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Chapter 1: Investment decisions
PART A – Project’s Cash Flows
Forecasting earnings A capital budget lists the projects and investments that a company plans to undertake during the coming year. Firms forecast the project’s future consequences for the firm determining the incremental earnings of a project. That is, the amount by which the firm’s earnings are expected to change.
Earnings and cash flows are not the same. To pass from earnings to cash flows we should add depreciation and amortization, subtract capital expenditures, and subtract the increase in NWC.
Feasibility Study
Revenue and Cost Estimates
- Estimated life of the project : four years
- Revenue estimates :
- Sales = 100,000 units/year.
-Per Unit Price = $235.
-Up-Front R&D = $15,000,000.
-Up-Front New Equipment = $7,500,000 (Expected life of the new equipment is 5 years (housed in existing lab)).
- Annual Overhead = $3,000,000.
-Per Unit Cost = $95.
Cost of the feasibility study : $300,
Are taxes relevant even if we make losses? Yes, for example, in year 0 the company will owe 6 $ million less. The firm should credit this tax savings to the project’s incremental earnings forecast.
Capital Expenditures and Depreciation
Investments in plant, property and equipment are a cash expense not directly listed as expense but a fraction of cost deducted each year as depreciation. Some methods are:
- Straight Line Depreciation: Asset’s cost is divided equally over its life ($7. million ÷ 5 years = $1.5 million/year).
Modified Accelerated Cost Recovery System (MACRS).
Net Working Capital (NWC)
The cash included in NWC is cash that is not invested to earn a market rate of return (non-invested cash held in the firm’s checking account, in a company safe or cash box). Firms may need to maintain a minimum cash balance to meet unexpected expenditures, and inventories of raw materials and finished products to accommodate production uncertainties and demand fluctuations. Also customers may not pay for the goods they purchase immediately (receivables). While sales are immediately counted as part of earnings, the firm does not receive any cash until the customers actually pay. In the same way, payables measure the credit the firm has received from its suppliers.
Most projects require investment in NWC:
- Cash held at registers, safe box or checking account.
- Inventories of raw materials or finished product.
- Receivables: earned but not charged (credit offered to customers)
- Payables: spent but not paid (credit received by suppliers)
- Further... sales, the average selling price, the average cost per unit will vary over time.
Where should we allocate the $300,000 of the feasibility study? This cost is not part of the cost of the project, we should not include this 300.000$ as part of the cost because is money we spend to know if the project is good or not, so it’s a sunk cost. If we do the feasibility study we spend this quantity and it doesn’t matter if we do the project or no.
PART B – Evaluating Risk-Free Projects
Assume that we have projects with known and certain future cash flows.
- (^) The methods and rules to decide whether to invest are: 1) Net present value rule. 2) Internal rate of return rule. 3) Payback period and payback rule. 4) Profitability index.
- Project selection: 1) Mutually exclusive projects. 2) Scalable projects with limited resources.
How to compare present and future? A euro today is worth more than one tomorrow. There is the possibility to earn interest. For example, if interest is 10% a year, investing 10 million today gives 11 million in a year:
- 10.000.000 x (1 + 0.1) = 11.000.
The future value in a year of 10 million is 11 million and the present value of 11 million in a year is 10 million.
Future and Present Values
The future value is the amount to which an investment will grow after earning interest:
The present value is the value today of a future expected cash flow:
Net Present Value: an example
Cash flows : immediate $81.6 million “outflow” and an “inflow” of $28 million per year for 4 years. Therefore, if discount rate is r = 0.10, the NPV is 7.2. Discount rate depends on the riskiness of the cash flows:
- Equal to risk-free rate (government bond) if cash flows are certain.
- Higher risk implies greater discount and lower present value. So the value today of a risky asset is lower than if the same asset was not risky.
The NPV Rule :
- Forecast future cash flows.
- Estimate a discount rate.
- Discount future cash flows.
- Go ahead if the present value of the payoff exceeds investment. If NPV > 0
NPV investment rule : when making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. In the case of a stand-alone project, we must accept the project if it’s NPV is positive.
its positive cash flows. If it is not the case, the IRR rule can lead to incorrect decisions.
The IRR has some pitfalls:
- There might be several IRRs or none.
- Ignores magnitude and cannot select among different projects.
- Even more problematic if our discount rates are not stable over time (with which one do we compare the cost of capital?)
Payback period and the payback rule
- The payback period is the number of periods (years) it takes before cumulative forecasted cash flow equals initial outlay.
- The payback rule says only to accept projects that “payback” in the desired time frame.
- This method is deficient, primarily because it ignores cash flows after payback period and the present value of future cash flows. Relies on an ad hoc decision: Which is the appropriate payback time?.
This rule is typically used for small investment decisions. In such cases, the cost of making an incorrect decision might not be large enough to justify the time required to calculate de NPV.
Project Selection
If only one from a set of positive NPV projects can be selected, we should select that with the largest NPV. When resources are limited, the profitability index (PI) helps selecting among various project combinations and alternatives:
- PI = (NPV - C0 ) / ( -C0 ) = PV / ( -C0 )
- (^) If resources are unlimited, we should select projects with PI>1.
When projects are mutually exclusive, the firm can only take on one of the projects even if many of them are attractive. Often this limitation is due to resource constraints. Then the firm must choose the best set of investments it can make given the resources it has available. Managers often work within a budget constraint that limits the amount of capital they may invest in a given period. The manager’s goal is to choose the projects that maximize the total NPV while staying within the budget.
Profitability Index
The profitability index measures the value created in terms of NPV per unit of resource consumed. After computing the profitability index, we can rank projects based on it. For it to be completely reliable, two conditions must be satisfied:
- The set of projects taken following the profitability index ranking completely exhausts the available resource.
- There is only a single relevant resource constraint.
PART C – Adjusting for Risk
Risky Cash Flows
Future cash flows should be from now on “expected cash flows”. Example : Expected cash flow of a project: CF=$100 per year for three years.
Discount rate needs to reflect risk of cash flows and therefore may need to be higher than the “risk-free” rate:
Second, incorporate the possibility that it has debt, so there is the need to take into account cost of debt as well as the cost of equity: We use weighted average cost of capital (WACC) (see next chapter).
CAPITAL ASSET PRICING MODEL (CAMP)
The expected return of any asset is equal to:
Risk-free rate and market risk premium
- (^) Risk-free rate : Use some government bond interest rate as a proxy.
- Equity risk-premium : Use country “index” portfolio e.g. FTSE 100, IBEX 35,…
Beta for a listed company
If a company is listed, use its past returns to estimate beta:
