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Topics

Overview and vocabulary !! Methods

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Analysis of potential projects. !! Long-term decisions; involve large expenditures. !! Very important to firms future.

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Estimate cash flows (inflows & outflows). !! Assess risk of cash flows. !! Determine r = WACC for project. !! Evaluate cash flows.

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Projects are:

independent, if the cash flows of one are unaffected by the acceptance of the other. !! mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

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0 Ls CFs: -100.00 0 Ss CFs: -100.00 10% 10% 1 10 1 70 2 60 2 50 3 80 3 20

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NPV = !

n

t=0

CFt . (1 + r)t

n

t=1

CFt . CF . 0 (1 + r)t

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0 Ls CFs: -100.00 9.09 49.59 60.11 18.79 = NPVL 10% 1 10 2 60 3 80

NPVS = $19.98.

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-100 10 60 80 10 CF0 CF1 CF2 CF3 I NPV = 18.78 = NPVL

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NPV = PV inflows Cost This is net gain in wealth, so accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

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If Franchise S and L are mutually exclusive, accept S because NPVs > NPVL . !! If S & L are independent, accept both; NPV > 0.

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0 CF0 Cost 1 CF1 2 CF2 Inflows 3 CF3

IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

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t=0

t=0

! (1 + IRR)t

CFt

= 0.

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0

IRR = ?

1 10

2 60

3 80

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0 -100

INPUTS OUTPUT 3

N I/YR

1 40

2 40

-100

PV

3 40

40

PMT

0

FV

9.70%

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If IRR > WACC, then the projects rate of return is greater than its cost-- some return is left over to boost stockholders returns.

Example: WACC = 10%, IRR = 15%. !! So this project adds extra return to shareholders.

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If S and L are independent, accept both: IRRS > r and IRRL > r. If S and L are mutually exclusive, accept S because IRRS > IRRL .

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Enter CFs in CFLO and find NPVL and NPVS at different discount rates:

r 0 5 10 15 20 NPVL 50 33 19 7 (4) NPVS 40 29 20 12 5

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NPV Profile

L

Crossover Point = 8.7%

S

IRRS = 23.6%

IRRL = 18.1%

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NPV ($) IRR > r and NPV > 0 Accept. r > IRR and NPV < 0. Reject.

IRR

r (%)

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NPV

L

r < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT r > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT

S 8.7 IRRS

%

IRRL

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!!

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Find cash flow differences between the projects. See data at beginning of the case. Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%. Can subtract S from L or vice versa, but easier to have first CF negative. If profiles dont cross, one project dominates the other.

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Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPVS > NPVL.

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NPV assumes reinvest at r (opportunity cost of capital). !! IRR assumes reinvest at IRR. !! Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

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MIRR is the discount rate which causes the PV of a projects terminal value (TV) to equal the PV of costs. !! TV is found by compounding inflows at WACC. !! Thus, MIRR assumes cash inflows are reinvested at WACC.

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0 -100.0

10%

1 10.0

10%

2 60.0

10%

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-100.0 PV outflows

0 -100.0 PV outflows $100 = $158.1 (1+MIRRL)3

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1

MIRR = 16.5%

3 158.1 TV inflows

MIRRL = 16.5%

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First, enter cash inflows in CFLO register: CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80 Second, enter I = 10. Third, find PV of inflows: Press NPV = 118.78

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!! !!

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For this problem, there is only one outflow, CF0 = -100, so the PV of outflows is -100. !! For other problems there may be negative cash flows for several years, and you must find the present value for all negative cash flows.

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Enter FV = 158.10, PV = -100, PMT = 0, N = 3. !! Press I = 16.50% = MIRR.

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MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. !! Managers like rate of return comparisons, and MIRR is better for this than IRR.

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Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. For example, nuclear power plant or strip mine.

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!! !!

!!

0 + 1 + + + + 2 + + + + 3 + + + 4 + + + + 5 + + N N NN

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N N

NN

NN

0 -800

r = 10%

1 5,000

2 -5,000

Enter CFs in CFLO, enter I = 10. NPV = -386.78 IRR = ERROR. Why?

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NPV

NPV Profile

IRR2 = 400%

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400

At very low discount rates, the PV of CF2 is large & negative, so NPV < 0. !! At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0. !! In between, the discount rate hits CF2 harder than CF1, so NPV > 0. !! Result: 2 IRRs.

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1. Enter CFs as before. 2. Enter a guess as to IRR by storing the guess. Try 10%: 10 STO IRR = 25% = lower IRR (See next slide for upper IRR)

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Now guess large IRR, say, 200: 200 STO IRR = 400% = upper IRR

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When there are nonnormal CFs and more than one IRR, use MIRR:

0 -800,000 1 5,000,000 2 -5,000,000

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Accept Project P?

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NO. Reject because MIRR = 5.6% < r = 10%. Also, if MIRR < r, NPV will be negative: NPV = -$386,777.

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Profitability Index

The profitability index (PI) is the present value of future cash flows divided by the initial cost. !! It measures the bang for the buck.

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Project L: 0 1 10 9.09 49.59 60.11 118.79

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10%

2 60

3 80

PIL = PV future CF Initial Cost $118.79 $100

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The number of years required to recover a projects cost, or how long does it take to get the businesss money back?

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0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 2 60 -30 30/80

2.4

3 80 50

= 2.375 years

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0 CFt -100 1 70 -30 0

1.6 2

50 20

3 20 40

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!!

Strengths:

Provides an indication of a projects risk and liquidity. !! Easy to calculate and understand.

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Weaknesses:

Ignores the TVM. !! Ignores CFs occurring after the payback period.

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0 CFt PVCFt -100 -100 10% 1 10 9.09 -90.91 2 60 49.59 -41.32 3 80 60.11 18.79

0 1 2 60 33.5 33.5 33.5

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Note: CFs shown in $ Thousands

CF0 CF1 NJ I NPV S -100 60 2 10 4.132 L -100 33 4 10 6.190

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Convert the PV into a stream of annuity payments with the same PV. !! S: N=2, I/YR=10, PV=-4.132, FV = 0. Solve for PMT = EAAS = $2.38. !! L: N=4, I/YR=10, PV=-6.190, FV = 0. Solve for PMT = EAAL = $1.95. !! S has higher EAA, so it is a better project.

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Note that Project S could be repeated after 2 years to generate additional profits. !! Use replacement chain to put on common life. !! Note: equivalent annual annuity analysis is alternative method, shown in Tool Kit and Web Extension.

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0 1 2 60 (100) (40) 3 4

60 60

60 60

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NPV = $7,547.

0 4,132 3,415 7,547 1 10% 2 4,132 3 4

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0 1 2 60 (105) (45) 3 4

Franchise S: (100) 60

60

60

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Consider another project with a 3-year life. !! If terminated prior to Year 3, the machinery will have positive salvage value. !! Should you always operate for the full physical life? !! See next slide for cash flows.

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Year 0 1 2 3 CF ($5000) 2,100 2,000 1,750 Salvage Value $5000 3,100 2,000 0

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0 1. No termination 2. Terminate 2 years 3. Terminate 1 year 1 2 2 4 3 1.75

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NPV(3) = -$123. !! NPV(2) = $215. !! NPV(1) = -$273.

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Conclusions

The project is acceptable only if operated for 2 years. !! A projects engineering life does not always equal its economic life.

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Finance theory says to accept all positive NPV projects. !! Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:

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Externally raised capital can have large flotation costs, which increase the cost of capital. !! Investors often perceive large capital budgets as being risky, which drives up the cost of capital.

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(More...)

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If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.

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Capital Rationing

Capital rationing occurs when a company chooses not to fund all positive NPV projects. !! The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.

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(More...)

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Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. !! Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital. (More...)

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Reason: Companies dont have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing. (More...)

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Reason: Companies believe that the projects managers forecast unreasonably high cash flow estimates, so companies filter out the worst projects by limiting the total amount of projects that can be accepted. Solution: Implement a post-audit process and tie the managers compensation to the subsequent performance of the project.

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