Corporate Finance: Answers to Tut 4

Question 1:

(i) Equate the NPV to zero when the project does not have any competitive advantages and work
backward to find the selling price that produces such outcome (zero NPV):

0 = -25,000,000 + [(200,000) (P-65)] / 1.092 +……+ [(200,000) (P-65)]/1.0912

0 = -25,000,000 + [200,000 x (PVIFA, 9%,11)]/1.09

X = 20.02

Solving, P = 85.02

(ii) CF0 = -$25million

CF1 = $ 0

CF2 to CF6 = $7m per year

CF7 to CF12 yearly cash flow will be 200,000 x (85.02 – 65) = 4.004 million

NPV = -25 + 7/1.092 + …..+7/1.096 + 4.004/1.097 +……+ 4.004/1.0912

NPV = -25 +[ 7(PVIFA 9%, 5)]/ 1.09 + [4.004(PVIFA 9%, 6)]/ 1.096

NPV = 10.69 million

(iii) PV of the decline in revenue of existing products:

[$1m (PVIFA9%, 11)]/1.09 = (1 x 6.805)/1.09 = 6.24 million

Adjusted NPV = 10.69 – 6.24 = 4.45 million

Question 2:
i) Expected annual cash flow = 0.50 (50000) + 0.50 (100000) = 75,000

NPV without abandon option = -180,000 + 75,000(PVIFA15%, 3) = -180,000 + 75,000(2.283) =

-8758 (using financial calculator)

 ii) Optimal abandonment strategy: to abandon in one year if subsequent cash flows are
worth less than abandonment value. (abandon value = 110,000 but when low cash
flow occurs, the PV of 50,000 cash flows per year for the next two years is only
50000/1.152 + 50000/1.153 = 37807 + 32876 =70,683. So you should abandon if the
yearly cash flows are 50,000.

If the high cash flow occurs and you do not abandon:

NPV = -180,000 + 100,000(PVIFA15%, 3)= -180,000 + 100000(2.283)= 48300

If the low cash flow occurs and you abandon:

NPV = -180,000 + [(50,000 + 110,000) / 1.15] = -40870

The expected NPV is then:

NPV with abandon option = 0.50(48300) + 0.50 (-40870) = 3715.

Optimal abandonment raises the NPV by 3715 – (-8758) = 12473.

Question 3:
(i) and (ii)

Decision Tree
 Without the option, value of business = 0.5 ($0.15million/0.1) + 0.5 ($0) = $750,000

With the option, value of business = 0.5 ($0.15million/0.1) + 0.5 ($500,000/1.1) = $977,273

Option value = 977273 – 750000 = 227,273

Question 4:
i) Operating Income After Tax = EBIT(1-T) = 92.35 (1- 0.28) = 66.5

Total Capital Investment (including adjustment made to the notes = 175.4 + 20 + (200-148.32) =
247.08

Dollar Cost of Capital =[WACC x Total Capital Investment] =9% x 247.08 = 22.24

EVA = Operating Income After Tax – Dollar Cost of Capital

EVA = = 66.5 – 22.24 = 44.26

ii)
Any three below:
-Empire Building

-Reduced effort

-Perks and private benefits

-Entrenching investment
 - Avoidance of risk

iii)
Pros:

- EVA highlights the relationship between Return on Investment (ROI) and cost of
capital. EVA is superior to accounting profits (such as ROA) as a measure of value
creation because it recognises the cost of capital and, hence, the riskiness of a firm's
operations (Lehn and Makhija, 1996).

- Tying compensation to EVA helps reduce waste of assets and working capital
investment. One of the effective ways to improve the EVA is through the better
utilization of assets and efficient allocation of resources.

- EVA makes cost of capital ‘visible’ to managers. Davidson (2003) argued that while
EVA does not only improve banks performance and profitability, its ability to boost
stock performance is significant. Further, Burkette and Hedley (1997) have claimed in
their report that implementing an EVA policy would trigger a company’s stock to rise.
The purpose of EVA is to change the behavior of management and their performance
(Wileman, 1999) and lead managers to act more like owners (Tully, 1993). In other
words, In using EVA, the interest of managers and the shareholders can be aligned and
thus agency costs can be reduced. It can be used to motivate managers to create
shareholder value by being a basis for management compensation (Stern et al., 1989).

- Using ROI in measuring performance could be counterproductive and EVA can avoid
this. – Give Example (an appropriate example is available in Brealey and Myers)

- Over time, a company must generate EVA in order for its market value to increase.
A related concept is market value added (MVA) where

MVA = Market value of the company – Total capital invested

A company that generates positive EVA should have a market value in excess of the accounting
book value of its capital. Taub (2003) found the change in EVA explains 35 percent of the change
in Market Value Added (MVA), or seven times more than sales growth, consequently the change
in EPS explains only about 3 percent of the change in MVA.

Cons:

- EVA may increase the short-sightedness of managers because in order to increase the
current year EVA, managers tend to overlook the long term prospect - Explain

- EVA is about current earnings and therefore not suitable to forecast the future cash flows
for capital budgeting decision.
 - The financial statements (Profit & Loss account and Balance Sheet for instance) need to
be adjusted accordingly before the EVA can be calculated accurately. - For instance, total
book value of assets should be adjusted to include the recent value of those intangible assets
(such as patent, R&D costs, brand name) that are either off balance sheet items or ‘expensed’
in the income statement.

- These adjustments can be complicated and tedious. Without making the necessary
adjustments to the financial statements, the EVA is flaw and we cannot compare the EVA of
two firms without making the necessary adjustments. Give example (an appropriate example
is available in Brealey and Myers)

- As a result, EVA is not popular in the real world. Furthermore, accounting standards do
not required firms to report their EVA.

- The efficiency of EVA in real world is questionable by many research findings. Knight
(1998) reported the EVA does not necessarily lead to improved financial performance,
higher stock prices and higher compensation. Broadening the issue, Prober (2000) stated
that many believe that EVA correlates well with a firm's stock prices, however the several
other studies have produced mixed results. For example, Mäkeläinen (1998) claimed ROI
or IRR are good performance measures compared to EVA. West and Worthington (2000)
found the simple earnings variable to be more closely associated with stock returns than
EVA, while Telaranta (1997) concluded that EVA is not any better than traditional
performance measures.

- On the other research by Turvey et al. (2000) had found that there is absolutely no
relationship between EVA and stock market performance. Fernandez (2001) observes a low
(and sometimes negative) correlation between EVA and MVA, and concludes that
traditional tools present higher levels of correlation with the increase in the MVA. This
observation is supported by studies carried out by Riceman et al. (2000).

Question 5:
1. True. Project managers must be able to answer why a project proposed by them have
positive NPVs. If a project manager estimated a project to have positive NPV but he is not
able to justify where does the positive NPV come from, then the positive NPV must contain
biases, errors or mistakes. Biases/errors or mistakes can occur due to various factors such
as do not take into account the competitors’ reaction to your project, selection of
inappropriate discount rate, inaccurate forecasting of the inputs being used in NPV
calculation etc.

2. Managers need to be highlighted that only projects with competitive advantages will be
able to generate positive NPV. They should be able to understand the link between
competitive advantage and the ROE of the project. Competitive advantage allows the firm
to be able to achieve ROE that is higher than the cost of capital of the project and
subsequently positive NPV.
 3. For instance, various sources of competitive advantages such as economy of scales,
economy of scope, branding and product differentiation, and government policy could
enable a project to generate revenues and incomes above the minimum acceptable or
required level by the providers of the capital (i.e. shareholders and debtholders).

4. Finally, a manager also needs to justify whether competitive advantage currently enjoyed
by the firm is sustainable in long term. The answer to this question depends much on the
source of the competitive advantage as some sources are more plausible to be sustained
(for example, effective continuous branding effort) than others. If a competitive advantage
is more likely unsustainable, this should be factored into the NPV analysis.

Q6 C Q7 C