Topic 4-Capital Budgeting Decision Criteria, Risk, and Real Options PDF

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Topic 4 Capital Budgeting: Decision Criteria, Risk, and Real Option I. II.

Net Present Value (NPV) Internal Rate of Return (IRR) A. IRR Decision Rule for Independent Projects B. IRR Decision Rule for Mutually Exclusive Projects C. NPV Profile for Two Mutually Exclusive Projects and the Crossover Rate D. Non-normal Projects and Multiple Internal Rates of Return

III.

Modified IRR

IV.

Profitability Index

V. VI. VII.

Payback Period Discounted Payback Period Mutually Exclusive Projects with Unequal Lives A. Replacement Chains B. Equivalent Annual Annuities (EAA) C. Conclusion about Unequal Lives

VIII. IX.

Capital Rationing Risk Analysis of Capital Budgeting A. Sensitivity Analysis B. Scenario Analysis C. Simulation (Monte Carlo) Analysis

X.

Real Options and Capital Budgeting Analysis A. Types of Real Options B. Evaluating Projects with Real Options

XI.

Common Capital Budgeting Pitfalls

1 Topic 4 Capital Budgeting: Decision Criteria, Risk, and Real Option In the previous topic, we started discussing the capital budgeting process. Specifically, the framework for capital budgeting analysis where we established that a firm will accept project until the marginal return on projects is equal to the marginal cost of capital. In addition, we covered the estimation of the relevant cash flows for the capital budgeting process. Namely, the net investment and the net cash flows. However, to complete the process, we need to understand the criteria on which managers base their decisions to evaluate investment proposals and determine which projects to accept and which projects to reject. There are six techniques that are commonly used for evaluating and selecting investment projects: 1. Net present value (NPV) 2. Internal rate of return (IRR) 3. Modified IRR (MIRR) 4. Profitability index (PI) 5. Payback (PB) period 6. Discounted payback (DPB) The best technique should maximize shareholders’ wealth. This can be broken down into separate criteria: 1. All cash flows should be considered. 2. The cash flows should be discounted at the opportunity cost of capital 3. The technique should select from a set of mutually exclusive projects the one that maximizes the shareholders’ wealth. 4. Managers should be able to consider on project independently from all others. In this topic, we will study each technique’s decision criteria and we will choose among the techniques the one that best captures all the required characteristics.

2 I.

Net Present Value (NPV) •

The NPV is defined as the present value of the stream of future net cash flows from a project minus the project’s net investment.

•

The NPV is:

T

NPV = ∑

t=1

where,

NCFt − NINV (1 + WACC)t

NPV= net present value

NCFt = net cash flow in time t T= expected project life

WACC= weighted average cost of capital NINV= net investment •

The NPV decision rule is to accept a project when the NPV is positive and to reject a project when its NPV is negative. If the resent value of the project’s net cash flows exceeds the project’s net investment outlay, the project contributes to the total value of the firm.

•

If two or more mutually exclusive investments have positive NPV, the project with the largest NPV should be selected. Example: NPV Calculation Consider the cash flows of the following two projects:

Year 0 Project A -$50,000 Project B -$50,000

1 $12,500 $5,000

2 $12,500 $10,000

3 $12,500 $15,000

4 $12,500 $15,000

5 6 $12,500 $12,500 $25,000 $30,000

The WACC for both projects is 14%. Calculate the NPV for both projects. Solution: NPVA = NPVB =

12,500 12,500 12,500 12,500 12,500 12,500 − 50,000 = −$1,391.65 + + + + + (1.14)2 (1.14)3 (1.14)4 (1.14)5 (1.14)6 1.14

5,000 10,000 15,000 15,000 25,000 30,000 + − 50,000 = $7,738.23 + + + + 1.14 (1.14)2 (1.14)3 (1.14)4 (1.14)5 (1.14)6

Which project should be accepted?

3 •

The benefits of using the NPV criterion include: o

It accurately accounts for the magnitude and timing of a project’s cash flows over its lifetime.

o

It shows whether a proposed project yields the required rate of return by the firm’s investors, and therefore consistent with the goal of shareholders’ wealth maximization.

•

o

It adheres to the principle of value additivity.

o

It represents the increase in the market value of the firm.

A disadvantage of the NPV criterion is that it is not easily understood by untrained decision markers as the payback period or the internal rate of return.

•

What causes some projects to have a positive or negative NPVs? When the market in which a firm is operating is not perfectly competitive, it is possible for a firm to earn abnormal profits and invest in positive NPV projects. Some examples of conditions that allow abnormal profits: o

Buyers preferences for established brand names.

o

Ownership or control of favored distribution systems.

o

Patent control of superior product designs or production techniques.

o

Exclusive ownership of superior natural resources deposits.

o

Inability of new firms to acquire necessary factors of production (management, labor, equipment).

o

Superior access to financial resources at lower costs (economies of scale in attracting capital).

o

Economies of scale in production and distribution arising from capital intensive production processes and high initial start-up costs.

o

Access to superior labor or managerial talents at cost which are not fully reflective of their value.

II.

Internal Rate of Return (IRR) •

The IRR is defined as the discount rate that equates the present value of the net cash flows of a project with the present value of the net investment. In other words, the IRR is the discount rate that makes the project’s NPV equal to zero.

4 •

The algebraic definition of the IRR is: T

NPV = ∑

t=1

NCFt − NINV = 0 (1 + IRR)t

A. IRR Decision Rule for Independent Projects •

The IRR decision rule for independent projects is to accept a project when its IRR exceeds the cost of capital and reject when its IRR is less than the cost of capital.

•

Like the NPV, the IRR takes account of the magnitude and timing of a project’s net cash flows over its entire life. Example: Calculating the IRR Consider the cash flows of the following two projects:

Year 0 Project A -$50,000 Project B -$50,000

1 $12,500 $5,000

2 $12,500 $10,000

3 $12,500 $15,000

4 $12,500 $15,000

5 6 $12,500 $12,500 $25,000 $30,000

The WACC for both projects is 14%. Calculate the IRR for both projects. Solution: NPVA =

12,500 12,500 12,500 12,500 12,500 12,500 + − 50,000 = 0 + + + + 2 3 4 5 ( ( ) ( ) ( ) ( ) 1 + IRR)6 1 + IRR 1 + IRR 1 + IRR 1 + IRR 1 + IRR

IRR A =12.97% NPV𝐁 =

5,000 15,000 15,000 25,000 30,000 10,000 + − 50,000 = 0 + + + + 2 3 4 5 (1 + IRR)6 (1 + IRR) (1 + IRR) (1 + IRR) 1 + IRR (1 + IRR)

IRR B =18.19%

•

NPV and IRR will always agree on accept/reject decisions for one project. (i.e., if NPV>0, then IRR>WACC; and if NPV...