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FINE 2000
Alan Marshall

Jessica Gahtan Finance Quiz 2 Notes Chapter 8: Net Present Value & Other Investment Criteria NPV Net Present Value (NPV) -­‐ Exactly what it sounds like – it’s the net of the present values -­‐ If it’s positive – the project is attractive. Simple as that. -­‐ You look at all the cash flows (negative in the first year and positive afterwards) -­‐ To calculate NPV: 1) forecast the cash flows, 2) estimate the opportunity cost of capital -­‐ When you need to choose between mutually exclusive projects, calculate the NPV of each project and, from those options that have a positive NPV, choose the one whose NPV is highest Other Investment Criteria Payback Period – Time until cash flows recover the initial investment of the project -­‐ The rule is that you should accept a project if its payback period is less than whatever the specified cut off period is – As a rule of thumb this rule works but it can lead to nonsensical decisions 0 1 2 Cash flow -1000 500 +750 Cumulative Cash -1000 -500 +250 flow -­‐ If the above happens, divide -500 by 750 – gives you payback period of 1.667 Discounted payback period – is the time it takes until discounted cash flows recover the initial investment in the project – basically you consider how long the project must last for there to be a positive NPV -­‐ Ignores all $ you make off the project after the cut-off Internal Rate of Return (IRR) is the amount you’ll make less the investment divided by the investment – Rate of Return = Profit/Investment – if the IRR > Opportunity cost of capital then this project is attractive • When NPV = 0, Rate of return = cost of capital A Closer look at the rate of return rule 1. The rate of return is the discount rate at which NPV = 0 2. The rate of return rule and the NPV rule are equivalent Calculating the Rate of return for Long Lived Projects Internal Rate of Return (IRR) –discount rate at which a project NPV=0 -­‐ The rate of return rule tells you to accept a project if the rate of return exceeds the opportunity cost of capital Jessica Gahtan Finance Quiz 2 Notes -­‐ The rate of return rule will give the you same answer as the NPV rule as long as the NPV of a project declines smoothly as the discount rate increases -­‐ NPV and IRR are discounted cash flow methods of choosing b/w projects – both are concerned w/ identifying those projects that make shareholders better off and both recognize that companies have a choice: they can invest in a project or (if the project isn’t attractive enough) they can give the money back to shareholders and let them invest themselves in the capital market A Word of Caution -­‐ Project IRR measures the profitability of the project, it’s an internal rate of return in the sense that it depends only on the project’s own cash flows -­‐ Opportunity cost of capital is the standard for deciding whether to accept projects -­‐ It’s equal to the return offered by equivalent risk investments in the capital market Some Pitfalls of the IRR Rule 1. Lending or borrowing – When NPV is higher as the discount rate increases, a project is only acceptable if the IRR is less than the opportunity cost of capital 2. Multiple rates of return – when there are multiple changes in the sign of the cash flows, the IRR rule doesn’t work, but the NPV rule always does – Some companies combine the later cash flows into one present value until there remains only one change in sign – i.e. they create a modified internal rate of return (MIRR) from this revised series 3. Mutually exclusive projects – doesn’t make sense to take the project with the highest IRR – take the project with the highest NPV. Remember, a high IRR is not an end in itself, you want projects that increase the value of the firm, projects that earn a good rate of return for a long time often have higher NPVs than those that offer high % rates of return but die young. IRR favours small projects with high rates of return but low NPVs. More Examples of Mutually Exclusive Projects -­‐ As long as at least one project has positive NPV, simply choose the project with the highest NPV Investment Timing Decision The decision rule for investment timing is to choose the investment date that results in the highest NPV today Long-versus-Short Term equipment Equivalent Annual Cost is the cost per period with the same present value as the cost of buying and operating a machine - Rule for comparing assets of different lives – select the machine that has the lowest equivalent annual cost Jessica Gahtan Finance Quiz 2 Notes Replacing an old machine When do you replace – don’t necessarily wait till the last second if the new machine will be more efficient and save you more than the cost of switching Capital Rationing Capital rationing sets a limit on the amount of funds available for investment -­‐ Soft rationing is when the limits are set by management – soft b/c if good projects are being passed up, management can simply relax the limit -­‐ Hard rationing is when the limits are set by investors Profitability index is NPV/Initial investment Pitfalls of the profitability index -­‐ It’s sometimes used to rank projects when there’s no soft/hard rationing imposed – could cause small projects to be favored over larger projects with a higher NPV A Last Look Do Questions: 1-8, 16, 19, 21, 22, 24, 29, 3 2, 35, 36, 44 Jessica Gahtan Finance Quiz 2 Notes Chapter 9: Using DCF Analysis to Make Investment Decisions Identifying Cash Flows Discount Cash Flows, not Profits -­‐ To calculate the NPV you need to discount cash flows not accounting profits – I/S’s show how well a firm has performed, they don’t show cash flows -­‐ When calculating NPV, recognize investment expenditures when they occur, not later when they show up as depreciation. Projects are financially attractive b/c of the cash they generate – either to be given out as dividends or to be reinvested in the firm – therefore, the focus of capital budgeting must be on cash flow, not profits -­‐ It’s not always easy to go from profits to cash flows –if you’re in doubt about what is a cash flow- count the dollars coming in and take away the dollars going out Discount Incremental Cash Flows Incremental cash flow = cash flow with project – cash flow without project -­‐ E.g. when considering launching a new project, you need to consider the cannibalization effect (decrease in sales of other products you sell) -­‐ When dealing with capital budgeting – you need to trace all incremental cash flows from a proposed project, this includes: Include  all  indirect  effects   -­‐ I.e. cannibalization of other products -­‐ Sometimes a project / product will increase existing business – even if, on its own, it has a negative NPV -­‐ To forecast incremental cash flow, you must trace out all effects of accepting the project Forget  Sunk  Costs   -­‐ They’re past and irreversible cash outflows -­‐ Sunk costs remain the same whether or not you accept the project – they, therefore, don’t affect project NPV -­‐ Even if you already invested a million bucks researching something – doesn’t mean that you should automatically keep with it because you already are losing $ Include  Opportunity  Costs   -­‐ The opportunity cost equals the cash that could be realized from selling the land now, and therefore is a relevant cash flow for project evaluation -­‐ When a resource can be traded fairly, this is simply the market price -­‐ Sometimes opportunity costs are hard to quantify – i.e. if you piss people off, that’s definitely something to consider when evaluating whether or not to do something Recognize  the  investment  in  working  capital   Net working capital is current assets minus current liabilities Jessica Gahtan Finance Quiz 2 Notes -­‐ Investments in working capital, just like investments in plan and equipment, results in cash outflows -­‐ Most projects include an additional investment in working capital Some common mistakes: -­‐ Forgetting about working capital entirely -­‐ Forgetting about working capital that changes during the life of the project -­‐ Forgetting the working capital is recovered at the end of the project – can recover investment (cash inflow) @ end of project Remember  shut  down  cash  flows   -­‐ At the end of the project, you might be able to sell some of the PPE dedicated to the project, and recover some of your investment in working capital – don’t forget these incremental cash flows Beware  of  Allocated  OH  Costs   -­‐ A project may generate extra OH costs, but then again, it may not. We should be cautious about assuming that the accountant’s allocation of OH costs represents the incremental cash flow that would be incurred by accepting the project -­‐ OH costs might be assigned – don’t want to include these costs since they’d be paid regardless. Discount Nominal Cash Flows by the Nominal Cost of Capital -­‐ You can’t mix and match real and nominal quantities- real cash flows must be discounted at a real discount rate, nominal cash flows at a nominal rate- discounting real cash flows at a nominal rate is a big mistake Separate Investment and Financing Decisions -­‐ Ignore HOW the project is financed – just treat is as an all-equity financed project -­‐ Treat all cash outflows required for the project as coming from shareholders and all cash inflows as going to them -­‐ Focuses exclusively on the PROJECT cash flows, not the cash flows associated with alternative financing schemes -­‐ Separate the analysis of your investment decision from you financing decision -­‐ First, ask whether the project has a positive NPV – THEN, if it’s a viable project, figure out the best financing strategy Calculating Cash Flows Total cash flow = Cash flow from investment in plant and equipment + cash flow from investment in working capital + cash flow from operations Capital Investment -­‐ Final cash flows may also be negative if there are significant shut down costs Jessica Gahtan Finance Quiz 2 Notes Investment in working capital -­‐ When a company builds up inventories of raw materials/finished gods, the company’s cash is reduced – the decrease in cash reflects the firm’s investment in inventories -­‐ Investment in A/R when customers are slow to pay their bills -­‐ When inventories are sold off, and customers pay their bills – firm’s investment in working capital is reduced as it converts these assets into cash -­‐ An increase in working capital is an investment, and therefore implies a negative cash flow; a decrease implies a positive cash flow. The cash flow is measured by the change in working capital, not the level of working capital. Operating Cash Flow Operating cash flow = revenues – costs – taxes -­‐ Most investments don’t result in additional revenues; they’re simply designed to reduce the costs of the company’s existing operations -­‐ When a firm calculates its taxable income, it makes a deduction for depreciation – depreciation affects the tax that the company pays, but isn’t a cash expense and shouldn’t be deducted when calculating operating cash flow 3  ways  to
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