Managerial Decision Making and Finances                                  (FIN 559)                              Kalle Ahi ...
Course details       Instructor: Kalle Ahi (MA)       Course credits: 3 EAP (20 contact hours)       Evaluation:       ...
About course web page             web-page       There is a course web-page based on moodle (in addition to        studen...
Instructor       Kalle Ahi (MA, Prague CERGE-EI 2007, MA, University of Tartu        2002)       Currently doctoral stud...
Topics covered       1. Introduction to financial management; investment appraisal        tools d techniques. 6 h        ...
 How    would You characterise the main    objective of a firm?6
....and the answer is    and       Let’s look at what the gurus have to say to us:                                   g   ...
Value of a firm       Why maximising corporate profit is not a good objective for a        company??       There are man...
Financial function in a firm   To learn to see and analyse the connection between    different managerial decisions and t...
Big p    g picture of corporate finance (Damodaran)                    p              (         )Capital budgeting   Weigh...
Big picture (2)    The ultimate aim – increase the value of the firm.    Investments should be made to the projects wher...
Financial accounting vs corporate finance    Financial Accounting is the process of gathering, aggregating     and summar...
FIN.FIN ACCOUNTING                           AND CORP FINANCE                                             CORP.■    Measur...
“Equity doesn t have a cost”* Equity doesn’t        cost    Profit and loss account doesn’t includes opportunity costs of...
1st Topic: Capital budgeting      p      p        g    g    Long term investment evaluation (capital expenditure) assumes...
Capital Budgeting Decision TechniquesAccounting rate of return (ARR): focuses on project’s impact                         ...
A Capital Budgeting Process Should: Account for the time value of money; A     t f th ti        l    f Account for risk; F...
Example: Global Wireless   Global Wireless is a worldwide provider of wireless    telephony devices.   Global Wireless i...
Global Wireless                       Initial Outlay   -$250                       Year 1 inflow    $35                   ...
Accounting Rate Of Return (ARR) Can be computed from available accounting data                   Average pr ofits afte r t...
Payback Period  The payback period is the amount of time required for the            firm to recover its initial investmen...
Payback Analysis For Global Wireless   Management s    Management’s cutoff is 2.75 years.   Western Europe project: init...
Pros and Cons of the Payback Method Advantages of payback method:    • Computational simplicity    • Easy to understand   ...
Discounted Payback    Discounted payback accounts for time value.                p y     •   Apply discount rate to cash ...
Net Present Value (NPV) NPV:The sum of the present values of a project’s cash inflows                                     ...
Net Present Value (NPV)                CF1        CF 2         CF 3               CF N NPV  CF 0                       ...
NPV Analysis for Global Wireless    Assuming Global Wireless uses 18% discount rate, NPVs            g                   ...
The NPV Rule and Shareholder Wealth                             28
Pros and Cons of NPV NPV is the “gold standard” of investment decision rules. Key benefits of using NPV as decision rule: ...
Internal Rate of Return (IRR) IRR: the discount rate that results in a zero NPV for a project.                    CF1     ...
NPV Profile and Shareholder Wealth                              31
IRR Analysis for Global Wireless Global Wireless will accept all projects with at least 18% IRR.  Western Europe project: ...
Pros and Cons of IRR Advantages of IRR:    • Properly adjusts for time value of money    • Uses cash flows rather than ear...
Multiple IRRs                                              IRR                              IRR When project cash flows ha...
No Real Solution Sometimes projects do not have a real IRR solution. Modify Global Wireless’s Western Europe project to in...
Conflicts Between NPV and IRR:The Scale ProblemTh S l P bl NPV and IRR do not always agree when ranking competing projects...
Conflicts Between NPV and IRR:The Scale ProblemTh S l P blWhy the conflict? The scale of the Western Europe expansion is ...
Conflicts Between NPV and IRR:The Ti iTh Timing P bl          Problem    The product development proposal generates a hig...
Conflicts Between NPV and IRR:The Ti iTh Timing P bl          Problem                            Because of the difference...
Profitability Index Calculated by dividing the PV of a project’s cash inflows by                                      proj...
MIRR – modified internal rate of return   Addresses several shortcomings that IRR – method has (but has    no cure to the...
Project evaluations in EXCEL    Check course home page for further examples.    42
Capital BudgetingMethods to generate, review, analyze, select, and implement long-  term iinvestment proposals:l Accounti...
Cash Flow Versus Accounting Profit      Capital budgeting is concerned with cash flow                                     ...
Cash Flows: Financing Costs and Taxes   Financing costs should be excluded when evaluating a                    project’s ...
Cash Flows: Noncash Expenses   Noncash expenses include depreciation, amortization, and depletion.   Accountants charge ...
Working Capital Expenditures    Many capital investments require additions to working capital                            ...
Working Capital for Calendar Sales Booth                            Oct 1           Nov 1           Dec 1          J      ...
Terminal Value When evaluating an investment with indefinite life span the                                                ...
Terminal Value             Different ways to calculate terminal values:             Diff                l l         i l l ...
Terminal Value of SDL Acquisition     Assume that cash flow continues to grow at 5% per year (g = 5%, r =      10%,      ...
Incremental Cash Flow           Incremental cash flows versus sunk costs:           I       t l    h fl              k    ...
Opportunity Costs    Cash flows from alternative investment opportunities,        forgone when one investment is undertake...
Cannibalization    Cannibalization refers to the loss of sales of an     existing product when a new product is introduce...
Example of a project    A small bakery is planning to expand it’s activities and is going     to introduce a new product ...
Project (II)    An investment into equipment is 74 000.- (straight line     depreciation, no accounting salvage value aft...
Years                        0         1         2         3         4       Assumptions1.1 Total sales                   ...
Capital Rationing Can a firm accept all investment projects with positive NPV?    Reasons why a company would not accept a...
Capital Rationing   Capital rationing: project combination that maximizes     shareholder wealth subject to funding constr...
Capital Rationing and the Profitability Index((12% required return)        q           )                                  ...
Equipment Replacement and Unequal Lives    A firm must purchase an electronic control device:     • First alternative: ch...
Equivalent Annual Cost (EAC)    EAC converts lifetime costs to a level annuity; eliminates the problem     of unequal liv...
Excess Capacity    Excess capacity is not a free asset as traditionally regarded by               p      y               ...
Excess Capacity    NPV of leasing excess capacity (assume 10% discount rate):                              125 ,000 2 ,00...
The Human Face of Capital Budgeting    Managers must be aware of optimistic bias in the assumptions           g          ...
Cash Flow and Capital Budgeting   Certain types of cash flows are common to many    investments   Opportunity costs shou...
Choosing the Right Discount Rate    The numerators focus on project cash flows covered in                        Chapter 9...
Weighted Average Cost of Capital (   g          g            p     (WACC)                                      )     Cost ...
Rules for Finding the Right Discount Rate 1. 1    When      Wh an all-equity firm invests i an asset similar t            ...
Sensitivity Analysis Sensitivity analysis allows mangers to test the impact of each               assumption underlying a ...
Sensitivity Analysis      GTI has developed a new skateboard. Base case assumptions yield                    p            ...
Table 10-4 Sensitivity Analysis of     Skateboard P j t     Sk t b    d Project     Dollar values in thousands except pric...
Scenario Analysis    Scenario analysis i a more complex f     S       i      l i is               l form of sensitivity a...
Monte Carlo Simulation    In M t C l i l ti     I a Monte Carlo simulation, analysts specify a range or a                ...
Monte Carlo Simulation    The     Th use of M t C l simulation h grown d               f Monte Carlo i l ti has          ...
Decision Trees    A decision tree is a visual representation of the     sequential choices that managers face over time  ...
Decision Trees for Odessa Investment      Trinkle Foods Limited of Canada has invented a new salt substitute,             ...
Decision Trees for Odessa InvestmentIf the test market is successful, the NPV of launching the product is C$10.23 million;...
Decision Trees for Odessa Investment • To work through a decision tree, begin at the end and then work backward to the   i...
Real Options in Capital Budgeting  Option i i  O ti pricing analysis i h l f l in examining multi-stage                  l...
Types of Real Options   Expansion     • If a product is a hit, expand production.    options  Abandonment    • Firm can ab...
Strategy and Capital Budgeting   Competition and NPV       Advocates of a positive NPV project should be able to        ...
Risk and Capital Budgeting    All-equity fi     All     it firms can di                          discount th i standard i...
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1 lecture fin559_2010

  1. 1. Managerial Decision Making and Finances (FIN 559) Kalle Ahi kalle.ahi@gmail.com 27th. september, 2010
  2. 2. 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 y a consultation)  The homeworks could be solved in teams (maximum of three persons allowed to work together) ll d k h )  The final exam consists of two parts: 1) theory (slosed book exam) and 2) problem solving (open book) 2
  3. 3. About course web page web-page There is a course web-page based on moodle (in addition to student information system – ÕIS) d i f i In order to access to the webpage:  First ti Fi t time users should first register at th f ll i web page: h ld fi t it t the following b https://moodle.e-ope.ee/ (choose “create new account”)  Now, if y have successfully registered and logged in, please choose , you y g gg ,p Estonian Business School from the course categories list  From sub-categories choose FIN - Majandusarvestuse ja rahanduse õppetool õ t l  Now you should see: Managerial Decision Making and Finances  The password for the course is:  From there you will soon find all relevant course information and study materials ( d l (currently yet under construction) l d ) 3
  4. 4. Instructor Kalle Ahi (MA, Prague CERGE-EI 2007, 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 y p p E-mail: kalle.ahi@gmail.com (please add course name on the subject line), phone: (+372) 5644722 ( 372) 4
  5. 5. Topics covered  1. Introduction to financial management; investment appraisal tools d techniques. 6 h t l and t h i hours  2. Financial reporting, different tools for financial analysis, additional information resources, preparation statements for resources analysis. 2 hours  3. System of financial ratios and practical applications, y p pp 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 i bl h fi i l l i f hours  5. 5 Budgeting in a firm (master budget) applications of budget), management accounting in planning and evaluation of performance) 4 hours5
  6. 6.  How would You characterise the main objective of a firm?6
  7. 7. ....and the answer is and Let’s look at what the gurus have to say to us: g y 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: Success 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 i to i fi i l is increase value.“ l “ 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 th assumption th t th managements primary goal i ti that the t i l is stockholder wealth maximization which translates into maximizing the price of the common stock. 7
  8. 8. Value of a firm Why maximising corporate profit is not a good objective for a company?? There are many reasons:  Net i N t income is actually an accounting figure th t is sometimes weakly i t ll ti fi that i ti kl related to actual cash the firm generates. Why?  Depreciation p  For many firms, most sales are made under terms of credit, but recognised as income  Also, the company itself may defer the payments to it’s 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. g 8
  9. 9. Financial function in a firm To learn to see and analyse the connection between different managerial decisions and their financial effect effect. Big picture of the FINANCIAL FUNCTION is based on a balance sheet model of a firm:  Evaluate the value of the investment projects: forecast the p j relevant cash flows, evaluate projects based on several decision criterias (like net present value) and analyse the risks involved (different scenarios etc ): FIXED ASSETS etc.):  Evaluate different financing options the firm has and find an optimal capital structure that minimizes the cost of capital the firm fi uses. INTEREST BEARING DEBT AND EQUITY  Make decisions about working capital in a firm. WORKING CAPITAL (net current assets) ( )9
  10. 10. Big p g picture of corporate finance (Damodaran) p ( )Capital budgeting Weighted average cost of capital (WACC) 10
  11. 11. 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 firm, should be returned to the shareholders. 11
  12. 12. Financial accounting vs corporate finance Financial Accounting is the process of gathering, aggregating and summarizing of financial data taken from an organizations accounting records and publishing in the form of annual (or more frequent) reports for the benefit of people outside the f ) f h b fi f l id h organization. There are many differences between (f Th d ff b (financial) accounting and l) d financial management – some of them are summarised in the following slide slide. 12
  13. 13. FIN.FIN ACCOUNTING AND CORP FINANCE CORP.■ Measures the past and current ■ Future is important standing of the company ■ Control and evaluation■ Reporting ■ No particular rules■ Accounting rules and laws■ Consolidated information ■ Segmental information■ Value is based on it’s accounting ■ Market value is important g balance sheet figure■ Generally no risks analysed ■ Evaluation of risks is important■ Equity doesn’t have a cost ■ Equity has (opportunity) cost■ Net profit is important ■ Cash is King!■ Is directed toward public ■ Is directed toward decision making (stakeholders) outside the firm within a firm 13
  14. 14. “Equity doesn t have a cost”* Equity doesn’t cost Profit and loss account doesn’t includes opportunity costs of equity. e it Even a positive net income could be insufficient from the viewpoint of owners. The point can be described by well-known 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 doesn’t have a cost” meaning that no interest is charged from equity. Firm doesn t have to pay dividends also equity doesn’t also. 14 14
  15. 15. 1st Topic: Capital budgeting p p g g 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 p p g, y g, g proposals that have been granted, and • Implementing and monitoring the proposals that have been selected. b l d Managers should separate investment and financing decisions. 15
  16. 16. Capital Budgeting Decision TechniquesAccounting rate of return (ARR): focuses on project’s impact project son accounting profits Payback period: commonly used for small scale projectsNet present value (NPV): best technique theoretically;difficult to calculate realisticallyInternal rate of return (IRR): widely used with strong intuitiveappealProfitability index (PI): related to NPV16
  17. 17. A Capital Budgeting Process Should: Account for the time value of money; A t f th ti l f Account for risk; Focus on (incremental) cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders’ wealth. 17
  18. 18. Example: Global Wireless Global Wireless is a worldwide provider of wireless telephony devices. Global Wireless is contemplating a major expansion of its p g j p wireless network in two different regions:  Western Europe expansion  A smaller investment in Southeast U.S. to establish a toehold 18
  19. 19. Global Wireless Initial Outlay -$250 Year 1 inflow $35 Year 2 i fl Y inflow $80 Year 3 inflow $130 Year 4 inflow $160 Year 5 inflow $175 Initial Outlay -$50 Year 1 inflow $18 Year 2 inflow $22 Year 3 inflow $25 Year 4 inflow $3019 Year 5 inflow $32
  20. 20. Accounting Rate Of Return (ARR) Can be computed from available accounting data Average pr ofits afte r taxes ARR  Average in vestment • Need only profits after taxes and depreciation depreciation. • Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows. Average profits = Average annual operating– Average annual g after taxes cash inflows depreciation ARR uses acco ntin numbers, not cash flows; ses accounting n mbers flo s no time value of money. 20
  21. 21. Payback Period The payback period is the amount of time required for the firm to recover its initial investment. • If the project’s payback period is less than the maximum acceptable payback period, accept th project. t bl b k i d t the j t • If the project’s payback period is greater than the maximum acceptable payback period, reject th project. i t bl b k i d j t the j t Management determines ( M td t i (sometimes arbitrarily) th ti bit il ) the maximum acceptable payback period. 21
  22. 22. Payback Analysis For Global Wireless Management s Management’s cutoff is 2.75 years. Western Europe project: initial outflow of -$250M  But cash inflows over first 3 years is only $245 million million.  Global Wireless will reject the project (3>2.75). Southeast U.S. project: initial outflow of -$50M S th tUS j t i iti l tfl f $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). 22
  23. 23. 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 23
  24. 24. Discounted Payback  Discounted payback accounts for time value. p y • Apply discount rate to cash flows during payback period. • Still ignores cash flows after payback period. g py p  Global Wireless uses an 18% discount rate. Reject (166.2 < 250) Reject (46.3<50) 24
  25. 25. Net Present Value (NPV) NPV:The sum of the present values of a project’s cash inflows project s and outflows. Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk. CF1 CF 2 CF 3 CF N NPV  CF 0     ...  (1  r ) (1  r ) 2 (1  r ) 3 (1  r ) N Accept projects if NPV > 0. 25
  26. 26. Net Present Value (NPV) CF1 CF 2 CF 3 CF N NPV  CF 0     ...  (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. j 26
  27. 27. NPV Analysis for Global Wireless  Assuming Global Wireless uses 18% discount rate, NPVs g , are: Western Europe project: NPV = $75.3 million 35 80 130 160 175 NPV W t Western Europe E  $ 75 .3   250      (1 .18 ) (1 .18 ) 2 (1 .18 ) 3 (1 .18 ) 4 (1 .18 ) 5 Southeast U.S. project: NPV = $25.7 million S h US j $25 7 illi 18 22 25 30 32 NPV Southeast U .S .  $ 25 .7   50      (1 .18 ) (1 .18 ) 2 (1 .18 ) 3 (1 .18 ) 4 (1 .18 ) 5Should Global Wireless invest in one project or both? 27
  28. 28. The NPV Rule and Shareholder Wealth 28
  29. 29. 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 • Doesn’t capture managerial flexibility (option value) well. 29
  30. 30. Internal Rate of Return (IRR) IRR: the discount rate that results in a zero NPV for a project. CF1 CF 2 CF 3 CF N NPV  0  CF 0     ....  (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. 30
  31. 31. NPV Profile and Shareholder Wealth 31
  32. 32. IRR Analysis for Global Wireless Global Wireless will accept all projects with at least 18% IRR. Western Europe project: IRR (rWE) = 27.8% 35 80 130 160 175 0   250      (1  rWE ) (1  rWE ) 2 (1  rWE ) 3 (1  rWE ) 4 (1  rWE ) 5 Southeast U.S. project: IRR (rSE) = 36.7% 18 22 25 30 32 0   50      (1  rSE ) (1  rSE ) 2 (1  rSE ) 3 (1  rSE ) 4 (1  rSE ) 5 32
  33. 33. 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 33
  34. 34. Multiple IRRs IRR IRR When project cash flows have multiple sign changes, there can be multiple IRRs. Which IRR do we use? 34
  35. 35. No Real Solution Sometimes projects do not have a real IRR solution. Modify Global Wireless’s Western Europe project to include a large negative outflow (-$355 million) in year 6. g g ( ) y • Th There i no real number th t will make NPV=0, so no real is l b that ill k NPV 0 l IRR. Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject! g j 35
  36. 36. Conflicts Between NPV and IRR:The Scale ProblemTh S l P bl NPV and IRR do not always agree when ranking competing projects. The scale problem: Project IRR NPV (18%) Western Europe 27.8% $75.3 mn Southeast U.S. 36.7% $25.7 mn • The Southeast U.S. project has a higher IRR, but doesn’t increase shareholders’ wealth as much as the Western Europe project. 36
  37. 37. Conflicts Between NPV and IRR:The Scale ProblemTh S l P blWhy 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 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 EEK. are mutually exclusive  Which one you choose? 37
  38. 38. Conflicts Between NPV and IRR:The Ti iTh Timing P bl Problem  The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR. g p g p p g 38
  39. 39. Conflicts Between NPV and IRR:The Ti iTh Timing P bl 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 M k i Campaign. h Marketing C i 39
  40. 40. Profitability Index Calculated by dividing the PV of a project’s cash inflows by project s 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 PV of CF (yrs1-5) Initial Outlay PI Western Europe $325.3 million $250 million 1.3 Southeast U.S. $75.7 million $50 million 1.5 • Both PI > 1.0, so both acceptable if independent. Like IRR, PI suffers from the scale problem. 40
  41. 41. MIRR – modified internal rate of return Addresses several shortcomings that IRR – method has (but has no cure to the scales problem) h l bl ) MIRR is a discount rate that equates the future value of the project cash flows to the present value of investments investments.  Where COFt – cash outflow at period t, CIFt – cash inflow at period t, k – reinvestment rate (pos cash flows) of financing rate ( g (p ) g (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% 12 6% 41
  42. 42. Project evaluations in EXCEL Check course home page for further examples. 42
  43. 43. Capital BudgetingMethods to generate, review, analyze, select, and implement long- term iinvestment proposals:l Accounting rate of return P b k Period Payback P i d Discounted payback period N Present Value (NPV) Net P Vl Internal rate of return (IRR) P fi bili i d Profitability index (PI) Modified internal rate of return (MIRR) Equivalent annuity (EAA) – later… 43
  44. 44. Cash Flow Versus Accounting Profit Capital budgeting is concerned with cash flow flow, not accounting profit. To evaluate a capital investment, we must know: 1. Incremental cash outflows of the investment (marginal cost of investment), and investment) 2. Incremental cash inflows of the investment (marginal benefit of investment). 3. 3 The timing and magnitude of cash flows and accounting profits can differ dramatically. 44
  45. 45. Cash Flows: Financing Costs and Taxes Financing costs should be excluded when evaluating a project’s 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. g Only after-tax cash flows are relevant as only such cash y y flows can be potentially distributed to investors. 45
  46. 46. Cash Flows: Noncash Expenses Noncash expenses include depreciation, amortization, and depletion. Accountants charge depreciation to spread a fixed asset’s costs over time to match its benefits. Capital budgeting analysis focuses on cash inflows and outflows when they actually occur. Non-cash expenses may (E N h (Estonia i a special case) affect cash fl i is i l ) ff h flow through their impact on taxes:  Compute after-tax net income and add depreciation back, or back  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 y ( g 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
  47. 47. Working Capital Expenditures Many capital investments require additions to working capital 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… • O Operate booth from November 1 to January 31 t b th f N b t J • Order $15,000 calendars on credit, delivery by Nov 1 • Must pay suppliers $5,000/month, beginning Dec 1 p y pp $ , , g g • Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10% in Jan • Always want to have $500 cash on hand 47
  48. 48. Working Capital for Calendar Sales Booth Oct 1 Nov 1 Dec 1 J Jan 1 Feb 1 Cash $0 $500 $500 $500 $0 Inventory 0 15,000 10,500 1,500 0 Accts payable 0 15,000 10,000 5,000 0 Net WC 0 500 1,000 1 000 (3,000) (3 000) 0 Monthly  in WC NA +500 +500 (4,000) +3,000 Payments and Oct 1 to Nov 1 to Dec 1 to Jan 1 to inventory Nov 1 Dec 1 Jan 1 Feb 1 Reduction in $0 $4,500 $9,000 $1,500 inventory [30%] [60%] [10%] Payments $0 ($5,000) ($5,000) ($5,000) Net cash flow ($500) ($500) +$4,000 ($3,000)48
  49. 49. Terminal Value When evaluating an investment with indefinite life span the life-span, project’s terminal value is calculated: Forecasts more than 5 to 10Construct cash-flow forecasts years have high margin of for 5 to 10 years error; use terminal value instead. i t d • 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. 49
  50. 50. Terminal Value Different ways to calculate terminal values: Diff l l i l l • 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 investment’s book value or liquidation value. JDS Uniphase cash flow projections for acquisition of SDL Inc. Year 1 Year 2 Year 3 Year 4 Year 5 $0.5 Billion $0 5 B ll $1.0 Billion $1 0 B ll $1.75 B ll $1 75 Billion $2.5 Billion $2 5 B ll $3.25 B ll $3 25 Billion 50
  51. 51. Terminal Value of SDL Acquisition  Assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, 10% cash flow for year 6 is $3 41 billion): $3.41 CF t  1 $3.41 PV t  , or PV 5   $68.2 rg 0 10  0 05 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 1  2  3  4  5  5  $ 48 . 67 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 $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 $3 25 • Caveat: market multiples fluctuate over time 51
  52. 52. Incremental Cash Flow Incremental cash flows versus sunk costs: I t l h fl k t Capital budgeting analysis should include only incremental costs. • Simple example: assume that your company undertook a market research and the costs were 200.000$. The market k h d h 200 000$ Th k research was successful and as a result, a more thorough project evaluation is to be undertaken Should the costs of undertaken. marketing research be included into the cash flow budget or not? Why or why not? 52
  53. 53. 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) g g g ( ) program. Indeed  you calculated the incremental costs and benefits from attending business school. What are the opportunity costs here? i h ? NPV of a project could fall substantially if opportunity costs are recognized! i d! 53
  54. 54. 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) d h ld b l d d l( ) cash flow. • Cannibalization is a “substitution” effect. • H However there could be some exceptions to this h ld b h rule. One should take into account the effect of potential competition. l 54
  55. 55. Example of a project A small bakery is planning to expand it’s 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. k  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 y p (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) 55
  56. 56. 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 56
  57. 57. Years 0 1 2 3 4 Assumptions1.1 Total sales 160 000 160 000 160 000 160 000 Quantity 40 000 - opportunity cost -5 000 -5 000 -5 000 -5 000 Sales price 4,00 - incremenatal loss insales l -18 000 18 -18 000 18 -18 000 18 -18 000 18 Prod P d cost t 1,80 1 802. Production cost -72 000 -72 000 -72 000 -72 0003. Transportation cost -20 000 -20 000 -20 000 -20 000 In into NWC 15 0004. General expenses -15 000 -15 000 -15 000 -15 000 Depr 18 5005. Depreciation -18 500 -18 500 -18 500 -18 500 Tranpost 0,506. EBIT 11 500 11 500 11 500 11 500 Fixed invest 74 0007. Taxes on dividends -1 834 -1 834 -1 834 -1 8348. Free cash flow Sale of inv (after( depr)(+depr) 28 166 28 166 28 166 28 166 tax) 8405 Gen expnses 15 000 0 1 2 3 4 effective tax rate 16%Cash flows Müügi kaotus 18 0001. Cash from operations 28 166 28 166 28 166 28 166 Alternatiivkulu 5 0002. Change in NWC -15 000 15 0003. Net fixed investments -74 000 8 405 Marketing research is aTotal cash flows -89 000 28 166 28 166 28 166 51 571 sunk cost 57 Required return 16%
  58. 58. Capital Rationing Can a firm accept all investment projects with positive NPV? Reasons why a company would not accept all projects: R h ld ll j Limited availability of skilled personnel to be involved with all the projects; p j ; 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. k t 58
  59. 59. 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 t Th steps above ensure th t managers select th b that l t the combination of projects with the highest NPV. 59
  60. 60. Capital Rationing and the Profitability Index((12% required return) q ) 60
  61. 61. Equipment Replacement and Unequal Lives  A firm must purchase an electronic control device: • First alternative: cheaper device higher maintenance costs, shorter period device, costs of utilization • Second device: more expensive, smaller maintenance costs, longer life span p g p  Expected cash outflows: • Using real discount rate of 7%: g Device A’ D i A’s cash outflow < Device B’s cash outflow h fl D i B’ h fl  select A? 61
  62. 62. 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: X X X Device A $ 15 ,936  1  2  X  $6,072 1 .07 1 .07 1 .07 3 Device B Y Y Y Y $ 18 ,065  1  2  3  Y  $5,333 1 .07 1 .07 1 .07 1 .07 4 • Since Device B’s annuity cost is lower, choose Device B. 62
  63. 63. Excess Capacity  Excess capacity is not a free asset as traditionally regarded by p y y g y 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. • I Incremental cost: i l investing $2 000 000 at present vs. two years from i $2,000,000 f today • Incremental cash inflow: $125,000 (at the beginning of the year) $125 000 63
  64. 64. Excess Capacity  NPV of leasing excess capacity (assume 10% discount rate): 125 ,000 2 ,000 ,000NPV  125 ,000  2,000 ,000   2   $ 108 , 471 1 .10 1 .1 • 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. X 2 , 000 , 000 NPV  X  2 , 000 , 000   2 0 1 . 10 1 .1 - X = $181,818 (at the beginning of the year) - Leasing the excess capacity for a price above $181,818 would increase shareholders wealth. ld i h h ld lth 64
  65. 65. The Human Face of Capital Budgeting  Managers must be aware of optimistic bias in the assumptions g p p made by project supporters.  Companies should have control measures in p p place to remove bias:  Investment analysis should be done by a group independent of y y g p p individual or group proposing the project.  Project analysts must have a sense of what is reasonable when forecasting a project’s 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. 65
  66. 66. Cash Flow and Capital Budgeting Certain types of cash flows are common to many investments Opportunity costs should be included in cash flow pp y projections Consider human factors in capital budgeting 66
  67. 67. Choosing the Right Discount Rate The numerators focus on project cash flows covered in Chapter 9. CF1 CF 2 CF 3 CF NNPV  CF 0     ...  (1  r ) (1  r ) 2 (1  r ) 3 (1  r ) N The denominators are the discount rates (cost of capital) Reflect opportunity costs to firm’s investors The denominator Reflect the project’s risk p j should: Be derived from market data 67
  68. 68. Weighted Average Cost of Capital ( g g p (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 Lox-in-a-Box 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.  D   E   50   100 WACC    rd    re   9 %   15 %  13 % DE DE  50  100  6850  100  
  69. 69. Rules for Finding the Right Discount Rate 1. 1 When Wh an all-equity firm invests i an asset similar t ll it fi i t in t i il to its existing assets, the cost of equity is the appropriate discount rate rate. 2. When a firm with both debt and equity invests in an asset similar to its existing assets, the WACC is the appropriate discount rate. 3. When the investment is more risky than the firm’s average investment, a higher discount rate than the WACC is required, and vice versa. 69
  70. 70. Sensitivity Analysis Sensitivity analysis allows mangers to test the impact of each assumption underlying a forecast. •S Sensitivity analysis involves calculating the NPV for various l l l l h NPVs f deviations from a “base case” set of assumptions. GTI has developed a new skateboard. Base case assumptions yield NPV = $236,000. 1. The project’s life is five y p j years. 2. The project requires an up-front investment of $7 million. 3. GTI will depreciate initial investment on straight line basis for five years. 70
  71. 71. Sensitivity Analysis GTI has developed a new skateboard. Base case assumptions yield p p y NPV = $236,000. 4. One year from now, the skateboard industry will sell 500,000 units. 5. Total industry unit volume will increase by 5% per year. 6. GTI expects to capture 5% of the market in the first year. 7. GTI expects to increase its market share by one percentage point each year after year one. 8. The selling price will be $200 in year one. 9. 9 Selling price will decline by 10% per year after year one one. 10. All production costs are variable and equal 60% of the selling price. 11. GTI s 11 GTI’s marginal tax rate is 30%. 30% 12. The appropriate discount rate is 14%. 71
  72. 72. Table 10-4 Sensitivity Analysis of Skateboard P j t Sk t b d Project Dollar values in thousands except price NPV Pessimistic Assumption Optimistic NPV -$558 $558 $8,000,000 2. I i i l i $8 000 000 2 Initial investment $6,000,000 $6 000 000 $1,030 $1 030 -343 450,000 units 4. Market size in year 1 550,000 units 815 -73 73 2% per year 5 Growth in market size 5. 8% per year 563 -1,512 3% 6. Initial market share 7% 1,984 -1,189 -1 189 0% 7. 7 Growth in market 2% per year 1,661 1 661 share -488 $175 8. Initial selling price $225 960 -54 62% of sales 9. costs 58% of sales 526 -873 -20% per year 10. Annual price change 0% per year 1,612 -115 16% 12. Discount rate 12% 61772
  73. 73. Scenario Analysis  Scenario analysis i a more complex f S i l i is l form of sensitivity analysis. f iti it l i  Rather than adjust one assumption up or down, analysts calculate the project NPV when a whole set of assumptions l l h j h h l f i changes in a particular way.  For F example, if consumer i l interest in GTI’ new skateboard i i GTI’s k b d is low, the project may achieve a lower market share and a lower selling price than originally anticipated anticipated. 73
  74. 74. Monte Carlo Simulation  In M t C l i l ti I a Monte Carlo simulation, analysts specify a range or a l t if probability distribution of potential outcomes for each of the model’s assumptions. model s • It is even possible to specify the degree of correlation between key variables. variables • A simulation software package is then used to take random “draws” from these distributions calculating the project’s cash flows (and distributions, project s 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 model s model’s assumptions. 74
  75. 75. Monte Carlo Simulation  The Th use of M t C l simulation h grown d f Monte Carlo i l ti has dramatically i th ti ll 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. p p y  Simulation’s 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. 75
  76. 76. Decision Trees  A decision tree is a visual representation of the sequential choices that managers face over time with regard to a particular investment 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. 76
  77. 77. 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 high, 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.  Trinkle’s cost of capital equals 15 percent. 77
  78. 78. Decision Trees for Odessa InvestmentIf 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
  79. 79. Decision Trees for Odessa Investment • To work through a decision tree, begin at the end and then work backward to the initial decision 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 today’s 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.79
  80. 80. Real Options in Capital Budgeting Option i i O ti pricing analysis i h l f l in examining multi-stage l i is helpful i i i lti t 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! 80
  81. 81. Types of Real Options Expansion • If a product is a hit, expand production. options Abandonment • Firm can abandon a project if not successful. • Shareholders have valuable option to default on options p debt. debt Follow-on investment • Similar to expansion options, but more complex (Ex: movie rights to sequel) options • Ability to use multiple production inputs Flexibility y (example: dual fuel industrial boiler) or produce dual-fuel options multiple outputs 81
  82. 82. Strategy and Capital Budgeting Competition and NPV  Advocates of a positive NPV project should be able to articulate the project’s competitive advantage before running the numbers  Otherwise in perfect financial markets for every project the NPV should not generally exceed 0. (Why?) 0 Strategic thinking and real options  Managers must articulate their strategy for a given investment  Many investments could have embedded options in them y p 82
  83. 83. Risk and Capital Budgeting  All-equity fi All it firms can di discount th i standard i t their t d d investment t t projects at cost of equity.  Firms with d b and equity can di Fi i h debt d i discount their standard h i d d investment projects using WACC.  A variety of tools exist to assist managers in understanding the i f l i i i d di h sources of uncertainty of a project’s cash flows. 83

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