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Investment Decision Making August 4-5, 2014

Investment Decision Making August 4-5, 2014. Learning Objective. Determine the economic value of a proposed capital investment. Capital Investment Decision Making.

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Investment Decision Making August 4-5, 2014

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  1. Investment Decision MakingAugust 4-5, 2014

  2. Learning Objective Determine the economic valueof a proposed capital investment.

  3. Capital Investment Decision Making • A capital investment is the commitment of current resources in the expectation of future benefits, e.g., purchase of a capital asset. The objective of a capital investment is to create economic value for the owner. • Economic value is defined as the value in today’s dollarsof the future benefits from that investment less the cost of acquiring it. Economic value is uniquely determined by what will happen in the future, not what has happened in the past. • To calculate the value of an investment in today’s dollars, you must estimate three things: • the amount and timing of the required investment outlay; • the amount and timing of projected future benefits (cash flows) from the project; and • the opportunity cost of the funds required to finance the project, i.e., the return you would expect to earn on alternative investments with similar risk. We refer to this as the cost of capital. 3

  4. Order of Battle • Using Discounted Cash Flow (DCF) Analysis to Estimate Economic Value • Investment Decision Rules: • net present value (NPV) • internal rate of return (IRR) • project payback • The Complexities of Estimating • future cash flows • the cost of capital • Determining Terminal Value • The Capital Structure Decision • The Debt Maturity Decision 4

  5. Time Value of Money • Money has time value. A dollar today is worth more than a dollar to be received in the future. Discounted cash flow analysis (DCF) is the technique used to quantify—in today’s dollars—the value of a future dollar or stream of future dollars. • Nomenclature: CFT= cash flow at the beginning or end of time period T. CFTcan be either positive or negative. K= the rate of discount applied to future cash flows. This is the opportunity cost of capital, referred to as the cost of capital. PV0= the present value of a stream of future cash flows, i.e., what it’s worth today. FVT= the future value of a stream of projected cash flows, i.e., what it’s worth at some future time T. 5

  6. Time Value of Money CF6 CF5 CF2 CF4 PV0 FVT CF1 CF3 CF0 • PV0 =What the stream of projected cash flows is worth today (time zero). • FVT= What the stream of projected cash flows is worth at some future time T. 6

  7. Formulas for Present and Future Value The present valueof a series of projected future cash flows is: PV0= CF1 + CF2 + CF3 + CF4 + …. + CFN (1+k) (1+k)2 (1+k)3 (1+k)4 (1+k)N The future valueof a series of current and projected future cash flows is: CF0(1+k)N + CF1(1+k)N-1 + CF2(1+k)N-2 + CF3(1+k)N-3 + … + CFN =FVN Where: PV0 = present value at time zero CFN = cash flow at time period N FVN = future value at time N k = cost of capital (discount rate) 7

  8. Formulas for Present and Future Value Present Value with K = 10% PV0= CF1 + CF2 + CF3 + CF4 (1+k) (1+k)2 (1+k)3 (1+k)4 $68.30 75.13 82.64 90.91 $316.98 $100 $100 $100 $100 Time 0 1 2 3 4 Future Value with K = 10% CF0(1+k)4 + CF1(1+k)3 + CF2(1+k)2 + CF3(1+k)1 = FV4 $100 $100 $100 $100 $110.00 121.00 133.10 146.41 $510.51 8

  9. Order of Battle • Using Discounted Cash Flow (DCF) Analysis to Estimate Economic Value • Investment Decision Rules: • net present value (NPV) • internal rate of return (IRR) • project payback • The Complexities of Estimating • future cash flows • the cost of capital • Determining Terminal Value • The Capital Structure Decision • The Debt Maturity Decision 9

  10. Decision Tools Net Present Value • Decision Rule: Accept a project with a positive Net Present Value (NPV); reject a project with a negative NPV. NPV measures the economic value contributed by the project. A positive NPV adds economic value, a negative NPV destroys it. • When choosing between alternative projects, select the one with the highest NPV. NPV = -CF0 + CF1 + CF2 + CF3 + CF4 + …. + CFN (1+k) (1+k)2 (1+k)3 (1+k)4 (1+k)N NPV is the present value of a projected stream of future cash flows, net of the cost of acquiring them (i.e., net cash flows), discounted at the cost of capital (k). NPV is thus the value today of an investment project adjusted for the timing of it’s net cash flows. 10

  11. Decision Tools Internal Rate of Return NPV = 0= -CF0 + CF1 + CF2 + CF3 + CF4 + …. + CFN (1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)N IRR is that discount rate r which forces an investment project’s NPV to equal zero. It measures the investment’s expected rate of return. • Decision Rule:Accept a project with an Internal Rate of Return (IRR) greater than the cost of capital; reject a project with an IRR less than the cost of capital. If the expected rate of return is greater than the cost of capital, the project adds economic value; if the IRR is lower, it destroys value. • When choosing between alternative projects, select the one with the highest IRR. • Use the IRR decision criteria when you don’t have a clear idea of the cost of capital. Evaluate the project on the basis of whether the IRR exceeds any reasonable estimate of the cost of capital. 11

  12. Decision Tools Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in annual cash flows for two years. What’s the IRR on this investment? NPV = 0 = -4000 + $2000 + $4000 (1+r)1 (1+r)2 IRR = r = 28.08% IRR=28.08% 12

  13. NPV vs. IRR Net Present Value NPV = -C0 + CF1 + CF2 + CF3 + …. + CFN (1+k) (1+k)2 (1+k)3 (1+k)N NPV = net present value at time zero C0 = cost of the project CF = future net cash flows from the project k = the organization's cost of capital Internal Rate of Return 0 = -C0 + CF1 + CF2 + CF3 + …. + CFN (1+r) (1+r)2 (1+r)3 (1+r)N C0 = cost of the project CF = future net cash flows from the project IRR = r 13

  14. It assumes you can reinvest cash flows at the IRR.The process of discounting explicitly assumes that internally generated cash flows are reinvested (e.g., in some other project) at the rate used in the denominator throughout the life of the investment. If you use the NPV technique, the cash flows are presumed to be reinvested at the organization's cost of capital k. Using the IRR technique assumes they are reinvested at the internal rate of return r. Problems with IRR $ 100 $ 100 $1100 $1300 Cash Flows Not Reinvested at 10% $1000 = $1300 (1+.0914)3 You earn a lower effective interest rate because the cash flows weren't reinvested over the life of the project at the discount rate of 10%. -$1000 $100 $100 0 1 2 3 $ 121 $ 110 $1100 $1331 Cash Flows Reinvested at 10% $1000 = $1331 (1+.10)3 -$1000 $100 $100 0 1 2 3 14

  15. IRR does not take into account the magnitude of the value created by the project, whereas NPV does so explicitly. The following two projects illustrate the problem: Problems with IRR Project C0 C1 IRR NPV@ 10% 1. ($10,000) $20,000 100% $8,182 2. ($20,000) $35,000 75% $11,818 • More than one change of sign in cash flow pattern can generate NPV=0 at two different discount rates, i.e., result in two different IRRs. The following cash flow generates IRRs of both -50% and 15.2%. • C0 C1 C2 C3 C5 C6 • ($1,000) $800 $150 $150 $150 ($150) 15

  16. Decision Tools Payback Period • The payback period of a project is the number of months/years it takes before the cumulative forecasted cash flow equals the initial outlay. Payback is used as a proxy for project risk. • The payback rule says only accept projects that recover the initial investment in the desired time frame. All other things being equal, choose the project with the shortest payback. 16

  17. Calculating Payback 2 4 0 1 3 The drawbacks to using payback are that it ignores: • cash flows occurring after the payback period, and • the time value of money ($240) $100 $105 $256 $110 Cumulative CFs: ($240) ($140) ($ 35) $ 75 $331 Payback = 2 + 35= 2.32 years 110 17

  18. Payback Examine the three projects and note the mistake we’d make if we insisted on only taking projects with a payback period of less than 2 years. 18

  19. Order of Battle • Using Discounted Cash Flow (DCF) Analysis to Estimate Economic Value • Investment Decision Rules: • net present value (NPV) • internal rate of return (IRR) • project payback • The Complexities of Estimating • future cash flows • the cost of capital • Determining Terminal Value • The Capital Structure Decision • The Debt Maturity Decision 19

  20. Cash Flows Cash flow estimation involves estimating the required investment outlays, annual net operating flows, and cash flows associated with project termination. • Use incremental after-tax cash flows. These are defined as the cash flows in each period minus what the firms’ cash flows would be if the project is not undertaken. • Don’t forget working capital requirements. • Include effects on existing business lines/activities. • Include the effect of inflation. • Include opportunity costs. • Include any strategic value • Ignore sunk costs. • Beware of allocated overhead costs. • Note: Cash flows do not include financing costs 20

  21. Weighted Average Cost of Capital • An organization’s cost of capital is based on the returns that investors require to supply capital to the business. If the business cannot earn at least the corporate cost of capital on its investments, it cannot pay the minimum return required by its capital suppliers. • The business cost of capital is calculated as the weighted average of the firm’s cost of debt plus its cost of equity. WACC = Debt x (1-t) iD + Equity x kE Debt+Equity Debt+Equity t = tax rate iD = cost of long-term debt kE = cost of equity 21

  22. Weighted Average Cost of Capital • The values of debt and equity used in the formula are market values, not book values. • The weighted average is based on the firm’s targeted capital structure, not the cost of financing that will be used to fund a specific project. • The cost of debt is not the interest rate on past financing; it is the rate today for funds borrowed for the duration of the project. • Because equity investments are riskier than debt investments, the cost of equity for any business can be regarded as the cost of its debt plus a risk premium. • The weighted average cost of capital (WACC) reflects the aggregate risk of the business. It can be used as the discount rate only for those projects under consideration that have average risk. If the project under consideration has risk that differs significantly from the firm’s average, then the cost of capital used for that project must be adjusted to account for the risk differential. 22

  23. Return Distributions on Two Projects Project risk rises with the likelihood of earning an actual rate of return below the expected return. It must be accounted for by increasing the required rate of return (cost of capital) Rate of return (%) 0 15 Expected Rate of Return 23

  24. Overview of the Capital Investment Decision Process • Forecast incremental cash flows arising from the project, including the required investment outlays, annual net operating flows, and cash flows associated with termination. • Assign a project cost of capital based on market conditions, the firm’s inherent risk, and the project’s risks relative to those of the overall business. • Calculate the project’s NPV. From a purely financial standpoint, those projects with a positive NPV are acceptable while those with a negative NPV should be rejected. • Consider any relevant subjective factors. For example: • strategic or social factors that cannot be quantified • impact on the ability of the organization to take advantage of future opportunities (option value of the project) • impact on firm or individual liability exposure 24

  25. Order of Battle • Using Discounted Cash Flow (DCF) Analysis to Estimate Economic Value • Investment Decision Rules: • net present value (NPV) • internal rate of return (IRR) • project payback • The Complexities of Estimating • future cash flows • the cost of capital • Determining Terminal Value • The Capital Structure Decision • The Debt Maturity Decision 25

  26. Value of an Annuity An annuity is a cash flow stream that can either be fixed, grow by a constant amount or grow at a fixed rate over time. The present value of a constant or fixed growth annuity is: PV0 = CF + CF(1+g) + CF(1+g)2+ CF(1+g)3+ …. + CF(1+g)N-1 (1+k) (1+k)2(1+k)3(1+k)4(1+k)N PV0 = present value future cash flows CF = cash flow g = growth rate of future cash flows k = the appropriate discount rate The above formula is mathematically equivalent to: PV0 = CF x 1+g k-g The expression 1+g is often referred to as the “cash flow multiplier” (M). k-g 26

  27. Terminal Value • The cash flows from an ongoing business don’t end at the forecast horizon. The method for valuing such as business is to project the annual cash flows until they reach a stable pattern (future time T), then assume a constant growth rate from then on. • The value of all future cash flows from future time T on (valued as a growing perpetuity) will be: PVT = CFT x 1+g k-g The expression 1+g is referred to as the “cash flow multiplier” (M). k-g • The valuation for such is a business is equal to: PV0 of the projected annual cash flows between the present and time T plus PV0of the terminal value at future time T 27

  28. Terminal Value Calculation $100 $90 $95 $105 $115 0 1 2 3 4 5 Assume the cost of capital K is 12%. Also assume that cash flows are expected to grow at a constant 5% annual rate after year 5. PV0 = $100 + $90 + $95 + $105 + $115 = $ 361 (1+k) (1+k)2 (1+k)3 (1+k)4 (1+k)5 TV5 = CF51+g = $115 x 1.05 =$1725 The multiplier 1+g= 1.05 = 15 k-g .12-.05 k-g .07 TV0 = $1,725 = $ 979 (1+k)5 The value of the business is: PV0 = $ 361 27% TV0 = $ 97973% Value = $ 1,340 100% 28

  29. Lessons I’ve Learned the Hard Way • Don’t get caught up in “deal heat.” Avoid the powerful tendency to filter out new information that disconfirms your decision. • At some point, the effect of more data is only to increase my degree of certainty, not the quality of my decision. • I’ll never get all the assumptions correct; the best I can hope for is that the errors cancel each other out. • Be realistic about risk. The more risky the investment, the greater I want the NPV to be relative to the size of the investment. • The longer it takes to get your cash out, the more problematic the return. • When you turn out to be really wrong—and you will—it’s usually because you’ve incorrectly anticipated the competition’s response. Your error will be reflected in the cash flows. • Focus as much or more on the terminal value assumptions as on the near term cash flows. 29

  30. Order of Battle • Using Discounted Cash Flow (DCF) Analysis to Estimate Economic Value • Investment Decision Rules: • net present value (NPV) • internal rate of return (IRR) • project payback • The Complexities of Estimating • future cash flows • the cost of capital • Determining Terminal Value • The Capital Structure Decision • The Debt Maturity Decision 30

  31. The Capital Structure Decision • Capital is the funds used to finance a business’s assets. • Capital structure is the financing mix on the right side of the balance sheet. It is the proportions of debt and equity used by a business. • The capital structure decision involves identifying the optimal mix of debt and equity. 31

  32. Impact of Capital Structure onRisk and Return • Consider a new for-profit walk-in clinic that needs $200,000 in assets to begin operations. • The business is expected to produce $150,000 in revenues and $100,000 in operating costs during the first year. • The clinic has only two capital structure alternatives: • No debt financing (all equity) • $100,000 of 10% debt (50/50 mix) 32

  33. Projected Balance Sheets All Equity50% Debt Current assets $100,000 $100,000 Fixed assets 100,000 100,000 Total assets $200,000 $200,000 Debt (10% cost) $ 0 $100,000 Common stock 200,000 100,000 Total claims $200,000 $200,000 33

  34. Projected Income Statements All Equity50% Debt Net revenue $150,000 $150,000 Operating costs 100,000 100,000 Operating income $ 50,000 $ 50,000 Interest expense 0 10,000 Taxable income $ 50,000 $ 40,000 Taxes (30%) 15,000 12,000 Net income $ 35,000 $ 28,000 Total $ to Suppliers of Capital $ 35,000 $ 38,000 ROE 17.5% 28.0% Memo: ROA 25% 25% 34

  35. Conclusions Based on net income, should we use debt financing? • Although the use of debt financing lowers net income, it increases the return to equity holders. • Debt financing allows more of a business’s operating income to flow through to suppliers of capital. Because debt financing levers up (increases) return, its use is called financial leverage. • However, for leveraging to increase expected ROE, the return on assets (Operating Income / TA) must exceed the interest rate. If this is not the case, the cost of leveraging will be higher than the inherent profitability of the assets. • In the example, the return on assets is 25% while the interest rate is only 10%, so leveraging “works.” 35

  36. Projected Income Statements All Equity50% Debt Net revenue $115,000 $115,000 Operating costs 100,000 100,000 Operating income $ 15,000 $ 15,000 Interest expense 0 10,000 Taxable income $ 15,000 $ 5,000 Taxes (30%) 4,500 1,500 Net income $ 10,500 $ 3,500 Total $ to suppliers of capital $ 10,500 $ 13,500 5.25% 3.5% ROE Memo: ROA 7.5% 7.5% 36

  37. Financial Risks of Leverage • Financial risk is the additional risk placed on owners (or non-creditor stakeholders in NFP businesses) when debt financing is used. The greater the proportion of debt financing, the greater the financial risk. • As firms use more and more debt financing, they face a higher probability of future financial distress and the greater potential of incurring bankruptcy costs. These effects, called financial distress costs, lower the values of stocks and bonds. • As more and more debt is used, managerial actions become more restricted due to restrictive covenants and oversight by creditors. Furthermore, debt holders tend to increase monitoring activity as more debt is used, which raises the cost of debt. Such costs, called agency costs, also lower the values of stocks and bonds. 37

  38. Trade-Off Theory % KE Cost of Capital ID Debt/Assets Optimal Leverage 38

  39. Order of Battle • Using Discounted Cash Flow (DCF) Analysis to Estimate Economic Value • Investment Decision Rules: • net present value (NPV) • internal rate of return (IRR) • project payback • The Complexities of Estimating • future cash flows • the cost of capital • Determining Terminal Value • The Capital Structure Decision • The Debt Maturity Decision 39

  40. Trade-Off Theory Implications • Both too little or too much debt is bad. • There is an optimal, or target, capital structure for every business that balances the costs and benefitsof debt financing. • Unfortunately, capital structure theory can not be used in practice to find a business’s optimal structure. • Firms should borrow more if they: • Have low business risk. • Employ tangible assets (buildings and equipment. • Expect to pay taxes at a high rate. • Firms should borrow less if they: • Have high business risk. • Employ intangible assets (intellectual capital and goodwill). • Expect to pay taxes at a low rate. 40

  41. The Debt Maturity Decision • Once the capital structure decision is made, another decision is necessary. Given the optimal amount of debt financing, what is the optimal maturity mix of that debt? • This decision is based on the business’s mix of permanent and temporary assets. • Alternative debt maturity policies include: • Maturity Matching: Matches the maturity of the assets with the maturity of the financing. • Aggressive: Uses short-term (temporary) capital to finance some permanent assets. • Conservative: Uses long-term (permanent) capital to finance some temporary assets. 41

  42. Conservative Financing Policy $ Marketable Securities Zero S-T Debt Net WC L-T Fin: Equity, Bonds Fixed Assets Time 42

  43. Maturity Matching Financing Policy $ S-T Loans Net WC L-T Fin: Equity, Bonds Fixed Assets Time 43

  44. Aggressive Financing Policy $ S-T Loans Net WC L-T Fin: Equity, Bonds Fixed Assets Time 44

  45. Super Aggressive Financing Policy $ S-T Loans Net WC L-T Fin: Equity, Bonds Fixed Assets Time 45

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