Investment Decisions and Capital Budgeting

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1 Investment Decisions and Capital Budgeting FINANCE 350 Global Financial Management Professor Alon Brav Fuqua School of Business Duke University 1 Issues in Capital Budgeting: Investment How should capital be allocated? Do I invest / launch a product / buy a building / scrap / outsource... Should I acquire / sell / accept offer for company or division? How should the capital budgeting process be organized? Which choices should I make? make or buy which distribution channel should I test market a product 2

2 Discounted Cash Flows A Tool For Rational Decision Making What can be an object of capital budgeting procedures? There must be a choice - choose a base case and an alternative. (Do nothing/status quo) Identify incremental cash flows from project Treat as incremental cash flows to shareholder (marginal impact) Calculate the value of the project. Taking into account timing and risk (t and r e ) Aggregate cash flows into one single number Show that doing all and only projects which have positive net present value maximizes the value of the firm. 3 Estimating Relevant Cash Flows The relevant cash flows for evaluating a new investment project are the incremental cash flows contributed by the project. Incremental = Firm s CFs - Firm s CFs Cash Flows with Project without Project Only Incremental Cash Flows are Relevant. But consider, Side effects of the project Investment in working capital. Forget about sunk costs. Include all opportunity costs Impact on taxes (depreciation & expense) Separate investment from financing decisions Cash flow uncertainty, use expected values 4

3 Example: Estimating Cash Flows A new machine costs $60,000 installation costs of $2,000. generates revenues of $155,000 and expenses of $100,000 annually. depreciated to its estimated salvage value of $6,000 over its seven year life. What are the relevant cash flows? 5 Compute Cash Flows Compute Tax Cash Flows Year Revenues 155, ,000 Expenses -100, ,000 Depreciation -8, ,000 Taxable Income 47, ,000 Tax 15, ,980 Compute Net Cash Flows Year Revenues 155, , ,000 Expenses -100, , ,000 Tax -15, ,980-15,980 Cost of Machine -62,000 Salvage 6,000 Net Cash Flow -62,000 39, ,020 45,020 6

4 Net Present Value: The General Case You have incremental cash flows: CF 0, CF 1, CF 2,..., CF T NPV in year 0 is present values of all incremental cash flows: CF1 CF2 CFT NPV = CF T ( 1+ r) ( 1+ r) ( 1+ r) = T t = 0 CF t ( 1+ r) t 7 Computing NPVs Example Step 1: Forecast cash flows Year CF Step 2: Determine the PVs of cash flows with 10% discount rate: Discount Factor [(1+r) -t ] Total Discounted Cash Flow = 29.6 Step 3: Sum! =

5 Positive NPV Projects We showed that a project with a cash flow: had an NPV of 10%. So what? Suppose the only shareholder has a bank account where she can borrow or deposit at 10%. Take on the project, draw out 29.6 and spend: Year Project Cash Flow Loan Cash Flow Interest Balance of account Payment to shareholder What if NPV is negative? Suppose you accept a negative NPV project: Year Project Cash Flow Loan Cash Flow Interest Balance of account Payment to shareholder Negative NPV means that you have to spend money today to be able to undertake the project! 10

6 Replicate the Project with Bonds Recall the argument about replication with zero coupon bonds Replicate project with 3 bonds (assuming the discount rate is 10% per annum): Invest in a 1-year bond with face value 50 Sell a 2 year bond with face value 30 Sell a 3 year bond with face value 200 Include project in your portfolio Year Project Cash Flow Buy Bond 1 (1 Year) Sell Bond 2 (2 Year) Sell Bond 3 (3 Year) Portfolio Portfolio has zero cash flows in the future (perfect replication) 11 Net Present Value (NPV) The NPV measures the amount by which the value of the firm s stock will increase if the project is accepted. NPV Rule: Accept all projects for which NPV > 0. Reject all projects for which NPV < 0. Suppose you have several mutually exclusive projects A, B, C,...: Choose the project with the highest NPV. Equivalent to breaking decision into sequence of binary decisions: Choice between A and B, compare winner of A vs B with C. 12

7 NPV Example Consider a drug company with the opportunity to invest $100 million in the development of a new drug. expected to generate $20 million in after-tax cash flows for the next 15 years. the required return is 10% What is the NPV of this investment project? What if the required return is 20%? NPV = $20[11/(1.10)15 ] $ NPV = $52.12million NPV = $20[11/(1.20)15 ] $ NPV = $6.49million 13 Sources of positive NPV Where does positive NPV come from? Competitive advantage for company from protection through: barriers to entry, specific resources, skills NPV measures value creation! Use caution in applying How much of your NPV comes from cash flows beyond 5 years (10 years)? Can you sustain your competitive advantage that long? Do your forecasts anticipate competition? What margins, growth do you anticipate relative to your competitors? 14

8 Special Topic: Comparing Projects with Different Lives Your firm must decide which of two machines it should use to produce its output. Machine A costs $100,000, has a useful life of 4 years, and generates after-tax cash flows of $40,000 per year. Machine B costs $65,000, has a useful life of 3 years, and generates after-tax cash flows of $35,000 per year. The machine is needed indefinitely and the discount rate is r p = 10%. Year Machine A Machine B = = = = = Comparing Projects with Different Lives Step 1: Calculate the NPV for each project for one reinvestment cycle: NPV A =$26,795 NPV B =$22,040 The NPV of A is received every 4 years The NPV of B is received every 3 years Year Machine A Machine B

9 Comparing Projects with Different Lives Step 2: Convert the NPVs for each project into an equivalent annual annuity. Recall the annuity formula: c 1 i PV = 1 c = PV i ( 1+ i) N 1 ( 1+ i) For project A, the equivalent annual payment is: c = $26, = $8, ( ) 4 For project B, the equivalent annual payment is: c = $22, = $8, ( ) 3 N Year Machine A Machine B Comparing Projects with Different Lives The firm is indifferent between the project and the equivalent annual annuity. Since the project is rolled over forever, the equivalent annual annuity lasts forever. The project with the highest equivalent annual annuity offers the highest aggregate NPV over time. (What is the aggregate NPV?) 18

10 Alternative Method: Payback Rule Payback Period Length of time required to recover the initial investment of the project. If PP less then pre-determined cutoff, accept the project. Consider 3 projects (Brealey & Myers): Cash Flows Payback NPV Project t=0 t=1 t=2 t=3 Period (Years) 10%) A -$2,000 $500 $500 $5,000 3 $2,624 B -$2,000 $500 $1,800 $0 2 -$58 C -$2,000 $1,800 $500 $0 2 $50 19 Alternative Method: Internal Rate of Return Internal rate of return (IRR). Rate of return to project required to obtain an NPV = 0. If IRR > opportunity cost of capital then accept project. Examples of Problems with IRR (Brealey & Myers) Problem 1: Sign changes in the cash flows Cash Flows NPV Project t=0 t=1 t=2 t=3 IRR 10%) A $1,000 -$3,600 $4,320 -$1,728 20% -$0.75 Problem 2: Multiple IRR s Cash Flows NPV Project t=0 t=1 t=2 t=3 t=4 T=5 T=6 IRR 10%) A -$1,000 $800 $150 $150 $150 $150 -$150-50% or 15.2% $74.90 Problem 3: No Real IRR Cash Flows NPV Project t=0 t=1 t=2 IRR 10%) A $1,000 -$3,000 $2,500 No Real IRR $339 Further Problems: Deciding among projects, which cost of capital to compare with? 20

11 Conclusions NPV has strong attractions: based on cash flows - so does not depend on accounting conventions fully reflects time value of money takes into account riskiness of project gives clear go/no go answer 21

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