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Valuation of Capital Investments

Valuation of Capital Investments Corporate Finance: March 28 (LA) and March 27 (OCC) Capital Investments Like common stock cash flows, payments from investments in capital are not determined Investments are the foremost decision of the management of the firm

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Valuation of Capital Investments

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  1. Valuation of Capital Investments Corporate Finance: March 28 (LA) and March 27 (OCC)

  2. Capital Investments • Like common stock cash flows, payments from investments in capital are not determined • Investments are the foremost decision of the management of the firm • The firm’s investment decisions should maximize shareholders’ wealth

  3. Investment Decision Rules • Discussion based on Chapter 6 (not assigned) • Corporate practice is not always good practice and some common rules are wrong • Payback period = time to recover investment, e.g $100 tool saving $50/year has two-year payback period • Average (accounting) return = Average Income/Average investment, e.g $50/year income and $100 tool with two year life implies $50/(($100+0)/2 = 100% return

  4. Payback Period andAverage Accounting Return • Payback period ignores future cash flows with possibly large present value. We can see the effect of this in the “Simple Present Value Factors” • Timing of cash flows critical in present value analysis • Accounting rate of return does not consider timing of cash flows at all

  5. Investment Valuations in Finance • Estimate future cash flows and current costs • Choose a discount rate or calculate internal rate of return • Accept project if net present value > 0 or internal rate > hurdle rate • Other criteria (payback period, average accounting return) are wrong • Use of net present value recommended

  6. Internal Rate of Return • Internal rate of return (IRR) is that discount rate which make NPV = 0 • Tricky in application, users must be wary of problems in computation and interpretation • Assumptions make IRR dangerous • Mathematical properties make interpretation of IRR hard or impossible • Net present value is the best method to evaluate investments

  7. Capital Budgeting impliesLimitated Funds for Investment • Why are funds limited? • What is suggested if NPV > 0 projects are rejected? • What is real corporate world like and what does that suggest about project screening? • Profitability index can be useful:

  8. Objective is to Maximize Value • PI > 1 means NPV > 0 • Initial Investment*(PI-1) = NPV since NPV=PVCF – C dividing each side by C • Rank PIs and take maximum combination of NPVs withing budget constraint • Easily programmed for large-firm administration

  9. Maximizing NPV using PIs withCapital Budgeting • Assume capital budget of $10 million • Have six projects as follows: • Project Cost PI • A $2 Million 1.5 • B 4 “ 1.4 • C 5 “ 1.3 • D 3 “ 1.05 • E 2 “ .90 • F Flexible 1.00 • How to maximize NPV with budget contraints?

  10. Topics in Investment Analysis • Estimating incremental cash flows, i.e. cash flows due to the investment decision • Importance of including net working capital • Inflation effects on cash flows and the choice of real or nominal discount rates • Analyzing components the present value of cash flows • Comparing projects with unequal lives

  11. Cash Flow Estimation • Cash flows from operations • Increase or decrease in sales • Increase or decrease in costs • Change in depreciation and taxes • Other cash flows from the decision • Changes in investment in working capital • Changes in fixed assets or required maintenance cycles • Initial cash flows from the investment

  12. Estimate the Cash Flows • Baldwin Example (pp. 200-206) • Inputs into cash flows • Question 7.1 • The Best Company example (question 7.2) • Scott Investors (question 7.21) • What are sources of value?

  13. Inflation Effects • Inflation means future revenues are inflated in terms of current purchasing power • Two ways of dealing with inflation • Discount rate includes an inflation allowance (most common since market rates are nominal rates) • Deflate projected revenues and costs to convert to current dollars and discount using real risk-adjusted discount rate • Steady or predictable versus varying inflation

  14. Components of Present Values • Components of cash flows from investment may have different risks • Tax-shield from depreciating original cost is risk free if the firm will certainly be paying taxes but tax savings are in inflated dollars • Investment costs are usually current and are not discounted, but not always true • Operating cash flow risk depends on project

  15. Replacement and Unequal Lives • If different acceptable machines must be replaced at different intervals or have different periodic lumpy costs like major maintenance over longer time periods, they must be made comparable to choose best • Two methods are used to compare • Replacement chain - compare a cost cycle • Equivalent annual cost - treat as annuities

  16. For Next Class • Read Chapter 3 • Review the “Financial Statement Analysis and Assumptions for Valuation” and compare to Chapters 2 and 3 • Review old midterms and bring questions to optional review session

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