Capital Budgeting Techniques

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LECTURE 5 (CHAPTERS 11,13)Project Valuation

• Capital Budgeting Techniques
• NPV vs. IRR, Payback, etc.
• Real Options
• Investment timing option,
• Growth option, etc.

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Capital Budgeting

• Analysis of potential additions to fixed
  assets, which are long-term decisions and
  typically require large capital expenses.

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Steps in undertaking an investment project 1.
Identification investment opportunities
(independent vs. mutually exclusive normal
vs. non-normal CFs). 2. Evaluation Estimate
CFs (inflows outflows), Assess
riskiness of the projects CFs,
Determine k. 3. Selection Find NPV and/or
IRR. Accept if NPV ? 0 (or IRR ? k). 4.
Implement and audit.
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Mutually Exclusive vs Independent Projects
Factory in Fullerton vs. Factory in Italy to
produce new products. Cannot accept both projects
? mutually exclusive
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Normal vs. Non-normal Projects

• Normal Project An investment or cost at t0,
  (negative CF) followed by a series of positive
  cash inflows.
• Non-Normal Project One or more outflows
  (investments) occur after inflows have begun.
  Most common Cost (negative CF), then string of
  positive CFs, then cost to terminate project.
  Nuclear power plant, strip mine.

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CF Patterns for Normal Non-Normal Projects
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Payback Discounted Payback

• Suppose you have I0 100, and CFs of 25 each for
  the next 5 years.
• The payback period is 4 years (100/25).
• If the discount rate is 7, then the discounted
  CFs 23.36, 21.84, 20.41, 19.07 and 17.82. The
  discounted payback period is 4.86 years. Sum of
  the 1st 4 years 84.68 (100 - 84.68 15.32),
  then 15.32/17.82 .86 years add 4 .86 years.
• Among other weaknesses, payback rules ignore CFs
  after the payback period. We will not use these
  rules, though they provide a rule of thumb.

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Net Present Value (NPV)

• Note the similarity between this formula and the
  basic finance formula. We assume that CF0 is a
  negative amount, and is the Investment. We
  calculate the present value (PV) of the future
  CFs, and obtain the simple formula NPV PV-I.

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What is Project Ls NPV?
Project S (CFs) -100, 70,50,20
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Calculator Solution
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NPV Rule

• NPV PV - I
• Net gain in wealth to firm.
• Accept project if NPV ? 0.
• Choose between mutually exclusive projects on
  basis of higher NPV. This method adds most value
  for shareholders.

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How do you choose projects with NPV?

• If Projects S and L are mutually exclusive,
  accept S because NPVS gt NPVL.
• If S L are independent, accept both, assuming
  that both NPVs ? 0.
• Note that NPVs change as cost of capital changes
  but IRR remains the same.

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Internal Rate of Return (IRR)
0
1
2
3
CF0
CF1
CF2
CF3
Invest- ment
Inflows

• IRR is the discount rate that forces the PV of
  the inflows the investment. This is the same
• as forcing NPV 0.

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Calculating Project Ls IRR
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Decision Rule for IRR

• If IRR ? k, accept project.
• If IRR lt k, reject project.
• As for NPV, if projects are independent, accept
  both (with IRR ? k0) and if mutually exclusive,
  accept the higher IRR.
• Rationale for IRR Rule
• If IRR gt k, then the projects rate of return is
  greater than the cost to finance the project -
  the return increases stock-holders wealth.
• For example if k 10, and IRR 13, the the
  project returns more than investors require.

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Reinvestment Rate Assumptions

• NPV assumes that CFs from the project are
  reinvested at k, the opportunity cost of capital.
• IRR assumes that the CFs are reinvested at the
  IRR.
• Reinvesting CFs from the project at the
  opportunity cost, k, is more realistic, so the
  NPV method is best. NPV should be used to choose
  between mutually exclusive projects.
• Nonetheless, managers prefer IRR, because it is
  expressed as a rate of return. We also have a
  modified IRR (MIRR), which you can study and use
  on the job. Another rule is the profitability
  index (PI).
• MIRR also avoids other problems with IRR - next.

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Intellect Project NPV and IRR
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Non-normal Project CFs 2 IRRs
2 IRRs result, because the Intellect project has
nonnormal CFs with two sign changes. Here is the
NPV Profile
k
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NPV and IRR using Excel

• The text demonstrates how to calculate NPV and
  IRR both by calculators and by Excel.
• We will review the basic Excel steps next.
• Assume that we have the following cash-flows I
  0 -1,000, CF1 200, CF2 400, CF3 500, CF4
  400. Use two ks 10 and 20.

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NPV IRR using Excel
The row and column headings are given above.
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Underlying Excel Formulas

• The NPV result (for both solutions) is in cell
  C4. The formula in that cell is
  NPV(A2,D2G2)C2
• We use C2, because our investment is at t0.
  In other words, Excel automatically assumes that
  the CFs occur beginning at t1.
• The IRR formula in cell F4 is IRR(C2G2,5)
• We add in the 5 as a guess for the IRR.

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Summary of Capital Budgeting Rules

• Good projects (NPV ? 0) result from a firms
  competitive advantage within its industry. If
  you cannot identify the value in a project, then
  it may not actually be valuable!
• Good firms use all 6 rules payback, discounted
  payback, NPV, IRR, MIRR and PI. Each provides
  some valuable information.
• Caution these 6 quantitative rules are guides
  only. They cannot take the place of managerial
  judgment. Unforeseen events (wars) cannot easily
  be calculated, and real options exist.

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Real Option

• Real options exist when managers can influence
  the size and risk of a projects cash flows by
  taking different actions during the projects
  life in response to changing market conditions.
• Alert managers always look for real options in
  projects.
• Smarter managers try to create real options.

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Financial Option

• An option is a contract which gives its holder
  the right, but not the obligation, to buy (or
  sell) an asset at some predetermined price within
  a specified period of time.

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Real Options vs. Financial Options

• Financial options have an underlying asset that
  is traded usually a security like a stock.
• A real option has an underlying real asset that
  is not a security for example a project or a
  growth opportunity and it isnt traded.
• The payoffs for financial options are specified
  in the contract.
• Real options are found or created inside of
  projects. Their payoffs can be varied.

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Types of Real Options

• Investment timing options waiting to invest
  first example below.
• Growth options
• Expansion of existing product line second
  example below.
• New products
• New geographic markets
• Abandonment options reduce or suspend
  operations.
• Flexibility options see note.

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Investment Timing Option Waiting to Invest

• Initial cost 70 million, Cost of Capital
  10, risk-free rate 6, cash flows occur for 3
  years. Annual
• Demand Probability Cash Flow
• High 30 45
• Average 40 30
• Low 30 15

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Procedure 1 DCF Analysis

• High CF0 -70, C0145,F013, I10, NPV 41.91
  M
• Avg. CF0 -70, C0130,F013, I10, NPV
  4.61 M
• Low CF0 -70, C0115,F013, I10, NPV -
  32.70 M
• Expected NPV.3(41.91).4(4.61).3(-32.70)
• 4.61 milliongt0

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• If we immediately proceed with the project, its
  expected NPV is 4.61 million.
• However, the project is very risky
• If demand is high, NPV 41.91 million.
• If demand is low, NPV -32.70 million.

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• If we wait one year, we will gain additional
  information regarding demand.
• If demand is low, we wont implement project.
• If we wait, the up-front cost and cash flows will
  stay the same, except they will be shifted ahead
  by a year.

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Procedure 2 Qualitative Assessment

• The value of any real option increases if
• the underlying project is very risky
• there is a long time before you must exercise
  the option
• This project is risky and has one year before we
  must decide, so the option to wait is probably
  valuable.

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Procedure 3 Decision Tree Analysis (Implement
only if demand is not low.)
Discount the cost of the project at the risk-free
rate, since the cost is known. Discount the
operating cash flows at the cost of capital.
Example 35.70 -70/1.06 45/1.12 45/1.13
45/1.14.
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Use these scenarios, with their given
probabilities, to find the projects expected NPV
if we wait.
E(NPV) 0.3(35.70)0.4(1.79)
0.3 (0) E(NPV) 11.42.
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Decision Tree with Option to Wait vs. Original
DCF Analysis

• Decision tree NPV is higher (11.42 million vs.
  4.61).
• In other words, the option to wait is worth 6.81
  million. If we implement project today, we gain
  4.61 million but lose the option worth 6.81
  million.
• Therefore, we should wait and decide next year
  whether to implement project, based on demand.

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The Option to Wait Changes Risk

• The cash flows are less risky under the option to
  wait, since we can avoid the low cash flows.
  Also, the cost to implement may not be risk-free.
• Given the change in risk, perhaps we should use
  different rates to discount the cash flows.
• But finance theory doesnt tell us how to
  estimate the right discount rates, so we normally
  do sensitivity analysis using a range of
  different rates.
• We do not consider the financial option price
  model/procedure (either binomial or
  Black/Scholes) nor do we examine financial
  engineering techniques.

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Other Factors to Consider When Deciding When to
Invest

• Delaying the project means that cash flows come
  later rather than sooner.
• It might make sense to proceed today if there are
  important advantages to being the first
  competitor to enter a market.
• Waiting may allow you to take advantage of
  changing conditions.

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Growth Option
A New Situation Cost is 75 Million, No Option
to wait.
NPV Example 36.91 -75 45/1.1 45/1.12
45/1.13.
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Expected NPV of New Situation

• E(NPV) 0.3(36.91)0.4(-0.39)
• 0.3 (-37.70)
• E(NPV) -0.39.
• The project now looks like a loser.

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Growth Option You can replicate the original
project after it ends in 3 years.

• NPV NPV Original NPV Replication
• -0.39 -0.39/(10.10)3
• -0.39 -0.30 -0.69.
• Still a loser, but you would implement
  Replication only if demand is high.

Note the NPV would be even lower if we
separately discounted the 75 million cost of
Replication at the risk-free rate.
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Decision Tree Analysis
Notes The 2004 CF includes the cost of the
project if it is optimal to replicate. The cost
is discounted at the risk-free rate, other cash
flows are discounted at the cost of capital.
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Expected NPV of Decision Tree

• E(NPV) 0.3(58.02)0.4(-0.39)
• 0.3 (-37.70)
• E(NPV) 5.94.
• The growth option has turned a losing project
  into a winner assuming that we have used good
  estimates.
• Our decisions are only as good as our best
  judgment (estimate).