Note 3

http://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P67_The_theory_and.pdf
Book Rate of Return
Average income divided by average book value
over project life
Also called accounting rate of return
Components reflect tax and accounting figures,
not market values or cash flows
assets book
income book
return of rate Book
Payback Period
Number of years before cumulative cash flow
equals initial outlay
Payback Rule
Only accept projects that pay back within desired
time frame
Ignores later year cash flows and present value of
future cash flows

Example
Find disadvantage of only taking projects with
payback period of two years or less
Example
Tool A costs $4,000. Investment will generate
$2,000 and $4,000 in cash flows for two years.
What is IRR?
0
) IRR 1 (
000 , 4
) IRR 1 (
000 , 2
000 , 4 NPV
2 1

% 08 . 28 IRR
Pitfall 1: Lending or Borrowing?
NPV of project increases as discount rate
increases for some cash flows
Pitfall 2: Multiple Rates of Return
Certain cash flows generate NPV = 0 at two
different discount rates
Following cash flow generates NPV = $A253 million at
IRR% of 3.5% and 19.54%
Pitfall 2: Multiple Rates of Return
Project can have 0 IRR and positive NPV
Pitfall 3: Mutually Exclusive Projects
IRR sometimes ignores magnitude of project
Pitfall 4: More than One Opportunity Cost of Capital
Term Structure Assumption
Assume discount rates stable during term of
project
Implies all funds reinvested at IRR
False assumption

While the internal rate of return (IRR) assumes the
cash flows from a project are reinvested at the IRR,
the modified IRR assumes that positive cash flows
are reinvested at the firm's cost of capital, and the
initial outlays are financed at the firm's financing
cost.

Therefore, MIRR more accurately reflects the cost
and profitability of a project.
For example, say a two-year project with an initial
outlay of $195 and a cost of capital of 12%, will return
$121 in the first year and $131 in the second year. To
find the IRR of the project so that the net present
value (NPV) = 0:

NPV = 0 = -195 + 121/(1+ IRR) + 131/(1 + IRR)
2
NPV = 0 when IRR = 18.66%


To calculate the MIRR of the project, we have to assume that the positive
cash flows will be reinvested at the 12% cost of capital. So the future
value of the positive cash flows is computed as:

$121(1.12) + $131 = $266.52 = Future Value of positive cash flows at t = 2

Now you divide the future value of the cash flows by the present value of
the initial outlay, which was $195, and find the geometric return for 2
periods.

MIRR=sqrt($266.52/195) -1 = 16.91%

You can see here that the 16.91% MIRR is materially lower than the IRR
of 18.66%. In this case, the IRR gives a too optimistic picture of the
potential of the project, while the MIRR gives a more realistic evaluation
of the project.
Profitability Index (PI)
Tool for selecting between project combinations
and alternatives
Set of limited resources and projects can yield
various combinations
Highest weighted average PI indicates optimal
project
investment
NPV
index ity Profitabil
Example
Select best projects for $300,000
Project NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Project NPV Investment PI

A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Example, continued




Select projects with highest weighted average PI
WAPI (BD) = 1.01
WAPI (A) = 0.77
WAPI (BC) = 1.12


Project NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Capital Rationing
Limit set on amount of funds available for
investment
Soft Rationing
Imposed by management
Hard Rationing
Imposed by unavailability of funds in capital
market
Rule 1: Only Cash Flow Is Relevant
Capital Expenses
Record capital expenditures when they occur
To determine cash flow from income, add back
depreciation and subtract capital expenditure
Working Capital
Difference between companys short-term
assets and liabilities
Rule 2: Estimate Cash Flows on an Incremental
Basis
Include taxes, salvage value, incidental
effects, and opportunity costs
Do not confuse average with incremental
payoffs
Forecast sales today, recognize after-sales
cash flow to come later
Forget sunk costs
Beware of allocated overhead costs
Rule 3: Treat Inflation Consistently
Use nominal interest rates to discount
nominal cash flows
Use real interest rates to discount real cash
flows
Same results from real and nominal figures
Inflation
Example
Project produces real cash flows of -$100 in year zero and
then $35, $50, and $30 in three following years. Nominal
discount rate is 15% and inflation rate is 10%. What is
NPV?

045 . 1
10 . 1
15 . 1
1
rate inflation + 1
rate discount nominal + 1
= rate discount Real

Inflation
ExampleNominal figures
$5.50
23 . 26 39.9 = 1.10 30 3
75 . 45 60.5 = 1.10 50 2
48 . 33 38.5 = 1.10 35 1
100 100 0
15% @ PV Flow Cash Year
3
2
15 . 1
9 . 39
3
15 . 1
5 . 60
2
15 . 1
5 . 38

Inflation
ExampleReal figures

50 . 5 $
26.29 = 30 3
45.79 = 50 2
33.49 = 35 1
100 100 0
PV@4.50% Flow Cash Year
3
2
1.045
30
1.045
50
1.045
35
=

Separate Investment and Financing Decisions
Regardless of financing, treat cash outflows
required for project as coming from investors
Regardless of financing, treat cash inflows as
going to investors
NPV Using Nominal Cash Flows


$3,520,000 or , 520 , 3
20 . 1
444 , 3
20 . 1
110 , 6

20 . 1
136 , 10
20 . 1
685 , 10
20 . 1
205 , 6
20 . 1
381 , 2
20 . 1
630 , 1
600 , 12 NPV
7 6
5 4 3 2


Problem 1: Investment Timing Decision
Some projects are more valuable if undertaken in
the future
Examine start dates (t) for investment and
calculate net future value for each date
Discount net values back to present

Problem 2: Choice between Long- and Short-Term Equipment
Example
Given the following cash flows from operating two
machines and a 6% cost of capital, which machine has
the higher value using the equivalent annual annuity
method?

Year
Machine 0 1 2 3 PV@6% E.A.A.
A +15 +5 +5 +5 28.37 10.61
B +10 +6 +6 21.00 11.45
E =

1(1+)

Equivalent Annual Cash Flow, Inflation, and
Technological Change
Inflation increases nominal costs of operating
equipment, but real costs remain unchanged
Real cash flows are not always constant


Equivalent Annual Cash Flow and Taxes
Lifetime costs should be calculated after tax
Operating costs are tax-deductible
Capital investment generates depreciation tax
shields
Problem 3: When to Replace an Old Machine
Example
A machine is expected to produce a net inflow of $4,000
this year and $4,000 next year before breaking. You can
replace it now with a machine that costs $15,000 and will
produce an inflow of $8,000 per year for three years.
Should you replace now or wait a year?
Problem 3: When to Replace an Old Machine
Example, continued

Problem 4: Cost of Excess Capacity
Example
A computer system costs $500,000 to buy and
operate at a discount rate of 6% and lasts five
years
Equivalent annual cost of $118,700
Undertaking project in year 4 has a present value of
118,700/(1.06)
4
, or about $94,000
Types of Analysis
Sensitivity
Analyzes effects of changes in sales, costs, etc., on project
Scenario
Project analysis given particular combination of assumptions
Simulation
Estimates probabilities of different outcomes
Break Even
Level of sales (or other variable) at which project breaks even

Example
Given expected cash-flow forecasts for Otobai
Companys Motor Scooter project, determine the
NPV of project given changes in cash- flow
components using 10% cost of capital. Assume
constant variables, except the one you are
changing.
Example, continued

3 15 - Flow Cash Net
3.0 flow cash Operating
1.5 after tax Profit
1.5 50% @ Taxes
3.0 profit Pretax
1.5 on Depreciati
3 costs Fixed
30 costs Variable
37.5 Sales
15 - Investment
10 - 1 Years 0 Year
Example, continued
bil 2 bil 3 bil 4 cost Fixed
275,000 300,000 360,000 cost Unit var
380,000 375,000 350,000 price Unit
.16 .1 .04 share Market
mil 1.1 mil 1.0 mil .9 size Market
Optimistic Expected c Pessimisti Variable
Outcomes
Example, continued
NPV calculationsOptimistic scenario
3.38 15 - Flow Cash Net
3.38 flow cash Operating
1.88 after tax Profit
1.88 50% @ Taxes
3.75 profit Pretax
1.5 on Depreciati
3 costs Fixed
33 costs Variable
41.25 Sales
15 - Investment
10 - 1 Years 0 Year

Modeling Process
Step 1: Model Project
Step 2: Specify Probabilities
Step 3: Simulate Cash Flows
Step 4: Calculate Present Value

Decision Trees
Diagram of sequential decisions and possible
outcomes
Help companies analyze options by showing
various choices and outcomes
Option to avoid a loss or produce extra profit has
value
Ability to create option has value that can be
bought or sold

Real Options
Option to expand
Option to abandon
Timing option
Flexible production facilities
$700 (.80)



$ 0 (.20)
$ 300 (.80)



$ 0 (.20)
$ 100 (.80)



$ 0 (.20)
Invest
Yes / No
NPV= ?
- $18
- $130
- $130
- $130
.25
.50
.25
$ 0
.44
.56
$700 (.80)



$ 0 (.20)
$ 300 (.80)



$ 0 (.20)
$ 100 (.80)



$ 0 (.20)
560
240
80
Invest
Yes / No
NPV= ?
- $18
- $130
- $130
- $130
.25
.50
.25
$ 0
.44
.56
$700 (.80)



$ 0 (.20)
$ 300 (.80)



$ 0 (.20)
$ 100 (.80)



$ 0 (.20)
56
0
24
0
80
Invest
Yes /
No
NPV= ?
-
$
1
8
- $130
- $130
- $130
.25
.5
0
.25
$ 0
.4
4
.5
6
560 20 . 0 80 . 700
$700 (.80)



$ 0 (.20)
$ 300 (.80)



$ 0 (.20)
$ 100 (.80)



$ 0 (.20)
560
240
80
Invest
Yes / No
NPV= ?
- $18
- $130
- $130
- $130
.25
.50
.25
$ 0
.44
.56

295
096 . 1
560
130 (upside) NPV
3

NPV = $295
$700 (.80)



$ 0 (.20)
$ 300 (.80)



$ 0 (.20)
$ 100 (.80)



$ 0 (.20)
560
240
80
Invest
Yes / No
NPV= ?
- $18
- $130
- $130
- $130
.25
.50
.25
$ 0
.44
.56
NPV = $295
NPV = $52
NPV = - $69
(do not invest, so NPV = 0)

$700 (.80)



$ 0 (.20)
$ 300 (.80)



$ 0 (.20)
$ 100 (.80)



$ 0 (.20)
560
240
80
Invest
Yes / No
NPV= ?
- $18
- $130
- $130
- $130
.25
.50
.25
$ 0
.44
.56
NPV = $295
NPV = $52
NPV = - $69
(do not invest, so NPV =
0)


83 $
096 . 1
) 25 . 295 ( ) 5 . 52 ( ) 25 . 0 (
NPV
2

NPV = $83
$700 (.80)



$ 0 (.20)
$ 300 (.80)



$ 0 (.20)
$ 100 (.80)



$ 0 (.20)
560
240
80
Invest
Yes / No
NPV= $19
- $18
- $130
- $130
- $130
.25
.50
.25
$ 0
.44
.56
NPV = $295
NPV = $52
NPV = - $69
(do not invest, so NPV = 0)

NPV = $83
19 $
) 0 56 (. ) 83 44 (. 18 NPV

$700 (.80)



$ 0 (.20)
$ 300 (.80)



$ 0 (.20)
$ 100 (.80)



$ 0 (.20)
560
240
80
Invest
Yes / No
NPV= $19
- $18
- $130
- $130
- $130
.25
.50
.25
$ 0
.44
.56
NPV = $295
NPV = $52
NPV = - $69
(do not invest, so NPV = 0)

NPV = $83
Boyne mountain resort
Chapter 5
9, 12, 14 15
Chapter 6
19, 21,26