CH9 - Lecture notes 9 PDF

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Professor: Peter Trager...

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Ch 9 part 1  3/22/2021 Financial Analysis techniques: ** most popular are NPV and IRR • Net Present Value • The Payback Rule • The Discounted Payback • The Average Accounting Return • The Internal Rate of Return • The Profitability Index • The Practice of Capital Budgeting CAPITAL BUDGETING The most important decision a company make  Analysis of potential projects  Long term decisions  Large expenditures  Difficult/impossible to reverse  Determines firm’s strategic direction Good Decision Criteria • We need to ask ourselves the following questions when evaluating capital budgeting decision rules: § Does the decision rule adjust for the time value of money? § Does the decision rule adjust for risk? § Does the decision rule provide information on whether we are creating value for the firm? Net Present Value ** Most popular method • The difference between the market value of a project and its cost • How much value is created from undertaking an investment? § The first step is to estimate the expected future cash flows. § The second step is to estimate the required return for projects of this risk level. § The third step is to find the present value of the cash flows and subtract the initial investment. NPV – Decision Rule • If the NPV is positive, accept the project.

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A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

Project Example Information • You are reviewing a new project and have estimated the following cash flows: § Year 0: CF = -165,000 § Year 1: CF = 63,120; NI = 13,620 § Year 2: CF = 70,800; NI = 3,300 § Year 3: CF = 91,080; NI = 29,100 § Average Book Value = 72,000 • Your required return for assets of this risk level is 12%. NPV = Initial cash flow + cash flows discounts

^^^ If we spend $165,000 to do project, then after 3 years of revenue we get a positive number so it’s ok to do.

NPV Example 2:  VP of Good Ideas at Calipari Bourbon Prof. Trager thinks that the company should buy some property down in the Distillery area and build a Beer Brewery to capitalize on the

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Calipari Brand name and growing cool scene in that area. John Calipari President and Chief Money guy thinks this is a terrible Idea so we will look at the numbers to decide if they should take this on or not. The purchase price for the land is $250,000 and it will cost $900,000 to build the brewery. They are projected to have revenue for 7 years and then sell the building and brewery at the end of the 7th year. Revenue is expected to be: o $125,000 the first 3 years o $200,000 in years 4-7 o Sell the building and machinery at the end of year 7 for $500,000 o Required Return for this project is 10% o Should they go ahead with the expansion?

CF0 = -$1,150,000 --> $250,000 + $900,000 CF1, CF2 & CF 3 = $125,000 CF4, CF5, & CF6 = $200,000 CF7 = $700,000 --> $200,000 + $500,000 I/Y = 10 NPV = -$106,251.07 NPV is negative don’t go into this business. Payback Period How long does it take to get the initial cost back in a nominal sense? Computation: • Estimate the cash flows. • Subtract the future cash flows from the initial cost until the initial investment has been recovered. Payback Period Decision Rule – Accept, if the payback period is less than some preset limit. •

Advantages § Easy to understand § Adjusts for uncertainty of later cash flows § Biased toward liquidity • Disadvantages § Ignores the time value of money § Requires an arbitrary cutoff point § Ignores cash flows beyond the cutoff date § Biased against long-term projects, such as research and development, and new projects • Favors projects with quick paybacks ** Not a method we should use for large capital decisions

Computing Payback  Example 2-Year Payback Criteria: If the project can pay itself off in two years we’ll do it

To find exact years till out of deficit:

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Take last cumulative CF that’s negative / next year’s CF (revenue) $31,080 / 91,080 = .34 years until it hits zero Add 2 years + .34 years = 2.34 payback period

Discounted Payback Period ** considers the time value of money unlike the payback method • Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis. • Compare to a specified required period. • Decision Rule: Accept the project if it pays back on a discounted basis within the specified time. •

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Advantages • Includes time value of money • Easy to understand • Does not accept negative estimated NPV investments when all future cash flows are positive • Biased towards liquidity Disadvantages • May reject positive NPV investments • Requires an arbitrary cutoff point • Ignores cash flows beyond the cutoff point • Biased against long-term projects, such as R&D and new products

Discounted Payback Example: • Assume we will accept the project if it pays back on a discounted basis in 2 years. • Compute the PV for each cash flow and determine the payback period using discounted cash flows. § Year 1: -165,000 +63,120/1.121 = -108,643  (56,357)

Year 2: -108,643 +70,800/1.122 = -52,202  (56,441) Year 3: -52,202 + 91,080/1.123 = +12,627  (64,829) • project pays back during year 3 § Payback in 2.8053 years (52,202/64,829 = .8053) • Every discounted payback is greater than normal payback method, which means a longer time of payback when using discount payback method Do we accept or reject the project? § REJECT § §

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Payback & Discount Payback Example • String Cheese Dairy Farms wants to plant all new grass to feed their cows. This new grass is supposed to create the best milk and therefore cheese but if they spend the money to plant the new grass they want to have it paid for in 3 years. It will cost $180,000 to prepare the soil and plant the new grass. They estimate that it will increase cash flow by: • $48,000 in year 1, $67,000 in year 2, $80,000 in year 3 and $90,000 in year 4. If the discount rate is 9% will this be a good investment using the payback method and then the discounted payback method? Required return is 10%. Payback Method: Year CF 0 ($180,000) 1 $48,000 2 $67,000 3 $80,000   

Cum CF’s ($180,000) ($132,000) ($65,000) $15,000

Payback = year 2 + 65,000/80,000 Payback = 2.8125 years Accept the project

Discounted Payback Method: 9% Discount Rate Year CF 0 ($180,000) 1 $48,000/1.1 = $43,636.36 2 $67,000/ (1.1)2nd = $55,371.9 3 $80,000/ (1.1)3rd = $60,105.18 4 $90,000/ (1.1)4th = $61,471.21   

Cum CF ($180,000) ($136,363.63) ($80,991.73) ($20,886.55) +$40,584.67

Payback Period 20,886.55/61,471.21 = .3398 Payback = 3.34 years Reject the project

Average Accounting Return  Many different definitions for AAR  Our definition: o AAR = Average Net Income / Average Book Value

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§ Average book value depends on how asset is depreciated Requires a target cutoff date Decision Rule: Accept project if AAR is greater than target rate. •

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Advantages § Easy to calculate § Needed information will usually be available Disadvantages § Not a true rate of return; time value of money is ignored § Uses an arbitrary benchmark cutoff rate § Based on accounting net income and book values, not cash flows and market values

Average Accounting Return (AAR) Example:

Required average accounting return = 25% Average Accounting Return (AAR) = 21.3%  REJECT project 21.3% < 25%

Internal Rate of Return • This is the most important alternative to NPV. • It is often used in practice and is intuitively appealing. • It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere. • Definition: IRR is the return that makes the NPV = 0 • Decision Rule: Accept the project if the IRR is greater than the required return. • If NPV = positive than IRR > R (required rate of return) • If NPV = negative than IRR < R

Advantages: • It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details. • Considers all cash flows • Considers time value of money • Provides indication of risk Disadvantages: why NPV is better • NPV and IRR will generally give us the same decision. • Exceptions: § Nonconventional cash flows – cash flow signs change more than once

IRR Example: • Enter the cash flows as you did with NPV. • cf0 = -165,000, cf1= 63,120, cf2=70,800, cf3=91,080 § Press IRR key (over PMT key) and then CPT. § IRR = 16.13% > 12% required return • Do we accept or reject the project? ACCEPT

NPV

70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 -10,000 0 -20,000

0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22 Discount Rate

IRR Example 2:  VP of Good Ideas at Calipari Bourbon Prof. Trager thinks that the company should buy some property down in the Distillery area and build a Beer Brewery to capitalize on the Calipari Brand name and growing cool scene in that area. John Calipari President and Chief Money guy thinks this is a terrible Idea so we will look at the numbers to decide if they should take this on or not.  The purchase price for the land is $250,000 and it will cost $900,000 to build the brewery. They are projected to have revenue for 7 years and then sell the building and brewery at the end of the 7th year. Revenue is expected to be: o $125,000 the first 3 years o $200,000 in years 4-7 o Sell the building and machinery at the end of year 7 for $500,000 o Required Return for this project is 10% o Should they go ahead with the expansion? CF0 = -$1,150,000 --> $250,000 + $900,000 CF1, CF2 & CF 3 = $125,000 CF4, CF5, & CF6 = $200,000 CF7 = $700,000 --> $200,000 + $500,000 IRR  CPT = 7.8%  7.8% IRR < 10% required rate of return so REJECT project o We knew NPV = -$106,251.07 so IRR had to be less than required return (10%)

IRR and Mutually Exclusive Projects - Mutually exclusive projects § If you choose one, you can’t choose the other. § Example: You one a piece of land and can either build a new distillery for Calipari Bourbon or a gas station. - Intuitively, you would use the following decision rules: § NPV – choose the project with the higher NPV § IRR – choose the project with the higher IRR Example  Mutually Exclusive Projects Period

Project A

Project B

0

-500

-400

1

325

325

2

325

200

IRR

19.43%

22.17%

NPV

64.05

60.74

Required return = 10% for both Which project should we accept and why? o IRR: Project B § 22.17% > 19.43% o NPV: Project A § 64.05 > 60.74 OVERALL: go with project with higher NPV, project A Conflicts Between NPV and IRR • NPV directly measures the increase in value to the firm. • Whenever there is a conflict between NPV and another decision rule, you should always use NPV. • IRR is unreliable in the following situations: § Nonconventional cash flows (NOT GOING OVER IN THIS COURSE) § Mutually exclusive projects Summary of Decisions for the Project o REJECT: Payback period, Discounted payback period, Average accounting return o ACCEPT: Net present value, Internal rate of return Profitability Index (PI) • Measures the benefit per unit cost, based on the time value of money.

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A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value. Decision Rule: If PI > 1.0  Accept the Project • NPV = positive then the present value of the future cash flows must be greater than initial investment, so PI larger than 1. • NPV = negative then PV of future cash flows is less than initial investment, so PI is small than 1. Advantages • Closely related to NPV, generally leading to identical decisions • Easy to understand and communicate • May be useful when available investment funds are limited Disadvantages • May lead to incorrect decisions in comparisons of mutually exclusive investments

PI conflict with mutually exclusive investments

** PV (15000) / cost (10000) = 1.5 ** OVERALL: choose project B because NPV is king

Decision Criteria Test • Does the payback rule account for the time value of money? • Payback method: N • Discounted method: Y • Average Accounting Return: N • Internal Rate of Return: Y • Does the payback rule account for the risk of the cash flows? • Payback method: N • Discounted method: Y • Average Accounting Return: N • Internal Rate of Return: Y • Does the payback rule provide an indication about the increase in value? • Payback method: N • Discounted method: N • Average Accounting Return: N

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• Internal Rate of Return: Y Should we consider the payback rule for our primary decision rule? • Payback method: N • Discounted method: N • Average Accounting Return: N • Internal Rate of Return: Y The IRR rule accounts for time value because it is finding the rate of return that equates all of the cash flows on a time value basis. The IRR rule accounts for the risk of the cash flows because you compare it to the required return, which is determined by the risk of the project. The IRR rule provides an indication of value because we will always increase value if we can earn a return greater than our required return. We could consider the IRR rule as our primary decision criteria, but as we will see, it has some problems that the NPV does not have. That is why we end up choosing the NPV as our ultimate decision rule

SUMMARY: Capital Budgeting in Practice • We should consider several investment criteria when making decisions. • NPV and IRR are the most commonly used primary investment criteria. • Payback is a commonly used secondary investment criteria. Net present value • Difference between market value and cost • Take the project if the NPV is positive. • Has no serious problems • Preferred decision criterion Internal rate of return • Discount rate that makes NPV = 0 • Take the project if the IRR is greater than the required return. • Same decision as NPV with conventional cash flows • IRR is unreliable with nonconventional cash flows or mutually exclusive projects. Profitability Index • Benefit-cost ratio • Take investment if PI > 1 • Cannot be used to rank mutually exclusive projects • May be used to rank projects in the presence of capital rationing Payback period • Length of time until initial investment is recovered • Take the project if it pays back within some specified period. • Doesn’t account for time value of money, and there is an arbitrary cutoff period Discounted payback period

• Length of time until initial investment is recovered on a discounted basis • Take the project if it pays back in some specified period. • There is an arbitrary cutoff period. Average Accounting Return • Measure of accounting profit relative to book value • Similar to return on assets measure • Take the investment if the AAR exceeds some specified return level. • Serious problems and should not be used QUIZ: • Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9%, and required payback is 4 years. § What is the payback period? § What is the NPV? § What is the IRR? § Should we accept the project? § What decision rule should be the primary decision method?

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Payback Method  (100,000) + 25,000 X 4 = 4 years NPV  cf0= -100,000, cf1-5=25,000, I=9 • NPV = -$2,758.72 IRR  cf0 = -100,000, cf1-5=25,000 • IRR= 7.93% We should reject the project. The NPV is negative and the IRR is less than R.

CH 9 homework: There is a project with the following cash flows : Year

Cash Flow

0 1 2 3 4 5

−$23,050 6,700 7,800 6,950 7,550 6,300

What is the payback period? - 3.21 years A new project has an initial cost of $200,000. The equipment will be depreciated on a straight-line basis to a zero-book value over the five-year life of the project. The projected net income each year is $12,750, $17,000, $19,040, $14,650, and $10,900, respectively. What is the average accounting return? - {12750+17000+19040+14650+10900} / 5 = 14868 - 200,000/2 = 100,000 - 14868/100,000 = .14868  14.87% Iron Works International is considering a project that will produce annual cash flows of $38,700, $47,400, $58,100, and $23,600 over the next four years, respectively. What is the internal rate of return if the project has an initial cost of $112,300? - 18.97%

A company. has a project available with the following cash flows: Year 0 1 2 3 4

Cash Flow −$36,880 12,450 14,670 19,380 10,760

If the required return for the project is 7.5 percent, what is the project's NPV? - $11,053.05

A project that provides annual cash flows of $17,000 for 6 years costs $60,000 today. If the required return is 10 percent, what is the NPV for this project? - 14039.43 IRR

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17.65%

Guerilla Radio Broadcasting has a project available with the following cash flows : Year 0 1 2 3 4

Cash Flow −$17,000 7,000 8,300 3,300 2,900

What is the payback period?

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2.52 years

A project that will last for 8 years is expected to have equal annual cash flows of $103,300. If the required return is 8.6 percent, what maximum initial investment would make the project acceptable?

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$580,346.27 First, we need to calculate the future value of the cash flows: FV= {103,300*[(1.086^8) - 1]} / 0.086 FV= $1,122,860.48 Now, we can determine the present value: PV= FV/(1+i)^n PV= 1,534,047.75 / (1.086^8) PV= $580,346.27

A project has the following cash flows: Year 0 1 2 3 4

Cash Flows −$128,800 53,000 63,800 51,600 28,100

The required return is 9.3 percent. What is the profitability index for this project?

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1.251 53000/1.093 + 63800/1.093^2 + 51600/1.093^3 + 28100/1.093^4 Profitability Index = 161101.09 / 128,800 = 1.251

Blinding Light Co. has a project available with the following cash flows: Year 0 1 2 3 4 5

Cash Flow −$35,550 7,880 9,450 13,350 15,490 10,160

What is the project's IRR?

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16.23%...