Evaluation of Investment Alternatives. Corporate Finance Fundamentals. FN1 Module 6. Strategic Decisions: Capital Budgeting Criteria

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1 Corporate Finance Fundamentals FN1 Module 6 Strategic Decisions: Capital Budgeting Criteria Lectures and handouts by: Ruth Heathcote 1 FN1 Module 6 1 FN1 Module 6 Part 1: Net Present Value Part 2: Risk-adjusted discount rates Part 3: Internal Rate of Return (IRR) Part 4: Payback and Discounted payback method Part 5: Profitability Index Part 6: Past exam questions 2 FN1 Module 6 2 Evaluation of Investment Alternatives Net Present Value (NPV) Internal Rate of Return (IRR) Payback Period and Discounted Payback Period Profitability Index (PI) 3 FN1 Module 6 3 1

2 Project Evaluation Techniques The following evaluation approaches (NPV, IRR, Discounted payback and PI) require the same data: Estimate of initial cost (CF 0 ) Net incremental after-tax cash flows CFBT(1-T) Cost of Capital (k) Estimate of useful life (n) Ending Cash flows (ECF n ) Corporate tax rate (T) Capital Cost Allowance Rate (d) 4 FN1 Module 6 4 Project Evaluation Techniques The payback method evaluation approach requires the following data only: Estimate of initial cost (CF 0 ) Net incremental after-tax cash flows CFBT(1-T) Estimate of useful life (n) Ending Cash flows (ECF n ) Corporate tax rate (T) Capital Cost Allowance Rate (d) DISCOUNT RATE NOT USED 5 FN1 Module 6 5 Part 1 Net Present Value 6 FN1 Module 6 6 2

3 Net Present Value (NPV) Formula 7 FN1 Module 6 7 Evaluating Investment Alternatives Net Present Value (NPV) Analysis NPV = the sum of the present value of all benefits minus the present value of costs 8 FN1 Module 6 8 Net Present Value (NPV) Analysis If benefits > cost, NPV will be positive and the project is acceptable and will add value to the firm. If benefits = cost, NPV will be equal to zero, and the project is acceptable, but will not add value to the firm. If benefits < cost, NPV will be negative and the project is unacceptable because it destroys firm value. 9 FN1 Module 6 9 3

4 Net Present Value (NPV) Analysis Decision Rule Accept all projects that generate a NPV > 0 Reject all projects that generate a NPV < 0 10 FN1 Module 6 10 Net Present Value Interpreted NPV is an absolute measure (expressed in present dollars) of the net incremental benefits the project is forecast to bring to the shareholders. In a perfectly efficient market, the total value of the firm should rise by the value of the NPV if the project is undertaken. Remember it is the manager s responsibility to maximize shareholder wealth 11 FN1 Module 6 11 Net Present Value We have identified that there are several long-term decision criteria, but the use of the Net Present Value method ensures that our focus is on building shareholder value. The Net Present value method has the fewest limiting assumptions 12 FN1 Module

5 Example If NPV is forecast to be + $250,000, then the PV of incremental benefits exceeds the present value of costs today by $250,000. Remember the PV is determined by discounting the forecast cash flows by the investor s required return. A positive NPV indicates that returns are greater than what investors require. This means a positive NPV adds value to the firm. 13 FN1 Module 6 13 Net Present Value Interpreted In this case, if there were 1,000,000 shares outstanding, acceptance of a $250,000 NPV project in an efficient market means that the market price of each share should rise by: 14 FN1 Module 6 14 NPV Example Problem: Initial outlay = $12,000 After-tax cash flow benefits: Year 1 = $5,000 Year 2 = $5,000 Year 3 = $8,000 Discount rate (k) = 15% 15 FN1 Module

6 NPV Example The Formula-based Approach Solution: 16 FN1 Module 6 16 Solution: NPV Example The Spreadsheet Approach 17 FN1 Module 6 17 The Financial Calculator Approach CF 2ND CLR WORK ENTER ENTER ENTER ENTER NPV 15 ENTER CPT gives $1, FN1 Module

7 Template Initial Cost (Co) - Working capital - Opportunity cost - PV of operating benefits + PVTS PVTSL + PV of Sn + PV of Release of WCn + NPV? 19 FN1 Module 6 19 Example 1 See Handout #1, Example 1 20 FN1 Module 6 20 Example 2 See Handout #1, Example 2 21 FN1 Module

8 FN1 Module 6 End: Next Part 1: Net Present Value Part 2: Risk-adjusted discount rates Part 3: Internal Rate of Return (IRR) Part 4: Payback and Discounted payback method Part 5: Profitability Index Part 6: Past exam questions 22 FN1 Module 6 22 Part 2 Risk-adjusted discount rates 23 FN1 Module 6 23 Firm s Cost of Capital (WACC = k) The weighted average cost of capital (WACC) is the relevant discount rate for NPV analysis only if the risk of the project being evaluated is similar to the risk of the overall firm If the risk of the project differs from the risk of the overall firm a risk-adjusted discount rate (RADR) should be used. 24 FN1 Module

9 Risk-Adjusted Discount Rates Remember that the discount rate applied to a project represents the return required by our providers of capital (investors). We know that investors are risk averse, and require a higher return for higher risk. This means that the correct discount rate for any project should be adjusted for risk. 25 FN1 Module 6 25 Required Rates of Return (RADR) Components The risk-free rate is equal to the real rate of return plus expected inflation (Fisher Equation) The risk premium is based on an estimate of the risk associated with the project. 26 FN1 Module 6 26 Risk-Adjusted Discount Rates (RADRs = k) RADRs can be estimated using a number of alternative techniques: 1. Use the CAPM formula after determining the project beta and using the current risk-free rate (RF) and an estimate of the market risk premium 2. Pure play approach where you find the cost of capital of a firm in the industry associated with the project. 27 FN1 Module

10 Risk-Adjusted Discount Rates For financial assets, we could measure the investor s reaction to risk by analyzing how share prices change as risk changes, and determine the relationship between risk and return, using the short term risk free interest rate, and the return on the market in our model (CAPM). Market risk, as measured by beta, may be an appropriate risk measure for capital investments for well-diversified investors. 28 FN1 Module 6 28 RADR RADR = RF + beta * (RM RF) In this application, beta represents the risk of the project. We can determine RF and RM. Have to estimate project beta. 29 FN1 Module 6 29 Estimating project beta Analyze historical holding-period returns for past similar projects against the returns on the market portfolio. Use holding-period returns for comparable companies in the same line of business as the proposed project. (Pure play method) 30 FN1 Module

11 Project beta Problems: Project betas can shift over time Some projects are safer at start up, others are riskier The CAPM looks one period into the future How accurate is it to use this 1 period rate for a capital budgeting proposal that has a 5 year life? 31 FN1 Module 6 31 Difficulties in estimating project betas Incomplete or unreliable data Difficulty in estimating periodic returns No historical data 32 FN1 Module 6 32 Difficulties in estimating project betas Unpredictable outcomes CAPM is a one period model projects are multiperiod Historical data may not predict future risk. 33 FN1 Module

12 Pure Play Approach This method is used to estimate a project s beta by analysis of comparable companies. In this approach, a firm would identify several publicly traded companies in the same or similar line of business as the proposed project, and determine the beta of this other firm. After making appropriate adjustments for risk (operating and financial leverage adjustments) a beta for the proposed project can be estimated. 34 FN1 Module 6 34 Pure Play Approach Problems: Difficult to find firms that are similar in risk to the proposed project If we want to determine the appropriate beta for this project, we want to measure project risk only. Must adjust the beta of a similar firm to remove financial risk, due to financial leverage 35 FN1 Module 6 35 Project risk and Financial risk Project risk = business risk The risk in the normal operations of the firm Factors affecting business risk include Variability of sales and operating costs Measured by analyzing earnings before interest and taxes. 36 FN1 Module

13 Project risk and Financial risk Financial risk The risk that a firm faces due to debt financing. Measured by analyzing variability in Net Income 37 FN1 Module 6 37 Importance of using correct discount rate Using a RADR adjusted for the uncertainty of timing and amount of a project s cash flows is consistent with the fact that our providers of capital do just that. If we use a lower discount rate than our investors require, then we will accept projects that would decrease the value of the firm If we use a higher discount rate than our investors require, then we will reject projects that would add value to the firm. 38 FN1 Module 6 38 Example 3 See Handout #1, Example 3 39 FN1 Module

14 FN1 Module 6 End: Next Part 1: Net Present Value Part 2: Risk-adjusted discount rates Part 3: Internal Rate of Return (IRR) Part 4: Payback and Discounted payback method Part 5: Profitability Index Part 6: Past exam questions 40 FN1 Module 6 40 Part 3 Internal Rate of Return (IRR) 41 FN1 Module 6 41 IRR The IRR is the same as the YTM for a bond. The IRR determines the economic rate of return for a given project. 42 FN1 Module

15 IRR The internal rate of return (IRR) is that discount rate that causes the NPV of the project to equal zero. If IRR > WACC (for a project in the same risk class as the firm), then the project is acceptable because it will return a rate of return on invested capital that is likely to be greater than the cost of funds used to invest in the project. 43 FN1 Module 6 43 IRR Decision Rule: Accept the project if the IRR > the risk adjusted discount rate for the project. 44 FN1 Module 6 44 Formula to Calculate IRR 45 FN1 Module

16 IRR Example Problem: Initial outlay = $12,000 After-tax cash flow benefits: Year 1 = $5,000 Year 2 = $5,000 Year 3 = $8,000 Cost of Capital = 15% 46 FN1 Module 6 46 Solution Using a Financial Calculator (TI BA II Plus) CF 2ND CLR WORK -12,000 5,000 5,000 8,000 ENTER ENTER ENTER ENTER IRR CPT gives 21.31% 47 FN1 Module 6 47 IRR versus NPV Both methods use the same basic decision inputs. The only difference is the assumed discount rate. The IRR assumes intermediate cashflows are reinvested at IRR NPV assumes they are reinvested at WACC This difference, however, can produce conflicting decision results under specific conditions 48 FN1 Module

17 Comparing NPV and IRR If there is more than one change in sign for the stream of cash flows in a project, for example cash outflow at time 0 (CFo), following by four years of cash inflows, then one year of cash outflows, then multiple IRR values may result in this case the IRR cannot be used for accept/reject, or ranking decisions. The NPV decision rule for accept/reject still works 49 FN1 Module 6 49 Example The CEO of BigCo has just bought a fancy financial calculator and calculated the IRR and NPV of a project: His calculator is telling him that the IRR is 26 percent, but when he uses a cost of capital of 1 percent, the NPV is negative. The CEO expects that if the IRR is greater than the cost of capital then the NPV should be positive. How are the CEO s observations possible? Hint: Construct the NPV profile of this project. 50 FN1 Module 6 50 Example Cash flows: C0 = -5,000 CF1 = 4,800 CF2 = 1,000 CF3 = 6,000 CF4 = -3,000 CF5 = -4, FN1 Module

18 Example 52 FN1 Module 6 52 Example The NPV profile is constructed by determining the NPV of the cash flows at different discount rates. This is an example of a project with more than one change of sign so we can have multiple IRR s implying that we can t rely on the standard result of decreasing the discount rate will increase the NPV 53 FN1 Module 6 53 Comparing NPV and IRR For ranking projects, the NPV decision rule will always result in the best decision. WHY? Because higher NPV implies greater contribution to firm wealth it is an absolute measure of wealth The higher IRR project may have a lower NPV, depending on the size of the project. EG. a 20% return on an initial investment of $1,000 would be ranked higher than a 15% return on a $1,000,000 project. 54 FN1 Module

19 Comparing NPV and IRR The NPV method assumes all future cash flows are re-invested at the discount rate. This is appropriate because it treats the reinvestment of all future cash flows consistently, and k is the investor s opportunity cost. The IRR method assumes cash flows from each project are reinvested at the project s IRR. This is inappropriate particularly when the IRR is high. 55 FN1 Module 6 55 NPV and IRR Compared Which method should be relied upon? It depends on which reinvestment assumption is most realistic. Most often, the NPV assumption of reinvestment at WACC is the most realistic because no rational manager would reinvest cash flows at rates lower than the firm s cost of capital. Projects with high IRRs are not common to assume that future cash flows will be reinvested at the inflated IRR rate is probably wrong. 56 FN1 Module 6 56 Limitations of IRR Method IRR can favor small projects with high rates of return but low NPV IRR can give misleading results when comparing mutually exclusive projects with different lives IRR cannot handle multiple cash flows in and out, as it gives multiple rates of return. 57 FN1 Module

20 Example The cash flows for a project proposal are provided below: Determine the NPV and IRR for this project, assuming the cost of capital for the firm is 7%, and the risk of this project is similar to the risk of the company. Co -5,000 Incremental after tax cash flows $1,500 N= 4 years ECF = 0 58 FN1 Module 6 58 Solution: NPV You can determine the PV of the benefits by using the annuity end function on your calculator: PMT = 1,500 N = 4 FV = 0 I/Y = 7 CPT PV = 5, NPV = -5, , = Conclusion: Accept project, as NPV>0 59 FN1 Module 6 59 Solution: IRR We can also solve this using the annuity function: PV = -5,000 PMT = +1,500 N = 4 FV = 0 CPT I/Y = 7.71% Conclusion: IRR > WACC Accept project 60 FN1 Module

21 Solution: IRR CF 2 nd clr work at CFo prompt -5,000 enter down at C01 prompt + 1,500 enter down At F01 prompt 4 enter IRR CPT Answer = 7.71% Decision: Accept project as IRR > WACC 61 FN1 Module 6 61 Example A firm is analyzing 2 mutually exclusive projects. The appropriate discount rate is 12%» Project A Project B Co -10,000-10,000 CF1 +2, ,000 CF2 +4,000 +3,000 CF3 +12,000 +3,000 Determine the NPV and IRR 62 FN1 Module 6 62 Project A Solution NPV NPV = -10, , , ,000 (1.12) (1.12)2 (1.12)3 = 3, FN1 Module

22 Project A Solution IRR CF 2 nd clr work At Co -10,000 enter down At C01 +2,000 enter down down At C02 +4,000 enter down down At C03 +12,000 enter down down IRR CPT 26.5% 64 FN1 Module 6 64 Project B Solution NPV NPV = -10, , , ,000 (1.12) (1.12)2 (1.12)3 = 3, FN1 Module 6 65 Project B Solution IRR CF 2 nd clr work At Co -10,000 enter down At C01 +10,000 enter down down At C02 +3,000 enter down down At C03 +3,000 enter down down IRR CPT FN1 Module

23 Summary NPV IRR Project A 3, % Project B 3, % Conflicting results!! NPV choose Project A IRR choose Project B 67 FN1 Module 6 67 NPV vs IRR In this example, project B yields a higher IRR because the highest cash flows are received in the early years. Remember, that the IRR method assumes that all cash flows can be invested at the IRR. 68 FN1 Module 6 68 Example A firm is analyzing the following project: Co -22,000 CF1 +15,000 CF2 +15,000 CF3 +15,000 CF4 +15,000 CF5-40,000 Determine the NPV and IRR The firm s cost of capital is 10% 69 FN1 Module

24 Solution NPV NPV; Using the CF function on our calculator : NPV = +711 Conclusion: Accept project 70 FN1 Module 6 70 Solution IRR IRR: Using the IRR function on our calculator: IRR = 5.6% BUT if we determine the PV of all of the cash flows in years 1 5 inclusive, discounted at 27.7%, we get a PV of $22,009. IRR = 27.7% Why do we get 2 IRR s? There are 2 changes of signs in the cash flows (- + -) 71 FN1 Module 6 71 Conclusion When there are multiple changes in the sign of the cash flows, the IRR rule does not work. The NPV rule always works. 72 FN1 Module

25 FN1 Module 6 End: Next Part 1: Net Present Value Part 2: Risk-adjusted discount rates Part 3: Internal Rate of Return (IRR) Part 4: Payback and Discounted payback method Part 5: Profitability Index Part 6: Past exam questions 73 FN1 Module 6 73 Part 4 Payback and Discounted payback method 74 FN1 Module 6 74 Payback Method The payback period is defined as the number of years required to fully recover the initial cash outlays associated with the project. Firms will choose an arbitrary cut-off period. Decision rule: Reject projects whose payback period is longer than the cut-off period. 75 FN1 Module

26 Payback Method It is often used by financial managers as one of a set of investment screens, because it gives the manager an intuitive sense of the project s risk. How does this method provide a measure of risk? Projects that pay for themselves quickly are viewed as less risky. 76 FN1 Module 6 76 Payback Method Use after tax, actual, incremental, nominal cash flows in analysis Ignore cash flows after cut-off period Ignore time value of money. 77 FN1 Module 6 77 Simple Payback Example A project is under consideration with the following cash flows: Initial investment = -100,000 Annual after tax cash flow benefits = 60,000 Useful life = 5 years CCA = N/A Cost of capital = 10% 78 FN1 Module

27 Payback Method 79 FN1 Module 6 79 Payback Method How did we determine the answer 1.7 years? After year one cash flows of 60,000 are received, there is still $40,000 of the initial $100,000 to recover. The second year expected cash flows are $60,000 for the entire year, so 40,000 should be recovered after 40,000/60,000 of the year =.6667 =.7 rounded. 80 FN1 Module 6 80 Limitations of payback period The cash flows beyond the payback period are not considered The payback method ignores the risk of the project cash flows and the rate of return the investors require (no discounting no adjustment for project risk) Choice of cut-off date is arbitrary 81 FN1 Module

28 Discounted payback Period Defined as the number of years to fully recover the initial cash outlay in terms of discounted cash flows. Firms will choose an arbitrary cut-off period. Decision rule: Reject projects whose discounted payback period is longer than the cut-off period. 82 FN1 Module 6 82 Discounted payback Period Does consider the time value of money. Ignores cash flows beyond the cut off date Cutoff date is arbitrary 83 FN1 Module 6 83 Discounted Payback Example A project is under consideration with the following cash flows: Initial investment = -100,000 Annual after tax cash flow benefits = 60,000 Useful life = 5 years CCA = N/A Cost of capital = 10% 84 FN1 Module

29 Discounted Payback Example 85 FN1 Module 6 85 Discounted Payback Method How did we come to the answer 1.9 years? After one year, discounted cash flows of $54,545 are recovered. Discounted cash flows of $45,455 are still required. In year 2, discounted cash flows of $49,587 are expected. If we expect to recover 49,587 in one year, then we expect to recover 45,455 in (45,455/49,587) years = 0.9 year Total = 1.9 years 86 FN1 Module 6 86 FN1 Module 6 End: Next Part 1: Net Present Value Part 2: Risk-adjusted discount rates Part 3: Internal Rate of Return (IRR) Part 4: Payback and Discounted payback method Part 5: Profitability Index Part 6: Past exam questions 87 FN1 Module

30 Part 5 Profitability Index 88 FN1 Module 6 88 Profitability Index Uses exactly the same decision inputs as NPV simply expresses the relative profitability of the project s incremental after-tax cashflow benefits as a ratio to the project s initial cost. PI = PV of incremental ATCF benefits PV of initial cost of project 89 FN1 Module 6 89 Profitability Index Decision Rule Accept all projects if PI > 1 WHY? because the PV of benefits exceeds the PV of costs. 90 FN1 Module

31 Profitability Index Advantages of this method: Provides the dollar-to-dollar return you obtain on a project Disadvantages: May provide no help for selecting projects under capital rationing conditions. 91 FN1 Module 6 91 Profitability Index (PI) PI is a ratio of the present value of benefits to costs. As a pure coefficient, as long as it exceeds 1.00 the project will increase the value of the firm if accepted. A PI of more than 1.0 indicates that the project is expected to earn a return greater than the required return. 92 FN1 Module 6 92 Capital Rationing The corporate practice of limiting the amount of funds dedicated to capital investments in any one year. Is academically illogical. Why would a manager not invest in a project that will offer a greater return than the cost of capital used to finance it? In the long-run could threaten a firm s continuing existence through erosion of its competitive position. 93 FN1 Module

32 Capital Rationing Practical Reasons for This Practice The firm may have owners who do not want to raise additional external equity because it will mean ownership dilution to them The firm may have so many great investment projects that they exceed the firm s short-term managerial capacity to take advantage of them. 94 FN1 Module 6 94 Example Consider a firm that has six different capital investment proposals this year. Each project has it s own IRR, NPV, PI and capital cost. Each project has the same risk as the firm as a whole. Assume the firm s cost of capital is 10%. Determine which projects should be chosen based on NPV, IRR, PI assuming no capital rationing. See Example 5 in Handout #1 95 FN1 Module 6 95 Example 96 FN1 Module

33 Projects Ranked by NPV Assume no capital rationing 97 FN1 Module 6 97 Projects Ranked by IRR Assume no capital rationing 98 FN1 Module 6 98 Projects Ranked by PI Assume no capital rationing 99 FN1 Module

34 Ranking of Projects In the Absence of Capital Rationing Project NPV IRR PI 1 C D D 2 F C C 3 E E F 4 B F E 5 D B B Capital Budget $9,369,000 $9,369,000 $9,369,000 Total NPV $679,803 $679,803 $679,803 Clearly, in the absence of capital rationing, all three methods choose value maximizing projects and reject value-destroying projects. 100 FN1 Module Example Consider a firm that has six different capital investment proposals this year. Each project has it s own IRR, NPV, PI and capital cost. Each project has the same risk as the firm as a whole. Assume the firm s cost of capital is 10%. The firm has a capital budget of $6,000,000. Determine which projects should be chosen based on NPV, IRR, PI See Example 6 in Handout #1 101 FN1 Module Projects Ranked by NPV Assume a capital budget of $6,000, FN1 Module

35 Projects Ranked by IRR Assume a capital budget of $6,000, FN1 Module Projects Ranked by PI Assume a budget of $6,000, FN1 Module Ranking of Projects Assuming a Limit on Capital Expenditures to $6,000,000 Project NPV IRR PI 1 C D D 2 F C C 3 E E F Capital Budget $5,960,000 $5,070,000 5,030,000 Total NPV $735,785 $656,168 $663, FN1 Module

36 Conclusion The NPV criterion produces the optimal combination of projects, when there is capital rationing. 106 FN1 Module FN1 Module 6 End: Next Part 1: Net Present Value Part 2: Risk-adjusted discount rates Part 3: Internal Rate of Return (IRR) Part 4: Payback and Discounted payback method Part 5: Profitability Index Part 6: Past exam questions 107 FN1 Module Part 6 Past exam questions 108 FN1 Module

37 Past Exam Questions Please note that past exam questions are to be used as a guideline and they are not updated to the newest materials. I have not seen your exam. 109 FN1 Module Past exam questions Question FN1 Module Past exam questions Question FN1 Module

38 Past exam questions Question FN1 Module Past exam questions Question FN1 Module Past exam questions Question FN1 Module

39 Past exam questions Question FN1 Module FN1 Module 6 End: Part 1: Net Present Value Part 2: Risk-adjusted discount rates Part 3: Internal Rate of Return (IRR) Part 4: Payback and Discounted payback method Part 5: Profitability Index Part 6: Past exam questions 116 FN1 Module