Chapter 6. How to Analyze Investment Projects

1. Chapter 6. How to Analyze Investment Projects Objective Explain Capital Budgeting Develop Criteria for Project Evaluation

2. The Nature of Project Analysis Where Do Investment Ideas Come From? The NPV Rule Estimating a Project’s Cash Flow Cost of Capital Sensitivity Analysis Using Spreadsheets Analyzing Cost-Reduction Projects Projects with Different Lives Ranking Mutually Exclusive Projects Inflation and Capital Budgeting Chapter 6 Contents

3. Capital Budget and Capital Budgeting • Once a company has decided what business it intends to be in, it must considers • proposals for investment projects • evaluating them • deciding which ones to accept and which to reject • It must prepare a plan (capital budget) for acquiring • factories, machinery, warehouses • research laboratories • showrooms, and • for training the personnel.

4. The Nature of Project Analysis • Starting point: An idea for increasing shareholder wealth • Procedures of project analysis • Forecasting cash flows: Decisions and events • Flexibility of decisions in the project’s life

5. Where Do Investment Ideas Come from? • Customers • R&D department • Competition • Production division • Incentive systems

6. Objectives • To show how to use discounted cash flow analysis to make decisions such as: • Whether to enter a new line of business • Whether to invest in equipment to reduce costs

7. NPV Rule Revisited • Invest if the proposed project’s NPV is positive. • Discount rate • Opportunity cost: The rate of return on comparable investment opportunities. • Cost of capital • NPV: The fair market value in competitive and efficient market.

8. Do the Project • DCF Payback

9. Don’t do the Project

10. Internal Rate of Return • Indifferent

12. Measurement of Value Market？ Accounting？ • Two approaches of measuring value: • Accounting:Book value—Historical cost • Financial:Market value—Discounting

13. The Source of Money The Use of Money The Balance Sheet Asset = Liability + Equity

14. Continued…… Corporate Finance Assets Liabilities and Equity Asset 1 Asset 2 Liabilities Asset 3 · · Equity · Asset n Total Assets Liabilities & Equity Accounting: Yes! Finance: No!

15. Capital Market Real Economy Firm Value +NPV Corporate Finance AssetsLiabilities and Equity Asset 1 Asset 2 Liabilities Asset 3 · · Equity · Assetn Total Assets Liabilities & Equity NPV

16. Example: PC1000 of Compusell Corp.

18. 2.2 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3 -5 PC1000: Cash Flows • A seven-year coupon bond with an annual coupon payment of $1.3 million, a face value of $2.2 million, and a price of $5 million.

19. Was 0% Was 0% Was 0%

20. Was 15%

21. Was 40%

22. Was 0%

23. Was 75%

24. Was 3,100,000

25. Sales Units Net CF Operations NPV Project 2000 200000 5005022 3000 550000 1884708 3604* 1003009 0 4000 1300000 1235607 5000 2050000 4355922 6000 2800000 7476237 Table 6.4 Project Sensitivity to Sales Volume • 3640 is the NPV break-even point.

27. Sensitivity of Project to Sale Volume $3,000,000 $2,500,000 $2,000,000 $1,500,000 Net CF from Operations $1,000,000 $500,000 $0 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 $500,000 Sales (Units)

29. Cost of Capital • Risk-adjusted discount rate (k) • The risk of a particular project may be different from the risk of the firm’s existing assets. • The risk that is relevant in computing a project’s cost of capital is the risk of the project’s cash flows and not the risk of the financing instruments (e.g., stocks, bonds) the firm issues to finance the project. • The cost of capital should reflect only the market-related risk of the project (its beta).

30. Illustration 1 • 25-year U.S. Treasury bonds paying $100 per year are selling in the market at $1,000. • A firm has the opportunity to buy $1 million worth of these bonds for $950 each. • The firm’s overall (average) cost of capital is 16%. • If discounted at 16%, the NPV of the opportunity is -$340,291. • However, no one will forgo the opportunity. • The correct cost of capital is nearly 10%.

31. Illustration 2 • Compusell Corporation is planning to finance the $5 million outlay required to undertake the PC1000 project by issuing bonds. • Compusell has a high credit rating because it has almost no debt outstanding and therefore can issue $5 million worth of bonds at an interest rate of 6% per year. • It would be a mistake to use 6% as the cost of capital in computing the NPV of the PC1000 project.

32. Illustration 3 • An all-equity financed firm with tree divisions: • An electronics division, 30% of the firm’s market value, cost of capital 22%; • A chemical division, 40% of the firm’s market value, cost of capital 17%; • A natural gas transmission division, 30% of the firm’s market value, cost of capital 14%. • The cost of capital for the firm is 0.3×22% + 0.4×17% + 0.3×14% = 17.6% . • If 17.6% is adopted as discount rate for all projects, then it is likely • to accept projects in the electronics division with negative NPV; • to pass up profitable natural gas transmission.

33. Illustration 4 • An all-equity financed steel company considering the acquisition of an integrated oil company that is 60% crude oil reserves and 40% refining. • The market capitalization rate on crude oil investments is 18.6% and on refining projects is 17.6%. • The market capitalization rate on the oil company shares is 18.2%. • The market capitalization rate for steel projects is 15.3%. • The market price of the oil company’s shares is “fair” ($100, expected return 18.2%) . • An investment banker reports that all the shares could be acquired for a tender offer bid of $110 per share. • With 15.3%, the NPV of the acquisition is –110+18.2/.153=$9. • With 18.2%, the NPV of the acquisition is –110+18.2/.182=-$10.

34. Example: Cost Reducing Project • A firm is considering an investment proposal to automate its production process to save on labor costs. • Invest $2 million now in equipment (an expected life of 5 years) and thereby save $700,000 per year in pretax labor costs. • The incremental cash flows due to the investment: • At the 10% discount rate, the NPV is $274,472.

35. Project with Different Lives • Suppose that there are two different types of equipment with different economic lives in the previous example. • The longer-lived requires twice the initial outlay but lasts twice as long. • An easier approach is called annualized capital cost. The Shorter-lived equipment The Long-lived equipment

36. Ranking Mutually Exclusive Projects • Sometimes two or more projects are mutually exclusive. • You own a parcel of land and have two alternatives: • Construct an office building; • Make a parking lot.

37. Ranking Mutually Exclusive Projects • Rule: This firm should choose the project with the highest NPV at any cost of capital below 20%.

38. Inflation and Capital Budgeting • Rule: There are two correct ways of computing NPV: • Use the nominal cost of capital to discount nominal cash flows. • Use the real cost of capital to discount real cash flows. • Never compare the IRR computed using real cash flow estimates to a nominal cost of capital.