Session 4 - NSV

Session 4 NPV and investment decisions
Corporate Finance
Session 4: NPV and investment decisions
1
30017 -1- Corporate Finance
Topics
NPV as decision tool and its competitors
Advantages and disadvantages of capital budgeting

techniques
Practical aspects of making investment decisions
Reading
BMA 2, 5, 6

Present Value
• Practice Question. You just won the lottery and it

pays $100,000 a year for 20 years. Suppose that
r=10%. Are you a millionaire?
• What if the $100,000 annual payments last

forever?

Present Value


Present Value


forever?

Present Value

forever?

The Opportunity Cost of Capital
opportunity cost of capital is the expected rate of return offered

Cash by equivalent (in time and risk) investments in financial markets
Investment Investment
opportunity Firm Shareholder opportunities
(real asset) (financial assets)
Invest Alternative: Shareholders invest

pay dividend to for themselves
shareholders

CFO Decision Tools

Survey Data on CFO Use of Investment Evaluation Techniques
SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal
of Financial Economics 61 (2001), pp. 187-243.

Internal Rate of Return
Practice question
You can purchase a machine for $4,000. The investment will
generate $2,000 and $4,000 in cash flows for two years,
respectively. What is the IRR on this investment?

Practice question
You can purchase a machine for $4,000. The investment will
generate $2,000 and $4,000 in cash flows in year 1 and 2,
respectively. What is the IRR on this investment?
30017 - 10 - Corporate Finance



Pitfall 1 - Lending or Borrowing?
• With some cash flows (as noted below) the NPV of the project increases
as the discount rate increases.
• This is contrary to the normal relationship between NPV and discount
rates.
Project C0 C1 IRR NPV @ 10%
A − 1,000 + 1,500 + 50% + 364
B + 1,000 − 1,500 + 50% − 364
1500 1500
A : −1000 + = 0⇔r= − 1 = 0.5
1+ r 1000
1500 1500
B : +1000 − = 0⇔r= − 1 = 0.5
1+ r 1000

Pitfall 2 - Multiple Rates of Return
• Certain cash flows can generate NPV=0 at two different discount
rates.
Cash Flows in millions
C0 C1...... ......C9 C10

− 30 10 10 − 65
• Reason is the double change in sign of the cash-flows

• There can be as many IRRs as there are sign changes
• Large end-of investment negative cash-flows are not rare – examples?

Pitfall 3 - Multiple Rates of Return

• It is possible to have NO IRR and a positive NPV

Mutually Exclusive Projects

• IRR ignores the scale of projects.
• Illustration: compute the associated IRR and NPV
(assuming that cost of capital is 10%)
Project CF Y0 CF Y1 IRR NPV(10%)
A -10000 20000
B -20000 35000

Mutually Exclusive Projects

• IRR ignores the scale of projects.
• Illustration: compute the associated IRR and NPV
(assuming that cost of capital is 10%)
Project CF Y0 CF Y1 IRR NPV(10%)
A -10000 20000 100% +8,182
B -20000 35000 75% +11,818


Pitfall 4 - Term Structure Assumption
• Suppose opportunity cost of capital changes over time
Cash Flows CF0 CF1 CF2 CF3

Opportunity r1 r2 r3
Cost of capital
• Easy to use NPV rule:
• But difficult to apply IRR rule

› Would require to compare IRR with a complex weighted average of
the discount rates

Applying NPV to real-world examples

Applying NPV to real-world examples
• You will apply NPV to a real problem in the Ocean Carriers

case (Session 7).
› Ocean Carriers is a shipping company
› Should the firm decide to purchase a new ship at $ 39M?
• Develop an understanding of how discounted cash flow

analysis can be used to make investment decisions.
› Identifying cash flows (e.g. CFs from investments, CFs from
operations)
› Forecasting expected cash flows (demand, costs, inflation, working
capital, taxes…)
› Determining the net present value of an investment

Keep in mind
1. Only cash flows matter
2. Estimate cash flows on an incremental basis

• Include all incidental effects
• Do not forget working capital requirements
• Beware of allocated overhead costs
• Remember salvage value
3. Taxes affect the profitability of projects
4. Treat inflation consistently

• Nominal interest rates to discount nominal CFs
• OR
• Real interest rates to discount real CFs

Inflation
Practice Question
You own a lease that will cost you $8,000 next

year, increasing at 3% a year (the forecasted
inflation rate) for 3 additional years (4 years total).
If (nominal) discount rates are 10%, what is the
present value cost of the lease?
1+nominal interest rate

1 + real interest rate = 1+inflation rate

Inflation
Nominal Cash-Flows and Nominal Discount Rates
Year Cash Flow PV @ 10%

1 8000 8000
1.10 = 7272.73
2 8000x1.03=8240 8240
1.102
= 6809.92
3 8000x1.032 =8487.20 8487.20
1.103
= 6376.56
4 8000x1.033 =8741.82 8741.82
1.104
= 5970.78
$26, 429.99

Inflation
Real Cash-Flows and Real Discount Rates
Year Cash Flow PV@6.7961%

1 8000
1.03 = 7766.99 7766.99
1.068 = 7272.73
2 8240
1.032
= 7766.99 7766.99
1.068 2
= 6809.92
3 8487.20
1.033
= 7766.99 7766.99
1.0683
= 6376.56
4 8741.82
1.034
= 7766.99 7766.99
1.068 4
= 5970.78
= $26 ,429.99

Do not forget about working capital
• Working capital components include:

› Inventory
› Accounts receivable and
› Accounts payable
• Careful: Net Working Capital (NWC) is NOT a cash flow

(it is a stock).
• The change in NWC is a cash flow!

Recipe for no mistakes

Decompose Cash-Flows for each year as:
• Cash-flows from investment (buying the machine… and

selling the machine)
• +Operating cash flow (Sales-Costs-Taxes)
• +Cash-flows from changes in working capital (negative

impact on CFs when net working capital increases,
positive impact on CFs when net working capital
decreases)

Recipe for no mistakes - Taxes
• ! for taxes, depreciation of assets matters, but depreciation is not a

cash-flow
• When you sell capital (say the machine), the difference between the
resell value and the book value of the machine is considered as a
capital gain which is taxed: this tax has to be taken into account.

How to forecast cash flows and compute NPV?
Consider IM&C’s Fertilizer Project (BMA Chapter
6)
There are direct and indirect sources of cash-flows:

• Salvage value of the plant (sold in year 7), Taxes, Working capital, the
role of depreciation…

IM&C’s Fertilizer Project - Cash flow analysis

IM&C’s Fertilizer Project - NPV
• NPV using nominal cash flows
1,630 2,381 6,205 10,685 10,136

NPV = −12,600 − + + + +
1.20 (1.20 ) 2
(1.20) (1.20) (1.20)5
3 4
6,110 3,444
+ + = 3,520 or $3,520,000
(1.20) (1.20)
6 7

Session 4 - NSV

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Session 4 NPV and investment decisions

Session 4: NPV and investment decisions

NPV as decision tool and its competitors

Advantages and disadvantages of capital budgeting

Practical aspects of making investment decisions

30017 -2- Corporate Finance

• Practice Question. You just won the lottery and it

• What if the $100,000 annual payments last

30017 -3- Corporate Finance

• Practice Question. You just won the lottery and it

30017 -4- Corporate Finance

• Practice Question. You just won the lottery and it

• What if the $100,000 annual payments last

30017 -5- Corporate Finance

• What if the $100,000 annual payments last

30017 -6- Corporate Finance

The Opportunity Cost of Capital

opportunity cost of capital is the expected rate of return offered

Invest Alternative: Shareholders invest

30017 -7- Corporate Finance

CFO Decision Tools

30017 -8- Corporate Finance

Internal Rate of Return

30017 -9- Corporate Finance

Internal Rate of Return

30017 - 10 - Corporate Finance

Internal Rate of Return

30017 - 11 - Corporate Finance

Internal Rate of Return

Internal Rate of Return

C0 C1...... ......C9 C10

• Reason is the double change in sign of the cash-flows

30017 - 13 - Corporate Finance

Internal Rate of Return

Pitfall 3 - Multiple Rates of Return

30017 - 14 - Corporate Finance

Internal Rate of Return

Mutually Exclusive Projects

Project CF Y0 CF Y1 IRR NPV(10%)

30017 - 15 - Corporate Finance

Internal Rate of Return

Mutually Exclusive Projects

Project CF Y0 CF Y1 IRR NPV(10%)

A -10000 20000 100% +8,182

B -20000 35000 75% +11,818

30017 - 16 - Corporate Finance

Internal Rate of Return

Cash Flows CF0 CF1 CF2 CF3

• Easy to use NPV rule:

• But difficult to apply IRR rule

30017 - 18 - Corporate Finance

Applying NPV to real-world examples

30017 - 19 - Corporate Finance

Applying NPV to real-world examples

• You will apply NPV to a real problem in the Ocean Carriers

• Develop an understanding of how discounted cash flow

30017 - 20 - Corporate Finance

2. Estimate cash flows on an incremental basis

3. Taxes affect the profitability of projects

4. Treat inflation consistently

30017 - 21 - Corporate Finance

You own a lease that will cost you $8,000 next