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CH 9
CH 9
Alex Tajirian
9-2
1. INTRODUCTION
# # Working with the left-hand-side of a balance sheet CAPITAL BUDGETING /INVESTING in Long-term Assets ! Definitions " " " Capital: Budget: Fixed assets used in production Plan of in- and outflows during some period A list of planned investment (i.e., expenditures on fixed assets) outlays for different projects.
Capital Budget:
"
Capital Budgeting: Process of selecting viable investment projects. Financial investment vs. economic investment
"
In this course, investments are needed in order to: " " " Expand in existing markets. Enter new markets. Replace existing capital assets.
morevalue.com, 1997
Alex Tajirian
9-3
Where do these projects come from? " " Suggested by managers of plants & divisions Upper management
! !
Investment and financing decisions are independent. Some common errors: " Expansion without incorporating cost of financing " Cost cutting without looking at revenue side " Ignoring alternative uses of capital
TOOLS CAN BE USED IN: ! ! ! ! M&As Divestitures & spin-offs Correct-sizing Other
morevalue.com, 1997
Alex Tajirian
9-4
CAPITAL BUDGETING OUTLINE ! Develop tools & criteria of selecting projects (Ch. 8): Given Q Relevant CFs Q The required return of the project (i.e., the risk of use of project CFs) Determine which CFs are relevant in project analysis (Ch. 10) Introduce possibility of forecast error in CF data used in analysis (Chapter 11) Assume that k (cost of financing) is known until Ch. 12
! !
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Alex Tajirian
9-5
Capital Budgeting
Dividend Policy
9-6
INVESTMENT DECISION
FINANCING DECISION
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Alex Tajirian
9-7
Capital Budgeting
morevalue.com, 1997
Alex Tajirian
9-8
Example:
#
Example:
9-9
Example: Calculating Payback Period Given the following CFs, and k = 10%, we get: Investment A B Initial cost $10,000 10,000 CF1 0 $10,000 CF2 $14,400 2,400
morevalue.com, 1997
Alex Tajirian
9-10
NPV ' PV of all Relevent CFs & Initial Investment ' CF1 (1%k) ' j
n t'1 n 1
% CF t
CF2 (1%k)
2
% ...%
CF n (1%k)
n
& I0
(1%k) CFt
& I0
' j
t'0
(1%k)t
where, CFt / Net cash flow (inflow - outflow) at time t I0 / Initial cost or investment outlays k / cost of capital (financing) / required return reflecting risk of use of CFs Note: CF0 / I0
morevalue.com, 1997
Alex Tajirian
9-11
Thus, NPV measures the additional market value that management expects the project to create (or destroy) if it is undertaken.
NPV Criteria:
Since the objective of the manager is to maximize value, then for
Choose All Projects with NPV > 0. Choose projects with the highest NPV.
Note:
morevalue.com, 1997
Alex Tajirian
9-12
CF1 0 $10,000
10,000 (1%.1)
1
choose A, since it has the highest NPV if mutually exclusive, or both if independent as they are both with NPV >0.
morevalue.com, 1997
Alex Tajirian
9-13
morevalue.com, 1997
Alex Tajirian
9-14
Example: Calculating additional Shareholder Value Using a project's NPV = $1,901 and assuming that there are 1,000 shares outstanding, then
If the project is adopted then the price of the stock should increase by $1.90.
morevalue.com, 1997
Alex Tajirian
9-15
Easy to determine profit if you have single CF in future. What about if we have multi-period payoffs?
Profit would be calculated as: Ending Value - Beginning Value = $80 - $100 But this calculation ignores the intermediate CFs, namely $10 and $60 in periods 1 and 2 respectively.
morevalue.com, 1997
Alex Tajirian
9-16
Thus, when examining the return on a project, we need a new tool that would incorporate all the cash flows of a project.
Definition of IRR :
IRR is defined as that particular k, such that the project breaks-even, i.e., when NPV = 0. Thus,
CF1 (1 % IRR)
CF2 (1 % IRR)2
% ... %
CF N (1 % IRR)N
Decision Rule:
IRR Criterion: Choose projects with IRR higher than cost of financing. If [the cost of financing "k"] < IRR Y NPV > 0 Y Additional value would be created. Obviously the larger the difference between k & IRR, the higher the NPV. Note: Use IRR cautiously for mutually exclusive projects! Limitations of IRR are discussed on p. 21.
morevalue.com, 1997
Alex Tajirian
9-17
&100 % Y
Y 100(1%IRR) ' 300 Y 100 % 100IRR ' 300 Y IRR ' The ROI is: ROI ' $300 & $100 ' 200% $100 300&100 200 ' ' 2 ' 200% 100 100
morevalue.com, 1997
Alex Tajirian
9-18
Example: Calculating IRR (multiple future CFs) Given: Periods 0 CF from project F IRRF = ? -100 1 10 2 60 3 80
morevalue.com, 1997
Alex Tajirian
9-19
Solution:
To calculate IRR (just like YTM) there is no simple formula to use. Thus, we need to use either trial & error method or a calculator. From definition of IRR,
CF0 %
!
% ... %
' 0
Guess an IRR, say IRR = 19%, then substituting in above equation yields:
& 100 %
You have guessed a number too high. Try a smaller #, say IRR = 17%, thus
& 100 %
If you try IRR = 18.1%, you get correct answer. IRRF = 18.1% (using either trial & error or calculator)
morevalue.com, 1997
Alex Tajirian
9-20
morevalue.com, 1997
Alex Tajirian
9-21
Problems With IRR for Mutually Exclusive Projects: Problem 1: Consider two projects such that returnA = 15%, returnB = 50%, and k = 10%. Which would you choose?
Now assume that they require the following initial investments: IA = $1,000,000 while IB = $100
Problem 2:
Possible existence of multiple IRRs. Every time the CFs change sign, you would get an additional IRR. (See NPV, IRR, "k" profile)
Problem 3:
morevalue.com, 1997
Alex Tajirian
9-22
AROR ' Accounting Rate of Return j accounting profit after tax t /N '
t'1
Source:
Kim, Crick, and Kim, "Do executives Practice What Academics Preach?" Management Accounting (November 1986), pp. 49-52.
morevalue.com, 1997
Alex Tajirian
9-23
<
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Alex Tajirian
9-24
3. SUMMARY T T
Payback Period NPV # # # Independent Projects Mutually exclusive NPV = sum of discounted CFs, where the discount rate is the cost of financing the project.
IRR # Criterion Two equivalent ways to look at it Break-even or ROI > cost of financing project # Calculation ! Trial & error ! Calculator
morevalue.com, 1997
Alex Tajirian
9-25
4. QUESTIONS I. True/Disagree-Explain
1. 2. 3. 4. 5. According to the NPV criterion, you should choose all projects with NPV > 0. According to the IRR criterion, you should choose projects with IRR < cost of financing. Ignoring brokerage fees, purchasing a stock in an efficient market is a zero NPV transaction. Capital budgeting tools can be used to analyze the merits of "flextime." A NPV > 0 project might not be undertaken because of its high risk, despite the manager's confidence in the accuracy of the CF estimates. If a company is expanding, then it is necessarily creating additional value to shareholders. If buying stocks is a NPV = 0 transaction, then no one would profit from them as an investor's profits would be zero.
6. 7.
II. Problems
1) Given: Project S Cost Annual Benefits # of years k $10,000 $4,000 5 14% Project L 25,000 8,000 5 14%
Which of these mutually exclusive projects is better based on NPV and IRR?
morevalue.com, 1997
Alex Tajirian
9-26
2.
3.
4.
5.
6.
7.
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Alex Tajirian
9-27
Calculate NPV NPVS = -10,000 + 4,000(PVIFA14%,5) = 3,732 NPVL = -25,000 + 8,000(PVIFA14%,5) = 2,465
Using IRR:
Since cost of capital for each = 14% < IRR. Y Accept S as it has a higher IRR. Obviously, you should choose both if they were independent.
morevalue.com, 1997
Alex Tajirian
9-28
morevalue.com, 1997
Alex Tajirian
9-29
choose $107 as
$107 ' 100.94 > $100 Y (1 % .06)
PVATT '
PVATT '
Total NPVindependent
Case 2:
You cannot borrow, or cost of borrowing is 400% and assume that a project with same risk as "great deal" has a return of 12%. Action: Mutually exclusive projects
morevalue.com, 1997
Alex Tajirian
9-30
300 (1 % 4)
morevalue.com, 1997
Alex Tajirian
9-31
Obviously, in this case you are better off taking $100 from ATT. Thus,
NPV ' & 100 % 300 ' & 100 % 267.8 ' 167.8 < NPVindependent 1% .12
You discount at 12%, since it is the return you have to forego if you invest in a project with same risk as ATT. NPVindependent > NPVmutually exclusive
morevalue.com, 1997
Alex Tajirian
9-32
b. RELATIONSHIP BETWEEN P, DIVIDENDS, g, & NPV p0 = PV (CF of existing business) + NPV ( dividend growth due to investment of future earnings)
EPS1 k % NPVGO .................................................. Let RR' Retention Ratio Y D1 ' (1& RR)(EPS1) Y return on retained earnings ' (RR)(EPS1)(ROE) where ROE ' EPS1 book equity per share
Y NPV1 ' & I0 % PV of increases CFs ' & (RR)(EPS1) % (RR)(EPS1)(ROE) k ROE . . k . .......(( ( )
Y NPV1, NPV2,.... are growing at a rate (RR)(ROE) ' g Y NPVGO ' NPV1 k & g
p0 '
EPS1 k
NPV1 k & g
'
D1 k & g
9-33
b. c. d.
RR Relative magnitudes of ROE and k; see equation (**) above. Growth, (RR)(ROE), does not necessarily imply NPV _.
morevalue.com, 1997
Alex Tajirian
9-34
c. WHERE DO NPV> 0 PROJECTS COME FROM? # # In long-run NPV = 0 ] excess economic profit = 0 Sources of NPV > 0 (Sources of competitive advantage) ! Barriers to entry ! product differentiation ! economies of scale ! better distribution channels ! luck INVESTMENT UNDER UNCERTAINTY Classical micro-economic theory
Observations: # Firms use cost of capital "hurdle rate" in NPV > 3 times cost of capital ] firms invest only if price is substantially > LRAC (Summers '87) # # Firms stay in business even after p < AVC First quarter of '85 $ started `. By end of '87, $ was at '78 level. But, import volume did not ` until 2 years later. (Krugman & Baldwin '87)
morevalue.com, 1997
Alex Tajirian
9-35
U.S. firms abandon project earlier than Japanese (TV, VCR, semiconductors)
Explanation: Agree NPV = NPV + flexibility option Sources of option value: # sunk costs in abandonment decision ! Severance pay for workers (-) ! scarp value (+) (Myers & Majd '85) " capital used is industry specific (eg. steel mills) Y Who is going to buy machinery when entire industry is suffering?! " lemon problem " stop and re-start needs additional costs (McDonald & Siegel '85) # Uncertainty: product price, operating costs, interest rates Y value in option to wait (Pindyck '91, Ross & Ingersoll '92) ! parameters: " if uncertainly is high Y value of waiting _ " if k is low Y future outcomes valued more Y value of option to wait and resolve future uncertainty _. " What happens if there are other firms in industry? Y "balance" between waiting and implementing (Fudenburg & Tirole '83, Stiglitz '89) " if k ` does not Y Investment _ as cost of waiting ` " Why did U.S. abandon color TVs, VCRs and semiconductors? The value of waiting to invest is governed by downside risk. But Japanese government supports
morevalue.com, 1997
Alex Tajirian
9-36
firms during downside through cartelization to avoid destructive competition. (Bernake '83) !
#
Remarks ! If 400% (in above illustration) is the cost of borrowing, maybe that is the Agree cost of financing. ! If a project sounds "too good to be Agree," it probably is "too good to be Agree." ! Role of market in information processing vs. personal borrowing market.
morevalue.com, 1997
Alex Tajirian