Long-Term Investment Analysis Chapter 18

1. Long-Term Investment AnalysisChapter 18 Budgeting is a form of planning Operational Budgeting -- revenues & expenses Capital Budgeting -- assets that generate returns more than a year even more significant, since projects will impact the firm for many years to come Problem of Limits: Every manager wants more equipment, more supplies, more buildings, more employees The issue is to accept good projects, and forego others 2002 South-Western Publishing

2. What Went Right/What Went Wrong With Nokia? • In Finland, Nokia made wireless telephones • The cell phone market took off in the 1990s • Nokia surpassed Motorola in worldwide market share • Then in 2001, Nokia’s share price tumbled as the packet-switching technology (3G) using the Internet, disrupted Nokia’s dominance • The future of Internet 3G cell phones may be great, but is uncertain. How much should Nokia invest?

3. Projects to reduce costs Projects to expand output New products or new markets Projects to meet governmental regulations Most capital projects require good information sales and cost projections advertising financing, etc. Categories of Capital Projects

4. Objective is to maximize the value, V, of the firm Objective Function of Top Management If IRR = 20% & MCC =10% then do it to increase V ROR MCC objective function is: Max V = {(Rt - Ct) / (1 + r ) t } IRR the decision rule is: Invest until IRR = MCC internal rate or return = marginal cost of capital Optimal Investment

5. The Capital Budgeting Process • Estimate initial costs • Bids, “request for proposals” (RFPs), Estimates, Guesses • Estimates net cash flows (NCFs) for the future depends of life of asset • often spreadsheets, Excel or Lotus, are helpful • NCF = ( R - C - D)·( 1 - t ) + D [18.5] • after tax cash flows, plus the depreciation tax shield, because • NCFt = (Rt -Et)( 1 - t ) + t • Dt

6. Include: only incremental cash flows all changes in working capital salvage value tax effects positive and negative externalities on other products Don’t Include: sunk costs overhead financial flows, such as interest or dividends Rule for Inflation: If using nominal cash flows, discount with a nominal discount rate If real NCF, real discount rates Include All Relevant NCFs

7. Evaluation of Capital Projects Four Criteria: 1. Consider all relevant NCFs 2. Discount at Firm’s Opportunity Cost of Capital 3. If mutually exclusive projects, pick the best one 4. If independent projects, pick the ones that maximize firm value

8. Selecting the Best Project • Payback Method • amount of time it take for NCFt = C0 • if mutually exclusive, pick shortest time • if independent, only arbitrary cut-off time periods • Internal Rate of Return, IRR • if mutually exclusive, pick the highest IRR • if independent, pick all projects with IRR > MCC • Net Present Value, NPV =  NCFt/( 1 + r) t • if mutual exclusive, pick highest NPV • if independent, pick all projects with positive NPVs

9. Can have multiple IRRs For mutually exclusive projects, IRR can say one thing and NPV the other Can have a tiny project with a Huge IRR If there is a restriction on the amount to invest List projects by descending profitability ratios (PR) Select top PR and next, until amount used up If PR < 1, don’t do it, it has a negative NPV Conflicts Between IRR & NPV Capital Rationing Therefore, NPV is always useful. Most financial economists advocate NPVs PR =  NCFt/( 1 + r) t C0

10. Opportunity Cost of Capital • Cost of Debt: ki = kd ( 1 - t ) after-tax interest • If kd = 9%, and t = .40 tax rate, ki = 5.4% • Cost of Equity: ke = rf + risk premium • If bought own shares ke = D0/P + g div. yield + growth rate • If using the CAPM ke = rf + ( km - rf ) • Weighted Average Cost of Capital (WACC) • ka = wi•ki + we•ke • there may be some optimal debt-equity structure

11. Optimal Debt-Equity Structure Argument ke ka Cost of Debt Financing is higher than equity financing, and rises with percentage debt Cost of Equity Financing rises with percentage debt ki optimal % Debt

12. One period ROR: r = A1/C0 - 1 Ex: $1,000 investment = C0, receive A1 =$1,200 20%, orr = 1200/1000 -1 Multiperiod ROR: IRR Find r, such that:  { At / (1 + r ) t = C0 where At are the net cash flows Problem: Find IRR if the NCF’s are as follows: Rates of Return: Various Methods Net Cash Flows There are several methods

13. Trial and Error Try 10%, 20% as the answer lies between, narrow to 17% Financial Calculator Enter the CF’s: -1000; 1000; 200 Push the IRR key Analytical: Solve the equation explicitly Find r, such that: 1000/(1+r) + 200/(1+r)2 = 1000 or, 1000(1+r)+200 = 1000(1+r)2 0 = -200 +1000 r + 1000 r 2 0 = 5•r 2 + 5•r -1 Quadratic Rule: r = [-5 ± SQRT{52 -4(5)(-1)}]/2(5) r = [-5 ± SQRT{45}]/10 r = -.50 ± .67 or +.17 or 17% IRR Methods

14. Texas Instruments BAII Plus Press CF CFo = -1000 ENTER Press CF1 = 1000 ENTER Press F01 = 1 Press CF2 = 200 ENTER Press IRR CPT 17.082

15. Constraints on cost-benefit analysis include • Physical constraints. Limited by technology. • Legal constraints. Laws on property rights. • Administrative constraints. Hire qualified administrators. • Distributional constraints. Must not harm. • Political constraints. What is possible vs best. • Financial or budget constraints. • Social and religious constraints. Cultural and religious considerations.

16. Cost Effectiveness Analysis • In cost-effectiveness analysiswe ask what are the costs of alternative means for reaching goal? • We know we must fight crime, but what is the cheapest way to do it? • Constant-cost studies specify the output for a given cost from alternative programs. • Least-cost studies alternative programs to achieve a given goal are examined in terms of cost. • Objective-level studies estimate the cost of achieving several performance levels of the same objective.