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Managerial Finance Finance 6335 Lecture 5 Chapter 6

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Managerial Finance Finance 6335 Lecture 5 Chapter 6 & 7 Alternative Decision Rules Fundamentals of Capital Budgeting Ronald F. Singer 6.1 NPV and Stand-Alone Projects ... – PowerPoint PPT presentation

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Title: Managerial Finance Finance 6335 Lecture 5 Chapter 6


1
Managerial Finance Finance 6335Lecture
5Chapter 6 7Alternative Decision
RulesFundamentals of Capital Budgeting Ronald
F. Singer
2
6.1 NPV and Stand-Alone Projects
  • Consider a take-it-or-leave-it investment
    decision involving a single, stand-alone project
    for Fredrick Feed and Farm (FFF).
  • The project costs 250 million and is expected to
    generate cash flows of 35 million per year,
    starting at the end of the first year and lasting
    forever.

3
NPV Rule
  • The NPV of the project is calculated as
  • The NPV depends on the discount rate, r
  • The Internal Rate of Return (IRR) is that
    discount rate that makes the NPV 0

4
Alternative Rules Versus the NPV Rule
  • Sometimes alternative investment rules may give
    the same answer as the NPV rule, but at other
    times they may disagree.
  • When the rules conflict, the NPV decision rule
    should be followed.

5
6.2 Alternative Decision Rules
  • The Payback Rule
  • The payback period is amount of time it takes to
    recover or pay back the initial investment. If
    the payback period is less than a pre-specified
    length of time, you accept the project.
    Otherwise, you reject the project.
  • The payback rule is used by many companies
    because of its simplicity.
  • However, the payback rule does not always give a
    reliable decision since it ignores the time value
    of money.

6
NPV Rule
  • The NPV of the project is calculated as
  • Therefore the Internal Rate of Return (IRR) is
    14

7
Figure 6.1 NPV of FFFs New Project
  • If FFFs cost of capital is 10, the NPV is 100
    million and they should undertake the investment.

8
Measuring Sensitivity with IRR
  • For FFF, if their cost of capital estimate is
    more than 14, the NPV will be negative, as
    illustrated on the previous slide.
  • In general, the difference between the cost of
    capital and the IRR is the maximum amount of
    estimation error in the cost of capital estimate
    that can exist without altering the original
    decision.

9
When does IRR work?
  • You can take all or no project (stand alone
    project)
  • Normal Project Negative Cash flows first,
    followed by positive cash flows
  • In other cases, the IRR rule may disagree with
    the NPV Rule. If that is the case always go with
    the NPV Rule

10
See excel File IRR, NPV versus Payback
11
Practical Problems in Capital Budgeting
  • We have stated that we want the firm to take all
    projects that generate positive NPV and reject
    all projects that have a negative NPV. Capital
    budgeting complications arise when you cannot,
    either physically or financial undertake all
    positive NPV projects. Then we have to devise
    methods of choosing between alternative positive
    NPV projects.

12
Mutually Exclusive Projects
  • IF,AMONG A NUMBER OF PROJECTS, THE FIRM CAN ONLY
    CHOOSE ONE, THEN THE PROJECTS ARE SAID TO BE
    MUTUALLY EXCLUSIVE.
  • For example Suppose you have the choice of
    modifying an existing machine, or replacing it
    with a brand new one. You could not do both and
    produce the desired amount of output. Thus,
    these projects are mutually exclusive. Given the
    cash flows below, which of these projects do you
    choose?

13
Mutually Exclusive Projects
  • Time Modify Replace
    Difference
  • 0 -100,000 -250,000
    -150,000
  • 1 105,000 130,000
    25,000
  • 2 49,000
    253,500 204,500
  • IRR .40 .30
    .25
  • Suppose the cost of capital is 10

14
Mutually Exclusive Projects
  • Time Modify Replace
    Difference
  • 0 -100,000 -250,000
    -150,000
  • 1 105,000 130,000
    25,000
  • 2 49,000
    253,500 204,500
  • IRR .40 .30
    .25
  • NPV(_at_ 10) 36,000 77,700
    41,700
  • Notice the conflict that can exist between NPV
    and IRR.

15
CAPITAL BUDGETING COMPLICATIONS
  • Capital Budgeting Complications occur when you
    cannot take all positive NPV PROJECTS. Thus, the
    firm is faced with the choice of two
    possibilities.
  • Remember Goal is still Max NPV of all
    possibilities

16
Differences in Scale
  • If a projects size is doubled, its NPV will
    double. This is not the case with IRR. Thus, the
    IRR rule cannot be used to compare projects of
    different scales.

17
Differences in Scale (cont'd)
  • Identical Scale
  • Consider two projects

Girlfriends Business Laundromat
Initial Investment 1,000 1,000
Cash FlowYear 1 1,100 400
Annual Growth Rate -10 -20
Cost of Capital 12 12
18
Differences in Scale (cont'd)
  • Identical Scale
  • Girlfriends Business

19
Differences in Scale (cont'd)
  • Identical Scale
  • Laundromat
  • IRR 20
  • Both the NPV rule and the IRR rule indicate the
    girlfriends business is the better alternative.

20
Figure 6.5 NPV of Investment Opportunities
  • The NPV of the girlfriends business is always
    larger than the NPV of the single machine
    laundromat. The IRR of the girlfriends business
    is 100, while the IRR for the laundromat is 20.

21
Differences in Scale (cont'd)
  • Changes in Scale
  • What if the laundromat project was 20 times
    larger?
  • The NPV would be 20 times larger, but the IRR
    remains the same at 20.
  • Give an discount rate of 12, the NPV rule
    indicates you should choose the 20-machine
    laundromat (NPV 5,000) over the girlfriends
    business (NPV 4,000).

22
Figure 6.6 NPV of Investment Opportunities with
the 20-Machine Laundromat
  • The NPV of the 20-machine laundromat is larger
    than the NPV of the girlfriends business only
    for discount rates less than 13.9.

23
Differences in Scale (cont'd)
  • Percentage Return Versus Impact on Value
  • The girlfriends business has an IRR of 100,
    while the 20-machine laundromat has an IRR of
    20, so why not choose the girlfriends business?
  • Because the 20-machine laundromat makes more
    money
  • It has a higher NPV.

24
Differences in Scale (cont'd)
  • Percentage Return Versus Impact on Value
  • Would you prefer a 200 return on 1 dollar or a
    10 return on 1 million?
  • The former investment makes only 2, while the
    latter opportunity makes 100,000.
  • The IRR is a measure of the average return, but
    NPV is a measure of the total dollar impact on
    value, and thus stockholders wealth.

25
Timing of Cash Flows
  • Another problem with the IRR is that it can be
    affected by changing the timing of the cash
    flows, even when that change in timing does not
    affect the NPV.
  • It is possible to alter the ranking of projects
    IRRs without changing their ranking in terms of
    NPV.
  • Hence you cannot use the IRR to choose between
    mutually exclusive investments.

26
Timing of Cash Flows (cont'd)
  • Assume you are offered a maintenance contract on
    the laundromat machines which would cost 250 per
    year per machine. With this contract, you would
    not have to pay for maintenance and so the cash
    flows from the machines would not decline.
  • The expected cash flows would then be
  • 400 250 150 per year per machine

27
Timing of Cash Flows (cont'd)
  • The time line would now be
  • The NPV of the project remains 5,000 but the IRR
    falls to 15.

28
Figure 6.7 NPV With and Without the Maintenance
Contract
29
Timing of Cash Flows (cont'd)
  • The NPV without the maintenance contract exceeds
    the NPV with the contract for discount rates that
    are greater than 12.
  • The IRR without the maintenance contract (20)
    is larger than the IRR with the maintenance
    contract (15).
  • The correct decision is to agree to the contract
    if the cost of capital is less than 12 and to
    decline the contract if the cost of capital
    exceeds 12. With a 12 cost of capital, you are
    indifferent.

30
Capital Rationing
  • In this situation, the decision maker is faced
    with a limited capital budget (or limitations on
    some other input). As a result, it may not be
    possible to take all positive net present value
    projects. Under this scenario, the problem is to
    find that combination of projects (within the
    capital budgeting constraint) that leads to the
    highest Net Present Value.
  • The problem here is that the number of
    possibilities become very large with a relatively
    small number of projects. Thus, in order to make
    the problem "manageable", we can systematize the
    search.

31
Capital Rationing
  • Since we have a constraint, what we want to do is
    invest in those projects which gives us the
    highest BENEFIT per dollar invested. (The
    highest bang per buck). What is the benefit?, it
    is the Present Value of the Cash Flows. So that
    we would want to choose that set of projects
    within the capital budgeting constraint that
    gives the highest
  • Net Present Value
  • INVESTMENT
  • This ratio is called the profitability Index.

32
Capital Rationing
  • For example, suppose we have a 13 million
    capital budgeting constraint, with 7 alternative
    capital budgeting projects with the following
    projections.
  • Project NPV Investment
  • A 10 15
  • B 8 10
  • C 4 2.5
  • D 6 5
  • E 5 2.5
  • F 7 5
  • G 4.5 3

33
Capital Rationing
  • Rank by Profitability Index (NPV/INV
  • Project Profitability Index
    Investment Total
  • E 2.0
    2.5 2.5
  • C 1.6 2.5 5.0
  • G 1.5 3
    8.0
  • F 1.4
    5 13.0 D
    1.2 5
  • B .8 10
  • A .667 15
  • COMBINATION WITH HIGHEST PROFITABILITY INDEX
    WITHIN THE CAPITAL BUDGET
  • (E,C,G,F) has a NPV of 20.5 million, and a cost
    of 13 million.

34
See Spreadsheet
35
Capital Rationing
  • However, if the budget were 15 million rather
    than 13 million we would have a problem. Adding
    D would go over the budget and be infeasible, but
    the combination CDEF has a higher NPV (22
    million) than the chosen combination of ECGF.
    This is because the amount spent was only 13
    million leaving 2 million in unspent funds. In
    this case, we are better off choosing a
    combination which spends all the funds.
  • THE ONLY WAY TO DO THIS RIGHT IS TO DO A FULL
    BLOWN LINEAR PROGRAMING PROBLEM WITH CONSTRAINTS.

36
Capital Budgeting
  • We are now ready to consider the capital
    budgeting decision.
  • As we said repeatedly, the idea is to invest in
    such a way that you maximize the Net Present
    Value of your decision.
  • What we mean by the NPV is the Present Value of
    the Cash Flow from Operations generated by the
    project less the initial Cash Investment

37
Cougar Enterprises
  • Pro-Forma Income Statement
  • (Year ending December 31, 2006)
  • ( thousand)
  • Sales 5,000
  • Less Operating Expenses (COGS)
    2,000
  • Depreciation Amortization
    500
  • Allocated G A Costs
    300
  • Operating Income (EBIT)
    2,200
  • Less Interest Expense
    770
  • Earnings Before Tax(taxable income)
    1,430
  • Less Tax (_at_ 40)
    572
  • Net Income (Earnings after Tax)
    858
  • Earnings per Share (EPS) Net Income/Shares
    0.858

38
Cougar Enterprises
  • Pro-Forma Cash Flow Statement
  • (Year ending December 31, 2006)
  • ( thousand)
  • Earnings Before Interest and Taxes 2,200
  • Less Tax on Operations (_at_ 40) (Note
    not 572)
    880
  • Operating Income after Tax (EBIT(1-t) )
    1,320
  • Plus Non-Cash Expenses (Depreciation
    Amortization)
    500
  • Less Change in Working Capital

    300
  • (Change a/c receivable 200
  • Change in Inventory
    100
  • Change other ST Assets 100
  • Less Change in a/c payable 150
  • Change in ST Liabil.
    (50)
  • Change in Working Capital
  • Free Cash Flow from Operations 1,520
  • Plus Interest Tax Shield
    (707 times 0.40)
    308
  • CASH FLOW

    1828
  • Less Net New Investment (net of capital
    gains tax)
    400
  • Less Cash Flow to Bondholders (Interest,
    principal, Bond Repurchase, Call) 770

39
Capital Budgeting Decisions Check List
  • 1. Net Present Value is the "Discounted value
    of incremental cash flow
  • 2. Cash flow is
  • CASH MONEY IN - CASH MONEY OUT

40
Capital Budgeting Decisions Check List
  • 3. Consider only if it is an incremental cash
    flow, and consider all incremental cash flows
  • (a) not historical, or averages
  • (b) consider only cash flows that appear as a
    result of the project
  • (c) consider the impact of the project on cash
    flows from other projects
  • (d) exclude fixed or sunk costs
  • (e) exclude allocated overhead unless it will
    change as a result of the project.

41
Capital Budgeting Decisions Check List
  • 4. Treat inflation consistently
  • Make sure that you have considered the impact of
    inflation on Cash Flows
  • 5. All Cash Flow should be on an After-Tax
    basis.
  • Use actual tax changes when paid!
  • Don't forget to allow for the tax on capital
    gains Use future marginal tax rates applied to
    future taxable income

42
Capital Budgeting Decisions Check List
  • 6. Include the opportunity cost of the project,
    even if there is no explicit cash flow realized
  • Account for assets sold and not sold as a result
    of adoption of a project.
  • 7. Account for changes in working capital and
    only changes in working capital. Recognize that
    working capital will in general be re-cooped at
    the end of the project.
  • 8. Ignore financing including the tax shield on
    interest

43
Capital Budgeting Decisions Check List
  • 9. Include Asset's Entire Life
  • 10. Include the depreciation tax shield, but not
    depreciation itself.

44
Capital Budgeting Decisions Check List
  • No matter how complicated the decision What is
    important?
  • MAXIMIZE NPV
  • PLAN TO TAKE ALL PROJECTS WITH A POSITIVE NET
    PRESENT VALUE AND REJECT ALL PROJECTS WITH A
    NEGATIVE NET PRESENT VALUE

45
Application of the NPV Rule and Capital Budgeting
  • For now we are going to assume that the
    appropriate discount rate is known.
  • The problem we want to tackle is to forecast the
    relevant cash flows.

46
Only Cash Flows Affect Wealth.
  • What is and is not Cash Flow
  • -Expenses are cash flow regardless of whether
    the accountant capitalizes and depreciates them
    or expenses them.
  • -Capital expenditures are cash outflows
    regardless of the fact that accountants
    depreciate them over a period.

47
Only Incremental cash flows are relevant
  • Not historical cash flows, not averages, not sunk
    costs!
  • Example 1 Consider a firm having made an
    investment one year in the past. The project
    required an initial investment of 10,000- with
    the expectation of 14,000 to be generated within
    two years. At a discount rate of 10 should the
    firm have made the investment?

48
Only Incremental cash flows are relevant

  • 14,000
  • -1---------------0-----------------1
  • 10,000
  • Of course it should have. The NPV was NPV
    1,564

49
Only Incremental cash flows are relevant
  • NOW THINGS CHANGE. A NEW DEVICE INTRODUCED BY A
    COMPETITOR MAKES THE PRODUCT OBSOLETE. THUS
    EXPECTED CASH FLOWS DECLINE TO 7,000. THAT IS
    THE INVESTMENT, DID NOT PAY OFF AS EXPECTED AND
    THE PROJECT IS NOW A LOSER.
  • SUPPOSE THAT FOR AN ADDITIONAL INVESTMENT OF
    5,000, YOU CAN REGAIN YOUR COMPETITIVE POSITION,
    SO THAT EXPECTED CASH FLOW INCREASES TO THE
    ORIGINAL 14,000. SHOULD YOU MAKE THE NEW
    INVESTMENT?

50
Only Incremental cash flows are relevant

  • 14,000
  • -1---------------0-----------------1
  • -10,000
    -5,000
  • Note that the project, looked at as a whole is
    still a loser
  • NPV(-1) -10,000 -
    5,000 14,000

  • (1.1) (1.1)2
  • - 2,975
  • BUT the additional investment should be
    made.
  • Determine the incremental cash flows.
  • Determine Net Present Value of the incremental
    cash flows
  • Incremental Cash Flow -5,000 7,000/(1.1)
    1,363.65

51
Only Incremental cash flows are relevant
  • Example 2 Assume that the original cash flow
    estimates were accurate. But, that you can, by
    making an additional investment of 1,000 generate
    total second period cash flow of 15,050. Should
    the additional investment be made?
  • (Still Assume r 10)

52
Only Incremental cash flows are relevant

  • 14,000
  • -1---------------------0-----------------
    ------1 initial
  • -10,000 -5,000

  • 1,050
  • -1---------------------0-----------------
    ------1 Incremental
  • -1,000
  • NPV (of Additional Investment) -1000
    1050 - 45.45

  • 1.1
  • Even though, the original project is a winner, do
    not make the additional investment
  • Y0u must Ignore Sunk Costs, and consider only
    incremental cash flows.

53
Treat inflation consistently
  • MAKE SURE THAT INFLATION IS ACCOUNTED FOR IN A
    CONSISTENT MANNER. EITHER
  • Revenues and Expenses are not necessarily
    effected uniformly by inflation
  • Depreciation expense is not effected by inflation

54
Tying up assets uses a valuable resource and must
be accounted for.
  • Example A firm is considering installing a
    brick manufacturing kiln. The initial investment
    will require 300,000 in building and equipment.
    The kiln will be located on a vacant lot having
    an estimated market value of 1,000,000. The
    project is expected to generate net cash flow of
    50,000 per year for 20 years. After 20 years,
    the kiln will be worthless. It is anticipated
    that the lot could be sold for 2,653,000 at the
    end of 20 years. At a 10 discount rate, is this
    a good investment? (Ignore taxes)

55
Tying up assets uses a valuable resource and must
be accounted for.
  • ALTERNATIVE ONE
  • Ignoring the opportunity cost of the (tied-up)
    land.
  • NET PRESENT VALUE CALCULATION
  • NPV-300,000 PMT(50,000, 10, 20)
  • -300,000 425,693.05 125,693.05
  • ACCEPT PROJECT
  • The problem with this is that you ignore the fact
    that you lose the use of 1,000,000 that you
    could have had if you had not adopted the project
    and sold the land (or used it in an alternative
    project).

56
Tying up assets uses a valuable resource and must
be accounted for.
  • ALTERNATIVE TWO
  • Explicitly consider the land as part of the
    inputs You estimate that the land will be worth
    2,653,000 in 20 years.
  • PRESENT VALUE CALCULATION
  • NPV -1,000,000 -300,000 PMT(50,000, 10,
    20)
  • PV(2,653,000, 10,20)
  • - 1,300,000 425,678 394,352
  • - 479,970
  • REJECT PROJECT
  • NOTICE HOW THE TIED UP LAND IS TREATED!

57
Rule 4 Tying up assets uses a valuable resource
and must be accounted for.
  • Other Incremental Costs Are
  • Increases in overhead costs as a result of
    project.
  • Increases in working capital as a result of
    project.
  • Notice the reduction in working capital would be
    a cash inflow at that time.
  • Do not use allocated overhead, or allocated
    working capital.

58
Changes in Working Capital Should be accounted for
  • Example
  • Suppose, due to the adoption of the project,
    the firm is required to increase working capital
    from 100,000 to 110,000 per annum for the life
    of the project. How do you account for the
    working capital?
  • So you see that this is simply a timing problem

59
Remember taxes
  • 1. Calculate all cash flows after taxes
  • 2. Include non-cash expenses (depreciation) for
    its effect on taxes, but not as a cash flow
    itself.
  • HOW TO HANDLE THE DEPRECIATION TAX SHIELD
  • We want the project's AFTER TAX CASH FLOW
  • Equals Before Tax Cash Flow Less Corporate
    Taxes
  • Taxes tc Cash revenue - Cash Expenses -
    Depreciation
  • Therefore, for each year
  • After Tax Cash Flow (Cash Revue - Cash
    Expenses)(1 - tc) tc Depr
  • Where tc x Depr is the Depreciation Tax Shield)

60
Remember taxes on Capital Gains
  • 3. Tax on gains/losses from sale of assets is an
    additional negative/positive
    cash flow
  • Tax on
  • Gains/Losses tc x (Market Value - Book
    Value)
  • On sale
  • If Market Value gt Book Value, then tax on gain is
    cash outflow.
  • If Market Value lt Book Value, then we have a loss
    on sale, tax is negative, and there is a cash
    inflow.

61
Remember taxes on Capital Gains
  • Example
  • XYZ Corp. has a project which is going to last 5
    years. P E for this project of 1,000,000 can
    assume a scrap value of 300,000 at the end of 5
    years. On a straight line basis, that means the
    firm depreciates the assets _at_ 140,000 per year,
    leaving 300,000 when the project ends.

62
Remember taxes and the effect of selling assets
  • However, you expect that you can sell the asset
    for 500,000 at the end of 5 years. Thus there
    is a taxable capital gain of (MV-BV) 200,000.
  • At a 35 Corporate Capital Gain Tax rate, that
    means that after tax cash flow from the disposal
    of PE is
  • 0.35 200,000 70,000
  • Thus the Cash flow from selling the asset is
  • 500,000 -70,000 430,000
  • (Remember to add back Book Value)

63
Ignore the means of financing both as a direct
cash flow and as its effect on taxes.
  • Interest payment is not a cash flow. Discounting
    already takes the value of time into account. To
    deduct interest would be double counting.
  • Example Suppose that you borrow 500, and put
    in 500 of your money into the following project.
    (Bank charges 8 on loan)

  • 0 1
  • Cash Flow -1000 1125
  • Interest
    -40
  • Net -1000
    1085
  • To say that we reject the project since NPV (of
    net cash flow) is negative at 10 (NPV -13) is
    double counting. We penalize the project twice,
    one by deducting interest, second by discounting.
  • The NPV of this project is- 1,000 (1,125) X
    (0.909) 23

64
STEPS IN PROJECT ANALYSIS
  • 1. MAKE INITIAL PROJECTIONS
  • Made by operations manager
  • Generally in form of income statement
  • Clarify assumptions
  • 2. ADJUST FOR INFLATION IF APPROPRIATE
  • 3. REARRANGE IN CASH FLOW FORM
  • 4. PERFORM NET PRESENT VALUE CALCULATIONS
  • 5. PERFORM "WHAT IF" CALCULATIONS
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