1 lecture fin559_2010
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Managerial Decision Making and Finances(FIN 559) (FIN 559)
Kalle AhiKalle [email protected]
27th. september, 2010
Course detailsCourse details Instructor: Kalle Ahi (MA) Course credits: 3 EAP (20 contact hours) Evaluation: There will be 2 homeworks each (a 15% -> 2x15%=30% of grade) First homework is due by the end of the course and the second before y
a consultation) The homeworks could be solved in teams (maximum of three persons
ll d k h )allowed to work together) The final exam consists of two parts: 1) theory (slosed book exam)
and 2) problem solving (open book)and 2) problem solving (open book)
2
About course web pageAbout course web-page There is a course web-page based on moodle (in addition to
d i f i ÕIS)student information system – ÕIS) In order to access to the webpage: Fi t ti h ld fi t i t t th f ll i b First time users should first register at the following web page:
https://moodle.e-ope.ee/ (choose “create new account”) Now, if you have successfully registered and logged in, please choose , y y g gg , p
Estonian Business School from the course categories list From sub-categories choose FIN - Majandusarvestuse ja rahanduse
õ t lõppetool Now you should see: Managerial Decision Making and
Finances The password for the course is: From there you will soon find all relevant course information and
d l ( l d )3
study materials (currently yet under construction)
InstructorInstructor Kalle Ahi (MA, Prague CERGE-EI 2007, MA, University of Tartu
2002) Currently doctoral studies at University of Tartu Lecturing experience: courses of investments, financial
management, financial analysis, money and banking, micro- and macroeconomics.
Since 2007 lecturer at Tallinn Technical University Since 2009 docent at Mainor School of Economics Currently also external expert for Enterprise Estoniay p p E-mail: [email protected] (please add course name on
the subject line), phone: (+372) 5644722
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the subject line), phone: ( 372) 5644722
Topics covered Topics covered 1. Introduction to financial management; investment appraisal
t l d t h i 6 htools and techniques. 6 hours 2. Financial reporting, different tools for financial analysis,
additional information resources preparation statements for additional information resources, preparation statements for analysis. 2 hours
3. System of financial ratios and practical applications, y p ppdecomposition of ratios, economic value added (EVA). 4 hours
4. Financial forecasting, different tools and techniques, i bl h fi i l l i f 4 sustainable growth rate, financial valuation of a company. 4
hours 5 Budgeting in a firm (master budget) applications of 5. Budgeting in a firm (master budget), applications of
management accounting in planning and evaluation of performance) 4 hours
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How would You characterise the main objective of a firm?objective of a firm?
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and the answer is....and the answer is Let’s look at what the gurus have to say to us:g y Van Horne: "In this book, we assume that the objective of the
firm is to maximize its value to its stockholders" Brealey & Myers: "Success is usually judged by value: Brealey & Myers: Success is usually judged by value:
Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in fi i l i i l “financial management is to increase value.“
Copeland & Weston: The most important theme is that the objective of the firm is to maximize the wealth of its objective of the firm is to maximize the wealth of its stockholders.“
Brigham and Gapenski: Throughout this book we operate on th ti th t th t' i l i the assumption that the management's primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.
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Value of a firmValue of a firm Why maximising corporate profit is not a good objective for a
?company? There are many reasons: N t i i t ll ti fi th t i ti kl Net income is actually an accounting figure that is sometimes weakly
related to actual cash the firm generates. Why? Depreciation p For many firms, most sales are made under terms of credit, but
recognised as income Also, the company itself may defer the payments to it’s creditors Change in accounting principles (LIFO vs FIFO) may influence the
net income but should not have an effect on the value of the firm net income but should not have an effect on the value of the firm (why?)
Creative accounting etc.
8
g
Financial function in a firm To learn to see and analyse the connection between
different managerial decisions and their financial effectdifferent managerial decisions and their financial effect.
Big picture of the FINANCIAL FUNCTION is based on a Big picture of the FINANCIAL FUNCTION is based on a balance sheet model of a firm: Evaluate the value of the investment projects: forecast the p j
relevant cash flows, evaluate projects based on several decision criteria's (like net present value) and analyse the risks involved (different scenarios etc ): FIXED ASSETS(different scenarios etc.): FIXED ASSETS
Evaluate different financing options the firm has and find an optimal capital structure that minimizes the cost of capital the fi INTEREST BEARING DEBT AND EQUITYfirm uses. INTEREST BEARING DEBT AND EQUITY
Make decisions about working capital in a firm. WORKING CAPITAL (net current assets)( )
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Big picture of corporate finance (Damodaran)g p p ( )
Capital budgeting Weighted average cost
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Capital budgeting Weighted average costof capital (WACC)
Big picture (2)Big picture (2) The ultimate aim – increase the value of the firm. Investments should be made to the projects where the return
is higher than the minimal acceptable hurdle rate The value of the project depends on the amount, timing and riskiness
of the (incremental) cash flows The projects that bear higher risk should have higher hurdle rate
(cost of capital) The hurdle rate may also depend on the sources of financing (equity The hurdle rate may also depend on the sources of financing (equity
and borrowings)
If there are no profitable use of capital within a firm the cash If there are no profitable use of capital within a firm, the cash should be returned to the shareholders.
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Financial accounting vs corporate financeFinancial accounting vs corporate finance Financial Accounting is the process of gathering, aggregating
and summarizing of financial data taken from an organization's accounting records and publishing in the form of annual (or
f ) f h b fi f l id h more frequent) reports for the benefit of people outside the organization.Th d ff b (f l) d There are many differences between (financial) accounting and financial management – some of them are summarised in the following slidefollowing slide.
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FIN ACCOUNTING AND CORP FINANCEAND CORP FINANCEFIN. ACCOUNTING AND CORP. FINANCEAND CORP. FINANCE
■ Measures the past and current Future is important■ Measures the past and current standing of the company
■ Reporting■ Accounting rules and laws
■ Future is important■ Control and evaluation■ No particular rules
■ Accounting rules and laws■ Consolidated information■ Value is based on it’s accounting
balance sheet figure
■ Segmental information■ Market value is important
g■ Generally no risks analysed■ Equity doesn’t have a cost■ Net profit is important
■ Evaluation of risks is important■ Equity has (opportunity) cost■ Cash is King!■ Net profit is important
■ Is directed toward public (stakeholders) outside the firm
■ Cash is King!■ Is directed toward decision making
within a firm
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“Equity doesn’t have a cost”*Equity doesn t have a cost Profit and loss account doesn’t includes opportunity costs of
e itequity. Even a positive net income could be insufficient from the
viewpoint of owners. The point can be described by well-known viewpoint of owners. The point can be described by well known performance measure: EVA (economic value added)
Very simplified example: Total sales (10 mil), operating cash expenses (8 mil), firm has outstanding debt 6 mil and equity 8mil. The average interest rate for debt is 10% and the required return on equity is 20%. Firm has made 14 mil of total return on equity is 20%. Firm has made 14 mil of total investments (incl. current assets).
Discuss, what could be the “economic profit” for a company. (comment on the performance of the company)
* “Equity doesn’t have a cost” meaning that no interest is charged from equity Firm doesn’t have to pay dividends also
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from equity. Firm doesn t have to pay dividends also.
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1st Topic: Capital budgetingp p g g
Long term investment evaluation (capital expenditure) assumes that the proceeds from an investment are spread over longer time horizon.
The capital budgeting process involves three basic steps:
• Generating long-term investment proposals;• Reviewing, analyzing, and selecting from the proposals g, y g, g p p
that have been granted, and• Implementing and monitoring the proposals that have
b l dbeen selected.
Managers should separate investment and financing decisions.
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Capital Budgeting Decision Techniques
Accounting rate of return (ARR): focuses on project’s impact
Capital Budgeting Decision Techniques
Accounting rate of return (ARR): focuses on project s impact on accounting profits
Payback period: commonly used for small scale projects
Net present value (NPV): best technique theoretically; difficult to calculate realisticallydifficult to calculate realistically
Internal rate of return (IRR): widely used with strong intuitive appeal
16Profitability index (PI): related to NPV
A Capital Budgeting Process Should:
A t f th ti l f
A Capital Budgeting Process Should:
Account for the time value of money;
Account for risk;
Focus on (incremental) cash flow;
Rank competing projects appropriately, and
Lead to investment decisions that maximize shareholders’
17wealth.
Example: Global WirelessExample: Global Wireless Global Wireless is a worldwide provider of wireless
telephony devices. Global Wireless is contemplating a major expansion of its p g j p
wireless network in two different regions: Western Europe expansion Western Europe expansion A smaller investment in Southeast U.S. to establish a toehold
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Global WirelessGlobal Wireless
Initial Outlay -$250
Year 1 inflow $35
Y 2 i fl $80Year 2 inflow $80
Year 3 inflow $130
Year 4 inflow $160Year 4 inflow $160
Year 5 inflow $175
Initial Outlay -$50
Year 1 inflow $18
Year 2 inflow $22
Year 3 inflow $25
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Year 4 inflow $30
Year 5 inflow $32
Accounting Rate Of Return (ARR)
Can be computed from available accounting data
Accounting Rate Of Return (ARR)
Can be computed from available accounting data
r taxesofits afteAverage prARR vestmentAverage in
ARR
• Need only profits after taxes and depreciation • Need only profits after taxes and depreciation. • Average profits after taxes are estimated by subtracting
average annual depreciation from the average annual
Average profits Average annual operating Average annual=
average annual depreciation from the average annual operating cash inflows.
ARR ses acco ntin n mbers not cash flo s
Average profitsafter taxes
Average annual operating cash inflows
gdepreciation
= –
20
ARR uses accounting numbers, not cash flows; no time value of money.
Payback Period
The payback period is the amount of time required for the
Payback Period
The payback period is the amount of time required for the firm to recover its initial investment.
• If the project’s payback period is less than the maximum t bl b k i d t th j tacceptable payback period, accept the project.
• If the project’s payback period is greater than the i t bl b k i d j t th j tmaximum acceptable payback period, reject the project.
M t d t i ( ti bit il ) th Management determines (sometimes arbitrarily) the maximum acceptable payback period.
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Payback Analysis For Global Wireless
Management’s cutoff is 2.75 years.
Payback Analysis For Global Wireless
Management s cutoff is 2.75 years. Western Europe project: initial outflow of -$250M But cash inflows over first 3 years is only $245 million But cash inflows over first 3 years is only $245 million. Global Wireless will reject the project (3>2.75).
S th t U S j t i iti l tfl f $50M Southeast U.S. project: initial outflow of -$50M Cash inflows over first 2 years cumulate to $40 million. Project recovers initial outflow after 2.40 years. Total inflow in year 3 is $25 million. So, the project
generates $10 million in year 3 in 0.40 years ($10 million $25 million).
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Global Wireless will accept the project (2.4<2.75).
Pros and Cons of the Payback Method
Advantages of payback method:
Pros and Cons of the Payback Method
Advantages of payback method:
• Computational simplicity• Computational simplicity• Easy to understand• Focus on cash flow• Focus on cash flow
Disadvantages of payback method:
• Does not account properly for time value of money• Does not account properly for risk• Cutoff period is arbitrary
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• Does not lead to value-maximizing decisions
Discounted Payback
Discounted payback accounts for time value.
Discounted Payback
p y• Apply discount rate to cash flows during payback period.• Still ignores cash flows after payback period.g p y p
Global Wireless uses an 18% discount rate.
24Reject (46.3<50)Reject (166.2 < 250)
Net Present Value (NPV)
NPV: The sum of the present values of a project’s cash inflows
Net Present Value (NPV)
NPV: The sum of the present values of a project s cash inflows and outflows.
Discounting cash flows accounts for the time value of money.
Choosing the appropriate discount rate accounts for risk.
NNCFCFCFCF
CFNPV ... 33
221
0 NrrrrCFNPV
)(...
)()()(
1111 320
25
Accept projects if NPV > 0.
Net Present Value (NPV)
CFCFCFCF
Net Present Value (NPV)
NN
rCF
rCF
rCF
rCF
CFNPV)(
...)()()(
1111 3
32
210
A key input in NPV analysis is the discount rate.
r represents the minimum return that the project must earn to satisfy investors.
r varies with the risk of the firm and /or the risk of the j
26
project.
NPV Analysis for Global Wireless
Assuming Global Wireless uses 18% discount rate, NPVs
NPV Analysis for Global Wireless
g ,are:
543217516013080352503.75$ EW tNPV
Western Europe project: NPV = $75.3 million
5432 )18.1()18.1()18.1()18.1()18.1(2503.75$ EuropeWesternNPV
S h U S j NPV $25 7 illi
5432.. )181(32
)181(30
)181(25
)181(22
)181(18507.25$ SUSoutheastNPV
Southeast U.S. project: NPV = $25.7 million
)18.1()18.1()18.1()18.1()18.1(
Should Global Wireless invest in one project or both?27
Should Global Wireless invest in one project or both?
The NPV Rule and Shareholder WealthThe NPV Rule and Shareholder Wealth
28
Pros and Cons of NPVPros and Cons of NPV
NPV is the “gold standard” of investment decision rules.
Key benefits of using NPV as decision rule:
• Focuses on cash flows, not accounting earnings• Makes appropriate adjustment for time value of money• Can properly account for risk differences between projects• Can properly account for risk differences between projects
Though best measure, NPV has some drawbacks:
• Lacks the intuitive appeal of payback, and
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• Doesn’t capture managerial flexibility (option value) well.
Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRR: the discount rate that results in a zero NPV for a project.
NN
rCF
rCF
rCF
rCF
CFNPV)(
....)()()(
1111
0 33
221
0
The IRR decision rule for an investing project is:
• If IRR is greater than the cost of capital, accept the project.
• If IRR is less than the cost of capital, reject the project.
30
NPV Profile and Shareholder WealthNPV Profile and Shareholder Wealth
31
IRR Analysis for Global WirelessIRR Analysis for Global Wireless
Global Wireless will accept all projects with at least 18% IRR.
Western Europe project: IRR (rWE) = 27.8%
17516013080355432 )1(
175)1(
160)1(
130)1(
80)1(
352500WEWEWEWEWE rrrrr
Southeast U.S. project: IRR (rSE) = 36.7%
5432 )1(32
)1(30
)1(25
)1(22
)1(18500
SESESESESE rrrrr
32
)()()()()( SESESESESE
Pros and Cons of IRR
Advantages of IRR:
Pros and Cons of IRR
Advantages of IRR:
• Properly adjusts for time value of money• Properly adjusts for time value of money• Uses cash flows rather than earnings• Accounts for all cash flowsAccounts for all cash flows• Project IRR is a number with intuitive appeal
Disadvantages of IRR:
• “Mathematical problems”: multiple IRRs, no real solutions• Scale problem
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•Timing problem
Multiple IRRsMultiple IRRs
IRR
IRR
When project cash flows have multiple sign changes, there can be multiple IRRs.
34Which IRR do we use?
multiple IRRs.
No Real SolutionNo Real Solution
Sometimes projects do not have a real IRR solution.
Modify Global Wireless’s Western Europe project to include a large negative outflow (-$355 million) in year 6.g g ( ) y
Th i l b th t ill k NPV 0 l • There is no real number that will make NPV=0, so no real IRR.
Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!
35
g j
Conflicts Between NPV and IRR:Th S l P bl
NPV and IRR do not always agree when ranking competing
The Scale Problem
NPV and IRR do not always agree when ranking competing projects.
The scale problem:
$75.3 mn27.8%Western Europe
NPV (18%)IRRProject
$25.7 mn36.7%Southeast U.S.
• The Southeast U.S. project has a higher IRR, but doesn’t increase shareholders’ wealth as much as the Western
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Europe project.
Conflicts Between NPV and IRR:Th S l P blThe Scale Problem
Why the conflict? The scale of the Western Europe expansion is roughly five times
that of the Southeast U.S. project. Even though the Southeast U.S. investment provides a higher rate of
return, the opportunity to make the much larger Western Europe investment is more attractiveinvestment is more attractive.
Another (simpler example): Assume that before the finance class starts two investment proposals are made to you:finance class starts two investment proposals are made to you: A) invest 1 EEK and after a class you receive 2 EEK B) invest 10 EEK and after a class you receive 12 EEK The projects B) invest 10 EEK and after a class you receive 12 EEK. The projects
are mutually exclusive Which one you choose?
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Which one you choose?
Conflicts Between NPV and IRR:Th Ti i P blThe Timing Problem
The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.
38
g p g p p g
Conflicts Between NPV and IRR:Th Ti i P blThe Timing Problem
Because of the differences in the timing of the two projects’ cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for h M k i C ithe Marketing Campaign.
39
Profitability Index
Calculated by dividing the PV of a project’s cash inflows by
Profitability Index
CFCFCF
Calculated by dividing the PV of a project s cash inflows by the PV of its initial cash outflows.
221
)1(...
)1()1(CF
rCF
rCF
rCF
PIN
N
Decision rule: Accept project with PI > 1.0, equal to NPV > 00CF
1.3$250 million$325.3 millionWestern Europe
PIInitial OutlayPV of CF (yrs1-5)Project
• Both PI > 1.0, so both acceptable if independent.
1.5$50 million$75.7 millionSoutheast U.S.
40Like IRR, PI suffers from the scale problem.
MIRR modified internal rate of returnMIRR – modified internal rate of return Addresses several shortcomings that IRR – method has (but has
h l bl )no cure to the scales problem) MIRR is a discount rate that equates the future value of the
project cash flows to the present value of investmentsproject cash flows to the present value of investments.
Where COFt – cash outflow at period t, CIFt – cash inflow at period t, k– reinvestment rate (pos cash flows) of financing rate (negative cash (p ) g ( gflows; could be different k-s), n – project lifetime (years)
The MIRR for product development is 13,8% and marketing campaign 12 6%12,6%
41
Project evaluations in EXCELProject evaluations in EXCEL Check course home page for further examples.
42
Capital BudgetingMethods to generate, review, analyze, select, and implement long-
i l
Capital Budgeting
term investment proposals: Accounting rate of return
P b k P i d Payback Period Discounted payback period
N P V l (NPV) Net Present Value (NPV) Internal rate of return (IRR)
P fi bili i d (PI) Profitability index (PI) Modified internal rate of return (MIRR)
Equivalent annuity (EAA) – later…
43
Cash Flow Versus Accounting Profit
Capital budgeting is concerned with cash flow
Cash Flow Versus Accounting Profit
Capital budgeting is concerned with cash flow,not accounting profit.
To evaluate a capital investment, we must know:
1. Incremental cash outflows of the investment (marginal cost of investment) andcost of investment), and
2. Incremental cash inflows of the investment (marginal benefit of investment).
3 The timing and magnitude of cash flows and accounting
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3. The timing and magnitude of cash flows and accounting profits can differ dramatically.
Cash Flows: Financing Costs and Taxes
Financing costs should be excluded when evaluating a
Cash Flows: Financing Costs and Taxes
Financing costs should be excluded when evaluating a project’s cash flows.
Both interest expense from debt financing and dividend payments to equity investors should be
excluded.
Financing costs are captured in the process of discounting future cash flows.g
Only after-tax cash flows are relevant as only such cash
45
y yflows can be potentially distributed to investors.
Cash Flows: Noncash ExpensesCash Flows: Noncash Expenses Noncash expenses include depreciation, amortization, and depletion. Accountants charge depreciation to spread a fixed asset’s costs over
time to match its benefits. Capital budgeting analysis focuses on cash inflows and outflows
when they actually occur.N h (E i i i l ) ff h fl Non-cash expenses may (Estonia is a special case) affect cash flow through their impact on taxes: Compute after-tax net income and add depreciation back or Compute after-tax net income and add depreciation back, or Ignore depreciation expense but add back its tax savings. (e.g. Depreciation tax shield)
In Estonia there is currently no tax shields (also including interest rate tax y ( gshield) - however, a realistic cash flow prognosis should take potential future dividends into account through potential tax costs (for instance, one can assume that an optimal debt/equity ratio is maintained and rest is
46
one can assume that an optimal debt/equity ratio is maintained and rest is paid out as dividends etc.)
Working Capital Expenditures
Many capital investments require additions to working capital
Working Capital Expenditures
Many capital investments require additions to working capital.• Net working capital (NWC) = current assets – current
liabilities• Increase in NWC is a cash outflow; decrease in NWC is a cash
inflow.
• An example…O t b th f N b 1 t J 31• Operate booth from November 1 to January 31
• Order $15,000 calendars on credit, delivery by Nov 1• Must pay suppliers $5,000/month, beginning Dec 1 p y pp $ , , g g• Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10%
in Jan• Always want to have $500 cash on hand
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• Always want to have $500 cash on hand
Working Capital for Calendar Sales Booth
Feb 1Jan 1Dec 1Nov 1Oct 1
Working Capital for Calendar Sales Booth
01,50010,50015,0000Inventory
$0$500$500$500$0Cash
J
(3 000)1 0005000Net WC
5,00010,00015,0000Accts payable
01,50010,50015,0000Inventory
0
0(4,000)+500+500NAMonthly in WC
(3,000)1,0005000Net WC 0
+3,000
Jan 1 to Feb 1
Dec 1 to Jan 1
Nov 1 to Dec 1
Oct 1 to Nov 1
Payments and
inventory
($5,000)($5,000)($5,000)$0Payments
$1,500
[10%]
$9,000
[60%]
$4,500
[30%]
$0Reduction in inventory
48
($5,000)($5,000)($5,000)$0Payments
($500)Net cash flow ($500) +$4,000 ($3,000)
Terminal Value
When evaluating an investment with indefinite life span the
Terminal Value
When evaluating an investment with indefinite life-span, the project’s terminal value is calculated:
Forecasts more than 5 to 10 Construct cash-flow forecasts
for 5 to 10 yearsyears have high margin of error; use terminal value
i t dinstead.
• The terminal value is intended to reflect the value of a project at a given future point in time.
• The terminal value is usually large relative to all the other
49
The terminal value is usually large relative to all the other cash flows of the project.
Terminal Value
Diff l l i l l
Terminal Value
Different ways to calculate terminal values:
• Use final year cash flow projections and assume thatall future cash flow grow at a constant rate (present value of a perpetuity);
• Multiply final cash flow estimate by a market multiple, or
• Use investment’s book value or liquidation value.
JDS Uniphase cash flow projections for acquisition of SDL Inc.
$3 25 B ll$2 5 B ll$1 75 B ll$1 0 B ll$0 5 B ll
Year 5Year 4Year 3Year 2Year 1
50
$3.25 Billion$2.5 Billion$1.75 Billion$1.0 Billion$0.5 Billion
Terminal Value of SDL Acquisition Assume that cash flow continues to grow at 5% per year (g = 5%, r =
10% cash flow for year 6 is $3 41 billion):
Terminal Value of SDL Acquisition
$68.20 050 10
$3.41PVor ,gr
CFPV 51t
t
10%, cash flow for year 6 is $3.41 billion):
0.050.10gr 5
• Terminal value is $68.2 billion; value of entire project is:
67.48$1.1
2.68$1.125.3$
1.15.2$
1.175.1$
1.11$
1.15.0$
554321
$42.4 billion of total $48.7 billion is from terminal value! Caveat: Very sensitive to terminal value (and hence growth rate)
• Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal value:• Terminal Value = $3 25 x 20 = $65 billion
51
• Terminal Value = $3.25 x 20 = $65 billion• Caveat: market multiples fluctuate over time
Incremental Cash Flow
I t l h fl k t
Incremental Cash Flow
Incremental cash flows versus sunk costs:
Capital budgeting analysis should include only incremental costs.
• Simple example: assume that your company undertook a k h d h 200 000$ Th k market research and the costs were 200.000$. The market
research was successful and as a result, a more thorough project evaluation is to be undertaken Should the costs of project evaluation is to be undertaken. Should the costs of marketing research be included into the cash flow budget or not? Why or why not?
52
Opportunity CostsOpportunity Costs
Cash flows from alternative investment opportunities, forgone when one investment is undertaken.
Some time ago You were thinking of attending the MA (MBA) g g g ( )program. Indeed you calculated the incremental costs and
benefits from attending business school. What are the i h ?opportunity costs here?
NPV of a project could fall substantially if opportunity costs i d!
53
are recognized!
CannibalizationCannibalization
Cannibalization refers to the loss of sales of an existing product when a new product is introduced
d h ld b l d d l ( ) and should be included as an incremental (negative) cash flow.
• Cannibalization is a “substitution” effect.
H h ld b h • However there could be some exceptions to this rule. One should take into account the effect of
l 54
potential competition.
Example of a projectExample of a project A small bakery is planning to expand it’s activities and is going
to introduce a new product – “cheese cake”. The expected sales are 40 000 cakes a year for every next 4 years. Sales price is 4,00.- The production cost is 1,80.- plus transportation costs 0,50.- per
kcake. The sales manager thinks that the introduction of a new product
could negatively affect the sales of other products and expects a loss could negatively affect the sales of other products and expects a loss of 18 000.- (1.80.- per cake)
The firm has already made some expenditures for market research y p(20 000.-)
There is a small opportunity cost as the rooms that are now going to be used were previously rented out for (5 000 a year)
55
Project (II)Project (II) An investment into equipment is 74 000.- (straight line
depreciation, no accounting salvage value after 4 years). However the equipment could be sold for 10 000.-
The investment into net working capital is 15000.- The incremental fixed costs are 15 000.- (mostly advertasing
costs) The owners expect to pay out 60% of the net profit. Hence
according to Estonian tax system, the tax rate is (21/79)% from dividends.
There is no general corporate tax on net profit
56
Years 0 1 2 3 4 Assumptions
1 Total sales 160 000 160 000 160 000 160 000 Quantity 40 0001. Total sales 160 000 160 000 160 000 160 000 Quantity 40 000 - opportunity cost -5 000 -5 000 -5 000 -5 000 Sales price 4,00- incremenatal loss inl 18 000 18 000 18 000 18 000 P d t 1 80sales -18 000 -18 000 -18 000 -18 000 Prod cost 1,80
2. Production cost -72 000 -72 000 -72 000 -72 0003. Transportation cost -20 000 -20 000 -20 000 -20 000 In into NWC 15 0004. General expenses -15 000 -15 000 -15 000 -15 000 Depr 18 5005. Depreciation -18 500 -18 500 -18 500 -18 500 Tranpost 0,506. EBIT 11 500 11 500 11 500 11 500 Fixed invest 74 0007. Taxes on dividends -1 834 -1 834 -1 834 -1 8348. Free cash flow(+depr) 28 166 28 166 28 166 28 166
Sale of inv (after tax) 8405( depr) 28 166 28 166 28 166 28 166Gen expnses 15 000
0 1 2 3 4 effective tax rate 16%Cash flows Müügi kaotus 18 000
tax) 8405
Cash flows Müügi kaotus 18 0001. Cash from operations 28 166 28 166 28 166 28 166 Alternatiivkulu 5 0002. Change in NWC -15 000 15 0003. Net fixed investments -74 000 8 405 Marketing research is aTotal cash flows -89 000 28 166 28 166 28 166 51 571 sunk cost
Required return 16%57
Capital RationingCapital Rationing
Can a firm accept all investment projects with positive NPV?
R h ld ll jReasons why a company would not accept all projects:
Limited availability of skilled personnel to be involved with all the projects;p j ;
Financing may not be available for all projects. Companies are reluctant to issue new shares to finance new projects
because of the negative signal this action may convey to the k t
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market.
Capital Rationing
Capital rationing: project combination that maximizes
Capital Rationing
Capital rationing: project combination that maximizes shareholder wealth subject to funding constraints
1. Rank the projects using Profitability Index (PI)
2. Select the investment with the highest PI
3. If funds are still available, select the second-highest PI, and so on, until the capital is exhausted.
Th t b th t l t th 59
The steps above ensure that managers select the combination of projects with the highest NPV.
Capital Rationing and the Profitability Index (12% required return)( q )
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Equipment Replacement and Unequal Lives A firm must purchase an electronic control device:
First alternative: cheaper device higher maintenance costs shorter period
Equipment Replacement and Unequal Lives
• First alternative: cheaper device, higher maintenance costs, shorter period of utilization
• Second device: more expensive, smaller maintenance costs, longer life spanp g p
Expected cash outflows:
• Using real discount rate of 7%:
D i A’ h fl D i B’ h fl
g
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Device A’s cash outflow < Device B’s cash outflow select A?
Equivalent Annual Cost (EAC) EAC converts lifetime costs to a level annuity; eliminates the problem
of unequal lives
Equivalent Annual Cost (EAC)
of unequal lives .
1. Compute NPV for operating devices A and B for their respective lifetimes: NPV of device A = $15,936 NPV of device B = $18,065
2. Compute annual expenditure (annuity cost) to make NPV of annuity equal to NPV of operating device:
$6,072 X 07.107.107.1
936,15$ 321 XXX
Device A
$5,333Y 07.107.107.107.1
065,18$ 4321 YYYYDevice B
62• Since Device B’s annuity cost is lower, choose Device B.
Excess Capacity
Excess capacity is not a free asset as traditionally regarded by
Excess Capacity
p y y g ymanagers.• Company has excess capacity in a distribution center warehouse.• In two years, the firm will invest $2,000,000 to expand the
warehouse.
The firm could lease the excess space for $125,000 per year (at the beginning of each year) for the next two years.• Expansion plans should begin immediately in this case to hold
inventory for new stores coming on line in a few months.I l i i $2 000 000 f • Incremental cost: investing $2,000,000 at present vs. two years from today
• Incremental cash inflow: $125 000 (at the beginning of the year)
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• Incremental cash inflow: $125,000 (at the beginning of the year)
Excess Capacity NPV of leasing excess capacity (assume 10% discount rate):
Excess Capacity
471,108$1.1
000,000,210.1000,125000,000,2000,125 2 NPV
• NPV negative: reject leasing excess capacity at $125,000 per year.
• The firm could compute the value of the lease that would allow break even.
01.1
000,000,210.1
000,000,2 2 XXNPV
- X = $181,818 (at the beginning of the year) - Leasing the excess capacity for a price above $181,818
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would increase shareholders wealth.
The Human Face of Capital BudgetingThe Human Face of Capital Budgeting
Managers must be aware of optimistic bias in the assumptions g p pmade by project supporters.
Companies should have control measures in place to remove p pbias: Investment analysis should be done by a group independent of y y g p p
individual or group proposing the project. Project analysts must have a sense of what is reasonable when
forecasting a project’s profit margin and its growth potential. Storytelling: The best analysts not only provide numbers to
highlight a good investment, but also can explain why the investment makes sense.
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Cash Flow and Capital Budgeting Certain types of cash flows are common to many
Cash Flow and Capital Budgeting
investments Opportunity costs should be included in cash flow pp y
projections Consider human factors in capital budgeting Consider human factors in capital budgeting
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Choosing the Right Discount Rate
The numerators focus on project cash flows covered in
Choosing the Right Discount Rate
The numerators focus on project cash flows covered in Chapter 9.
NN
rCF
rCF
rCF
rCF
CFNPV)(
...)()()(
1111 3
32
210 rrrr )()()()( 1111
The denominators are the discount rates (cost of capital)
The denominator
Reflect opportunity costs to firm’s investors
Reflect the project’s risk
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should:p j
Be derived from market data
Weighted Average Cost of Capital (WACC)
Cost of equity applies to projects of an all-equity firm.
g g p ( )
But what if firm has both debt and equity? Problem is akin to finding expected return of portfolio.
Use weighted average cost of capital (WACC) as discount Use weighted average cost of capital (WACC) as discount rate.
• Lox in a Box is a chain of fast food stores• Lox-in-a-Box is a chain of fast food stores.• Firm has $100 million equity (E), with cost of equity re = 15%;• Also has bonds (D) worth $50 million, with rd = 9%.
Also has bonds (D) worth $50 million, with rd 9%.• Assume that the investment considered will not change the cost
structure or financial structure.
68%13%15
10050100%9
1005050
ed r
EDEr
EDDWACC
Rules for Finding the Right Discount RateRules for Finding the Right Discount Rate
1 Wh ll it fi i t i t i il t 1. When an all-equity firm invests in an asset similar to its existing assets, the cost of equity is the appropriate discount rateappropriate discount rate.
2. When a firm with both debt and equity invests in an asset similar to its existing assets, the WACC is the appropriate discount rate.
3. When the investment is more risky than the firm’s average investment, a higher discount rate than the WACC is required, and vice versa.
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Sensitivity Analysis
Sensitivity analysis allows mangers to test the impact of each
Sensitivity Analysis
Sensitivity analysis allows mangers to test the impact of each assumption underlying a forecast.
S l l l l h NPV f • Sensitivity analysis involves calculating the NPVs for various deviations from a “base case” set of assumptions.
GTI has developed a new skateboard. Base case assumptions yield NPV = $236,000.NPV $236,000.
1. The project’s life is five years.p j y2. The project requires an up-front investment of $7 million.3. GTI will depreciate initial investment on straight line basis for five years.
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Sensitivity AnalysisSensitivity Analysis
GTI has developed a new skateboard. Base case assumptions yield p p yNPV = $236,000.
4. One year from now, the skateboard industry will sell 500,000 units.
5. Total industry unit volume will increase by 5% per year.
6. GTI expects to capture 5% of the market in the first year.
7. GTI expects to increase its market share by one percentage point each year after year one.
8. The selling price will be $200 in year one.
9 Selling price will decline by 10% per year after year one9. Selling price will decline by 10% per year after year one.
10.All production costs are variable and equal 60% of the selling price.
11 GTI’s marginal tax rate is 30%
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11.GTI s marginal tax rate is 30%.
12.The appropriate discount rate is 14%.
Table 10-4 Sensitivity Analysis of Sk t b d P j tDollar values in thousands except price
Skateboard Project
NPV Pessimistic Assumption Optimistic NPV$558 $8 000 000 2 I i i l i $6 000 000 $1 030
Dollar values in thousands except price
-$558 $8,000,000 2. Initial investment $6,000,000 $1,030
-343 450,000 units 4. Market size in year 1 550,000 units 815
73 2% per year 5 Growth in market size 8% per year 563-73 2% per year 5. Growth in market size 8% per year 563
-1,512 3% 6. Initial market share 7% 1,984
-1 189 0% 7 Growth in market 2% per year 1 661-1,189 0% 7. Growth in market share
2% per year 1,661
-488 $175 8. Initial selling price $225 960
-54 62% of sales 9. costs 58% of sales 526
-873 -20% per year10. Annual price change 0% per year 1,612
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-115 16% 12. Discount rate 12% 617
Scenario AnalysisScenario Analysis
S i l i i l f f iti it l i Scenario analysis is a more complex form of sensitivity analysis. Rather than adjust one assumption up or down, analysts
l l h j NPV h h l f i calculate the project NPV when a whole set of assumptions changes in a particular way.F l if i i GTI’ k b d i For example, if consumer interest in GTI’s new skateboard is low, the project may achieve a lower market share and a lower selling price than originally anticipatedselling price than originally anticipated.
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Monte Carlo SimulationMonte Carlo Simulation
I M t C l i l ti l t if In a Monte Carlo simulation, analysts specify a range or a probability distribution of potential outcomes for each of the model’s assumptions. the model s assumptions.
• It is even possible to specify the degree of correlation between key variables variables.
• A simulation software package is then used to take random “draws” from these distributions calculating the project’s cash flows (and from these distributions, calculating the project s cash flows (and NPV) over and over again.
• The simulation produces the probability distribution of project cash • The simulation produces the probability distribution of project cash flows (and NPVs) as well as sensitivity figures for each of the model’s assumptions.
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model s assumptions.
Monte Carlo SimulationMonte Carlo Simulation
Th f M t C l i l ti h d ti ll i th The use of Monte Carlo simulation has grown dramatically in the last decade because of steep declines in the costs of computer power and simulation software.power and simulation software.
The bottom line is that simulation is a powerful, effective tool when used properly. p p y
Simulation’s fundamental appeal is that it provides decision makers with a probability distribution of NPVs rather than a single point estimate of the expected NPV.
Simulations can be aided using specialised software. For instance excel based crystal ball. We look at it the next time we meet.
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Decision TreesDecision Trees
A decision tree is a visual representation of the sequential choices that managers face over time with regard to a particular investmentwith regard to a particular investment.
• The value of decision trees is that they force analysts to think through a series of “if-then” statements that describe how they will react as the future unfolds.
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Decision Trees for Odessa InvestmentDecision Trees for Odessa InvestmentTrinkle Foods Limited of Canada has invented a new salt substitute,
branded Odessa.
Trinkle is deciding whether to spend 5-million Canadian dollars (C$) to test-market a new line of potato chips flavored with Odessa in Vancouver.
Depending on the outcome, Trinkle may spend an additional C$50 million 1 year later to launch a full line of snack foods across Canada.
If consumer acceptance in Vancouver is high the company predicts that its If consumer acceptance in Vancouver is high, the company predicts that its full product line will generate net cash inflows of C$12 million per year for 10 years.
If consumers respond less favorably, cash inflows from a nationwide launch is expected to be just C$2 million per year for 10 years.
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Trinkle’s cost of capital equals 15 percent.
Decision Trees for Odessa Investment
If the test market is successful, the NPV of launching the product is C$10.23 million;
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if the initial test results are negative, and it launches the product, it will have an NPV of – C$39.96 million.
Decision Trees for Odessa Investment• To work through a decision tree, begin at the end and then work backward to the
initial decision
Decision Trees for Odessa Investment
initial decision.
• Suppose one year from now, Trinkle learns that the Vancouver market test was successful:
• If the initial test results are unfavorable and it launches the product:
• We then evaluate today’s decision about whether to spend the C$5 million. The expected NPV of conducting the market test is:
• Spending the money for market testing does not appear worthwhile.
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Real Options in Capital Budgeting
O ti i i l i i h l f l i i i lti t
Real Options in Capital Budgeting
Option pricing analysis is helpful in examining multi-stage projects.
Embedded options arise naturally from investment.Called real options to distinguish from financial options.
Value of a project equals value captured by NPV, plus option.
Options can transform negative NPV projects into positive
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NPV!
Types of Real Options
Expansion
Types of Real Options
Expansion options
• If a product is a hit, expand production.
Abandonment options
• Firm can abandon a project if not successful.• Shareholders have valuable option to default on
debtp debt.
Follow-on investment
options
• Similar to expansion options, but more complex (Ex: movie rights to sequel)
Flexibility • Ability to use multiple production inputs (example: dual fuel industrial boiler) or produce
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yoptions
(example: dual-fuel industrial boiler) or produce multiple outputs
Strategy and Capital BudgetingStrategy and Capital Budgeting Competition and NPV Advocates of a positive NPV project should be able to
articulate the project’s competitive advantage beforerunning the numbersrunning the numbers
Otherwise in perfect financial markets for every project the NPV should not generally exceed 0 (Why?)NPV should not generally exceed 0. (Why?)
Strategic thinking and real options Managers must articulate their strategy for a given Managers must articulate their strategy for a given
investment Many investments could have embedded options in themy p
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Risk and Capital Budgeting
All it fi di t th i t d d i t t
Risk and Capital Budgeting
All-equity firms can discount their standard investment projects at cost of equity.Fi i h d b d i di h i d d Firms with debt and equity can discount their standard investment projects using WACC.A i f l i i i d di h A variety of tools exist to assist managers in understanding the sources of uncertainty of a project’s cash flows.
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