR12.96
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Whats wrong with IRR?

• Pitfall 1 - Mutually Exclusive Projects
• IRR sometimes ignores the magnitude of the
  project.
• The following two projects illustrate that
  problem.
• Example
• You have two proposals to choose between. The
  initial proposal (H) has a cash flow that is
  different from the revised proposal (I). Using
  IRR, which do you prefer?

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Internal Rate of Return (1)

• Example
• You have two proposals to choose between. The
  initial proposal (H) has a cash flow that is
  different from the revised proposal (I). Using
  IRR, which do you prefer?

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Internal Rate of Return
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Whats wrong with IRR (2)?

• Pitfall 2 - Lending or Borrowing?

Example
project
C0
C1
IRR ()
NPV at 10
150
50
36.4
-100
J
K
-150
50
-36.4
100
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Whats wrong with IRR (3)?

• Pitfall 3 - Multiple Rates of Return
• Certain cash flows can generate NPV0 at two
  different discount rates.
• The following cash flow generates NPV0 at both
  (-50) and 15.2.
• Example
• A project costs 1000 and produces a cash flow
  of 800 in year 1, a cash flow of 150 every
  year from year 2 to year 5, and a cash flow of
  -150 in year 6.

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Payback period rule

• Payback period is the number of periods such that
  cash flows recover the initial investment of the
  project.
• The payback rule specifies that a project be
  accepted if its payback period is less than the
  specified cutoff period. The following example
  will demonstrate the absurdity of this rule.

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Payback period rule

• The following example shows that all the three
  projects have a payback period of 2. If the
  payback period used by the firm is 2, the firm
  can take project C and lose money.
• Cash Flows
• Prj. C0 C1 C2 C3 Payback
  NPV_at_10
• A -2000 1000 1000 10000 2 7,429
• B -2000 1000 1000 0 2 -264
• C -2000 0 2000 0 2 - 347

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Some points to remember in calculating free cash
flows

• Depreciation and accounting profit
• Incremental cash flows
• Change in working capital requirements
• Sunk costs
• Opportunity costs
• Forget about financing

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Cash flows, accounting profit and depreciation

• Discount actual cash flows
• Using accounting income, rather than cash flows,
  could lead to wrong investment decisions
• Dont treat depreciation as real cash flows

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Example

• A project costs 2,000 and is expected to last 2
  years, producing cash income of 1,500 and 500
  respectively. The cost of the project can be
  depreciated at 1,000 per year. Given a 10
  required return, compare the NPV using cash flow
  to the NPV using accounting income.

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Solution (using accounting profit)
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Solution (using cash flows)
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Forget about financing

• When valuing a project, ignore how the project is
  financed.
• You can assume that the firm is financed by
  issuing only stocks or the firm has no debt but
  just equity

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Incremental cash flows

• Incremental cash flows are the increased cash
  flows due to investment
• Do not get confused about the average cost or
  total cost?
• Do you have examples about incremental costs?

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Working capital

• Working capital is the difference between a
  firms short-term assets and liabilities.
• The principal short-term assets are cash,
  accounts receivable, and inventories of raw
  materials and finished goods.
• The principal short-term liabilities are accounts
  payable.
• The change in working capital represents real
  cash flows and must be considered in the cash
  flow calculation

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Example

• We know that inventory is working capital.
  Suppose that inventory at year 1 is 10 m, and
  inventory at year 2 is 15. What is the change in
  working capital? Why does this change represent
  real cash flows?

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Sunk costs

• The sunk cost is past cost and has nothing to do
  with your investment decision
• Is your education cost so far at SFSU is sunk
  cost?

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Opportunity cost

• The cost of a resource may be relevant to the
  investment decision even when no cash changes
  hands.
• Give me an example about the opportunity cost of
  studying at SFSU?

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Inflation rule

• Be consistent in how you handle inflation!!
• Use nominal interest rates to discount nominal
  cash flows.
• Use real interest rates to discount real cash
  flows.
• You will get the same results, whether you use
  nominal or real figures

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Example

• You own a lease that will cost you 8,000 next
  year, increasing at 3 a year (the forecasted
  inflation rate) for 3 additional years (4 years
  total). If discount rates are 10 what is the
  present value cost of the lease?

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Inflation

• Example - nominal figures

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Inflation

• Example - real figures

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How to calculate free cash flows?

• Free cash flows cash flows from operations
  cash flows from the change in working capital
  cash flows from capital investment and disposal
• We can have three methods to calculate cash flows
  from operations, but they are the exactly same,
  although they have different forms.

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How to calculate cash flows from operations?

• Method 1
• Cash flows from operations revenue cost (cash
  expenses) tax payment
• Method 2
• Cash flows from operations accounting profit
  depreciation
• Method 3
• Cash flows from operations (revenue
  cost)(1-tax rate) depreciation tax rate

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Example

• revenue 1,000
• Cost 600
• Depreciation 200
• Profit before tax 200
• Tax at 35 70
• Net income 130

Given information above, please use three methods
to calculate Cash flows
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Solution

• Method 1
• Cash flows1000-600-70330
• Method 2
• Cash flows 130200330
• Method 3
• Cash flows (1000-600)(1-0.35)2000.35
• 330

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A summary example ( Blooper)

• Now we can apply what we have learned about how
  to calculate cash flows to the Blooper example,
  whose information is given in the following slide.

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Blooper Industries
(,000s)
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Cash flows from operations for the first year
or 3,950,000
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Blooper Industries

• Net Cash Flow (entire project) (,000s)

NPV _at_ 12 3,564,000