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Managerial Finance Finance 6335 Lecture 5 Chapter 6 & 7 Alternative Decision Rules Fundamentals of Capital Budgetin

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. Consider a take-it-or-leave-it investment decision involving a single, stand-alone project for Fredrick Feed and Farm (FFF).

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Managerial Finance Finance 6335 Lecture 5 Chapter 6 & 7 Alternative Decision Rules Fundamentals of Capital Budgetin

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  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 FFF’s New Project • If FFF’s 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(@ 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 project’s 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:

  18. Differences in Scale (cont'd) • Identical Scale • Girlfriend’s Business

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

  20. Figure 6.5 NPV of Investment Opportunities • The NPV of the girlfriend’s business is always larger than the NPV of the single machine laundromat. The IRR of the girlfriend’s 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 girlfriend’s 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 girlfriend’s business only for discount rates less than 13.9%.

  23. Differences in Scale (cont'd) • Percentage Return Versus Impact on Value • The girlfriend’s business has an IRR of 100%, while the 20-machine laundromat has an IRR of 20%, so why not choose the girlfriend’s 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 (@ 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 (@ 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 Less: Cash Flow to Preferred stockholders 100 Free Cash Flow to Common Stockholders 558 EBITDA 2,700

  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. OnlyCashFlowsAffectWealth. 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

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