Slide 1

Slide 2

1 Finance School of Management Objective Explain Capital Budgeting Develop Criteria for Project Evaluation Chapter 6. How to Analyze Investment Projects

Slide 3

2 Finance School of Management Chapter 6 Contents The Nature of Project Analysis Where Do Investment Ideas Come From? The NPV Rule Estimating a Projects Cash Flow Cost of Capital Sensitivity Analysis Using Spreadsheets Analyzing Cost- Reduction Projects Projects with Different Lives Ranking Mutually Exclusive Projects Inflation and Capital Budgeting

Slide 4

3 Finance School of Management Capital Budget and Capital Budgeting Once a company has decided what business it intends to be in, it must considers proposals for investment projects evaluating them deciding which ones to accept and which to reject It must prepare a plan (capital budget) for acquiring factories, machinery, warehouses research laboratories showrooms, and for training the personnel.

Slide 5

4 Finance School of Management The Nature of Project Analysis Starting point: An idea for increasing shareholder wealth Procedures of project analysis Forecasting cash flows: Decisions and events Flexibility of decisions in the projects life

Slide 6

5 Finance School of Management Where Do Investment Ideas Come from? Customers R&D department Competition Production division Incentive systems

Slide 7

6 Finance School of Management Objectives To show how to use discounted cash flow analysis to make decisions such as: Whether to enter a new line of business Whether to invest in equipment to reduce costs

Slide 8

7 Finance School of Management NPV Rule Revisited Invest if the proposed projects NPV is positive. Discount rate Opportunity cost: The rate of return on comparable investment opportunities. Cost of capital NPV: The fair market value in competitive and efficient market.

Slide 9

8 Finance School of Management DCF Payback Do the Project

Slide 10

9 Finance School of Management Dont do the Project

Slide 11

10 Finance School of Management Indifferent Internal Rate of Return

Slide 12

11 Finance School of Management

Slide 13

12 Finance School of Management Measurement of Value Accounting Market Two approaches of measuring value: Accounting: Book valueHistorical cost Financial: Market valueDiscounting

Slide 14

13 Finance School of Management Asset = Liability + Equity The Use of Money The Source of Money The Balance Sheet

Slide 15

14 Finance School of Management Corporate Finance Assets Liabilities and Equity Asset 1 Asset 2 Liabilities Asset 3 Equity Asset n Total Assets Liabilities & Equity Continued Accounting: Yes! Finance: No!

Slide 16

15 Finance School of Management Corporate Finance Assets Liabilities and Equity Asset 1 Asset 2 Liabilities Asset 3 Equity Asset n Total Assets Liabilities & Equity NPV NPV + NPV Firm Value Capital Market Real Economy

Slide 17

16 Finance School of Management Example: PC1000 of Compusell Corp.

Slide 18

17 Finance School of Management

Slide 19

18 Finance School of Management PC1000: Cash Flows 2.2 1.3 -5 1.3 A seven-year coupon bond with an annual coupon payment of $1.3 million, a face value of $2.2 million, and a price of $5 million.

Slide 20

19 Finance School of Management Was 0%

Slide 21

20 Finance School of Management Was 15%

Slide 22

21 Finance School of Management Was 40%

Slide 23

22 Finance School of Management Was 0%

Slide 24

23 Finance School of Management Was 75%

Slide 25

24 Finance School of Management Was 3,100,000

Slide 26

25 Finance School of Management Table 6.4 Project Sensitivity to Sales Volume 3640 is the NPV break-even point. Sales UnitsNet CF OperationsNPV Project 20002000005005022 30005500001884708 3604 * 10030090 400013000001235607 500020500004355922 600028000007476237

Slide 27

26 Finance School of Management

Slide 28

27 Finance School of Management Sensitivity of Project to Sale Volume $500,000 $0 $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000 2,0002,5003,0003,5004,0004,5005,0005,5006,000 Sales (Units) Net CF from Operations

Slide 29

28 Finance School of Management

Slide 30

29 Finance School of Management Cost of Capital Risk-adjusted discount rate (k) The risk of a particular project may be different from the risk of the firms existing assets. The risk that is relevant in computing a projects cost of capital is the risk of the projects cash flows and not the risk of the financing instruments (e.g., stocks, bonds) the firm issues to finance the project. The cost of capital should reflect only the market-related risk of the project (its beta).

Slide 31

30 Finance School of Management Illustration 1 25-year U.S. Treasury bonds paying $100 per year are selling in the market at $1,000. A firm has the opportunity to buy $1 million worth of these bonds for $950 each. The firms overall (average) cost of capital is 16%. If discounted at 16%, the NPV of the opportunity is -$340,291. However, no one will forgo the opportunity. The correct cost of capital is nearly 10%.

Slide 32

31 Finance School of Management Illustration 2 Compusell Corporation is planning to finance the $5 million outlay required to undertake the PC1000 project by issuing bonds. Compusell has a high credit rating because it has almost no debt outstanding and therefore can issue $5 million worth of bonds at an interest rate of 6% per year. It would be a mistake to use 6% as the cost of capital in computing the NPV of the PC1000 project.

Slide 33

32 Finance School of Management Illustration 3 An all-equity financed firm with tree divisions: An electronics division, 30% of the firms market value, cost of capital 22%; A chemical division, 40% of the firms market value, cost of capital 17%; A natural gas transmission division, 30% of the firms market value, cost of capital 14%. The cost of capital for the firm is 0.322% + 0.417% + 0.314% = 17.6%. If 17.6% is adopted as discount rate for all projects, then it is likely to accept projects in the electronics division with negative NPV; to pass up profitable natural gas transmission.

Slide 34

33 Finance School of Management Illustration 4 An all-equity financed steel company considering the acquisition of an integrated oil company that is 60% crude oil reserves and 40% refining. The market capitalization rate on crude oil investments is 18.6% and on refining projects is 17.6%. The market capitalization rate on the oil company shares is 18.2%. The market capitalization rate for steel projects is 15.3%. The market price of the oil companys shares is fair ($100, expected return 18.2%). An investment banker reports that all the shares could be acquired for a tender offer bid of $110 per share. With 15.3%, the NPV of the acquisition is 110+18.2/.153=$9. With 18.2%, the NPV of the acquisition is 110+18.2/.182=-$10.

Slide 35

34 Finance School of Management Example: Cost Reducing Project A firm is considering an investment proposal to automate its production process to save on labor costs. Invest $2 million now in equipment (an expected life of 5 years) and thereby save $700,000 per year in pretax labor costs. The incremental cash flows due to the investment: At the 10% discount rate, the NPV is $274,472.

Slide 36

35 Finance School of Management Project with Different Lives Suppose that there are two different types of equipment with different economic lives in the previous example. The longer-lived requires twice the initial outlay but lasts twice as long. An easier approach is called annualized capital cost. The Shorter-lived equipment The Long-lived equipment

Slide 37

36 Finance School of Management Ranking Mutually Exclusive Projects Sometimes two or more projects are mutually exclusive. You own a parcel of land and have two alternatives: Construct an office building; Make a parking lot.

Slide 38

37 Finance School of Management Ranking Mutually Exclusive Projects Rule: This firm should choose the project with the highest NPV at any cost of capital below 20%.

Slide 39

38 Finance School of Management Inflation and Capital Budgeting Rule: There are two correct ways of computing NPV: Use the nominal cost of capital to discount nominal cash flows. Use the real cost of capital to discount real cash flows. Never compare the IRR computed using real cash flow estimates to a nominal cost of capital.