Managerial Decision Making and Finances

(FIN 559)

Kalle Ahi
kalle.ahi@gmail.com
27th. september, 2010

Course details
Instructor: Kalle Ahi (MA) Course credits: 3 EAP (20 contact hours) Evaluation:
There will be 2 homeworks each (a 15% -> 2x15%=30% of grade) First homework is due by the end of the course and the second before a consultation) The homeworks could be solved in teams (maximum of three persons allowed to work together) The final exam consists of two parts: 1) theory (slosed book exam) and 2) problem solving (open book)

About course web-page

There is a course web-page based on moodle (in addition to student information system IS) In order to access to the webpage:
First time users should first register at the following web page: https://moodle.e-ope.ee/ (choose create new account) Now, if you have successfully registered and logged in, please choose Estonian Business School from the course categories list From sub-categories choose FIN - Majandusarvestuse ja rahanduse ppetool Now you should see: Managerial Decision Making and Finances The password for the course is: finances11 From there you will soon find all relevant course information and study materials (currently yet under construction)
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Instructor
Kalle Ahi (MA, Prague CERGE-EI 2006, MA, University of Tartu 2002) Currently doctoral studies at University of Tartu Lecturing experience: courses of investments, financial management, financial analysis, money and banking, micro- and macroeconomics. Since 2007 lecturer at Tallinn Technical University Since 2009 docent at Mainor School of Economics Currently also external expert for Enterprise Estonia E-mail: kalle.ahi@gmail.com (please add course name on the subject line), phone: (+372) 5644722
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Topics covered
1. Introduction to financial management; investment appraisal tools and techniques. 6 hours 2. Financial reporting, different tools for financial analysis, additional information resources, preparation statements for analysis. 2 hours 3. System of financial ratios and practical applications, decomposition of ratios, economic value added (EVA). 4 hours 4. Financial forecasting, different tools and techniques, sustainable growth rate, financial valuation of a company. 4 hours 5. Budgeting in a firm (master budget), applications of management accounting in planning and evaluation of performance) 4 hours
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How would You characterise the main objective of a firm?

....and the answer is

Lets look at what the gurus have to say to us: Van Horne: "In this book, we assume that the objective of the firm is to maximize its value to its stockholders" Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value. Copeland & Weston: The most important theme is that the objective of the firm is to maximize the wealth of its stockholders. Brigham and Gapenski: Throughout this book we operate on the assumption that the management's primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.
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Value of a firm
Why maximising corporate profit is not a good objective for a company? There are many reasons:
Net income is actually an accounting figure that is sometimes weakly related to actual cash the firm generates. Why? Depreciation For many firms, most sales are made under terms of credit, but recognised as income Also, the company itself may defer the payments to its creditors Change in accounting principles (LIFO vs FIFO) may influence the net income but should not have an effect on the value of the firm (why?) Creative accounting etc.
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Financial function in a firm

To learn to see and analyse the connection between different managerial decisions and their financial effect. Big picture of FINANCIAL FUNCTION is based on a balance sheet model of a firm:
Evaluate the value of the investment projects: forecast the relevant cash flows, evaluate projects based on several decision criteria's (like net present value) and analyse the risks involved (different scenarios etc.): FIXED ASSETS Evaluate different financing options the firm has and find an optimal capital structure that minimizes the cost of capital the firm uses. INTEREST BEARING DEBT AND EQUITY Make decisions about working capital in a firm. WORKING CAPITAL (net current assets)
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Big picture of corporate finance (Damodaran)

Capital budgeting
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Weighted average cost of capital (WACC)

Big picture (2)

The ultimate aim increase the value of the firm. Investments should be made to the projects where the return is higher than the minimal acceptable hurdle rate
The value of the project depends on the amount, timing and riskiness of the (incremental) cash flows The projects that bear higher risk should have higher hurdle rate (cost of capital) The hurdle rate may also depend on the sources of financing (equity and borrowings)

If there are no profitable use of capital within a firm, the cash should be returned to the shareholders.
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Financial accounting vs corporate finance

Financial Accounting is the process of gathering, aggregating and summarizing of financial data taken from an organization's accounting records and publishing in the form of annual (or more frequent) reports for the benefit of people outside the organization. There are many differences between (financial) accounting and financial management some of them are summarised in the following slide.

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FIN. ACCOUNTING

AND CORP. FINANCE

Measures the past and current standing of the company Reporting Accounting rules and laws Consolidated information Value is based on its accounting balance sheet figure Generally no risks analysed Equity doesnt have a cost Net profit is important Is directed toward public (stakeholders) outside the firm

Future is important Control and evaluation No particular rules Segmental information Market value is important Evaluation of risks is important Equity has (opportunity) cost Cash is King! Is directed toward decision making within a firm

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Equity doesnt have a cost*

Profit and loss account doesnt includes opportunity costs of equity. Even a positive net income could be insufficient from the viewpoint of owners.The point can be described by well-known performance measure: EVA (economic value added) Very simplified example:Total sales (10 mil), operating cash expenses (8 mil), firm has outstanding debt 6 mil and equity 8 mil.The average interest rate for debt is 10% and the required return on equity is 20%. Firm has made 14 mil of total investments (incl. current assets). Discuss, what could be the economic profit for a company. (comment on the performance of the company) * Equity doesnt have a cost meaning that no interest is charged from equity. Firm doesnt have to pay dividends also.
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1st Topic: Capital budgeting

Long term investment evaluation (capital expenditure) assumes that the proceeds from an investment are spread over longer time horizon.
The capital budgeting process involves three basic steps: Generating long-term investment proposals; Reviewing, analyzing, and selecting from the proposals that have been granted, and Implementing and monitoring the proposals that have been selected.

Managers should separate investment and financing decisions.

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Capital Budgeting Decision Techniques

Accounting rate of return (ARR): focuses on projects impact on accounting profits
Payback period: commonly used for small scale projects

Net present value (NPV): best technique theoretically; difficult to calculate realistically Internal rate of return (IRR): widely used with strong intuitive appeal Profitability index (PI): related to NPV
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A Capital Budgeting Process Should:

Account for the time value of money; Account for risk; Focus on (incremental) cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders wealth.
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Example: Global Wireless

Global Wireless is a worldwide provider of wireless telephony devices. Global Wireless is contemplating a major expansion of its wireless network in two different regions:
Western Europe expansion A smaller investment in Southeast U.S. to establish a toehold

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Global Wireless
Initial Outlay Year 1 inflow Year 2 inflow Year 3 inflow Year 4 inflow Year 5 inflow -$250 $35 $80 $130 $160 $175

Initial Outlay Year 1 inflow Year 2 inflow Year 3 inflow Year 4 inflow
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-$50 $18 $22 $25 $30 $32

Year 5 inflow

Accounting Rate Of Return (ARR)

Can be computed from available accounting data

ARR =

Average pr ofits afte r taxes Average in vestment

Need only profits after taxes and depreciation. Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.
Average profits after taxes = Average annual operating cash inflows Average annual depreciation

ARR uses accounting numbers, not cash flows; no time value of money. 20

Payback Period
The payback period is the amount of time required for the firm to recover its initial investment.

If the projects payback period is less than the maximum acceptable payback period, accept the project. If the projects payback period is greater than the maximum acceptable payback period, reject the project. Management determines (sometimes arbitrarily) the maximum acceptable payback period.
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Payback Analysis For Global Wireless

Managements cutoff is 2.75 years. Western Europe project: initial outflow of -$250M But cash inflows over first 3 years is only $245 million. Global Wireless will reject the project (3>2.75). Southeast U.S. project: initial outflow of -$50M Cash inflows over first 2 years cumulate to $40 million. Project recovers initial outflow after 2.40 years. Total inflow in year 3 is $25 million. So, the project generates $10 million in year 3 in 0.40 years ($10 million $25 million). Global Wireless will accept the project (2.4<2.75).
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Pros and Cons of the Payback Method

Advantages of payback method:
Computational simplicity Easy to understand Focus on cash flow

Disadvantages of payback method: Does not account properly for time value of money Does not account properly for risk Cutoff period is arbitrary Does not lead to value-maximizing decisions
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Discounted Payback
Discounted payback accounts for time value.

Apply discount rate to cash flows during payback period. Still ignores cash flows after payback period.

Global Wireless uses an 18% discount rate.

Reject (166.2 < 250)

Reject (46.3<50)
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Net Present Value (NPV)

NPV:The sum of the present values of a projects cash inflows and outflows. Discounting cash flows accounts for the time value of money.

Choosing the appropriate discount rate accounts for risk.

NPV = CF 0 +

CF 3 CF N CF1 CF 2 + + + ... + (1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) N

Accept projects if NPV > 0.

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Net Present Value (NPV)

NPV = CF 0 + CF 3 CF N CF1 CF 2 + + + ... + (1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) N

A key input in NPV analysis is the discount rate.

r represents the minimum return that the project must earn to satisfy investors. r varies with the risk of the firm and /or the risk of the project.
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NPV Analysis for Global Wireless

Assuming Global Wireless uses 18% discount rate, NPVs are: Western Europe project: NPV = $75.3 million
NPV Western
Europe

= $ 75 .3 = 250 +

35 80 130 160 175 + + + + (1 .18 ) (1 .18 ) 2 (1 .18 ) 3 (1 .18 ) 4 (1 .18 ) 5

Southeast U.S. project: NPV = $25.7 million

NPV Southeast
U .S .

= $ 25 .7 = 50 +

18 22 25 30 32 + + + + (1 .18 ) (1 .18 ) 2 (1 .18 ) 3 (1 .18 ) 4 (1 .18 ) 5

Should Global Wireless invest in one project or both?

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The NPV Rule and Shareholder Wealth

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Pros and Cons of NPV

NPV is the gold standard of investment decision rules. Key benefits of using NPV as decision rule:
Focuses on cash flows, not accounting earnings Makes appropriate adjustment for time value of money Can properly account for risk differences between projects

Though best measure, NPV has some drawbacks:

Lacks the intuitive appeal of payback, and Doesnt capture managerial flexibility (option value) well.
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Internal Rate of Return (IRR)

IRR: the discount rate that results in a zero NPV for a project.

NPV = 0 = CF 0 +

CF 3 CF N CF1 CF 2 + + + .... + (1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) N

The IRR decision rule for an investing project is: If IRR is greater than the cost of capital, accept the project. If IRR is less than the cost of capital, reject the project.
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NPV Profile and Shareholder Wealth

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IRR Analysis for Global Wireless

Global Wireless will accept all projects with at least 18% IRR. Western Europe project: IRR (rWE) = 27.8%
0 = 250 + 35 80 130 160 175 + + + + (1 + rWE ) (1 + rWE ) 2 (1 + rWE ) 3 (1 + rWE ) 4 (1 + rWE ) 5

Southeast U.S. project: IRR (rSE) = 36.7%

0 = 50 + 18 22 25 30 32 + + + + (1 + rSE ) (1 + rSE ) 2 (1 + rSE ) 3 (1 + rSE ) 4 (1 + rSE ) 5
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Pros and Cons of IRR

Advantages of IRR:
Properly adjusts for time value of money Uses cash flows rather than earnings Accounts for all cash flows Project IRR is a number with intuitive appeal

Disadvantages of IRR:
Mathematical problems: multiple IRRs, no real solutions Scale problem Timing problem
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Multiple IRRs

IRR

IRR

When project cash flows have multiple sign changes, there can be multiple IRRs. Which IRR do we use?
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No Real Solution
Sometimes projects do not have a real IRR solution. Modify Global Wirelesss Western Europe project to include a large negative outflow (-$355 million) in year 6.

There is no real number that will make NPV=0, so no real IRR. Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!
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Conflicts Between NPV and IRR:

The Scale Problem
NPV and IRR do not always agree when ranking competing projects. The scale problem:
Project Western Europe Southeast U.S. IRR 27.8% 36.7% NPV (18%) $75.3 mn $25.7 mn

The Southeast U.S. project has a higher IRR, but doesnt increase shareholders wealth as much as the Western Europe project.
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12

Conflicts Between NPV and IRR:

The Scale Problem
Why the conflict? The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project. Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive.

Another (simpler example): Assume that before the finance class starts two investment proposals are made to you:
A) invest 1 EEK and after a class you receive 2 EEK B) invest 10 EEK and after a class you receive 12 EEK. The projects are mutually exclusive Which one you choose?
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Conflicts Between NPV and IRR:

The Timing Problem

The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.
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Conflicts Between NPV and IRR:

The Timing Problem
Because of the differences in the timing of the two projects cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign.

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Profitability Index
Calculated by dividing the PV of a projects cash inflows by the PV of its initial cash outflows.

CF1 CF2 CFN + + ... + (1 + r ) (1 + r ) 2 (1 + r ) N PI = CF0

Decision rule: Accept project with PI > 1.0, equal to NPV > 0
Project Western Europe Southeast U.S. PV of CF (yrs1-5) $325.3 million $75.7 million Initial Outlay $250 million $50 million PI 1.3 1.5

Both PI > 1.0, so both acceptable if independent.

Like IRR, PI suffers from the scale problem. 40

MIRR modified internal rate of return

Addresses several shortcomings that IRR method has (but has no cure to the scales problem) MIRR is a discount rate that equates the future value of the project cash flows to the present value of investments.

Where COFt cash outflow at period t, CIFt cash inflow at period t, k reinvestment rate (pos cash flows) of financing rate (negative cash flows; could be different k-s), n project lifetime (years) The MIRR for product development is 13,8% and marketing campaign 12,6%
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Project evaluations in EXCEL

Check course home page for further examples.

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Capital Budgeting
Methods to generate, review, analyze, select, and implement longterm investment proposals: Accounting rate of return Payback Period Discounted payback period Net Present Value (NPV) Internal rate of return (IRR) Profitability index (PI) Modified internal rate of return (MIRR) Equivalent annuity (EAA) later
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Cash Flow Versus Accounting Profit

Capital budgeting is concerned with cash flow, not accounting profit. To evaluate a capital investment, we must know: 1. Incremental cash outflows of the investment (marginal cost of investment), and 2. Incremental cash inflows of the investment (marginal benefit of investment). 3. The timing and magnitude of cash flows and accounting profits can differ dramatically. 44

Cash Flows: Financing Costs and Taxes

Financing costs should be excluded when evaluating a projects cash flows.

Both interest expense from debt financing and dividend payments to equity investors should be excluded. Financing costs are captured in the process of discounting future cash flows. Only after-tax cash flows are relevant as only such cash flows can be potentially distributed to investors.
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Cash Flows: Noncash Expenses

Noncash expenses include depreciation, amortization, and depletion. Accountants charge depreciation to spread a fixed assets costs over time to match its benefits. Capital budgeting analysis focuses on cash inflows and outflows when they actually occur. Non-cash expenses may (Estonia is a special case) affect cash flow through their impact on taxes:
Compute after-tax net income and add depreciation back, or Ignore depreciation expense but add back its tax savings. (e.g. Depreciation tax shield)

In Estonia there is currently no tax shields (also including interest rate tax shield) - however, a realistic cash flow prognosis should take potential future dividends into account through potential tax costs (for instance, one can assume that an optimal debt/equity ratio is maintained and rest is paid out as dividends etc.) 46

Working Capital Expenditures

Many capital investments require additions to working capital. Net working capital (NWC) = current assets current liabilities Increase in NWC is a cash outflow; decrease in NWC is a cash inflow.
An example

Operate booth from November 1 to January 31 Order $15,000 calendars on credit, delivery by Nov 1 Must pay suppliers $5,000/month, beginning Dec 1 Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10% in Jan Always want to have $500 cash on hand
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Working Capital for Calendar Sales Booth

Oct 1 Cash Inventory Accts payable Net WC Monthly in WC Payments and inventory Reduction in inventory Payments
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Nov 1 $500 15,000 15,000 500 +500 Nov 1 to Dec 1 $4,500 [30%] ($5,000) ($500)

Dec 1 $500 10,500 10,000 1,000 +500

Jan 1 $500 1,500 5,000 (3,000) (4,000)

Feb 1 $0 0 0 0 +3,000

$0 0 0 0 NA Oct 1 to Nov 1 $0 $0 ($500)

Dec 1 to Jan 1 $9,000 [60%] ($5,000) +$4,000

Jan 1 to Feb 1 $1,500 [10%] ($5,000) ($3,000)

Net cash flow

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Terminal Value
When evaluating an investment with indefinite life-span, the projects terminal value is calculated:

Construct cash-flow forecasts for 5 to 10 years

Forecasts more than 5 to 10 years have high margin of error; use terminal value instead.

The terminal value is intended to reflect the value of a project at a given future point in time. The terminal value is usually large relative to all the other cash flows of the project.
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Terminal Value
Different ways to calculate terminal values:

Use final year cash flow projections and assume that all future cash flow grow at a constant rate (present value of a perpetuity); Multiply final cash flow estimate by a market multiple, or Use investments book value or liquidation value.

JDS Uniphase cash flow projections for acquisition of SDL Inc.

Year 1 $0.5 Billion Year 2 $1.0 Billion Year 3 $1.75 Billion Year 4 $2.5 Billion
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Year 5 $3.25 Billion

Terminal Value of SDL Acquisition

Assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):

PV t =

CF t + 1 $3.41 , or PV 5 = = $68.2 rg 0.10 0.05

Terminal value is $68.2 billion; value of entire project is:

$ 0 .5 $1 $ 1 . 75 $ 2 .5 $ 3 . 25 $ 68 . 2 + + + + + = $ 48 . 67 1 . 11 1 .12 1 .13 1 .14 1 .15 1 . 15

$42.4 billion of total $48.7 billion is from terminal value! Caveat: Very sensitive to terminal value (and hence growth rate) Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal value: Terminal Value = $3.25 x 20 = $65 billion Caveat: market multiples fluctuate over time
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Incremental Cash Flow

Incremental cash flows versus sunk costs:

Capital budgeting analysis should include only incremental costs.

Simple example: assume that your company undertook a market research and the costs were 200.000$. The market research was successful and as a result, a more thorough project evaluation is to be undertaken. Should the costs of marketing research be included into the cash flow budget or not? Why or why not?
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Opportunity Costs
Cash flows from alternative investment opportunities, forgone when one investment is undertaken. Some time ago You were thinking of attending the MA (MBA) program. Indeed you calculated the incremental costs and benefits from attending business school. What are the opportunity costs here?

NPV of a project could fall substantially if opportunity costs are recognized!

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Cannibalization
Cannibalization refers to the loss of sales of an existing product when a new product is introduced and should be included as an incremental (negative) cash flow.

Cannibalization is a substitution effect. However there could be some exceptions to this rule. One should take into account the effect of potential competition.
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Example of a project
A small bakery is planning to expand its activities and is going to introduce a new product cheese cake.
The expected sales are 40 000 cakes a year for every next 4 years. Sales price is 4,00.The production cost is 1,80.- plus transportation costs 0,50.- per cake. The sales manager thinks that the introduction of a new product could negatively affect the sales of other products and expects a loss of 18 000.- (1.80.- per cake) The firm has already made some expenditures for market research (20 000.-) There is a small opportunity cost as the rooms that are now going to be used were previously rented out for (5 000 a year)
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Project (II)
An investment into equipment is 74 000.- (straight line depreciation, no accounting salvage value after 4 years). However the equipment could be sold for 10 000.The investment into net working capital is 15000.The incremental fixed costs are 15 000.- (mostly advertasing costs) The owners expect to pay out 60% of the net profit. Hence according to Estonian tax system, the tax rate is (21/79)% from dividends. There is no general corporate tax on net profit

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Years 1. Total sales - opportunity cost - incremenatal loss in sales 2. Production cost 3. Transportation cost 4. General expenses 5. Depreciation 6. EBIT 7. Taxes on dividends 8. Free cash flow (+depr)

Assumptions Quantity Sales price Prod cost In into NWC Depr Tranpost Fixed invest 40 000 4,00 1,80 15 000 18 500 0,50 74 000

160 000 160 000 160 000 160 000 -5 000 -5 000 -5 000 -5 000 -18 000 -72 000 -20 000 -15 000 -18 500 11 500 -1 834 28 166
0 1 28 166 -15 000 -74 000 -89 000

-18 -72 -20 -15 -18 11 -1

000 000 000 000 500 500 834

-18 000 -72 000 -20 000 -15 000 -18 500 11 500 -1 834

-18 000 -72 000 -20 000 -15 000 -18 500 11 500 -1 834

28 166
2 28 166

28 166 28 166
3 28 166 4 28 15 8 51 166 000 405 571

Cash flows 1. Cash from operations 2. Change in NWC 3. Net fixed investments Total cash flows
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Sale of inv (after tax) 8405 Gen expnses 15 000 effective tax rate 16% Mgi kaotus 18 000 Alternatiivkulu 5 000 Marketing research is a sunk cost Required return 16%

28 166

28 166

28 166

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Capital Rationing
Can a firm accept all investment projects with positive NPV? Reasons why a company would not accept all projects:

Limited availability of skilled personnel to be involved with all the projects; Financing may not be available for all projects. Companies are reluctant to issue new shares to finance new projects because of the negative signal this action may convey to the market.
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Capital Rationing
Capital rationing: project combination that maximizes shareholder wealth subject to funding constraints
1.

Rank the projects using Profitability Index (PI)

2.

Select the investment with the highest PI

3.

If funds are still available, select the second-highest PI, and so on, until the capital is exhausted. The steps above ensure that managers select the combination of projects with the highest NPV. 59

Capital Rationing and the Profitability Index (12% required return)

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Equipment Replacement and Unequal Lives

A firm must purchase an electronic control device: First alternative: cheaper device, higher maintenance costs, shorter period of utilization Second device: more expensive, smaller maintenance costs, longer life span Expected cash outflows:

Using real discount rate of 7%:

Device As cash outflow < Device Bs cash outflow 61 select A?

Equivalent Annual Cost (EAC)

EAC converts lifetime costs to a level annuity; eliminates the problem of unequal lives .
1. Compute NPV for operating devices A and B for their respective lifetimes: NPV of device A = $15,936 NPV of device B = $18,065 2. Compute annual expenditure (annuity cost) to make NPV of annuity equal to NPV of operating device:
Device A Device B

$ 15 ,936 =

X X X + + 1 .07 1 1 .07 2 1 .07 3

X = $6,072

$ 18 ,065 =

Y Y Y Y + + + 1 .07 1 1 .07 2 1 .07 3 1 .07 4

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Y = $5,333

Since Device Bs annuity cost is lower, choose Device B.

Excess Capacity
Excess capacity is not a free asset as traditionally regarded by managers. Company has excess capacity in a distribution center warehouse. In two years, the firm will invest $2,000,000 to expand the warehouse. The firm could lease the excess space for $125,000 per year (at the beginning of each year) for the next two years. Expansion plans should begin immediately in this case to hold inventory for new stores coming on line in a few months. Incremental cost: investing $2,000,000 at present vs. two years from today Incremental cash inflow: $125,000 (at the beginning of the year)
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Excess Capacity
NPV of leasing excess capacity (assume 10% discount rate):

NPV = 125 ,000 2,000 ,000 +

125 ,000 2 ,000 ,000 + = $ 108 , 471 1 .10 1 . 12

NPV negative: reject leasing excess capacity at $125,000 per year. The firm could compute the value of the lease that would allow break even.

NPV = X 2 , 000 , 000 +

X 2 , 000 , 000 + =0 1 . 10 1 .12

- X = $181,818 (at the beginning of the year) - Leasing the excess capacity for a price above $181,818 would increase shareholders wealth.
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The Human Face of Capital Budgeting

Managers must be aware of optimistic bias in the assumptions made by project supporters. Companies should have control measures in place to remove bias: Investment analysis should be done by a group independent of individual or group proposing the project. Project analysts must have a sense of what is reasonable when forecasting a projects profit margin and its growth potential. Storytelling: The best analysts not only provide numbers to highlight a good investment, but also can explain why the investment makes sense.
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Cash Flow and Capital Budgeting

Certain types of cash flows are common to many investments Opportunity costs should be included in cash flow projections Consider human factors in capital budgeting

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Choosing the Right Discount Rate

The numerators focus on project cash flows covered in Chapter 9.

NPV = CF 0 +

CF1 CF 2 CF 3 CF N + + + ... + 2 3 (1 + r ) (1 + r ) (1 + r ) (1 + r ) N

The denominators are the discount rates (cost of capital)

Reflect opportunity costs to firms investors

The denominator should:

Reflect the projects risk

67 Be derived from market data

Weighted Average Cost of Capital (WACC)

Cost of equity applies to projects of an all-equity firm.
But what if firm has both debt and equity? Problem is akin to finding expected return of portfolio.

Use weighted average cost of capital (WACC) as discount rate. Lox-in-a-Box is a chain of fast food stores.
Firm has $100 million equity (E), with cost of equity re = 15%; Also has bonds (D) worth $50 million, with rd = 9%. Assume that the investment considered will not change the cost structure or financial structure. 50 D E 100 WACC = rd + re = 9 % + 15 % = 13 % 6850 + 100 D+E D+E 50 + 100

Rules for Finding the Right Discount Rate

1.

When an all-equity firm invests in an asset similar to its existing assets, the cost of equity is the appropriate discount rate. When a firm with both debt and equity invests in an asset similar to its existing assets, the WACC is the appropriate discount rate. When the investment is more risky than the firms average investment, a higher discount rate than the WACC is required, and vice versa.

2.

3.

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Sensitivity Analysis
Sensitivity analysis allows mangers to test the impact of each assumption underlying a forecast. Sensitivity analysis involves calculating the NPVs for various deviations from a base case set of assumptions. GTI has developed a new skateboard. Base case assumptions yield NPV = $236,000.
1. 2. 3.

The projects life is five years. The project requires an up-front investment of $7 million. GTI will depreciate initial investment on straight line basis for five years.
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Sensitivity Analysis
GTI has developed a new skateboard. Base case assumptions yield NPV = $236,000.
4. 5. 6. 7. 8. 9.

One year from now, the skateboard industry will sell 500,000 units. Total industry unit volume will increase by 5% per year. GTI expects to capture 5% of the market in the first year. GTI expects to increase its market share by one percentage point each year after year one. The selling price will be $200 in year one. Selling price will decline by 10% per year after year one. production costs are variable and equal 60% of the selling price. marginal tax rate is 30%.
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10. All

11. GTIs 12. The

appropriate discount rate is 14%.

Table 10-4 Sensitivity Analysis of Skateboard Project

Dollar values in thousands except price
NPV -$558 -343 -73 -1,512 -1,189 -488 -54 -873 -115
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Pessimistic

Assumption

Optimistic $6,000,000 550,000 units 8% per year 7% 2% per year $225 58% of sales 0% per year 12%

NPV $1,030 815 563 1,984 1,661 960 526 1,612 617

$8,000,000 2. Initial investment 450,000 units 4. Market size in year 1 2% per year 5. Growth in market size 3% 0% $175 6. Initial market share 7. Growth in market share 8. Initial selling price

62% of sales 9. costs -20% per year 10. Annual price change 16% 12. Discount rate

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Scenario Analysis
Scenario analysis is a more complex form of sensitivity analysis. Rather than adjust one assumption up or down, analysts calculate the project NPV when a whole set of assumptions changes in a particular way. For example, if consumer interest in GTIs new skateboard is low, the project may achieve a lower market share and a lower selling price than originally anticipated.

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Monte Carlo Simulation

In a Monte Carlo simulation, analysts specify a range or a probability distribution of potential outcomes for each of the models assumptions. It is even possible to specify the degree of correlation between key variables. A simulation software package is then used to take random draws from these distributions, calculating the projects cash flows (and NPV) over and over again. The simulation produces the probability distribution of project cash flows (and NPVs) as well as sensitivity figures for each of the models assumptions.
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Monte Carlo Simulation

The use of Monte Carlo simulation has grown dramatically in the last decade because of steep declines in the costs of computer power and simulation software. The bottom line is that simulation is a powerful, effective tool when used properly. Simulations fundamental appeal is that it provides decision makers with a probability distribution of NPVs rather than a single point estimate of the expected NPV. Simulations can be aided using specialised software. For instance excel based crystal ball. We look at it the next time we meet.

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Decision Trees
A decision tree is a visual representation of the sequential choices that managers face over time with regard to a particular investment.

The value of decision trees is that they force analysts to think through a series of if-then statements that describe how they will react as the future unfolds.

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Decision Trees for Odessa Investment

Trinkle Foods Limited of Canada has invented a new salt substitute, branded Odessa.

Trinkle is deciding whether to spend 5-million Canadian dollars (C$) to test-market a new line of potato chips flavored with Odessa in Vancouver. Depending on the outcome, Trinkle may spend an additional C$50 million 1 year later to launch a full line of snack foods across Canada. If consumer acceptance in Vancouver is high, the company predicts that its full product line will generate net cash inflows of C$12 million per year for 10 years. If consumers respond less favorably, cash inflows from a nationwide launch is expected to be just C$2 million per year for 10 years. Trinkles cost of capital equals 15 percent.
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Decision Trees for Odessa Investment

If the test market is successful, the NPV of launching the product is C$10.23 million; if the initial test results are negative, and it launches the product, it will have an NPV of C$39.96 million. 78

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Decision Trees for Odessa Investment

To work through a decision tree, begin at the end and then work backward to the initial decision. Suppose one year from now, Trinkle learns that the Vancouver market test was successful:

If the initial test results are unfavorable and it launches the product:

We then evaluate todays decision about whether to spend the C$5 million. The expected NPV of conducting the market test is: Spending the money for market testing does not appear worthwhile.
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Real Options in Capital Budgeting

Option pricing analysis is helpful in examining multi-stage projects. Embedded options arise naturally from investment. Called real options to distinguish from financial options.

Value of a project equals value captured by NPV, plus option.

Options can transform negative NPV projects into positive NPV!

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Types of Real Options

Expansion options Abandonment options Follow-on investment options Flexibility options
If a product is a hit, expand production.

Firm can abandon a project if not successful. Shareholders have valuable option to default on debt.

Similar to expansion options, but more complex (Ex: movie rights to sequel)

Ability to use multiple production inputs (example: dual-fuel industrial boiler) or produce multiple outputs
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Strategy and Capital Budgeting

Competition and NPV
Advocates of a positive NPV project should be able to articulate the projects competitive advantage before running the numbers Otherwise in perfect financial markets for every project the NPV should not generally exceed 0. (Why?)

Strategic thinking and real options

Managers must articulate their strategy for a given investment Many investments could have embedded options in them

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Risk and Capital Budgeting

All-equity firms can discount their standard investment projects at cost of equity. Firms with debt and equity can discount their standard investment projects using WACC. A variety of tools exist to assist managers in understanding the sources of uncertainty of a projects cash flows.

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