Chapter 6

Investment Decision Rules

6-2

Investment Decisions

• Leave the latte, take the chocolate

• (Bloomberg, Sept 15, 2009) Kraft may be ready to give up coffee and hot dogs in exchange for chocolate. The the food giant might sell assets like Maxwell House and Oscar Mayer in order to raise enough cash to finance an acquisition of British candy company Cadbury.

• Kraft last week proposed making a $16.7 billion stock-and-cash bid for Cadbury, and at the time said it would have no problem financing the transaction. The company planned to pay 60 percent of the price tag in stock and raise about $8 billion in cash for the rest.

6-3

Parallel Petroleum to be bought by Apollo Global

• Sept 15 (Reuters) - Independent oil and gas company Parallel Petroleum Corp (PLLL.O) said it agreed to be bought by investor Leon Black's Apollo Global Management LLC for $132 million in cash.

• The $3.15 per share offer represents an 11 percent premium to Parallel stock's close on Monday on Nasdaq, and the total deal value is $483 million, including assumption of $351 million in debt.

How are investment decisions made?

6-4

6-5

Graham and Harvey, 2002

“It is a major tenet of modern finance theory that

the value of an asset (or an entire company) equals the discounted present value of its expected future cash flows. Hence, companies contemplating investments in capital projects should use the net present value rule: that is, take the project if the NPV is positive (or zero); reject if NPV is negative.”

6-6

Graham and Harvey, 2002

6-7

NPV and Stand-Alone Projects

• Researchers at FFF face an investment decision. The project requires $250 million to build a new plant. The benefits will be $35 million per year, starting at the end of the first year and lasting forever. Should the firm take the project?

6-8

NPV of FFF’s New Project

The graph shows the NPV as a function of the discount rate. The NPV is positive only for discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of capital of 10%, the project has a positive NPV of $100 million.

6-9

Alternative Decision Rules

• The Payback Rule • The Internal Rate of Return Rule • Economic Profit or EVA • Why Do Rules Other Than the NPV Rule Persist?

6-10

Using the Payback Rule

6-11

Merits of the Payback Rule

• Cons– Ignores timing and risk of cash flows (time-value-of-money)– Imposes an arbitrary payback threshold– Completely ignores the cash flows after the payback point– If the project generates both positive and negative cash flows

(other than the initial outlay) we can have multiple payback periods and no clear interpretation

• Pros?– Simplicity – Accounts for the liquidity of the project– Accounts for the uncertainty of the cash flows

6-12

IRR

• Take a project if its IRR exceeds the opportunity cost of capital

• The IRR is the rate at which the NPV is zero.

6-13

Deviations between NPV and IRR

• John Star is offered $1 million to write a book. He will forgo $500,000 a year for three years in opportunity costs. Should he take the book deal?

6-14

NPV of Star’s $1 million Book Deal

When the benefits of an investment occur before the costs, the NPV is an increasing function of the discount rate.

6-15

Non-existent IRR

• John Star is offered $1 million per year in each of the next three years if he gave four lectures per month. He will forgo $500,000 a year for three years in opportunity costs. Should he take the lecture deal?

6-16

NPV of Lecture Contract

No IRR exists because the NPV is positive for all values of the discount rate. Thus the IRR rule cannot be used.

6-17

Multiple IRRs

• John Star is offered $1 million to write a book. He will forgo $500,000 a year for three years in opportunity costs. After the book is written (in year 3), he will receive $20,000 per year in royalties, forever. Should he take the book deal?

6-18

NPV of Star’s Book Deal with Royalties

In this case, there is more than one IRR, invalidating the IRR rule. If the opportunity cost of capital is either below 4.723% or above 19.619%, Star should make the investment.

6-19

Mutually Exclusive Investment Opportunities

• Don is evaluating two investment opportunities:

1) Invest $1,000, get $1,100 in year 1, declining at 10% thereafter, forever.

2) Invest $1,000, get $400, declining at 20% thereafter, forever.

6-20

NPV of Don’s Investment Opportunities with the Single-Machine Laundromat

The NPV of his girlfriend’s business is always larger than the NPV of the single-machine laundromat. The same is true for the IRR; the IRR of his girlfriend’s business is 100%, while the IRR for the laundromat is 20%.

6-21

Project of Different Scale

• Suppose Don can install 20 laundromats instead of 1?

6-22

NPV of Don’s Investment Opportunities with the 20-Machine Laundromat

As in Figure 6.5, the IRR of his girlfriend’s business is 100%, while the IRR for the laundromat is 20%. But in this case, the NPV of his girlfriend’s business is larger than the NPV of the 20-machine laundromat only for discount rates in excess of 13.9%.

6-23

Economic Value Added: EVA®

• EVA  is a measure of performance developed by the consulting company Stern Stewart. It measures the value that your company (or division within a company) creates through its investment and financing decisions.

• EVA= Economic Profit = “Profit” – Capital Charge

 

6-24

• In general,

EVA = (Net Operating Profit After Tax ) - [(Cost of Capital %) * (Total Capital)]

• where NOPAT = EBIT x (1 - T)

6-25

Comparison between NPV and EVA

NPV = PV ( Future CF ) - Initial Outlay EVA = NOPAT - Capital Charge = NOPAT - Cost of  Capital x Level of Capital

                                  NPV                                     EVA Application           Projects or Investment Decision         Performance Evaluation of the

Firm or Division

Time                    Project's Life                          Any defined period

Base                    Cash Flows                              NOPAT

Capital Expenditure   Reduces CF                       Increased Level of Capital

Depreciation            Added to NOPAT                          Reduces Level of Capital

Working Capital        Affects CF                         Affects Level of Capital