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Session 2
Session 2
Session 2
Finance @
EDHEC
Prof. Schroth
Corporate Finance 1
Introduction
MSc inFinance
NPV Analysis
Incremental earnings
Free cash flow
EDHEC Business School
Other criteria
The Payback rule
The IRR rule Enrique Schroth
Project
Analysis
Break-even analysis Professor of Finance
Sensitivity analysis EDHEC Business School
Revision
Lecture 2
21 September 2022
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Fundamentals of Capital Budgeting
Corporate
Finance @
EDHEC
Prof. Schroth
Learning objectives:
Introduction
(Berk and DeMarzo, Chapters 7 and 8)
NPV Analysis
Incremental earnings
Free cash flow 1 Identify relevant cash flows for a capital budgeting
Other criteria
The Payback rule
problem.
The IRR rule
2 Explain why opportunity costs must be included in cash
Project
Analysis flows, while interest expense must not.
Break-even analysis
Sensitivity analysis 3 Calculate taxes that must be paid.
Revision
4 Calculate free cash flows for a given project.
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Learning objectives (contd.)
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
Revision
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Forecasting earnings
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
1 The Capital Budget is a list of the investments that a
NPV Analysis
company plans to undertake.
Incremental earnings
Free cash flow
Other criteria
2 Capital Budgeting is the process used to analyze
The Payback rule
The IRR rule
alternate investments and decide which ones to accept.
Project
Analysis
Break-even analysis
3 Incremental Earnings is the amount by which the firm’s
Sensitivity analysis
earnings are expected to change as a result of the
Revision
investment decision.
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Incremental earnings
Corporate
Finance @
EDHEC
Prof. Schroth
Example: Cisco, PLC has completed a $300,000 feasibility
Introduction study to assess the attractiveness of a new improved wireless
NPV Analysis router, HomeNet. The project will have an estimated life of
Incremental earnings
Free cash flow four years.
Other criteria
The Payback rule • The marketing division has provided the following
The IRR rule
Project
estimates of sales and sales costs:
Analysis • sales forecast: 100,000 units per year;
• estimated prices: retail, $360; wholesale $260;
Break-even analysis
Sensitivity analysis
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Incremental earnings (cont’d.)
Corporate
Finance @ • Further estimates of costs provided by the engineering
EDHEC
Prof. Schroth
department:
• up-front engineeering and design cost: $5 million;
Introduction • up-front software development cost: $10 million;
NPV Analysis • cost of new equipment (testing lab), amortized over 5
years (capex): $7.5 million.
Incremental earnings
Free cash flow
Other criteria
The Payback rule • Other assumptions:
The IRR rule
• Corporate taxes (on Earnings Before Interest and
Project
Analysis Taxes, EBIT) are 40%;
Break-even analysis • The project is fully internally financed: no interest
Sensitivity analysis
Revision
expenses (more on this later);
• the salvage value at the end of the project is zero;
• the continuation value at the end of the project is zero;
⇒ Reality check: installed capital will often have a
salvage or continuation value (more on this later).
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HomeNet’s incremental earnings forecast
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
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Depreciation, interest and taxes
Corporate
Finance @
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Unlevered Net Income
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
The Unlevered net income is calculated as
Free cash flow
Revision
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Opportunity costs and earnings externalities
Corporate
Finance @
• Opportunity costs to consider:
EDHEC
The company’s warehouse that houses HomeNet’s lab
could be otherwise rented out for $200,000 per year
Prof. Schroth
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
11 / 33
Incremental earnings forecast (updated)
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
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From earnings to cash flow
Corporate
Finance @
EDHEC
Prof. Schroth
• Earnings are an accounting measure of a firm’s
Introduction performance
NPV Analysis
Incremental earnings
• We are interested in how a project adds to the firm’s
Free cash flow
available cash (Why?)
Other criteria
The Payback rule • The project’s free cash flow (FCF) in each period is
The IRR rule
Project
defined as
Analysis
Break-even analysis
Sensitivity analysis FCF = Unlevered Net Income + Depreciation
Revision −CapEx − ∆ Net Working Capital
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Depreciation, CapEx and Net working capital
Corporate
Finance @
EDHEC
• Depreciation is a non-cash expense. The free cash flow
Prof. Schroth
estimate is adjusted for this non-cash expense.
Introduction
• Capital Expenditures are the actual cash outflows when
NPV Analysis
Incremental earnings an asset is purchased. These cash outflows must be
Free cash flow
Other criteria
included in calculating free cash flow.
The Payback rule • Most projects wil require an investment in net working
The IRR rule
Project
capital (NWC) for, e.g.,
Analysis • maintain a minimum cash balance to meet unexpected
Break-even analysis
Sensitivity analysis expenditures;
Revision • to keep inventories to meet uncertain production
requirements;
⇒ the cash account varies according to these!
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Net working capital
Corporate
Finance @
EDHEC The cash balance also varies depending on the timing of
Prof. Schroth payments and collections:
Introduction • Sales are immediately counted as part of earnings but the
NPV Analysis firm may not receive any cash until the customers pay →
Incremental earnings
Free cash flow the Receivables account.
Other criteria
The Payback rule
• The Payables account measures the credit the firm has
The IRR rule
received from its suppliers, i.e., cost of sales not yet paid
Project
Analysis in cash.
Break-even analysis
Sensitivity analysis
⇒ Receivables - Payables = Trade credit.
Revision
NWCt = Casht + Inventoryt + Trade creditt .
∆NWC = NWCt − NWCt −1 .
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Net working capital at HomeNet
Corporate
Finance @
EDHEC Suppose HomeNet will have no cash nor inventory
Prof. Schroth requirements, but:
Introduction • Customers are expected to pay on average within 55 days;
NPV Analysis ⇒ Receivables amount to 55/365 = 15% of annual sales.
Incremental earnings
Free cash flow
• The corporation needs an average 55 days to pay its bills;
Other criteria
The Payback rule ⇒ Payables are 55/365 = 15% of annual cost of goods
The IRR rule
sold.
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
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Net working capital at HomeNet
Corporate
Finance @
EDHEC Suppose HomeNet will have no cash nor inventory
Prof. Schroth requirements, but:
Introduction • Customers are expected to pay on average within 55 days;
NPV Analysis ⇒ Receivables amount to 55/365 = 15% of annual sales.
Incremental earnings
Free cash flow
• The corporation needs an average 55 days to pay its bills;
Other criteria
The Payback rule ⇒ Payables are 55/365 = 15% of annual cost of goods
The IRR rule
sold.
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
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And finally ...
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
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Calculating the NPV
Corporate
Finance @
EDHEC
The present value of a net cash flow in year t is
Prof. Schroth
1
PV(FCFt ) = FCFt × ;
Introduction
(1 + r )t
NPV Analysis | {z }
Incremental earnings
HomeNet’s
Free cash flow
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Calculating the NPV for HomeNet (cont’d.)
Corporate
Finance @
• What is r ?
EDHEC
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
19 / 33
Calculating the NPV for HomeNet (cont’d.)
Corporate
Finance @
• What is r ?
EDHEC
Should it be the risk-free rate?
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
19 / 33
Calculating the NPV for HomeNet (cont’d.)
Corporate
Finance @
• What is r ?
EDHEC
Should it be the risk-free rate? No!
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
19 / 33
Calculating the NPV for HomeNet (cont’d.)
Corporate
Finance @
• What is r ?
EDHEC
Should it be the risk-free rate? No!
Prof. Schroth
• A project’s specific discount rate, r , must reflect the
Introduction
project’s opportunity cost of capital
NPV Analysis
Incremental earnings
⇒ the expected return of an equally risky investment
Free cash flow
in the financial market
Other criteria
The Payback rule
⇒ Riskier investments pay higher returns (higher r )
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
19 / 33
Calculating the NPV for HomeNet (cont’d.)
Corporate
Finance @
• What is r ?
EDHEC
Should it be the risk-free rate? No!
Prof. Schroth
• A project’s specific discount rate, r , must reflect the
Introduction
project’s opportunity cost of capital
NPV Analysis
Incremental earnings
⇒ the expected return of an equally risky investment
Free cash flow
in the financial market
Other criteria
The Payback rule
⇒ Riskier investments pay higher returns (higher r )
The IRR rule
• Suppose the HomeNet’s Cost of Capital is 12% (much
Project
Analysis more on how to obtain this number later!):
Break-even analysis
Sensitivity analysis
Revision
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Back to the NPV rule
Corporate
Finance @
EDHEC
Prof. Schroth
• Launching the HomeNet project produces a positive
Introduction NPV, while not launching the project produces a 0 NPV.
NPV Analysis
Incremental earnings • To maximise shareholder value:
Free cash flow
Other criteria
1 Ideally, undertake any project with positive NPV;
The Payback rule 2 If projects are mutually exclusive: take the one with the
The IRR rule
highest NPV.
Project
Analysis
Break-even analysis • Can we think of other decision criteria?
Sensitivity analysis
Revision
• Can we inform NPV decision making with further project
analysis?
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The Payback rule
Corporate
Finance @ • The payback period is amount of time it takes to recover
EDHEC
Prof. Schroth
or pay back the initial investment.
⇒ If the payback period is less than a pre-specified
Introduction
length of time, accept the project. Otherwise, reject it.
NPV Analysis
Incremental earnings • The payback rule is used y many companies because of its
Free cash flow
Other criteria
simplicity.
The Payback rule
The IRR rule
Example: projects A, B, and C are expected to last more than
Project five years. Their required investments and annual cash flows
Analysis
Break-even analysis
are:
Sensitivity analysis
Revision Project A B C
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The Payback rule (cont’d).
Corporate
Finance @
Solution:
EDHEC
• Project A pays back in £80 M/ £25 M = 3.2 years
Prof. Schroth
• Project B pays back in £120 M/ £30 M = 4.0 years
Introduction
NPV Analysis
• Project C pays back in £150 M/ £35 M = 4.29 years
Incremental earnings
Free cash flow
Pitfalls of the Payback rule:
Other criteria • Ignores the project’s cost of capital;
The Payback rule
The IRR rule
• Ignores cash flows after the payback period;
Project
Analysis • Relies on an ad hoc decision criterion.
Break-even analysis
Sensitivity analysis
Revision
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The Payback rule (cont’d).
Corporate
Finance @
Solution:
EDHEC
• Project A pays back in £80 M/ £25 M = 3.2 years
Prof. Schroth
• Project B pays back in £120 M/ £30 M = 4.0 years
Introduction
NPV Analysis
• Project C pays back in £150 M/ £35 M = 4.29 years
Incremental earnings
Free cash flow
Pitfalls of the Payback rule:
Other criteria • Ignores the project’s cost of capital;
The Payback rule
The IRR rule
• Ignores cash flows after the payback period;
Project
Analysis • Relies on an ad hoc decision criterion.
Break-even analysis
Sensitivity analysis
⇒ In the example above, the payback rule might lead us to:
Revision
• Accept project B if we can wait 4 years, yet its NPV could
be negative (e.g., for a discount rate of 8%)!
• Reject project C if we cannot wait more than 4, yet it
could have the highest NPV (e.g., over six years)!
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The IRR rule
Corporate
Finance @
EDHEC
NPV Analysis
that solves
Incremental earnings
N
Free cash flow
1
Other criteria ∑ FCFt × (1 + IRR )t = 0.
The Payback rule t =0
The IRR rule
Project
Analysis
Break-even analysis
• The rule is to undertake any project where the IRR is
Sensitivity analysis
greater than the opportunity cost of capital
Revision
• When will the IRR agree with the NPV rule, and when
not?
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Analysing the IRR rule: Delayed Investment
Corporate
Finance @
EDHEC
Example: Suppose you are offered £1 M for your memoirs.
Prof. Schroth Writing your memoirs would cost you three years of work but
each year, each of which you could have earned £500 K. What
Introduction
NPV Analysis
is the NPV is your opportunity cost of capital is 10%. What is
Incremental earnings the IRR?
Free cash flow
Revision
• The NPV is negative (Reject) but the IRR = 23.38%,
which is huge (> 10% → Accept!)
• What is going on?
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IRR and dealyed costs
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
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Analysing the IRR rule: Shifting payoffs
Corporate
Finance @
EDHEC
Prof. Schroth Example: Suppose the publisher sweetens the deal to write
Introduction
your memoirs by offering £550,000 in advance and £1,000,000
NPV Analysis
in four years when the book is published. Should you now
Incremental earnings accept or reject the new offer?
Free cash flow
Other criteria
The Payback rule
For any discount rate, r , the NPV is
The IRR rule
Revision +
(1 + r )4
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Indeterminate IRRs
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
Corporate
Finance @
EDHEC
Prof. Schroth The break-even level of an input is the level that causes the
Introduction NPV of the investment to equal zero.
NPV Analysis ⇒ The IRR is the break-even level of the discount rate
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis ⇒ The IRR of the HomeNet project is very large: 24.1%
Revision
⇒ HomeNet has a ’normal’ cash flow (costs before benefits):
IRR rule agrees with NPV rule.
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Break-Even Analysis (cont’d).
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction We can carry out the break-even analysis for ALL other inputs
NPV Analysis (’parameters’) of the project:
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
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Sensitivity Analysis
Corporate
Finance @
EDHEC
Prof. Schroth
A good sensitivity analysis shows how the NPV varies with a
Introduction change in one of the assumptions, holding the other
NPV Analysis assumptions constant.
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
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Sensitivity Analysis for HomeNet
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
NPV Analysis
Incremental earnings
Free cash flow
Other criteria
The Payback rule
The IRR rule
Project
Analysis
Break-even analysis
Sensitivity analysis
Revision
Corporate
Finance @
EDHEC
Prof. Schroth
Project
3 How do you choose between mutually exclusive capital
Analysis budgeting decisions?
Break-even analysis
Sensitivity analysis
4 How does scenario analysis differ from sensitivity analysis?
Revision
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Revision questions
Corporate
Finance @
EDHEC
Prof. Schroth
Introduction
Revision
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