Corporate Finance: Project Selection and Evaluation, Diapositivas de Gestión Financiera

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Corporate FinanceChapter 1: Investment Decisions

Albert Banal-Estanol

Corporate Finance - Chapter 1

In this chapter… 

Part (a):

Compute projects’ cash flows



Computing earnings, and free cash flows



Necessary inputs?



Part (b): Evaluate risk-free projects: 

Decide whether to invest in a project



Project selection



Part (c): Adjusting for risk: 

How to adjust the “discount rate”?



(more in forthcoming chapters!)

Corporate Finance - Chapter 1

Feasibility study



Estimated life of the project: four years



Revenue estimates: 

Sales = 100,000 units/year



Per Unit Price = $



Cost Estimates: 

Up-Front R&D = $15,000,



Up-Front New Equipment = $7,500,000^ 

Expected life of the new equipment is 5 years (housed in existing lab)



Annual Overhead = $3,000,



Per Unit Cost = $



Cost of the feasibility study $300,

Corporate Finance - Chapter 1

Incremental Earnings Forecast

Are taxes relevant even if we make losses?

Corporate Finance - Chapter 1

From Earnings to Cash Flows

Outflow Inflow

Corporate Finance - Chapter 1

Net Working Capital (NWC)



Definition



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 paid (credit offered to customers)



Payables: spent but not paid (credit received by suppliers)

Trade credit

: difference between receivables & payables

Net Working Capital

Current Assets

Current Liabilities

Cash

Inventory

Receivables

Payables

Corporate Finance - Chapter 1

Indirect effects and real-world complexities(not considered here)



Project Externalities 

Cannibalization

is when sales of a new product displaces sales of existing product



Would customers of HomeNet have purchased existing Linksys wireless routers?



Opportunity costs 

The value a resource could have provided in its best alternative use



Homenet’s equipment will be housed in an existing lab, but what is the opportunitycost of not using the space in an alternative way (e.g., renting it out)?



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?

Part (b): evaluating risk-free projects

Corporate Finance - Chapter 1

How to compare present and future? 

Future Value: Amount to which an investment will grow afterearning interest 

For example, 10 million after two years will be



Present Value: Value today of a future (expected) cash flow 

For example, 12.1 million in two years is





t

r

C

FV

0 



m

m

FV

2

t

t

C

r

PV







1

1





m

m

PV

10

1 .

12

1 .

0

1

1

2









Discount factor

Discount rate

Corporate Finance - Chapter 1

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.

, the NPV is:



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(more on that in part (c) of this chapter)

4

3

2

1

NPV

Corporate Finance - Chapter 1

In general, the NPV rule: Step 1: Forecast future cash flows

(see part (a) of this chapter)

Step 2: Estimate discount rate

(see part (c) of this chapter)

Step 3: Discount future cash flowsStep 4: Go ahead if PV of payoff exceeds

investment, i.e. if NPV > 0

T

T r

C r C r C r C

C

PV

C

NPV

3 3 2 2 1 0 0

Corporate Finance - Chapter 1

But, are there other criteria?

ProfitabilityIndex, 12%

Payback, 57%

IRR, 76% NPV, 75%

Book rate ofreturn, 20%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Survey Data on CFO Use of Investment Evaluation Techniques

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,”Journal of Financial Economics 61 (2001), pp. 187-243.

Corporate Finance - Chapter 1

Example 2

-£10.00 -£15.

-£5.

£5.00£0.

£20.00£15.00£10.

NPV (m)

discount rate

Rate of return: 10%

Corporate Finance - Chapter 1

Introducing interim cash flows



No interim cash flows: 

AV

0

: 80m and AV

2

: 96.8m



With interim cash flows: 

AV

0

: 80m, AV

2

: 96.8m, C

1

: 2m, C

2

: 2m

%

10

or

0

)

1 (

8 .

96

80

2

     

y

y

r

r

NPV

%

4 .

12

or

0

)

1 (

8 .

96

)

1 (

2

)

1 (

2

80

2

2

1

         

y

y

y

y

r

r

r

r

NPV