Appendix A: Evaluating Investment Projects

Transcription

1 Appendix A: Evaluating Investment Projects Five s to Evaluate Projects 1. Payback Period 2. Discounted Payback Period 3. Net Present Value 4. Profitability Index 5. Internal Rate of Return 1. Payback Period The payback period the time it takes to get the investment back. Back-of-the-envelope. 1. Payback Period The payback period technique ignores the time value of money, risk, and post payback cashflow overall there is no connection between an investment s payback period and its profitability A shorter payback period is not always better than a longer period New York: John Wiley & Sons, 2002, p

2 Payback Period for TWIT TWIT: Cost Assumptions $1bn in capital invested in the first year Operating cost of $200 million/ year each year TWIT: Revenue Assumptions Year 1: $100m Year 6: $500m 2: $200m 7: $500m 3: $300m 8: $500m 4: $400m 5: $500m Payback Period with No Discounting Find the smallest i for which the inequality is true. I = year N = total years C= cash flow (net) (and including investment) N i = 1 C i 0 2

3 Payback Period Build a table with individual period cash flows and add them together th until the sum becomes positive, as in the following example Year Operating Costs Adding up Revenues Net Cash Flow ($m) Cumulative Net Cash Flow ($m) ($1100) (1100) (1100) (1000) (800) (500) (200) The Sum of the Net cash flows becomes positive in year Discounted Payback Period The time needed to pay back the original investment in terms of discounted future cash flows New York: John Wiley & Sons, 2002, p. 64. Each cash flow is discounted back to the beginning of the investment at a rate that reflects both the time value of money and the uncertainty of the future cash flows New York: John Wiley & Sons, 2002, p

4 This rate is the cost of capital (the return required by creditors and owners) to compensate them for the time value of money and the risk associated with the investment New York: John Wiley & Sons, 2002, p. 65. Discounted Payback Period Formula Similar, but uses discounted cash flows: N i= 1 C (1 + i r ) i 0 Adding up the discounted cash flows, using as the discount rate the cost of capital, assumed r=12% 2. Discounted Payback Period But the discounted payback period technique omits information about profitability of an investment it ignores everything after the breakeven point New York: John Wiley & Sons, 2002, p

5 3. Net Present Value Net Present Value (NPV) = present value of all expected future cash flows 3. Net Present Value NPV > 0 : The investment increases the value of the firm the return is more than sufficient to compensate for the required return of the investment New York: John Wiley & Sons, 2002, p. 71. New York: John Wiley & Sons, 2002, p. 73. Net Present Value for TWIT Present value of all future cash flows, up to 20 years from now Where Ci is the net cash flow in - year i. PV in year i is NCF i /(1+r) i 20 NPV = PV i = 1 i Year NCF PV 1 (1100) (982.1) NPV:

6 Net Present Value of Cash Flows up to 20 yrs The NPV of 20 years of cash flows is $545.5M 5M (including the outflow of investment) 3. Net Present Value NPV calculations result in a dollar amount, but what is it as a percentage of return? PI = 4. Profitability Index PV of inflows Investment Profitability Index : Cash Flow Year Operating Revenue Operating Cost NCF (1100)

7 PV of inflows = $1,527.6 Investment = $1,000 $ 1,527.6 / $1,000 = 1.52 The PI>1. It returns $1.52 for each $1 invested. But no consideration for time value of money. 5. Internal Rate of Return An investment s internal rate of return (IRR) is the discount rate that makes the present value of all expected future cash flows equal to zero New York: John Wiley & Sons, 2002, p. 86. In case of capital rationing with IRR, the firm cannot determine how to distribute the capital budget to maximize wealth because the investments producing the highest yield do not necessarily produce the greatest wealth New York: John Wiley & Sons, 2002, p. 91, 92. Evaluating projects by using IRR indicates the ones that maximize wealth as long as: (1) the projects are independent (the acceptance of one does not prevent the acceptance of the other), and (2) they are not limited by capital rationing New York: John Wiley & Sons, 2002, p

8 Difference between NPV and IRR: NPV assumes cash flows are reinvested at the cost of capital IRR assumes cash flows are reinvested at the internal rate of return New York: John Wiley & Sons, 2002, p. 89. When evaluating mutually exclusive projects with different useful lives and different scales (that is, very different cash flow amounts), the one with the highest IRR may not be the one with the best NPV New York: John Wiley & Sons, 2002, p. 89. Hurdle rate update Hurdle rate should be higher for riskier projects and reflect the financing i mix used owners funds (equity) or borrowed money (debt). Hurdle Example Suppose a proposed new investment costs $1 million and its WACC is estimated t to be 10% per annum (costs are calculated as a perpetuity) 8

9 Hurdle Rate Example Nominal hurdle rates that the sample firms used for a typical project in year Decision i Rule: Accept if IRR > hurdle rate Iwan Meier, Vefa Tarhan, Corporate Investment Decision Practices and the Hurdle Rate Premium Puzzle, February 27, 2006 Using WACC: expected return = 10% Adding in risk (say indirect cost of $0.5million): expected return = 150,000/1,000,000=15% Clearly, requiring an investment to have an expected return of 10% (WACC) is not enough to returning the cost of the capital employed in that investment. Boyle, Glenn; Corporate Investment Policy: What is the Cost of Capital? Boyle, Glenn; Corporate Investment Policy: What is the Cost of Capital? 9

10 Johnson & Johnson hurdled rate of return of 15% or more over their lifetime. Survey shows The majority of companies don t adjust hurdle rates for different projects or divisions. Iwan Meier, Vefa Tarhan, Corporate Investment Decision Practices and the Hurdle Rate Premium Puzzle, February 27, 2006 Survey Sample: Cross-section 127 Firms 53.9% -- always use the company-wide hurdle rate 13.8% -- use the hurdle rate that are in the same industry as the division Iwan Meier, Vefa Tarhan, Corporate Investment Decision Practices and the Hurdle Rate Premium Puzzle, February 27, % -- adjust the industry hurdle rate for tax rate, cost of debt, capital structure etc. Iwan Meier, Vefa Tarhan, Corporate Investment Decision Practices and the Hurdle Rate Premium Puzzle, February 27,

11 Formula: 0 = C i IRR N i = 1 (1 + ) i Thus, we must solve: C 20 i 0 = i i = 1 (1 + IRR ) Where C i = each cash flow term from previous Finding the IRR Use a financial calculator to find the discount rate that satisfies the equation. For TWIT, IRR= 18.5% The decision rule for the internal rate of return is to invest in a project if it provides a return greater than the firm s cost of capital 11

12 For TWIT IRR = 18.5% Cost of Capital = 12% IRR > 12% Google IPO Method: Modified Dutch Auction 2. -Value of offering: $1.67 billion -Initial market cap: $23.1 billion Stages in the Capital Budget Process 12

13 1. Investment screening techinques 2. Capital budget proposal Selected projects from stage 1 are proposed with expected cost of investment and an estimate of expected revenues Peterson, Pamela P. & Fabozzi, Frank J. Capital Budgeting: Theory and Practice. New York: John Wiley & Sons, page 6, Budgeting approval and authorization Authorization of a project allows for further investigation and analysis. Approval allows expenditures to be made for the project Peterson, Pamela P. & Fabozzi, Frank J. Capital Budgeting: Theory and Practice. New York: John Wiley & Sons, page 6, Project tracking As work continues on a project, managers report periodically on progress. This allows identification of cost over-runs and underperforming projects Peterson, Pamela P. & Fabozzi, Frank J. Capital Budgeting: Theory and Practice. New York: John Wiley & Sons, page 6,

14 5. Post-completion audit Periodically after a project has been approved, its costs and revenues are evaluated to determine if the project should be continued. Peterson, Pamela P. & Fabozzi, Frank J. Capital Budgeting: Theory and Practice. New York: John Wiley & Sons, page 6,