Download FIN320F Duvic Chapter Notes Unit 8-18 and more Study notes Finance in PDF only on Docsity!
L1: Scenario: Who Gets Your Support? ● Nathan appoints Dianne to the investment committee at TMI. The committee needs her new perspective right away on deciding how to evaluate different opportunities for the company → NPV as our main guide Key Concepts: The Capital Budgeting Process ● Capital assets have a substantial impact on the organizations as they are usually expensive, last for a substantial period of time, and are not easily disposed of. ● Managers should therefore carefully consider all aspects of the project and choose an appropriate decision rule. This is true for all organizations: for-profit, non-profit or governmental organizations. ● Substantial productive assets, such as a large vehicle, involve two classes of expenses ○ Short-term operating expenses are where the benefits are enjoyed in the same period as the expense—such as the diesel fuel to run the vehicle on a daily basis. ○ Long-term capital expenses involve obtaining the major asset: a company will pay a substantial amount today to obtain the vehicle, but will use it for its business over several years Steps of the Capital Budgeting Process: ● A formal Capital Budgeting Process should be used to guide capital expenditure decisions. ● Its six phases consider how the proposed project supports strategic goals, identifies the nature of the project, and how it would affect wealth. This process also guides how the project would be implemented, managed, and closed down. It ends with an audit of the project to improve the organization's approach to capital budgeting ● 1: Develop Long-Term Goals ○ Does the investment fit the company? A pharmaceutical company wouldn’t normally purchase a KFC franchise. While this is a fairly obvious, in reality there are many investments made that really don’t fit the company or its future plans ○ Is the investment economically profitable? Ultimately, a capital investment has to produce economic profit. Managers may convince themselves that they have to be in a market or produce a good; however, indefinitely producing a good at a loss is not viable ● 2: Screen Investments ○ What is the nature of the investment? Investments may expand revenue, reduce costs, renew major assets, or be required by government regulation. Each type of investment has unique characteristics that managers must consider in their decisions; the reason you undertake the investment will be very important in classifying cash flows in the next unit ● 3: Evaluate Investments ○ Is the investment economically desirable? → Managers must determine the economic profitability of the investment
■ 1 → Estimate the cash flows involved ■ 2 → Evaluate cash flows using a chosen evaluation method ● 4: Implement the Project ○ How will the project begin? Managers must obtain the capital needed for the investment. These managers must translate the capital budgeting plan into action. This is a very important phase, as any weaknesses in the plan will be discovered once the project is begun ● 5: Control ○ What will change? During the long life of a capital asset, managers can be assured that many aspects of their economic environment will change. Technology, government fiscal and monetary policy, globalization, social changes, and smart competitors will have an effect on the investment. Consequently, managers will have to modify the project over its productive life or even cut the project’s productive life short ● 6: Audit ○ How can the capital budgeting process be refined? Companies repeatedly make capital budgeting decisions. Here practice, while not making perfect, will help develop the company’s capital budgeting process and make better decisions in future projects Key Concepts: Economic Decision Rules ● Economic decision rules are based on the concept of economic value: identifying the cash flows involved in a project, properly placing them in time, and evaluating them using the appropriate opportunity cost ○ Net Present Value (NPV) → NPV is a dollar measure of the impact of a project on the company's wealth. It uses the opportunity cost to bring all of the project's incremental cash flows back to the present and then compares inflows to outflows to see if the project is acceptable. ○ Internal Rate of Return (IRR) → IRR gives the rate of return earned on a project. To make a decision managers must compare the IRR to the opportunity cost. They should only accept the project if it earns (IRR) more that should be expected (RRR) given other projects of equivalent risk. ○ Profitability Index (PI) → PI is a ratio that calculates the relative wealth created per dollar invested. It uses the same inputs--present values of inflows and present value of outflows--used for NPV but shows managers the relative wealth created rather than the total wealth created. This specialized, relative measure has some specialized applications The Cerebral Stimulator Project Example: ● Nathan Burris, of TMI, is preparing for the next board of directors meeting which
● All three methods recommended the project, which makes sense as they all involve free cash flows and the opportunity cost ● A special note on calculations: The calculator has functions that calculate NPV and IRR directly, but these functions require a specific way to enter cash flows. Application: NPV and IRR
- Net Present Value: a. NPV description: NPV is the sum of the present values of a project’s cash flows. It’s a way of doing cost-benefit analysis. i. For most projects their cash flows occur at different points in time. A valid comparison is possible only if these cash flows can be restated as of a single point in time. This involves using the opportunity cost, which reflects the basic time value of money (risk free interest rate) and an appropriate risk premium. ii. NPV takes into account all aspects of economic value: cash flows, the timing of these cash flows, and the risk-adjusted opportunity cost.
iii. The NPV decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV. b. NPV desirability: NPV is superior to the other methods of analysis presented in our course because it directly measures a decision’s impact on wealth. i. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and not certain, but this is a problem shared by the other performance criteria as well. ii. A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted. This does not mean the shareholders get a check for that amount: it is a statement of the expected increase in wealth given the project, which should be reflected by an increase in the stock price.
- Internal Rate of Return: a. IRR description: The IRR is the rate of return earned on an investment. It is the discount rate that causes the NPV of a series of cash flows to be equal to zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR discount rate, the net value of the project is zero. i. For investments, the IRR decision rule is to accept projects with IRRs greater than the opportunity cost. For example, if a project has an IRR = 12%, and projects of equivalent risk earn a return of 8%, then the project is earning above what would be expected of a similar project and should be accepts. Projects earning less than the opportunity cost should be rejected. If the opportunity cost is 8%, but a project’s IRR = 6%, then the project should be rejected, as the investor should be able to obtain a project earning 8%. b. Relationship between IRR and NPV: IRR is the interest rate that a project earns, whereas the required rate of return is the opportunity cost of the project: the rate of return the project should earn given its risk. NPV directly uses the opportunity cost to evaluate the project’s cash flows, and is thus is preferred in all situations to IRR. For stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques; however, IRR can lead to ambiguous results if there are non-conventional cash flows, and also ambiguously ranks some mutually exclusive projects. c. Appropriate uses of the IRR: IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as “12%”, than in absolute terms, such as “$46,000.” i. IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown or uncertain; in this situation, IRR might provide more information about the project than would NPV.
- Profitability Index: a. PI description: The profitability index is the present value of the future cash
quality of life for the disabled. These organizations also have no stock price or market determined discount rate to use in their decisions. However, like for-profit corporations, cost-benefit analysis is important and must be done as effectively as possible given these limitations. c. Finally, realistic cost/benefit analysis should definitely be used by the U.S. government and would go a long way toward balancing the budget! In fact, cost- benefit analysis is often written into the laws passed by Congress and state legislatures. The major difficulty here is that government benefits/contracts/payments for some groups are considered “fat” by others, so the allocation is often done along political, not economic or true social lines.
- Calculating IRR. A firm evaluates all of its projects by applying the IRR rule. If the required return is 11 percent, should the firm accept the following project? a. Enter all cash flows using the cash flow function. Just enter the initial cash flow and hit the CFj key. Enter the next cash flow and press the CFj key again. Repeat until all cash flows have been entered b. Initial cash flow: -168,500 → Cash flow 1: $86,000 → Cash flow 2: $91,000 → Cash flow 3: $53,000 → To get IRR press downshift Then CST/IRR → Your project earns an IRR of 18.8%
- Calculating NPV. For the cash flows in the previous problem, suppose the firm uses the NPV decision rule. At a required return of 9 percent, should the firm accept this project? What if the required return was 21 percent? a. 9% - Enter all cash flows using CFj → Initial cash flow: -168,500 → Cash flow 1: $86,000 → Cash flow 2: $91,000 → Cash flow 3: $53, i. 9% → Press I/YR → Press downshift key → Press PRC/NPV b. 21% - To get the NPV at 21%, just enter 21, press the I/YR button, then downshift and NPV
- Calculating IRR. What is the IRR of the following set of cash flows? a. Enter each cash flow and press the CFj → Initial cash flow: -19,400 → Cash flow 1: $9,800 → Cash flow 2: $11,300 → Cash flow 3: $6, b. To get IRR press downshift → Then IRR → Your project earns an IRR of 22.09%
- Calculating Profitability Index. What is the profitability index for the following set of cash flows if the relevant discount rate is 10 percent? What if the discount rate is 15 percent? If it is 22 percent? a. 10% - Initial cash flow: $0 Press CFJ → Cash flow 1: $15,800 Press CFJ → Cash flow 2: $13,600 Press CFJ → Cash flow 3: $8,300 Press CFJ b. Inter 10 → Press I/YR → Press downshift → Press PRC/NPV c. At the 10% discount rate the present value of the project’s cash flows is
$31,839.22 → We need only divide this by the initial investment to get the PI → = $31,839.22 / $27,500 = 1. Key Concepts: Two more Decision Rules ● Payback calculates the amount of time it takes for a project to “payback” its initial investment. The shorter the payback period the quicker the company gets its initial investment back and begins to see profit. Managers set the maximum payback period they will accept. Projects with payback periods shorter than this maximum will be acceptable; projects exceeding this project will be rejected. ○ Payback period = Cost of project / Annual cash inflow ● The average accounting return is the rate of return earned on a project. It is calculated by comparing the average net income earned by a project to the cost of the project, measured by the average book value. In a way similar to Payback, managers will set a minimum AAR. If the project earns more than this specified rate, it is accepted. If the ARR is less, the project will be rejected. While useful for some purposes the ARR is not based on future cash flows, and does not use the opportunity cost. It is thus of limited use in making decisions about the future. ○ AAR = Average net income / Average book value The Cerebral Stimulator Project: Payback: ● Payback is a simple rule that focuses on when a project becomes profitable The Cerebral Stimulator Project: Average Accounting Return Example: ● AAR uses accounting numbers → uses Net Income → use the average book value which reflects the cost of the project, adjusted for depreciation
the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and reject projects that take longer to payback. b. Difficulties with payback. The worst problem associated with payback period is that it ignores the time value of money. In not using time value, it also does not use an opportunity cost which would reflect the uncertainty of the cash flows. Additionally, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method, such as the market- based opportunity cost. The payback period is biased towards short-term projects as it ignores any cash flows that occur after the cutoff point. c. Advantages of payback. Despite its shortcomings, payback is often used because the analysis is straightforward and simple. Payback may be sufficient for some small projects that are not of great consequence. Also, projects concerned with maintenance are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important. It may also be used when opportunity cost would be difficult to estimate, such as risky investments in an unstable country,
- Average Accounting Return: a. Information and procedures. The average accounting return is interpreted as an average measure of the accounting performance of a project over time, computed as the average net income with respect to average (total) book value. Given some predetermined cutoff for AAR, the decision rule is to accept projects with an AAR in excess of the target measure, and reject all other projects. b. Difficulties with AAR. AAR is not a measure of cash flows and market value, but a measure of financial statement accounts that often bear little semblance to the relevant value of a project. In addition, the selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial manager, both the reliance on accounting numbers rather than relevant market data and the exclusion of time value of money considerations are troubling. Despite these problems, AAR continues to be used in practice because (1) the accounting information is usually available, (2) analysts often use accounting ratios to analyze firm performance, and (3) managerial compensation is often tied to the attainment of certain target accounting ratio goals.
- Calculating Payback. Global Toys Inc. imposes a payback cutoff of three years for its international investment projects. If the company has the following two projects available, should it accept either of them? a. Project A: This project requires an investment of $60,000 today. The first two years have inflows totaling $51,000. i. Cash flows = $23,000 + 28,000 = $51,
ii. The cash flows are still short by $9,000 ($60,000 - $51,000) of recapturing the initial investment, and we need 47% of the third year to get this last $9,000 → $9,000 / $19,000 =. iii. The payback for Project A is = 2.47 years b. Project B: This project requires an initial investment of $105,000.The first three years have inflows totaling $76, i. Cash flows = $21,000 + 26,000 + 29,000 = $76, ii. The cash flows are still short by $29,000 ($105,000 - $76,000) of recapturing the initial investment, and we need 11% of the third year to get this last $29,000 → $29,000 / $260,000 =. iii. The payback for Project B is = 3.11 years c. Accept Project A and Reject Project B
- Calculating AAR. You're trying to determine whether or not to expand your business by building a new manufacturing plant. The plant has an installation cost of $12.5 million, which will be depreciated straight-line to zero over its four-year life. If the plant has projected net income of $1,368,000, $1,935,000, $1,738,000, and $1,310,000 over these four years, what is the project's average accounting return (AAR)? a. Average net income: The average net income is the income for each year divided by the number of periods. For this project: i. Average net income = ($1,368,000 + 1,935,000 + 1,738,000 + 1,310,000)/4 = $1,587, b. Average book value: The average book value the average value in the balance sheet for the assets. For this project. For straight-line depreciation with no salvage value we can just add the beginning and ending book values and divide by 2. i. Average book value = ($12,500,000 + 0)/2 = $6,250, c. Average accounting return: For this project: i. The AAR is: $1,587,750 / $6,250,000 = .2540 or 25.4% d. Average accounting return logically focuses on the rate of return earned on a project. It uses accounting information which is available to the managers and which they are familiar with.Like payback, accounting does not use time value or a risk-adjusted discount rate. It also uses accounting revenues and expenses, not cash flows. Also, the AAR is set by managers, not based on a market- determined opportunity cost Lesson 2: Special Capital Budgeting Situations Scenario: Choose a Project ● Cathy shares her research breakthrough with Nathan and Dianne, but there are only two project options to pursue → One size does not fit all. There are some special situations that companies face in making their capital budgeting decisions. Key Concepts: Special Capital Budgeting Situations Copy
Mutually Exclusive Projects Example:
Special Situation: Capital Rationing ● It has been assumed that if a project is acceptable to managers, then the company will have the funds to finance the project. However, this is not always the case → The issue of limited resources will always haunt organizations and can lead to capital rationing ● Capital Rationing Situations and Process: ● Companies face two possible capital rationing situations: 1) soft rationing and 2) hard rationing. Once the type of rationing has been identified, the next step is to rank the situations. Then, the final step is to determine if the project fits within the capital budget. ○ Soft Rationing occurs when limits on investments are made by a firm's managers for better control of the firm. With soft rationing companies may want to: ■ Limit growth to a manageable level. The saying is 'growth can kill.' Some companies have had difficulties in growing too fast. They cannot manage the influx of customers, keep quality high, hire enough qualified workers, and overstretch managerial talent. ■ Existing owners may not want to issue additional financial securities, which might dilute their control of the company. ○ Hard Rationing occurs when funds are not available and managers must choose the 'best' projects from among all available projects. Companies face hard rationing when: ■ They may not have sufficiently retained earnings to finance all profitable projects. ■ They may not be able to secure additional bank financing.
$78,500 → Cash flow 1: $43,000 → Cash flow 2: $29,000 → Cash flow 3: $23,000 → Cash flow 4: $21,000 → To get IRR press downshift - Then CST/IRR to get IRRA = 20.70% i. Examining the IRRs of the projects, we see that the IRRA is greater than the IRRB, so the IRR decision rule implies accepting Project A. This may not be a correct decision, however, because the IRR criterion may have a ranking problem for mutually exclusive projects. To see if the IRR decision rule is correct or not, we need to evaluate the project NPVs. b. NPV: Given the comparison of all cash flows discounted to time zero using the risk-adjusted discount rate of 11%, which project has the greatest impact on wealth: the highest NPV? i. Project A: Enter all cash flows (CFj) using Initial cash flow: -$78,500 → Cash flow 1: $43,000 → Cash flow 2: $29,000 → Cash flow 3: $23, → Cash flow 4: $21,000 → 11% - Press I/YR → Press downshift key - Press PRC/NPV → If you entered the cash flows to determine the IRR of project A, you don’t have to put them in again. Just enter the discount rate and solve for the NPV, which is $14,426.54. ii. The NPVB is greater than the NPVA, so we should accept Project B. While the initial investment is the same, Project B has higher cash flows and produces a higher NPV. If you can invest in only one project, B is the better—wealth increasing—investment. c. What project should you accept? i. Both projects are, on their own, acceptable, as each has an IRR greater than the discount rate of 11%, and each also has a positive NPV, again calculated at the discount rate of 11%. ii. Where there is a conflict between the recommendations between NPV and IRR, choose NPV. IRR is a relative measure of performance, whereas NPV provides a dollar measure of the wealth created. As we saw in Unit 10, a positive NPV would increase the stock price. As project B has the greatest increase in wealth for the shareholders, it’s the best choice.
- Problems with Profitability Index. The Matterhorn Corporation is trying to choose between the following two mutually exclusive design projects: a. Profitability Index: Project 1: Calculator steps can be used to compute PI. Just set the initial cash flow at zero, solve for the Present Value of inflows and then divide by the outflows to get the PI: Initial cash flow: $0 → Cash flow 1: $28,300 → Cash flow 2: $34,800 → Cash flow 3: $43,700 → Enter 11 & Press I/YR → Press downshift & Press PRC/NPV → This gives the PV of inflows of $85,693,02 → Divide this by the outflows of $78,000 to get the PI 1 of 1.
i. As these projects are mutually exclusive, the profitability index decision rule implies that we accept Project 2, since PI 2 is greater than the PI 1. b. NPV: Project 1: ** Follow PI Calculations but put Initial Cash Flow # as original
NOT 0 → Enter all other Cash flows → Enter 11 & Press I/YR → Press
downshift & Press PRC/NPV to get = $7,693. i. The NPV decision rule implies accepting Project I, since the NPV 1 is greater than the NPV 2 c. Explain the difference in project acceptance: i. Profitability Index, like IRR, is a relative measure. For standard independent projects NPV, IRR and PI should give the same accept/reject decision. For mutually exclusive projects the relative rankings of IRR and PI may differ from the ranking given by NPV. ii. Using the profitability index to compare mutually exclusive projects can be ambiguous when the magnitudes of the cash flows for the two projects are of different scale. In this problem, Project I is roughly 2. times as large as Project II and produces a larger NPV, yet the profitability index criterion implies that Project II is more acceptable. As always, NPV measures the increase in wealth resulting from the project decision and in the event of a conflict between NPV, IRR and NPV should guide your decisions Working Words
- Operating expenses are short term expenses where the benefits are enjoyed in the same period as the expenses are incurred.
- Capital expenses involve obtaining the major productive asset: a company will pay a substantial amount today to obtain the equipment, technology or other resource and will use this asset as part of the production process over several years.
- Capital Budgeting Process is a formal way for managers to guide their capital expenditure decisions.. This process consists of six steps or phases.
- Net Present Value (NPV): A dollar measure of the impact of a project on the company's wealth. It uses the opportunity cost to bring all of the project's incremental cash flows back to the present and then compares inflows to outflows to see if the project is acceptable.
- Internal Rate of Return (IRR) : The rate of return earned on a project. To make a decision managers must compare the IRR to the opportunity cost. They should only accept the project if it earns (IRR) more that should be expected (RRR) given other projects of equivalent risk.
- Profitability Index (PI): A ratio that calculates the relative wealth created per dollar invested. It uses the same inputs--present values of inflows and present value of outflows--used for NPV but shows managers the relative wealth created rather than the total wealth created. This specialized, relative measure has some specialized applications.
