[ppt]introduction to corporate finance - john wiley & sons · web viewthe irr assumes...

Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

CHAPTER 13CHAPTER 13 Capital Budgeting, Risk Capital Budgeting, Risk

Considerations and Other Considerations and Other Special IssuesSpecial Issues

CHAPTER 13 – Capital Budgeting, Risk Considerations and Other Special Issues

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Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• The Nature of Capital Expenditure DecisionsThe Nature of Capital Expenditure Decisions• The Appropriate Discount RateThe Appropriate Discount Rate• Evaluation of Investment Alternatives using NPV, IRR, Evaluation of Investment Alternatives using NPV, IRR,

PI and Payback ApproachesPI and Payback Approaches• Capital RationingCapital Rationing• Independent and Interdependent ProjectsIndependent and Interdependent Projects• Comparing Mutually Exclusive Projects with Unequal Comparing Mutually Exclusive Projects with Unequal

LivesLives• International ConsiderationsInternational Considerations• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions


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Learning ObjectivesLearning Objectives

1.1. The similarities between corporate investment techniques The similarities between corporate investment techniques and the techniques used to value sharesand the techniques used to value shares

2.2. The basic capital budgeting processThe basic capital budgeting process3.3. The most important approaches used to determine the The most important approaches used to determine the

value of a firm’s capital expenditures (capex)value of a firm’s capital expenditures (capex)4.4. The reasons that firms sometimes use techniques that The reasons that firms sometimes use techniques that

may seem inconsistent with value maximization.may seem inconsistent with value maximization.


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Important Chapter TermsImportant Chapter Terms

• Bottom-up analysisBottom-up analysis• Capital budgetingCapital budgeting• Capital expendituresCapital expenditures• Capital rationingCapital rationing• Chain replication approachChain replication approach• Contingent projectsContingent projects• Crossover rateCrossover rate• Discounted cash flow (DCF) Discounted cash flow (DCF)

methodologiesmethodologies• Discounted payback periodDiscounted payback period• Equivalent annual NPV Equivalent annual NPV

approachapproach• Five ForcesFive Forces

• Independent projectsIndependent projects• Internal rate of return (IRR)Internal rate of return (IRR)• Investment opportunity Investment opportunity

schedule (IOS)schedule (IOS)• Mutually exclusive projectsMutually exclusive projects• Net present value (NPV)Net present value (NPV)• Payback periodPayback period• Profitability indexProfitability index• Pure play approachPure play approach• Risk-adjusted discount Risk-adjusted discount

rates (RADRs)rates (RADRs)• Top-down analysisTop-down analysis


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Capital Expenditures (capex)Capital Expenditures (capex)

Capital expenditures are a firm’s Capital expenditures are a firm’s investments in long-lived assets.investments in long-lived assets.

Long-lived assets may be:Long-lived assets may be:– Tangible (property, plant and equipment)Tangible (property, plant and equipment)– Intangible (research and development, patents, Intangible (research and development, patents,

copyrights, trademarks, brand names, and copyrights, trademarks, brand names, and franchise agreements)franchise agreements)


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Capital ExpendituresCapital ExpendituresImportanceImportance

Capex decisions determine the future Capex decisions determine the future direction of the company.direction of the company.

• CAPEX decisions are among the most important that CAPEX decisions are among the most important that the firm can make because:the firm can make because:

– Often involve very significant outlay of money and Often involve very significant outlay of money and managerial timemanagerial time

– Often take many years to demonstrate their returnsOften take many years to demonstrate their returns– Are often irrevocableAre often irrevocable– Because of their size and long-term nature, they can Because of their size and long-term nature, they can

significantly alter the risk of the entire firm.significantly alter the risk of the entire firm.


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Capital Expenditure DecisionsCapital Expenditure DecisionsCapital BudgetingCapital Budgeting

Capital budgeting is the process through Capital budgeting is the process through which a firm makes capital expenditure which a firm makes capital expenditure decisions by:decisions by:

1.1. Identifying investment alternativesIdentifying investment alternatives2.2. Evaluating these alternativesEvaluating these alternatives3.3. Implementing the chosen investment decisions, Implementing the chosen investment decisions,

andand4.4. Monitoring and evaluating the implemented Monitoring and evaluating the implemented

decisions.decisions.


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Capital Expenditure DecisionsCapital Expenditure DecisionsFive ForcesFive Forces

Michael Porter’s Five Forces model identified five critical Michael Porter’s Five Forces model identified five critical factors that determine the attractiveness of an industry:factors that determine the attractiveness of an industry:

1.1. Entry barriersEntry barriers2.2. Threat of substitutesThreat of substitutes3.3. Bargaining power of buyersBargaining power of buyers4.4. Bargaining power of suppliersBargaining power of suppliers5.5. Rivalry among existing competitorsRivalry among existing competitors

Companies do exert control over how they strive to create a Companies do exert control over how they strive to create a competitive advantage within their industry.competitive advantage within their industry.

They can strive for:They can strive for:1.1. Cost leadership: strive to be a low-cost producerCost leadership: strive to be a low-cost producer2.2. Differentiation: offer “differentiated” productsDifferentiation: offer “differentiated” products

Once attained, competitive advantage is difficult to sustain, Once attained, competitive advantage is difficult to sustain, and this requires on-going planning and investment.and this requires on-going planning and investment.

CAPEX must be made with a strategic focus and be subject to CAPEX must be made with a strategic focus and be subject to and pass rigorous financial analysis. and pass rigorous financial analysis.


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Capital Expenditure DecisionsCapital Expenditure DecisionsBottom-up and Top-Down AnalysisBottom-up and Top-Down Analysis

Bottom-up Analysis is an investment strategy Bottom-up Analysis is an investment strategy in which capex decisions are considered in in which capex decisions are considered in isolation, without regard for whether the isolation, without regard for whether the firm should continue in this business or for firm should continue in this business or for general industry and economic trends.general industry and economic trends.

Top-down Analysis is an investment strategy Top-down Analysis is an investment strategy that focuses on strategic decisions, such as that focuses on strategic decisions, such as which industries or products the firm which industries or products the firm should be involved in, looking at the overall should be involved in, looking at the overall economic picture.economic picture.


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Capital Expenditure DecisionsCapital Expenditure DecisionsDCF MethodolgiesDCF Methodolgies

Capex decisions, like security valuation, must take Capex decisions, like security valuation, must take into account the into account the timing, magnitude and riskinesstiming, magnitude and riskiness of the of the net incremental, after-tax cash flow benefitsnet incremental, after-tax cash flow benefits that an initial investment is forecast to produce.that an initial investment is forecast to produce.

Unlike security valuation decisions, analysts can Unlike security valuation decisions, analysts can change the underlying cash flows by changing the change the underlying cash flows by changing the structure of the project.structure of the project.


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Capital Expenditure DecisionsCapital Expenditure DecisionsDCF MethodologiesDCF Methodologies

The ability to restructure capex proposals means The ability to restructure capex proposals means that capex analysis can be iterative and circular that capex analysis can be iterative and circular as illustrated below:as illustrated below:

Project Proposal

Project Analysis

Forecast Outcome Positive (+ NPV)

Forecast Outcome Not Viable (- NPV)

Restructure Proposal

Proceed with Implementation Planning


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Capital Expenditure DecisionsCapital Expenditure DecisionsDCF MethodologiesDCF Methodologies

All discounted cash flow approaches All discounted cash flow approaches require:require:– Estimate of the initial cost of the CAPEX Estimate of the initial cost of the CAPEX – Estimate of the net incremental after-tax cash Estimate of the net incremental after-tax cash

flow benefits the investment is forecast to flow benefits the investment is forecast to produce (we need to know when these cash produce (we need to know when these cash flows will occur and how large they will be)flows will occur and how large they will be)

– Estimate of the required rate of return on the Estimate of the required rate of return on the project (relevant discount rate project (relevant discount rate kk))


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Where Where CFCFtt = estimated future after-tax incremental cash flow at = estimated future after-tax incremental cash flow at time time ttCFCF00 = the initial after-tax incremental cash outlay = the initial after-tax incremental cash outlay

Evaluating Investment AlternativesEvaluating Investment AlternativesThe Cash Flow Pattern for a Traditional Capital ExpenditureThe Cash Flow Pattern for a Traditional Capital Expenditure

0 1 2 3 … n

CF1 CF2 CF3 … CFn

CF0

13-1 FIGURE


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Firm’s Cost of Capital (WACC = Firm’s Cost of Capital (WACC = kk))

• The firm’s cost of capital determines the minimum rate of The firm’s cost of capital determines the minimum rate of return that would be acceptable for a capital project. return that would be acceptable for a capital project.

• WACC is the discount rate (k) we use in NPV analysis and the WACC is the discount rate (k) we use in NPV analysis and the hurdle rate when using IRRhurdle rate when using IRR

• The weighted average cost of capital (WACC) is the relevant The weighted average cost of capital (WACC) is the relevant discount rate for NPV analysis. (assuming the risk of the project discount rate for NPV analysis. (assuming the risk of the project being evaluated is similar to the risk of the overall firm)being evaluated is similar to the risk of the overall firm)

• If the risk of the project differs from the risk of the overall firm a If the risk of the project differs from the risk of the overall firm a risk-adjusted discount rate (RADR) should be used.risk-adjusted discount rate (RADR) should be used.


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Risk-Adjusted Discount Rates (RADRs = Risk-Adjusted Discount Rates (RADRs = kk))

• RADRs can be estimated using a number of alternative RADRs can be estimated using a number of alternative techniques:techniques:1.1. Use the CAPM formula after determining the project beta and using Use the CAPM formula after determining the project beta and using

the current risk-free rate (RF) and an estimate of the market risk the current risk-free rate (RF) and an estimate of the market risk premiumpremium• This approach involves forecast ROA that must be regressed against the This approach involves forecast ROA that must be regressed against the

ROA of the market index. Estimation errors can be significant.ROA of the market index. Estimation errors can be significant.

2.2. Pure play approach where you find the cost of capital of a firm in the Pure play approach where you find the cost of capital of a firm in the industry associated with the project. industry associated with the project. • The key to this approach is that the firm must not be diversified across The key to this approach is that the firm must not be diversified across

industries but truly represent an investment solely in that industry.industries but truly represent an investment solely in that industry.


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Evaluation of Investment AlternativesEvaluation of Investment AlternativesDCF MethodologiesDCF Methodologies

• Net Present Value (NPV)Net Present Value (NPV)• Internal Rate of Return (IRR)Internal Rate of Return (IRR)• Payback Period and Discounted Payback Payback Period and Discounted Payback

PeriodPeriod• Profitability Index (PI)Profitability Index (PI)


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Project Evaluation TechniquesProject Evaluation TechniquesNet Present Value (NPV) FormulaNet Present Value (NPV) Formula

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Evaluating Investment AlternativesEvaluating Investment AlternativesNet Present Value (NPV) AnalysisNet Present Value (NPV) Analysis

NPV = the sum of the present value of all benefits minus NPV = the sum of the present value of all benefits minus the present value of coststhe present value of costs

If benefits > cost, NPV will be positive and the If benefits > cost, NPV will be positive and the project is acceptable.project is acceptable.

If benefits < cost, NPV will be negative and the If benefits < cost, NPV will be negative and the project is unacceptable because it destroys firm project is unacceptable because it destroys firm value.value.

11

n

ii

i stInitial Cok)(BenefitsCash Flow NPV


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Evaluating Investment AlternativesEvaluating Investment AlternativesNet Present Value InterpretedNet Present Value Interpreted

Example:Example:If NPV is forecast to be + $250,000, then the PV of incremental If NPV is forecast to be + $250,000, then the PV of incremental benefits exceeds the present value of costs today by $250,000. benefits exceeds the present value of costs today by $250,000. Remember the PV is determined by discounting the forecast Remember the PV is determined by discounting the forecast cash flows by the investor’s required return. A positive NPV cash flows by the investor’s required return. A positive NPV indicates that returns are greater than what investors require. indicates that returns are greater than what investors require. This means a positive NPV adds value to the firm.This means a positive NPV adds value to the firm.

In this case, if there were 1,000,000 shares outstanding, In this case, if there were 1,000,000 shares outstanding, acceptance of a $250,000 NPV project in an efficient market acceptance of a $250,000 NPV project in an efficient market means that the market price of each share should rise by:means that the market price of each share should rise by:

25.0$000,000,1000,250$

gOutstandin Shares ofNumber NPV Price Sharein Increase


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Evaluating Investment AlternativesEvaluating Investment AlternativesNet Present Value InterpretedNet Present Value Interpreted

NPV is an absolute measure (expressed in NPV is an absolute measure (expressed in present dollars) of the net incremental present dollars) of the net incremental benefits the project is forecast to bring to the benefits the project is forecast to bring to the shareholders.shareholders.

In a perfectly efficient market, the total value In a perfectly efficient market, the total value of the firm should rise by the value of the NPV of the firm should rise by the value of the NPV if the project is undertaken.if the project is undertaken.

Remember – it is the manager’s responsibility to Remember – it is the manager’s responsibility to maximize shareholder wealthmaximize shareholder wealth


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NPV ExampleNPV ExampleThe Formula-based ApproachThe Formula-based Approach

Problem:Problem:• Initial outlay = $12,000Initial outlay = $12,000• After-tax cash flow benefits:After-tax cash flow benefits:

– Year 1 = $5,000Year 1 = $5,000– Year 2 = $5,000Year 2 = $5,000– Year 3 = $8,000Year 3 = $8,000

• Discount rate (k) = 15%Discount rate (k) = 15%

389,1$000,12$260,6$781,3$348,4$

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NPV ExampleNPV ExampleThe Spreadsheet ApproachThe Spreadsheet Approach




Initial cost = $12,000Cost of Capital = 15.0%

Year CashflowAfter-tax

incremental CF PV FactorPresent Value

0 Initial cost -$12,000 1 -$12,0001 ATCF operating benefit 5,000 0.869565 $4,3482 ATCF operating benefit 5,000 0.756144 $3,7813 ATCF operating benefit 8,000 0.657516 $5,260

NPV = $1,389


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NPV ExampleNPV ExampleThe Financial Calculator ApproachThe Financial Calculator Approach





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NPV ExampleNPV ExampleSolution Using a Financial Calculator (TI BA II Plus)Solution Using a Financial Calculator (TI BA II Plus)

CF 2ND CLR WORK

-12000

5000

5000

8000

15

gives $1,388.67

ENTER

ENTER

ENTER

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CPT

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NPV ProfileNPV Profile

• Is a set of NPVs for a project that are created by Is a set of NPVs for a project that are created by varying the discount rate used to find the present varying the discount rate used to find the present value of the cash flows.value of the cash flows.

• The slope of the NPV line that is created when you The slope of the NPV line that is created when you graph these results, depends on the useful life of the graph these results, depends on the useful life of the project and on the timing of the receipt of the net project and on the timing of the receipt of the net incremental benefits.incremental benefits.– The longer the life of the project, the steeper the slope of the The longer the life of the project, the steeper the slope of the

NPV profile line because more distant cash flows are affected NPV profile line because more distant cash flows are affected more by the discounting process.more by the discounting process.

(The following slide demonstrates what an NPV Profile looks like)(The following slide demonstrates what an NPV Profile looks like)


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NPV ProfileNPV Profile

NPV ($)

Discount Rate (k) (%)


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NPV ExampleNPV ExampleA Spreadsheet Modeling ApproachA Spreadsheet Modeling Approach

Initial cost = $100,000AT cash flow benefits = $60,000Useful life(years) = 6Cost of Capital = 12%

Year Cashflow After-tax incremental CF PV Factor Present Value0 Initial cost -$100,000 1 -$100,0001 ATCF operating benefit 60,000 0.892857 $53,5712 ATCF operating benefit 60,000 0.797194 $47,8323 ATCF operating benefit 60,000 0.71178 $42,7074 ATCF operating benefit 60,000 0.635518 $38,1315 ATCF operating benefit 60,000 0.567427 $34,0466 ATCF operating benefit 60,000 0.506631 $30,398

NPV = $146,684

Here is a spreadsheet model used to calculate a $100,000 project that has a 6 year life, offers equal annual after-tax cash flow benefits over that life of $60,000 per annum when the relevant cost of capital is 12%.

The NPV result is positive and the project is acceptable because the project looks like it will increase the value of the firm with these assumptions.


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NPV ExampleNPV ExampleStress Testing the ProjectStress Testing the Project

Now, let us stress – test the model. We can start by setting the discount rate to 0%. (ie. No time value to money)


Year Cashflow After-tax incremental CF PV Factor Present Value0 Initial cost -$100,000 1 -$100,0001 ATCF operating benefit 60,000 1 $60,0002 ATCF operating benefit 60,000 1 $60,0003 ATCF operating benefit 60,000 1 $60,0004 ATCF operating benefit 60,000 1 $60,0005 ATCF operating benefit 60,000 1 $60,0006 ATCF operating benefit 60,000 1 $60,000

NPV = $260,000

Notice that at a 0% discount rate, all of the present value factors become 1. And we work with absolute dollar values. NPV is forecast to be it’s greatest at a 0% discount rate.


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Increasing the discount rate to 5%, we discount the more distant cash flows more heavily and the NPV of the project falls from $260,000 to $204,542.



NPV = $204,542


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Increasing the discount rate to 10%, the NPV of the project falls from $204,542 (at 5%) to $161,316.



NPV = $161,316


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Increasing the discount rate to 20%, the NPV of the project falls to $99,531.



NPV = $99,531


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Increasing the discount rate to 50%, the NPV of the project falls to $9,465.

It is hard to imagine a project having risk that requires a return of more than 50%. Even at a discount rate of 50%, the project has a positive NPV!



NPV = $9,465


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Increasing the discount rate to 60%, the NPV of the project falls to -$5,960. At that discount rate, the project would decrease the value of the firm if accepted.



NPV = -$5,960

Somewhere between 50% and 60%, the NPV turned to $0. Remember, the IRR of the project is that discount rate that causes the NPV to be equal to $0.00


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Initial cost = $100,000AT cash flow benefits = $60,000Useful life(years) = 6Cost of Capital = 55.8055%


NPV = $0

A discount rate of 55.8055% causes the NPV to be equal to $0. This is the project’s IRR. Now we can graph the results of the stress test. NPV is on the vertical axis because it is the dependent variable and discount rate is on the horizontal.


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Project NPV ProfileProject NPV Profile

NPV$

$260,000

Discount Rate (%)IRR = 55.8%

0 0% 5% 10% 20% 40% 50% 60%


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NPV$

$260,000

$146,684


0 0% 5% 10% 20% 40% 50% 60%

IF the appropriate discount rate (k) is 12%, then the NPV is forecast to be positive.


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NPV$

$260,000

$146,684


0 0% 5% 10% 20% 40% 50% 60%

Even if your estimate of the project’s required return (RADR) is wrong, the project’s NPV remains positive over a wide range of values for k (from 0% to 55%)


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NPV ProfilesNPV Profiles

• The slope of the NPV profile depends on the The slope of the NPV profile depends on the timing and magnitude of cash flows.timing and magnitude of cash flows.

• Projects with cash flows that occur late in the Projects with cash flows that occur late in the project’s life will have an NPV that is more project’s life will have an NPV that is more sensitive to discount rate changes.sensitive to discount rate changes.


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IRRIRR

• The internal rate of return (IRR) is that discount rate The internal rate of return (IRR) is that discount rate that causes the NPV of the project to equal zero.that causes the NPV of the project to equal zero.

• If IRR > WACC, then the project is acceptable because If IRR > WACC, then the project is acceptable because it will return a rate of return on invested capital that is it will return a rate of return on invested capital that is likely to be greater than the cost of funds used to likely to be greater than the cost of funds used to invest in the project.invest in the project.


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Project Evaluation TechniquesProject Evaluation TechniquesInternal Rate of Return (IRR)Internal Rate of Return (IRR)

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IRR ExampleIRR ExampleThis Example Will Be Used To Demonstrate Alternative Approaches to This Example Will Be Used To Demonstrate Alternative Approaches to

Solve for IRRSolve for IRR



• Cost of Capital = 15%Cost of Capital = 15%


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IRR ExampleIRR ExampleFormula-based Approach to the SolutionFormula-based Approach to the Solution

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13 - 46

IRR ExampleIRR ExampleFormula-based Approach to the Solution – Linear InterpolationFormula-based Approach to the Solution – Linear Interpolation

Summarizing our results:Summarizing our results:Discount RateDiscount Rate Present Value of BenefitsPresent Value of Benefits

20%20% $12,268.52$12,268.52IRRIRR $12,000$12,000

25%25% $11,296$11,296

We can now We can now estimateestimate the IRR assuming a linear relationship between PV of benefits the IRR assuming a linear relationship between PV of benefits (which isn’t exactly true because compound interest is a curvilinear relationship)(which isn’t exactly true because compound interest is a curvilinear relationship)

IRR is between 20% and

25%

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IRR ExampleIRR ExampleSolution Using a Financial Calculator (TI BA II Plus)Solution Using a Financial Calculator (TI BA II Plus)

CF 2ND CLR WORK

-12,000

5,000

5,000

8,000

gives 21.31%

ENTER

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IRR ExampleIRR ExampleSpreadsheet Model-based Approach to the SolutionSpreadsheet Model-based Approach to the Solution

A B C D E1 Time Type of Cash Flow ATCF2 0 Initial Project cost = -$12,0003 1 Incremental ATCF Benefit= $5,0004 2 Incremental ATCF Benefit= $5,0005 3 Incremental ATCF Benefit= $8,00067 IRR = 21.31282726%Simply place the cash flows into their own individual cells on the spreadsheet, remembering that the cost of the project is a negative cash flow representing funds leaving the firm.

Next, insert the built-in IRR function (fx) into a cell and provide the function values in the format of: =IRR(value 0, value 1, value 2,…, guess)

=IRR(D2:D5,0.10)


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IRR versus NPVIRR versus NPV

• Both methods use the same basic decision Both methods use the same basic decision inputs.inputs.

• The only difference is the assumed discount The only difference is the assumed discount rate.rate.

• The IRR assumes intermediate cashflows are The IRR assumes intermediate cashflows are reinvested at IRR…NPV assumes they are reinvested at IRR…NPV assumes they are reinvested at WACCreinvested at WACC– This difference, however, can produce conflicting This difference, however, can produce conflicting

decision results under specific conditionsdecision results under specific conditions


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Evaluating Investment AlternativesEvaluating Investment AlternativesComparing NPV and IRRComparing NPV and IRR

Issue NPV IRR1. Future cash flows

change signIt still works the same for both accept/reject and ranking decisions.

Multiple IRRs may result - in this case, the IRR cannot be used for either accept/reject or ranking decisions.

2. Ranking projects Higher NPV implies greater contribution to firm wealth - it is an absolute measure of wealth.

The higher IRR project may have a lower NPV, and vice versa, depending on the appropriate discount rate, and the size of the

3. Reinvestment rate assumed for future cash flows received

Assumes all future cash flows are reinvested at the discount rate. This is appropriate because it treats the reinvestment of all future cash flows consistently, and k is the investor's opportunity cost.

Assumes cash flows from each project are reinvested at that project's IRR. This is inappropriate, particularly when the IRR is high.

Table 13 - 1 NPV versus IRR


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IRR versus NPVIRR versus NPVConditions Where NPV and IRR Will Give Conflicting Decision ResultsConditions Where NPV and IRR Will Give Conflicting Decision Results

1.1. Evaluating two or more mutually exclusive Evaluating two or more mutually exclusive investment proposalsinvestment proposals

2.2. NPV profiles of the projects have different NPV profiles of the projects have different slopes and cross at a positive NPVslopes and cross at a positive NPV

3.3. The cost of capital (relevant discount rate The cost of capital (relevant discount rate kk) ) is lower than the crossover discount rate.is lower than the crossover discount rate.


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Evaluating Investment AlternativesEvaluating Investment AlternativesTwo NPV ProfilesTwo NPV Profiles

13 - 2 FIGURE

A

NPV ($)

700

500

0


Crossover Rate = 9%

12 15

B


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Evaluating Investment AlternativesEvaluating Investment AlternativesTwo NPV ProfilesTwo NPV Profiles

13 - 2 FIGURE

A

NPV ($)

700

500

0


Crossover Rate = 9%

12 15

B

If k is less than 9%, then project A will have a higher NPV

than B and A should be chosen to

maximize the value of the firm.

IRRB>IRRA

The IRR approach would lead us to

believe the Project B is best!

However, NPVA is greater when

k<9%


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Evaluating Investment AlternativesEvaluating Investment AlternativesComparing NPV and IRRComparing NPV and IRR

• Both techniques use the same inputsBoth techniques use the same inputs• NPV measures in absolute terms, the estimated NPV measures in absolute terms, the estimated

increase in the value of the firm today the project increase in the value of the firm today the project is expected to produce.is expected to produce.– NPV assumes cash flows are reinvested at WACCNPV assumes cash flows are reinvested at WACC

• IRR estimates the rate of return on the projectIRR estimates the rate of return on the project– IRR assumes cash flows produced by the project are IRR assumes cash flows produced by the project are

reinvested by the firm at the project’s IRR.reinvested by the firm at the project’s IRR.

The reason for the different accept/reject decisions The reason for the different accept/reject decisions is the different reinvestment rate assumptions is the different reinvestment rate assumptions

used by the two techniques.used by the two techniques.


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Evaluating Investment AlternativesEvaluating Investment AlternativesNPV and IRR ComparedNPV and IRR Compared

Which method should be relied upon?Which method should be relied upon?– It depends on which reinvestment assumption is It depends on which reinvestment assumption is

most realistic.most realistic.– Most often, the NPV assumption of reinvestment at Most often, the NPV assumption of reinvestment at

WACC is the most realistic because no rational WACC is the most realistic because no rational manager would reinvest cash flows at rates lower manager would reinvest cash flows at rates lower than the firm’s cost of capital.than the firm’s cost of capital.

– Projects with high IRRs are not common – to Projects with high IRRs are not common – to assume that future cash flows will be reinvested at assume that future cash flows will be reinvested at the inflated IRR rate is probably wrong.the inflated IRR rate is probably wrong.


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Evaluation TechniquesEvaluation TechniquesCFO PreferencesCFO Preferences

Despite the inherent superiority of the NPV Despite the inherent superiority of the NPV approach, CFOs continue to use other approach, CFOs continue to use other approaches and do not favour NPV over approaches and do not favour NPV over IRR.IRR.

Perhaps, the reason for this is that it is Perhaps, the reason for this is that it is difficult for people to understand what a difficult for people to understand what a positive NPV really means.positive NPV really means.

(See Figure 13 – 3 on the following slide.)(See Figure 13 – 3 on the following slide.)


13 - 57

CFO PreferencesCFO PreferencesEvaluation TechniqueEvaluation Technique

13 - 3 FIGURE

0% 10% 20% 30% 40% 50% 60% 70% 80%

IRRNPV

Hurdle RatePayback

Sensitivity AnalysisP/E multiples

Discounted paybackReal options

Book rate of returnSimulation analysis

Profitability IndexAPV

Evaluation Technique

Source: Data from Graham, John R. and Harvey, Campbell R. “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics 60 (2001), p. 187-243.

Payback and Discounted PaybackPayback and Discounted Payback

Capital Budgeting, Risk Capital Budgeting, Risk Considerations and Other Special Considerations and Other Special

IssuesIssues


13 - 59

Payback MethodPayback Method

• This is a simple approach to capital budgeting that is This is a simple approach to capital budgeting that is designed to tell you how many years it will take to recover designed to tell you how many years it will take to recover the initial investment.the initial investment.

• It is often used by financial managers as one of a set of It is often used by financial managers as one of a set of investment screens, because it gives the manager an investment screens, because it gives the manager an intuitive sense of the project’s risk.intuitive sense of the project’s risk.


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Simple Payback ExampleSimple Payback Example

Initial cost = $100,000AT cash flow benefits = $60,000Useful life(years) = 5Cost of Capital = N/A

Year CashflowAfter-tax incremental

Cash Flows PV FactorCumulative Cash Flows

0 Initial cost -$100,000 -$100,0001 ATCF operating benefit $60,000 -$40,0002 ATCF operating benefit $60,000 $20,0003 ATCF operating benefit $60,000 4 ATCF operating benefit $60,000 5 ATCF operating benefit $60,000 6 ATCF operating benefit $60,000

Payback period = 1.7 years


13 - 61

Discounted Payback ExampleDiscounted Payback Example

Initial cost = $100,000AT cash flow benefits = $60,000Useful life(years) = 5Cost of Capital = 10.0%

Year CashflowAfter-tax incremental

Cash Flows PV Factor

Present Value of

ATCFsCumulative Cash Flows

0 Initial cost -$100,000 1 -$100,000 -$100,0001 ATCF operating benefit $60,000 0.90909091 $54,545 -$45,4552 ATCF operating benefit $60,000 0.82644628 $49,587 $4,1323 ATCF operating benefit $60,000 0.7513148 $45,079 $49,2114 ATCF operating benefit $60,000 0.68301346 $40,981 $90,1925 ATCF operating benefit $60,000 0.62092132 $37,255 $127,4476 ATCF operating benefit $60,000 0.56447393 $33,868 $161,316

Payback period = 1.9 years


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Discounted Payback GraphedDiscounted Payback Graphed

NPV$

Years

Discounted PaybackPoint


13 - 63

Discounted PaybackDiscounted Payback

• Overcomes the lack of consideration of the Overcomes the lack of consideration of the time value of money…time value of money…

• Graphing the cumulative PV of cash flows can Graphing the cumulative PV of cash flows can help us see the pattern of cash flows beyond help us see the pattern of cash flows beyond the payback point.the payback point.

• If carried to the end of the project’s useful If carried to the end of the project’s useful life…will tell us the project’s NPV (if you are life…will tell us the project’s NPV (if you are using the firm’s WACC)using the firm’s WACC)


13 - 64

Profitability IndexProfitability Index

• Uses exactly the same decision inputs as NPV Uses exactly the same decision inputs as NPV • simply expresses the relative profitability of the projects simply expresses the relative profitability of the projects

incremental after-tax cashflow benefits as a ratio to the incremental after-tax cashflow benefits as a ratio to the project’s initial cost.project’s initial cost.

PI = PI = PV of incremental ATCF benefitsPV of incremental ATCF benefitsPV of initial cost of projectPV of initial cost of project

If PI>1, then we accept; because the PV of benefits exceeds the PV of If PI>1, then we accept; because the PV of benefits exceeds the PV of costs.costs.


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Project Evaluation TechniquesProject Evaluation TechniquesProfitability Index (PI)Profitability Index (PI)

• PI is a ratio of the present value of benefits to costs.PI is a ratio of the present value of benefits to costs.• As a pure coefficient, as long as it exceeds 1.00 the As a pure coefficient, as long as it exceeds 1.00 the

project will increase the value of the firm if accepted.project will increase the value of the firm if accepted.• A PI of more than 1.0 indicates that the project is A PI of more than 1.0 indicates that the project is

expected to earn a return greater than the required expected to earn a return greater than the required return.return.

outflows)(cash PVinflows)PV(cash

PI[ 13-3]


13 - 66

Independent and Interdependent ProjectsIndependent and Interdependent Projects

Independent ProjectsIndependent Projects– Are projects that have no relationship with one anotherAre projects that have no relationship with one another– Accepting one project has no impact on the decision to Accepting one project has no impact on the decision to

accept another projectaccept another projectContingent ProjectsContingent Projects

– Are projects for which the acceptance of one requires the Are projects for which the acceptance of one requires the acceptance of another, either before-hand or acceptance of another, either before-hand or simultaneously.simultaneously.

Mutually Exclusive ProjectsMutually Exclusive Projects– Are projects that are substitutes of one anotherAre projects that are substitutes of one another– Acceptance of one automatically means the other is Acceptance of one automatically means the other is

rejected.rejected.


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Evaluating Mutually Exclusive Projects Evaluating Mutually Exclusive Projects with Unequal Liveswith Unequal Lives

There are two approaches to adjust for unequal There are two approaches to adjust for unequal lives among mutually exclusive projects:lives among mutually exclusive projects:1.1. Chain replication approachChain replication approach

• A way to compare projects with unequal lives by finding a A way to compare projects with unequal lives by finding a time horizon into which all the project lives under time horizon into which all the project lives under consideration divide equally, and then assuming each consideration divide equally, and then assuming each project repeats until it reaches this horizon.project repeats until it reaches this horizon.

2.2. Equivalent Annual NPV (EANPV) approachEquivalent Annual NPV (EANPV) approach• A way to compare projects by finding the NPV of the A way to compare projects by finding the NPV of the

individual projects, and then determining the amount of an individual projects, and then determining the amount of an annual annuity that is economically equivalent to the NPV annual annuity that is economically equivalent to the NPV generated by each project over its respective time horizon.generated by each project over its respective time horizon.


13 - 68

Evaluating Mutually Exclusive Projects with Evaluating Mutually Exclusive Projects with Unequal LivesUnequal Lives

The Chain Replication ApproachThe Chain Replication Approach

Consider two mutually exclusive projects A and Consider two mutually exclusive projects A and B.B. – Useful life of A is 2 years.Useful life of A is 2 years.– Useful Life of B is 3 years.Useful Life of B is 3 years.O 1 2A

O 1 2

O 1 2

O 1 2 3BO 1 2 3

You can now calculate NPV for both alternatives assuming replication over a six year time horizon.


13 - 69

Project Evaluation TechniquesProject Evaluation TechniquesEquivalent Annual NPV (EANPV) ApproachEquivalent Annual NPV (EANPV) Approach

k)(11-1

NPVProject

n

k

PANPV[ 13-4]


13 - 70

Capital RationingCapital Rationing

• The corporate practice of limiting the amount The corporate practice of limiting the amount of funds dedicated to capital investments in of funds dedicated to capital investments in any one year.any one year.

• Is academically illogical.Is academically illogical.– Why would a manager not invest in a project that will Why would a manager not invest in a project that will

offer a greater return than the cost of capital used to offer a greater return than the cost of capital used to finance it?finance it?

• In the long-run could threaten a firm’s In the long-run could threaten a firm’s continuing existence through erosion of its continuing existence through erosion of its competitive position.competitive position.


13 - 71

Capital RationingCapital RationingPractical Reasons for This PracticePractical Reasons for This Practice

• The firm may have owners who do not want The firm may have owners who do not want to raise additional external equity because it to raise additional external equity because it will mean ownership dilution to themwill mean ownership dilution to them

• The firm may have so many great investment The firm may have so many great investment projects that they exceed the firm’s short-projects that they exceed the firm’s short-term managerial capacity to take advantage term managerial capacity to take advantage of them.of them.


13 - 72

Capital RationingCapital RationingRanking ProjectsRanking Projects

• Under capital rationing, the cost of capital is no Under capital rationing, the cost of capital is no longer the appropriate opportunity costlonger the appropriate opportunity cost

• IRR may have more validity because the firm may IRR may have more validity because the firm may be able to reinvest its cash flows at rates that are be able to reinvest its cash flows at rates that are higher than the cost of capital.higher than the cost of capital.

• The PI may be a useful starting point because it The PI may be a useful starting point because it ranks projects on PV per unit of investment.ranks projects on PV per unit of investment.

• In the absence of capital rationing, NPV, IRR and In the absence of capital rationing, NPV, IRR and PI will select value-maximizing projects. PI will select value-maximizing projects.

See Figure 13 – 4 on the following slide for Rothman’s unconstrained See Figure 13 – 4 on the following slide for Rothman’s unconstrained Investment opportunity schedule.Investment opportunity schedule.


13 - 73

Optimal InvestmentOptimal InvestmentRothman’s Inc.’s Investment and Internal Fund Availability, 2006Rothman’s Inc.’s Investment and Internal Fund Availability, 2006

13 - 4 FIGURE

$11,976 Million

Rate of Return

WACC

Internal Funds Available

OPTIMAL INVESTMENT

IOS

$177,607 Million


13 - 74

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)

• An Investment opportunity schedule is the prioritized An Investment opportunity schedule is the prioritized list of capital projects, ranked from highest to lowest.list of capital projects, ranked from highest to lowest.

• At the same time, the cumulative investment required At the same time, the cumulative investment required is listed.is listed.

Example:Example:Consider a firm that has six different capital investment proposals this Consider a firm that has six different capital investment proposals this year. Each project has it’s own IRR, NPV, PI and capital cost. year. Each project has it’s own IRR, NPV, PI and capital cost.

(See the next slide)(See the next slide)


13 - 75

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)

Example:Example:Consider a firm that has six different capital investment proposals this year. Consider a firm that has six different capital investment proposals this year. Each project has it’s own IRR, NPV, PI and capital cost. Each project has the Each project has it’s own IRR, NPV, PI and capital cost. Each project has the same risk as the firm as a whole.same risk as the firm as a whole.

Firm's Cost of Capital = 10.00%

Capital Project Initial Cost

Annual ATCF

BenefitsUseful

Life NPV IRR PIA $1,500,000 $290,000 7 -$88,159 8.19% 0.94B $3,000,000 $700,000 6 $48,682 10.55% 1.02C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13D $70,000 $20,000 7 $27,368 21.08% 1.39E $1,000,000 $290,000 5 $99,328 13.82% 1.10F $960,000 $200,000 8 $106,985 12.99% 1.11


13 - 76

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Ranked by NPVProjects Ranked by NPV

Example:Example:In the absence of capital rationing the projects as ranked by NPV would be:In the absence of capital rationing the projects as ranked by NPV would be:

Project A would be unacceptable because of a forecast negative NPVProject A would be unacceptable because of a forecast negative NPV



Annual ATCF

BenefitsUseful

Life NPV IRR PIC $4,000,000 $1,040,000 6 $529,471 14.40% 1.13F $960,000 $200,000 8 $106,985 12.99% 1.11E $1,000,000 $290,000 5 $99,328 13.82% 1.10B $3,000,000 $700,000 6 $48,682 10.55% 1.02D $70,000 $20,000 7 $27,368 21.08% 1.39

$9,030,000 $811,835A $1,500,000 $290,000 7 -$88,159 8.19% 0.94


13 - 77

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Ranked by IRRProjects Ranked by IRR

Example:Example:In the absence of capital rationing the projects as ranked by IRR would be:In the absence of capital rationing the projects as ranked by IRR would be:

Project A would be unacceptable because forecast IRR < WACC.Project A would be unacceptable because forecast IRR < WACC.



Annual ATCF

BenefitsUseful

Life NPV IRR PID $70,000 $20,000 7 $27,368 21.08% 1.39C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13E $1,000,000 $290,000 5 $99,328 13.82% 1.10F $960,000 $200,000 8 $106,985 12.99% 1.11B $3,000,000 $700,000 6 $48,682 10.55% 1.02

$9,030,000 $811,835

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94


13 - 78

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Ranked by PIProjects Ranked by PI

Example:Example:In the absence of capital rationing the projects as ranked by PI would be:In the absence of capital rationing the projects as ranked by PI would be:

Project proposal A would be unacceptable because the forecast PI is less than 1.0.Project proposal A would be unacceptable because the forecast PI is less than 1.0.



Annual ATCF

BenefitsUseful

Life NPV IRR PID $70,000 $20,000 7 $27,368 21.08% 1.39C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13F $960,000 $200,000 8 $106,985 12.99% 1.11E $1,000,000 $290,000 5 $99,328 13.82% 1.10B $3,000,000 $700,000 6 $48,682 10.55% 1.02

$9,030,000 $811,835

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94


13 - 79

Ranking of ProjectsRanking of ProjectsIn the Absence of Capital RationingIn the Absence of Capital Rationing

ProjectProject NPVNPV IRRIRR PIPI11 CC DD DD22 FF CC CC33 EE EE FF44 BB FF EE55 DD BB BB

Capital BudgetCapital Budget $9,369,000$9,369,000 $9,369,000 $9,369,000 $9,369,000$9,369,000

Total NPVTotal NPV $679,803$679,803 $679,803 $679,803 $679,803 $679,803

Clearly, in the absence of capital rationing, all three methods choose value Clearly, in the absence of capital rationing, all three methods choose value maximizing projects and reject value-destroying projects.maximizing projects and reject value-destroying projects.


13 - 80

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Selected by NPV under Capital Rationing Limit of $6 million Projects Selected by NPV under Capital Rationing Limit of $6 million

Example:Example:Under capital rationing the projects selected by NPV would be:Under capital rationing the projects selected by NPV would be:



Annual ATCF

BenefitsUseful

Life NPV IRR PIC $4,000,000 $1,040,000 6 $529,471 14.40% 1.13F $960,000 $200,000 8 $106,985 12.99% 1.11E $1,000,000 $290,000 5 $99,328 13.82% 1.10

$5,960,000 $735,785B $3,000,000 $700,000 6 $48,682 10.55% 1.02D $70,000 $20,000 7 $27,368 21.08% 1.39

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94


13 - 81

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Selected by IRR under Capital Rationing Limit of $6 millionProjects Selected by IRR under Capital Rationing Limit of $6 million

Example:Example:Under capital rationing the projects selected by IRR would be:Under capital rationing the projects selected by IRR would be:



Annual ATCF

BenefitsUseful

Life NPV IRR PID $70,000 $20,000 7 $27,368 21.08% 1.39C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13E $1,000,000 $290,000 5 $99,328 13.82% 1.10

$5,070,000 $656,168F $960,000 $200,000 8 $106,985 12.99% 1.11B $3,000,000 $700,000 6 $48,682 10.55% 1.02

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94


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Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Selected by PI under Capital Rationing Limit of $6 millionProjects Selected by PI under Capital Rationing Limit of $6 million

Example:Example:Under capital rationing the projects selected by PI would be:Under capital rationing the projects selected by PI would be:



Annual ATCF

BenefitsUseful

Life NPV IRR PID $70,000 $20,000 7 $27,368 21.08% 1.39C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13

$4,070,000 $556,840F $960,000 $200,000 8 $106,985 12.99% 1.11E $1,000,000 $290,000 5 $99,328 13.82% 1.10B $3,000,000 $700,000 6 $48,682 10.55% 1.02

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94


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Ranking of ProjectsRanking of ProjectsAssuming a Limit on Capital Expenditures to $6,000,000Assuming a Limit on Capital Expenditures to $6,000,000

ProjectProject NPVNPV IRRIRR PIPI11 CC DD DD22 FF CC CC33 EE EE

Capital BudgetCapital Budget $5,960,000$5,960,000 $5,070,000 $5,070,000 $4,070,000 $4,070,000Total NPVTotal NPV $735,785$735,785 $656,168 $656,168 $556,840 $556,840

Capital rationing is an artificial limit on capex.Capital rationing is an artificial limit on capex.Only NPV ranking will ensure maximization of shareholder wealth Only NPV ranking will ensure maximization of shareholder wealth

under these constrained conditions.under these constrained conditions.


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International ConsiderationsInternational Considerations

• Capex decisions involving direct foreign Capex decisions involving direct foreign investment must take into account investment must take into account additional factors:additional factors:– Political riskPolitical risk– Potential legal and regulatory issuesPotential legal and regulatory issues– Adjust for foreign exchange riskAdjust for foreign exchange risk– Adjust for foreign taxationAdjust for foreign taxation– How can the project be financed if local capital How can the project be financed if local capital

markets are poorly developed?markets are poorly developed?


13 - 85

International InvestmentInternational Investment

• Export Development Canada (EDC) is a federal Export Development Canada (EDC) is a federal crown corporation that helps Canadian firms crown corporation that helps Canadian firms export and make foreign direct investment export and make foreign direct investment decisions (FDI)decisions (FDI)

• EDC provides insurance products to help mitigate EDC provides insurance products to help mitigate some of the risks of FDIsome of the risks of FDI

• FDI outside Canada is a growing phenomenon in FDI outside Canada is a growing phenomenon in Canada as Canadian companies increasingly are Canada as Canadian companies increasingly are seeking international investment opportunities.seeking international investment opportunities.

• EDC is encouraging Canadian companies to look EDC is encouraging Canadian companies to look beyond the U.S. as FDI targets.beyond the U.S. as FDI targets.


13 - 86

Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:– How capital decisions are made in companiesHow capital decisions are made in companies– About capital expenditure evaluation tools including About capital expenditure evaluation tools including

NPV, IRR, profitability index, payback period and NPV, IRR, profitability index, payback period and discounted payback perioddiscounted payback period

– Why NPV is the preferred evaluation approachWhy NPV is the preferred evaluation approach– How to adjust analysis for conditions of capital How to adjust analysis for conditions of capital

rationing, risk differences across corporate divisions, rationing, risk differences across corporate divisions, and effects of foreign direct investment.and effects of foreign direct investment.


13 - 87

CopyrightCopyright

Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd.Permissions Department, John Wiley & Sons Canada, Ltd. The The purchaser may make back-up copies for his or her own use only and purchaser may make back-up copies for his or her own use only and not for distribution or resale.not for distribution or resale. The author and the publisher assume no The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained these files or programs or from the use of the information contained herein.herein.

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