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Purpose Methods

The objective of the corporation is to Maximise Shareholders Wealth To do this we need to invest in those projects that will give the correct rate of return for the risk involved To do this we need to be able to

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1. Identify suitable investment opportunities 2. Decide on the best selection method 3. Identify the cash flows that will be generated by those investments 4. Discount them at the correct cost of capital 5. Choose the best one or ones from those available

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The ideal selection method will Select the project that maximises shareholders wealth Consider all cash flows Discount the cash flows at the appropriate market determined opportunity cost of capital Will allow managers to consider each project independently from all others

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Methods for evaluating projects Payback ARR, Accounting Rate of Return IRR. Internal rate of return is the discount rate that will give a Net Present Value of 0. NPV is the Net Present Value of a stream of cash flows discounted at the correct cost of capital for the degree of risk inherent in realising those cash flows NPV is best but what do companies use and why?

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Figure 6.1 NPV of FFFs New Project

The graph shows the NPV as a function of the discount rate. The NPV is positive only for discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of capital of 10%, the project has a positive NPV of $100 million.

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We know that the NPV is the best method because; The reinvestment rate assumption Value additivity Differences in scale Multiple IRRs

Why not IRR and does it have a use? 1. Delayed Investments The Bonzo Dog DoDah Band are offered USD2,000,000 today from a rich investor to make a new vinyl LP. They calculate that they will need three years to make the recording and that they will have to give up earnings in each of those years of USD 1,000,000. Should they do it?

ACFL1 9

1st question. What is the opportunity cost of capital? Say 6% 2nd question. What is the IRR? With a wild stabbing guess say 23.38%

+2,000,000 1,000,000 1,000,000 1,000,000

1.2338 (1.2338)2 (1.2338)3 - 1,999,855 = -810,504 - 656,917 - 532,434 Thats close enough

ACFL1 10

But using 6% as the cost of capital

+ 2,000,000 1,000,000 1,000,000 -1,000,000

(1.06) -2,673,022 = -943,396 So what should they do? (1.06)2 (1.06)3 - 889,996 - 839,630

ACFL1

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Value Additivity Try working out the NPV for the following

- 1,000,000 + 350,000 +650,000 +650,000 +650,000 - 1,000,000 + 650,000 +650,000 +650,000 + 350,000 At 10% and now combine them. What is the combined NPV? Answer = 787,686 and 855,509 = 1,643,195 As combined flows = 1,643,193

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-1,000,000 + 350,000 +650,000 +650,000 +650,000

- IRR = 39%

-1,000,000 + 650,000 +650,000 +650,000 + 350,000

- IRR = 49%

- 2,000,000 + 1,000,000 +1,300,000 + 1,300,000 +1,000,000

- IRR = 43.5%

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Issues of scale What would you prefer A return of 50 % or one of 20% ? an NPV of 50 or an NPV of 500? Depends for the IRR but you would prefer the higher NPV

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Project A with IRR of 12% -1201 + 500 + 500 + 500 PVF 1.1200 1.2544 1.4049 PV +1201 446 399 356 Double the scale IRR still 12% -2402 +1000 +1000 +1000 PV +2402 893 797 712

ACFL1 15

Figure 6.4 B&DeM

In this case, there is more than one IRR, invalidating the IRR rule. If the opportunity cost of capital is either below 4.723% or above 19.619%, Star should make the investment.

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So, its NPV But. Some Reasons for usage of wrong techniques. Managers prefer % figures => IRR, ARR Managers dont understand NPV/ Complicated Calculations. Payback simple to calculate. Short-term compensation schemes => Payback (Levy 200 203, Pike 1985 pg 49). Behavioural Factors (see later section on Behavioural Finance!!) Increase in Usage of correct DCF techniques: Computers. Management Education.

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How do we decide when resources are constrained? We need to maximise NPV which may mean not going for the project with the highest NPV, rather the combination of projects that gives the highest total NPV. Why would resources be constrained? This could be due to Capital Rationing

ACFL1 18

150million to invest Three projects Project NPV Investment PI* A 100 125 .80 B 80 75 1.07 C 70 75 .93 *PI = Profitability Index = Value Created Resource Consumed

ACFL1 19

What about other scarce resources? E.g. bright Bath Students There are never enough

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Profitability Index = Value created Resource consumed

= NPV RC

Bath Students

Project

A B C D E

NPV

30 35 20 15 12

100 150 70 80 28

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A mere 200 students are available

Project

E A C B D

NPV

12 30 20 35 15

Headcount

Headcount PI

Cumulative requirement

28 100 70 150 80

28 128 198

Broken the budget

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Try this one 380 tonnes of scarce material Project A B C D E NPV 50 20 45 15 35

Mats Usage

Mats PI

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What do you notice?

So?

Now Moving on

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Remember We have to look at all the relevant, incremental cash flows - Taxes/tax losses - Opportunity costs - Depreciation - Working capital - Cannibalisation

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Illustrations using examples from B&DeM New project, units 100,000 pa at 260 per unit = 26 million Cost of production is 110 per unit = 11M Gross profit 15 million pa Operating expenses = 2.8 million pa 5 million to be spent on design and engineering 10 million on software 7.5 million equipment depreciated over 5 years on straight line basis

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Table 7.1 HomeNets Incremental Earnings Forecast (Spreadsheet)

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Points to make so far 1 Tax losses 2 Depreciation 3 Interest cost Now Opportunity cost

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New lab will be housed in existing space. What should the cost be? Well what are the alternative uses? Suppose could rent for 200,000 pa for years 1 to 4 then this is a foregone income of 200,000 x (1-.4)

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Cannibalisation 25 % of the sales of the new product will come from existing sales of a similar product. How do we account for this? Lost revenue at price of 100 per unit 100,000 x .25 x 100 = 2,500,000 But there will be lower cost of sales 100,000 x .25 x 60 (cost per unit) = 1.5 m

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Table 7.2 HomeNets Incremental Earnings Forecast Including Cannibalization and Lost Rent

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Need to work out the Free Cash Flow i.e. the effect of the project on the companys cash. So far looked at sales and costs just need to add a couple of things in. 1. Depreciation (which you are already familiar with 2. Net working capital

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Table 7.3 Calculation of HomeNets Free Cash Flow (Including Cannibalization and Lost Rent)

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Anything else? Timing of cash flows Liquidation/salvage value Terminal Value - multiple - constant growth

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Constant Growth 1) Year 5 free cash flow is 3,000,000. If cost of capital is 10% then PV at end year 5 of future cash flows is 3,000,000 = 30,000,000 .10 2) Suppose expect to grow at 3% pa thereafter Then PV at end year five of future cash flows is 3,000,000 = 42,857,143 .10 - .03

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Break even analysis Using the IRR to give a feel for the margin of safety ref the cost of capital Sensitivity analysis Scenario analysis

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Sensitivity Analysis

Table 7.9 Best- and Worst-Case Parameter Assumptions for HomeNet

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Figure 7.1 HomeNets NPV Under Best- and Worst-Case Parameter Assumptions

Green bars show the change in NPV under the best-case assumption for each parameter; red bars show the change under the worst-case assumption. Also shown are the breakeven levels for each parameter. Under the initial assumptions, HomeNets NPV is $5.0 million.

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Table 7.10 Scenario Analysis of Alternative Pricing Strategies

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Figure 7.2 Price and Volume Combinations for HomeNet with Equivalent NPV

The graph shows alternative price per unit and annual volume combinations that lead to an NPV of $5.0 million. Pricing strategies with combinations above this line will lead to a higher NPV and are superior.

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Summary Investments should add to shareholder wealth NPV is the correct method Incremental free cash flows Forecasting cash flows

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Before moving on to other aspects of using the NPV approach we should consider EVA or Economic Value Added. The cash flows of a project less a capital charge that reflects the opportunity cost of the capital invested as well as any capital consumed How does it differ from NPV?

ACFL1 43

Basically NPV gives the return of a project over a period of time while EVA focuses more on the individual time segments within the overall period but will give the same result

ACFL1

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Project C E B A D NPV 45 35 20 50 15 Mats PI

(NPV per T)

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