aswath damodaran - new york...
TRANSCRIPT
Will the benefits persist if investors hedge the risk instead of the firm?
NoYes
NoYes
Can marginal investors hedge this risk cheaper
than the firm can?
NoYes
Is there a significant benefit in terms of higher expected cash flows or a lower discount rate?
NoYes
Is there a significant benefit in terms of higher cash flows or a lower discount rate?
What is the cost to the firm of hedging this risk?
Negligible High
Do not hedge this risk. The benefits are small relative to costs
Hedge this risk. The benefits to the firm will exceed the costs
Hedge this risk. The benefits to the firm will exceed the costs
Let the risk pass through to investors and let them hedge the risk.
Hedge this risk. The benefits to the firm will exceed the costs
Indifferent to hedging risk
Cash flow benefits- Tax benefits- Better project choices
Discount rate benefits- Hedge "macro" risks (cost of equity)- Reduce default risk (cost of debt or debt ratio)
Survival benefits (truncation risk)- Protect against catastrophic risk- Reduce default risk
Value Trade Off
Earnings Multiple- Effect on multiple
Earnings- Level- Volatility
X
Pricing Trade
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AcquisitionsandProjects
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¨ Anacquisition isaninvestment/project like anyotherandalloftherulesthatapplytotraditional investments shouldapplytoacquisitions aswell. Inotherwords,foranacquisition tomakesense:¤ ItshouldhavepositiveNPV.Thepresentvalueoftheexpectedcashflows
fromtheacquisitionshouldexceedthepricepaidontheacquisition.¤ TheIRRofthecashflowstothefirm(equity)fromtheacquisition>Costof
capital(equity)ontheacquisition¨ Inestimatingthecashflowsontheacquisition,weshouldcountin
anypossible cashflowsfromsynergy.¨ Thediscountratetoassess thepresentvalueshouldbebasedupon
theriskoftheinvestment (targetcompany) andnottheentityconsidering theinvestment (acquiringcompany).
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TataMotorsandHarmanInternational
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¨ HarmanInternationalisapubliclytradedUSfirmthatmanufactureshighendaudioequipment.TataMotorsisanautomobilecompany,basedinIndia.
¨ TataMotorsisconsideringanacquisitionofHarman,withaneyeonusingitsaudioequipmentinitsIndianautomobiles,asoptionalupgradesonnewcars.
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EstimatingtheCostofCapitalfortheAcquisition(nosynergy)
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1. Currency:EstimatedinUS$,sincecashflowswillbeestimatedinUS$.2. Beta:HarmanInternationalisanelectroniccompanyandweusetheunleveredbeta
(1.17)ofelectronicscompaniesintheUS.3. EquityRiskPremium:ComputedbasedonHarman’soperatingexposure:
4. Debtratio&costofdebt:TataMotorsplanstoassumetheexistingdebtofHarmanInternationalandtopreserveHarman’sexistingdebtratio.Harmancurrentlyhasadebt(includingleasecommitments)tocapitalratioof7.39%(translatingintoadebttoequityratioof7.98%)andfacesapre-taxcostofdebtof4.75%(basedonitsBBB- rating).
LeveredBeta=1.17(1+(1-.40)(.0798))=1.226CostofEquity=2.75%+1.226(6.13%)=10.26%
CostofCapital=10.26%(1-.0739)+4.75%(1-.40)(.0739)=9.67%
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EstimatingCashflows- FirstSteps
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¨ OperatingIncome:Thefirmreportedoperatingincomeof$201.25milliononrevenuesof$4.30billionfortheyear.Addingbacknon-recurringexpenses(restructuringchargeof$83.2millionin2013)andadjustingincomefortheconversionofoperatingleasecommitmentstodebt,weestimatedanadjustedoperatingincomeof$313.2million.Thefirmpaid18.21%ofitsincomeastaxesin2013andwewillusethisastheeffectivetaxrateforthecashflows.
¨ Reinvestment:Depreciationin2013amountedto$128.2million,whereascapitalexpendituresandacquisitionsfortheyearwere$206.4million.Non-cashworkingcapitalincreasedby$272.6millionduring2013butwas13.54%ofrevenuesin2013.
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Bringingingrowth
¨ WewillassumethatHarman International isamaturefirm,growing2.75%inperpetuity.
¨ Weassumethatrevenues, operating income,capitalexpenditures anddepreciationwillallgrow2.75%fortheyearandthatthenon-cashworkingcapitalremain13.54%ofrevenues infutureperiods.
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ValueofHarmanInternational:BeforeSynergy
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¨ Earlier,weestimatedthecostofcapitalof9.67%astherightdiscountratetoapplyinvaluingHarmanInternationalandthecashflowtothefirmof$166.85millionfor2014(nextyear),assuminga2.75%growthrateinrevenues,operatingincome,depreciation,capitalexpendituresandtotalnon-cashworkingcapital.Wealsoassumedthatthesecashflowswouldcontinuetogrow2.75%ayearinperpetuity.
¨ Addingthecashbalanceofthefirm($515million)andsubtractingouttheexistingdebt($313million,includingthedebtvalueofleases)yieldsthevalueofequityinthefirm:
¨ ValueofEquity =ValueofOperatingAssets+Cash– Debt
=$2,476+$515- $313million=$2,678million
¨ ThemarketvalueofequityinHarmaninNovember2013was$5,428million.
¨ TotheextentthatTataMotorspaysthemarketprice,itwillhavetogeneratebenefitsfromsynergythatexceed$2750million.
MeasuringInvestmentReturnsII.InvestmentInteractions,OptionsandRemorse…
Lifeistooshortforregrets,right?
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Independentinvestmentsaretheexception…
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¨ Inalloftheexampleswehaveusedsofar,theinvestmentsthatwehaveanalyzedhavestoodalone.Thus,ourjobwasasimpleone.Assesstheexpectedcashflowsontheinvestmentanddiscountthemattherightdiscountrate.
¨ Intherealworld,mostinvestmentsarenotindependent.Takinganinvestmentcanoftenmeanrejectinganotherinvestmentatoneextreme(mutuallyexclusive)tobeinglockedintotakeaninvestmentinthefuture(pre-requisite).
¨ Moregenerally,acceptinganinvestmentcancreatesidecostsforafirm’sexistinginvestmentsinsomecasesandbenefitsforothers.
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I.MutuallyExclusiveInvestments
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¨ Wehavelookedathowbesttoassessastand-aloneinvestmentandconcludedthatagoodinvestmentwillhavepositiveNPVandgenerateaccountingreturns(ROCandROE)andIRRthatexceedyourcosts(capitalandequity).
¨ Insomecases,though,firmsmayhavetochoosebetweeninvestmentsbecause¤ Theyaremutuallyexclusive:Takingoneinvestmentmakestheother
oneredundantbecause theybothserve thesamepurpose¤ Thefirmhaslimitedcapitalandcannottakeeverygoodinvestment
(i.e., investmentswithpositiveNPVorhighIRR).
¨ Usingthetwostandarddiscountedcashflowmeasures,NPVandIRR,canyielddifferentchoiceswhenchoosingbetweeninvestments.
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ComparingProjectswiththesame(orsimilar)lives..
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¨ Whencomparingandchoosingbetweeninvestmentswiththesamelives,wecan¤ Compute theaccountingreturns(ROC,ROE)oftheinvestmentsandpicktheonewiththehigherreturns
¤ Compute theNPVoftheinvestments andpicktheonewiththehigherNPV
¤ Compute theIRRoftheinvestments andpicktheonewiththehigherIRR
¨ Whileitiseasytoseewhyaccountingreturnmeasurescangivedifferentrankings(andchoices)thanthediscountedcashflowapproaches,youwouldexpectNPVandIRRtoyieldconsistentresultssincetheyarebothtime-weighted,incrementalcashflowreturnmeasures.
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Case1:IRRversusNPV
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¨ Considertwoprojectswiththefollowingcashflows:Year Project1CF Project2CF0 -1000 -10001 800 2002 1000 3003 1300 4004 -2200 500
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Project’sNPVProfile
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Whatdowedonow?
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¨ Project1hastwointernalratesofreturn.Thefirstis6.60%,whereasthesecondis36.55%.Project2hasoneinternalrateofreturn,about12.8%.
¨ Whyaretheretwointernalratesofreturnonproject1?
¨ Ifyourcostofcapitalis12%,whichinvestmentwouldyouaccept?a. Project1b. Project2
¨ Explain.
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Case2:NPVversusIRR
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Cash Flow
Investment
$ 350,000
$ 1,000,000
Project A
Cash Flow
Investment
Project B
NPV = $467,937IRR= 33.66%
$ 450,000 $ 600,000 $ 750,000
NPV = $1,358,664IRR=20.88%
$ 10,000,000
$ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000
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Whichonewouldyoupick?
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¨ Assumethatyoucanpickonlyoneofthesetwoprojects.YourchoicewillclearlyvarydependinguponwhetheryoulookatNPVorIRR.Youhaveenoughmoneycurrentlyonhandtotakeeither.Whichonewouldyoupick?a. ProjectA.Itgivesmethebiggerbangforthebuckandmore
marginforerror.b. ProjectB.Itcreatesmoredollarvalueinmybusiness.
¨ IfyoupickA,whatwouldyourbiggestconcernbe?
¨ IfyoupickB,whatwouldyourbiggestconcernbe?
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CapitalRationing,UncertaintyandChoosingaRule
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¨ Ifabusinesshaslimitedaccesstocapital,hasastreamofsurplusvalueprojectsandfacesmoreuncertaintyinitsprojectcashflows,itismuchmorelikelytouseIRRasitsdecisionrule.¤ Small,high-growth companies andprivatebusinesses aremuchmorelikely touseIRR.
¨ Ifabusinesshassubstantialfundsonhand,accesstocapital,limitedsurplusvalueprojects,andmorecertaintyonitsprojectcashflows,itismuchmorelikelytouseNPVasitsdecisionrule.
¨ Asfirmsgopublicandgrow,theyaremuchmorelikelytogainfromusingNPV.
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Thesourcesofcapitalrationing…
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Cause Number of firms Percent of total Debt limit imposed by outside agreement 10 10.7 Debt limit placed by management external to firm
3 3.2
Limit placed on borrowing by internal management
65 69.1
Restrictive policy imposed on retained earnings
2 2.1
Maintenance of target EPS or PE ratio 14 14.9
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AnAlternativetoIRRwithCapitalRationing
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¨ TheproblemwiththeNPVrule,whenthereiscapitalrationing,isthatitisadollarvalue.Itmeasuressuccessinabsoluteterms.
¨ TheNPVcanbeconvertedintoarelativemeasurebydividingbytheinitialinvestment.Thisiscalledtheprofitabilityindex.¤ Profitability Index(PI)=NPV/Initial Investment
¨ Intheexampledescribed,thePIofthetwoprojectswouldhavebeen:¤ PIofProjectA=$467,937/1,000,000=46.79%¤ PIofProjectB=$1,358,664/10,000,000=13.59%¤ ProjectAwouldhavescoredhigher.
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Case3:NPVversusIRR
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Cash Flow
Investment
$ 5,000,000
$ 10,000,000
Project A
Cash Flow
Investment
Project B
NPV = $1,191,712IRR=21.41%
$ 4,000,000 $ 3,200,000 $ 3,000,000
NPV = $1,358,664IRR=20.88%
$ 10,000,000
$ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000
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Whythedifference?
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¨ Theseprojectsareofthesamescale.BoththeNPVandIRRusetime-weightedcashflows.Yet,therankingsaredifferent.Why?
¨ Whichonewouldyoupick?a. ProjectA.Itgivesmethebiggerbangforthebuckand
moremarginforerror.b. ProjectB.Itcreatesmoredollarvalueinmybusiness.
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NPV,IRRandtheReinvestmentRateAssumption
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¨ TheNPVruleassumesthatintermediatecashflowsontheprojectgetreinvestedatthehurdlerate(whichisbaseduponwhatprojectsofcomparableriskshouldearn).
¨ TheIRRruleassumesthatintermediatecashflowsontheprojectgetreinvestedattheIRR.ImplicitistheassumptionthatthefirmhasaninfinitestreamofprojectsyieldingsimilarIRRs.
¨ Conclusion:WhentheIRRishigh(theprojectiscreatingsignificantsurplusvalue)andtheprojectlifeislong,theIRRwilloverstatethetruereturnontheproject.
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SolutiontoReinvestmentRateProblem
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WhyNPVandIRRmaydiffer..Evenifprojectshavethesamelives
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¨ AprojectcanhaveonlyoneNPV,whereasitcanhavemorethanoneIRR.
¨ TheNPVisadollarsurplusvalue,whereastheIRRisapercentagemeasureofreturn.TheNPVisthereforelikelytobelargerfor“largescale” projects,whiletheIRRishigherfor“small-scale” projects.
¨ TheNPVassumesthatintermediatecashflowsgetreinvestedatthe“hurdlerate”,whichisbaseduponwhatyoucanmakeoninvestmentsofcomparablerisk,whiletheIRRassumesthatintermediatecashflowsgetreinvestedatthe“IRR”.
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Comparingprojectswithdifferentlives..
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-$1500
$350 $350 $350 $350$350
-$1000
$400 $400 $400 $400$400
$350 $350 $350 $350$350
Project B
NPV of Project A = $ 442IRR of Project A = 28.7%
NPV of Project B = $ 478IRR for Project B = 19.4%
Hurdle Rate for Both Projects = 12%
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WhyNPVscannotbecompared..Whenprojectshavedifferentlives.
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¨ Thenetpresentvaluesofmutuallyexclusiveprojectswithdifferentlivescannotbecompared,sincethereisabiastowardslonger-lifeprojects.TocomparetheNPV,wehaveto¤ replicatetheprojectstilltheyhavethesamelife(or)¤ convertthenetpresentvaluesintoannuities
¨ TheIRRisunaffectedbyprojectlife.WecanchoosetheprojectwiththehigherIRR.
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Solution1:ProjectReplication
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Project A: Replicated
-$1500
$350 $350 $350 $350$350 $350 $350 $350 $350$350
Project B
-$1000
$400 $400 $400 $400$400 $400 $400 $400 $400$400
-$1000 (Replication)
NPV of Project A replicated = $ 693
NPV of Project B= $ 478
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Solution2:EquivalentAnnuities
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¨ EquivalentAnnuityfor5-yearproject¤ =$442*PV(A,12%,5years)¤ =$122.62
¨ EquivalentAnnuityfor10-yearproject¤ =$478*PV(A,12%,10years)¤ =$84.60
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Whatwouldyouchooseasyourinvestmenttool?
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¨ Giventheadvantages/disadvantagesoutlinedforeachofthedifferentdecisionrules,whichonewouldyouchoosetoadopt?a. ReturnonInvestment(ROE,ROC)b. PaybackorDiscountedPaybackc. NetPresentValued. InternalRateofReturne. ProfitabilityIndex
¨ Doyouthinkyourchoicehasbeenaffectedbytheeventsofthelastquarterof2008?Ifso,why?Ifnot,whynot?
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Whatfirmsactuallyuse..
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DecisionRule %ofFirmsusingasprimarydecisionrulein1976 1986 1998
IRR 53.6% 49.0% 42.0%AccountingReturn 25.0% 8.0% 7.0%
NPV 9.8% 21.0% 34.0%PaybackPeriod 8.9% 19.0% 14.0%ProfitabilityIndex 2.7% 3.0% 3.0%
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II.SideCostsandBenefits
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¨ Mostprojectsconsideredbyanybusinesscreatesidecostsandbenefitsforthatbusiness.¤ Thesidecostsinclude thecostscreatedbytheuseofresourcesthatthebusiness alreadyowns(opportunity costs)andlostrevenues forotherprojectsthatthefirmmayhave.
¤ Thebenefits thatmaynotbecapturedinthetraditional capitalbudgetinganalysis includeprojectsynergies (where cashflowbenefitsmayaccruetootherprojects)andoptionsembedded inprojects(including theoptionstodelay,expandorabandonaproject).
¨ Thereturnsonaprojectshouldincorporatethesecostsandbenefits.
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A.OpportunityCost
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¨ Anopportunitycostariseswhenaprojectusesaresourcethatmayalreadyhavebeenpaidforbythefirm.
¨ Whenaresourcethatisalreadyownedbyafirmisbeingconsideredforuseinaproject,thisresourcehastobepricedonitsnextbestalternativeuse,whichmaybe¤ asaleoftheasset,inwhichcasetheopportunity costistheexpectedproceedsfromthesale,netofanycapitalgainstaxes
¤ rentingorleasingtheassetout,inwhichcasetheopportunitycostistheexpectedpresentvalueoftheafter-taxrentalorlease revenues.
¤ useelsewhere inthebusiness, inwhichcasetheopportunitycostisthecostofreplacingit.
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Case1:ForegoneSale?
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¨ AssumethatDisneyownslandinRioalready.Thislandisundevelopedandwasacquiredseveralyearsagofor$5millionforahotelthatwasneverbuilt.Itisanticipated,ifthisthemeparkisbuilt,thatthislandwillbeusedtobuildtheofficesforDisneyRio.Thelandcurrentlycanbesoldfor$40million,thoughthatwouldcreateacapitalgain(whichwillbetaxedat20%).Inassessingthethemepark,whichofthefollowingwouldyoudo:¤ Ignorethecostoftheland,sinceDisneyownsitsalready¤ Usethebookvalueoftheland,whichis$5million¤ Usethemarket valueoftheland,whichis$40million¤ Other:
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Case2:IncrementalCost?AnOnlineRetailingVentureforBookscape
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¨ Theinitialinvestmentneeded tostarttheservice, includingtheinstallationofadditionalphonelinesandcomputerequipment,willbe$1million.These investmentsareexpected tohavealifeoffouryears,atwhichpointtheywillhavenosalvagevalue.Theinvestments willbedepreciated straightlineover thefour-year life.
¨ Therevenues inthefirstyearareexpected tobe$1.5million,growing20%inyeartwo,and10%inthetwoyearsfollowing.Thecostofthebookswillbe60%oftherevenues ineachofthefouryears.
¨ Thesalariesandotherbenefits fortheemployeesareestimated tobe$150,000inyearone,andgrow10%ayearforthefollowingthreeyears.
¨ Theworkingcapital,whichincludes theinventoryofbooksneeded fortheservice andtheaccounts receivablewillbe10%oftherevenues; theinvestments inworkingcapitalhavetobemadeatthebeginningofeachyear.Attheendofyear4,theentireworkingcapitalisassumedtobesalvaged.
¨ Thetaxrateonincomeisexpected tobe40%.
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Costofcapitalforinvestment
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¨ Wewillre-estimate thebetaforthisonlineprojectbylookingatpublicly tradedonline retailers.Theunlevered totalbetaofonlineretailersis3.02,andweassume thatthisprojectwill befundedwiththesamemixofdebtandequity(D/E=21.41%,Debt/Capital=17.63%)thatBookscapeusesintherestofthebusiness.Wewillassume thatBookscape’s taxrate(40%)andpretaxcostofdebt(4.05%)applytothisproject.LeveredBetaOnlineService =3.02[1+(1– 0.4)(0.2141)] =3.41CostofEquityOnlineService =2.75%+3.41(5.5%)=21.48%CostofCapitalOnlineService=21.48%(0.8237) +4.05%(1– 0.4)(0.1763)=18.12%
¨ Thisismuchhigher thanthecostofcapital(10.30%)wecomputedforBookscapeearlier, butitreflectsthehigher riskoftheonlineretailventure.
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IncrementalCashflowsonInvestment
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NPV of investment = $76,375
0 1 2 3 4Revenues $1,500,000 $1,800,000 $1,980,000 $2,178,000
Operating ExpensesLabor $150,000 $165,000 $181,500 $199,650Materials $900,000 $1,080,000 $1,188,000 $1,306,800Depreciation $250,000 $250,000 $250,000 $250,000
Operating Income $200,000 $305,000 $360,500 $421,550Taxes $80,000 $122,000 $144,200 $168,620After-tax Operating Income $120,000 $183,000 $216,300 $252,930+ Depreciation $250,000 $250,000 $250,000 $250,000- Change in Working Capital $150,000 $30,000 $18,000 $19,800 -$217,800+ Salvage Value of Investment $0Cash flow after taxes -$1,150,000 $340,000 $415,000 $446,500 $720,730Present Value -$1,150,000 $287,836 $297,428 $270,908 $370,203
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Thesidecosts…
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¨ Itisestimatedthattheadditionalbusinessassociatedwithonlineorderingandtheadministrationoftheserviceitselfwilladdtotheworkloadforthecurrentgeneralmanagerofthebookstore.Asaconsequence,thesalaryofthegeneralmanagerwillbeincreasedfrom$100,000to$120,000nextyear;itisexpectedtogrow5percentayearafterthatfortheremainingthreeyearsoftheonlineventure.Aftertheonlineventureisendedinthefourthyear,themanager’ssalarywillrevertbacktoitsoldlevels.
¨ ItisalsoestimatedthatBookscapeOnlinewillutilizeanofficethatiscurrentlyusedtostorefinancialrecords.Therecordswillbemovedtoabankvault,whichwillcost$1000ayeartorent.
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NPVwithsidecosts…
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¨ Additional salarycosts=PVof$34,352
¨ OfficeCosts¤ After-TaxAdditionalStorageExpenditureperYear=$1,000(1– 0.40)=$600¤ PVofexpenditures=$600(PVofannuity,18.12%,4yrs)=$1,610
¨ NPVwithOpportunityCosts=$76,375– $34,352– $1,610=$40,413¨ Opportunitycostsaggregated intocashflows
Year Cashflows Opportunity costs Cashflow with opportunity costs Present Value0 ($1,150,000) ($1,150,000) ($1,150,000)1 $340,000 $12,600 $327,400 $277,170 2 $415,000 $13,200 $401,800 $287,968 3 $446,500 $13,830 $432,670 $262,517 4 $720,730 $14,492 $706,238 $362,759 Adjusted NPV $40,413
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Case3:ExcessCapacity
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¨ IntheValeexample,assumethatthefirmwilluseitsexistingdistributionsystemtoservicetheproductionoutofthenewironoremine.Theminemanagerarguesthatthereisnocostassociatedwithusingthissystem,sinceithasbeenpaidforalreadyandcannotbesoldorleasedtoacompetitor(andthushasnocompetingcurrentuse).Doyouagree?a. Yesb. No
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AFrameworkforAssessingTheCostofUsingExcessCapacity
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¨ IfIdonotaddthenewproduct,whenwillIrunoutofcapacity?
¨ IfIaddthenewproduct,whenwillIrunoutofcapacity?
¨ WhenIrunoutofcapacity,whatwillIdo?¤ Cutbackonproduction:costisPVofafter-taxcashflowsfromlostsales
¤ Buynewcapacity:costisdifferenceinPVbetweenearlier&laterinvestment
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ProductandProjectCannibalization:ARealCost?
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¨ AssumethatintheDisneythemeparkexample,20%oftherevenuesattheRioDisneyparkareexpectedtocomefrompeoplewhowouldhavegonetoDisneythemeparksintheUS.Indoingtheanalysisofthepark,youwoulda. Lookatonlyincremental revenues (i.e.80%ofthetotalrevenue)b. Lookattotalrevenues attheparkc. Chooseanintermediate number
¨ WouldyouranswerbedifferentifyouwereanalyzingwhethertointroduceanewshowontheDisneycablechannelonSaturdaymorningsthatisexpectedtoattract20%ofitsviewersfromABC(whichisalsoownedbyDisney)?a. Yesb. No