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#$% is a measure of the amount of market value created by undertakin! an investment pro&ect. he interest rate' r' will reflect the risk of the cash flows.
Finding t&e mar'et value o t&e investment (se discounted cash flow valuation )calculate present values*. +ompute the present values of future cash flows Net "resent #alue !ule $N"#%: (n investment s&ould )e accepted i t&e net present value is positive and re*ected i t&e net present value is negative+ "ositive N"# pro*ects create s&are&older value+
Using N"#
he marketin! department of your firm is considerin! whether to invest in a new product. he costs associated with introducin! this new product and the expected cash flows over the next four years are listed below. )-ssume these cash flows are 1../ likely*. he appropriate discount rate for these cash flows is "./ per year. 0hould the firm invest in this new product? +osts1 $romotion and advertisin! $roduction 3 related costs 5ther ,otal Cost -00+00 )2 million* 1..... 4..... 1.....
.ear . 1 " , 4
N"# 0
N"# Example
-ssume you have the followin! information on $ro&ect 81 Initial outlay 921'1.. :equired return ; 1./
-nnual cash revenues and expenses are as follows1 <ear :evenues =xpenses 1 21'... 27.. " "'... 1'... >raw a time line and compute the #$% of pro&ect 8.
.ear 1 " , 4
Example: Calculating t&e pa1)ac' period: he pro&ected cash flows from a proposed investment are listed below. he initial cost is 27... What is the payback period for this investment?
.ear 1 " , Cas& Flo/ 21..... "..... 7..... (ccumulated Cas& Flo/ 21.....
What is the #$% of the lon! pro&ect? he short pro&ect? Which pro&ect would you pick usin! #$% rule? -ssume the appropriate discount rate is "./.
-d&usts for uncertainty of later cash flows )by i!norin! them alto!ether*
Disadvantages
.ear 1 " , 4
It does not consider the risk differences between investments. <et' we can discount with a hi!her interest rate for a riskier pro&ect.
Bow do you come up with the ri!ht discounted payback period cut9off? -rbitrary number.
(dvantages If a pro&ect ever pays back on a discounted basis' then it must have a positive #$%.
Disadvantages
Cay re&ect positive #$% pro&ects -rbitrary discounted payback period ?iased a!ainst lon!9term pro&ects
Internal rate o return: he discount rate that makes the present value of future cash flows equal to the initial cost of the investment. =quivalently' the discount rate that !ives a pro&ect a zero #$%. I!! !ule: -n investment is accepted if its I:: is !reater than the required rate of return. -n investment should be re&ected otherwise. Calculating I!!: Like the < C' trial and error' financial calculators and financial spreadsheets are used to calculate the I::.
I!! Illustrated
Initial outlay ; 92".. <ear 1 " , 7. 1.. 17. +ash flow
Eind the I:: such that #$% ; . . ".. ; 9".. F 7. F 1 )1FI::* 1.. F 17. " )1FI::* )1FI::*, F 17. )1FI::*,
1.
Conventional Cas& Flo/s: he first cash flow )the initial investment* is ne!ative and all the remainin! cash flows are positive
"ro*ect is independent: - pro&ect is independent if the decision to accept or re&ect the pro&ect does not affect the decision to accept or re&ect any other pro&ect.
When one or both of these conditions are not met' problems with usin! the I:: rule can result.
11
Unconventional Cas& Flo/s: +ash flows come first and investment cost is paid later. In this case' the cash flows are like those of a loan and the I:: is like a borrowin! rate. hus' in this case a lower I:: is better than a hi!her I::
4ultiple rates o return pro)lem: he possibility that more than one discount rate makes the #$% of an investment pro&ect zero. Example: - strip9minin! pro&ect requires an initial investment of 26.. he cash flow in the first year is 2177. In the second year' the mine is depleted' but the firm has to spend 21.. to restore the land. >iscount :ate .../ 1.... ".... "7... ,.... ,,.,, 4.... #$% 927... 91.@4 9.."A .... ...6 .... 9..,1
Example 5: -ssume you are considerin! a pro&ect for which the cash flows are as follows1 <ear +ash flows . 92"7" 1 14,1 " 9,.,7 , "A7. 4 91... What is the I::? -t "7/ -t ,,.,,/ -t 4".A6/ -t 66.6@/ #$% ; #$% ; #$% ; #$% ;
(se the #$% profiles ake the difference in the pro&ectsG cash flows each period and calculate the
I::.
=xample1 If pro&ect - has a cost of 27.. and cash flows of 2,"7 for two periods' while pro&ect ? has a cost of 24.. and cash flows of 2,"7 and 2".. respectively' the incremental cash flows are1
$eriod . 1 " I!! $ro&ect 97.. ,"7 ,"7 1D.4, $ro&ect ? 94.. ,"7 ".. "".1@ Incremental 91.. . 1"7 11.A
Disadvantages
Incremental Cas& Flo/s: -ny chan!es in the firmGs future cash flows that are a direct consequence of takin! the pro&ect. =xample1 Bonda +orporation
,&e Stand6(lone "rinciple: he evaluation of a pro&ect based on the pro&ectGs incremental cash flows. %iew each pro&ect as a HminifirmH with its own assets' revenues and costs.
(spects o Incremental Cas& Flo/s $7&ic& costs s&ould )e included in incremental cas& lo/s8% Sun' Costs: - cash flow already paid or already promised to be paid+
9pportunit1 Costs: -ny cash flow lost by takin! one course of action rather than another.
Side E ects: $ro&ects often hurt or help one another Erosion: :evenues !ained by a new pro&ect at the expense of the firmGs other products or services.
Net 7or'ing Capital: In all capital bud!etin! pro&ects we will assume that net workin! capital is recovered at the end of the pro&ect.
(se pro forma income and balance sheet statements )exclude interest expense* for capital bud!etin!.
>etermine sales pro&ections' variable costs' fixed costs and estimated capital requirements. Use pro orma statements to compute pro*ect cas& lo/s "ro*ect Cas& Flo/s ; F $ro&ect operatin! cash flow $ro&ect capital spendin! $ro&ect additions to net workin! capital
Depreciation
=conomic and future market values are i!nored. 0trai!ht line1 - fixed percenta!e of the asset base. 0ince depreciation has cash flow consequences only because it affects the tax bill' the /a1 depreciation is computed or tax purposes is t&e relevant met&od or capital investment decisions+ 4odi ied (ccelerated Cost !ecover1 S1stem $4(C!S%: 1DA6 ax :eform -ct allows firms to Hfront9loadH depreciation char!es.
4odi ied (C!S "ropert1 Classes Class ,9year 79year @9year Examples =quipment used in research -utos' computers Cost industrial equipment 4odi ied (C!S Depreciation (llo/ances .ear 1 " , 4 7 6 @ A 361ear ,,.,,/ 44.44 14.A" @.41 :61ear "..../ ,"... 1D.". 11.7" 11.7" 7.@6 ;61ear 14."6/ "4.4D 1@.4D 1".4D A.D, A.D, A.D, 4.47
Boo' versus 4ar'et #alue: If an assetGs value when sold )i.e.' salva!e value* exceeds )is lower than* its book value' the difference is treated as a !ain )loss* for tax purposes.
1 " , 4 7 6
Why mi!ht a firm prefer accelerated depreciation' such as C-+:0 tables' to strai!ht9line depreciation?
1.
".
!ecovering N7C at t&e end o t&e "ro*ect .ear . 1 " .ear . 1 " N7C 27..'... 26..'... 2A..'... N7C 27..'... 2@..'... 26..'... (dditions to N7C (dditions to N7C
1+
0eparately forecast revenues' costs and depreciation and discount each item. +an use different discount rates
5+
7&ole pro*ect discounting >etermine pro&ect cash flows from financial statements a. b. 5peratin! +ash Elow #et +apital 0pendin! i. ii. We will only buy equipment at date .. We will only sell equipment at the end of the pro&ect. If' at the end of the pro&ect' we sell the equipment and the market value is !reater than the book value' we record the after9tax cash flow from the sale.
c.
-dditions to #W+ i. We will always recover #W+ at the end of the pro&ect.
=quipment is 79year -+:0 and is expected to have a salva!e value of 1./ of cost after 6 years.
=xpenditures for balls and buckets are 2,'... initially. balls and buckets will !row at 7/ per year.
he cost of replacin!
=valuate the pro&ect for 6 years. 0hould your friends proceed with the pro&ect?
9perating Costs per .ear Item Land Lease Water =lectricity 0eed 3 Eertilizer Labor )0alaried* Iasoline Caintenance Insurance Ciscellaneous ,otal Cost $=% 1"'...... 1'7..... ,'...... "'...... ,.'...... 1'7..... 1'...... 1'...... 1'...... :3?000+00
Increase in N7C
.ear . 1 " , 4 7 6
EBI, 2....
C Depreciation 2....
6 ,axes 2....
.ear . 1 " , 4 7 6
Step >: 7&at is t&e N"# o t&is pro*ect8 .ear . 1 " , 4 7 6 "resent #alue Factor 1... ,otal Cas& Flo/s )2"1'......* "#$Cas& Flo/s% )2"1'......*
1. ".
he pieces of equipment have different economic lives Whatever piece the firm buys' it needs it indefinitely. -s a result' the piece of equipment will be replaced when it wears out.
Example: - firm is considerin! which of two stampin! machines to buy. Cachine - costs 21.. to buy and 21. per year to operate. It wears out and must be replaced every two years. Cachine ? costs 214. to buy and 2A per year to operate. It lasts for , years and then must be replaced. I!norin! taxes' which machine should the firm buy if the appropriate discount rate is 1./? What is the present value of the cost of Cachine -?
#ote1 here are no workin! capital consequences. 0hould the firm undertake the pro&ect?
<ear .
<ear 1
<ear "
<ear ,
<ear 4
<ear 7
<ear 6
0hould the firm undertake the pro&ect if the discount rate is 1. percent per year? Why or why not?