UNIT 8 Project Valuation Should we build this plant?

What is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future.

Steps to capital budgeting Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC.

What is the difference between independent and mutually exclusive projects? Independent projects – if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.

What is the difference between normal and nonnormal cash flow streams? Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

Net Present Value (NPV) Sum of the PVs of all cash inflows and outflows of a project:

What is Project L’s NPV? Year CFt PV of CFt 0 -100 -$100 1 10 9.09 0 -100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPVL = $18.79 NPVS = $19.98

Excel NPV Reminder You may use Excel’s NPV function to calculate NPV but be careful! Use Excel’s NPV function to find NPV of CF1-n and then subtract CF0 from this result.

Rationale for the NPV method NPV = PV of inflows – Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. In this example, accept S if mutually exclusive (NPVs > NPVL), and accept both if independent.

Internal Rate of Return (IRR) IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0: Use Excel’s IRR function.

How is a project’s IRR similar to a bond’s YTM? They are the same thing. Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project. EXAMPLE: Suppose a 10-year bond with a 9% annual coupon and $1,000 par value sells for $1,134.20. Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

Rationale for the IRR method If IRR > WACC, the project’s return exceeds its costs and there is some return left over to boost stockholders’ returns. If IRR > WACC, accept project. If IRR < WACC, reject project. If projects are independent, accept both projects, as both IRR > WACC = 10%. If projects are mutually exclusive, accept S, because IRRs > IRRL.

NPV Profiles A graphical representation of project NPVs at various different costs of capital. WACC NPVL NPVS 0 $50 $40 5 33 29 10 19 20 15 7 12 20 (4) 5

Drawing NPV profiles . . . . . . . . . . . S L NPV ($) IRRL = 18.1% 60 . 50 . 40 . Crossover Point = 8.7% . 30 . . IRRL = 18.1% 20 . . S . 10 L IRRS = 23.6% . . Discount Rate (%) 5 10 15 20 23.6 -10

Comparing the NPV and IRR methods If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive … If WACC > crossover rate, the methods lead to the same decision and there is no conflict. If WACC < crossover rate, the methods lead to different accept/reject decisions.

Reasons why NPV profiles cross Size (scale) differences – the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high WACC favors small projects. Timing differences – the project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF especially good, NPVS > NPVL.

Reinvestment rate assumptions NPV method assumes CFs are reinvested at the WACC. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.

What is the payback period? The number of years required to recover a project’s cost, or “How long does it take to get our money back?” Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.

Calculating payback Project L’s Payback Calculation CFt -100 10 60 1 2 3 CFt -100 10 60 80 Cumulative -100 -90 50 -30 PaybackL = 2 + / = 2.375 years = 30 80 PaybackL = 2.375 years PaybackS = 1.600 years

Strengths and weaknesses of payback Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses Ignores the time value of money. Ignores CFs occurring after the payback period.

Proposed Project Total depreciable cost Changes in working capital Equipment: $200,000 Shipping: $10,000 Installation: $30,000 Changes in working capital Inventories will rise by $25,000 Accounts payable will rise by $5,000 Effect on operations New sales: 100,000 units/year @ $2/unit Variable cost: 60% of sales

Proposed Project Life of the project Tax rate: 40% WACC: 10% Economic life: 4 years Depreciable life: MACRS 3-year class Salvage value: $25,000 Tax rate: 40% WACC: 10%

Determining project value Estimate relevant cash flows Calculating annual operating cash flows. Identifying changes in working capital. Calculating terminal cash flows. 0 1 2 3 4 Initial OCF1 OCF2 OCF3 OCF4 Costs + Terminal CFs NCF0 NCF1 NCF2 NCF3 NCF4

Initial year net cash flow Find Δ NOWC. ⇧ in inventories of $25,000 Funded partly by an ⇧ in A/P of $5,000 Δ NOWC = $25,000 - $5,000 = $20,000 Combine Δ NOWC with initial costs. Equipment -$200,000 Installation -40,000 Δ NOWC -20,000 Net CF0 -$260,000

Determining annual depreciation expense Year Rate x Basis Depr 1 0.33 x $240 $ 79 2 0.45 x 240 108 3 0.15 x 240 36 4 0.07 x 240 17 1.00 $240 Due to the MACRS ½-year convention, a 3-year asset is depreciated over 4 years.

Annual operating cash flows 1 2 3 4 Revenues 200.0 - Op Costs -120.0 - Depr’n Expense -79.2 -108.0 -36.0 -16.8 Operating Income (BT) 0.8 -28.0 44.0 63.2 - Tax (40%) 0.3 -11.2 17.6 25.3 Operating Income (AT) 0.5 26.4 37.9 + Depr’n Expense 79.2 108.0 36.0 16.8 Operating CF 79.7 91.2 62.4 54.7 (Thousands of dollars)

Terminal net cash flow Salvage value 25,000 Tax on SV (40%) -10,000 Recovery of NOWC $20,000 Salvage value 25,000 Tax on SV (40%) -10,000 Terminal CF $35,000 Q. How is NOWC recovered? Q. Is there always a tax on SV? Q. Is the tax on SV ever a positive cash flow?

Should financing effects be included in cash flows? No, dividends and interest expense should not be included in the analysis. Financing effects have already been taken into account by discounting cash flows at the WACC of 10%. Deducting interest expense and dividends would be “double counting” financing costs.

Should a $50,000 improvement cost from the previous year be included in the analysis? No, the building improvement cost is a sunk cost and should not be considered. This analysis should only include incremental investment.

If the facility could be leased out for $25,000 per year, would this affect the analysis? Yes, by accepting the project, the firm foregoes a possible annual cash flow of $25,000, which is an opportunity cost to be charged to the project. The relevant cash flow is the annual after-tax opportunity cost. A-T opportunity cost = $25,000 (1 – T) = $25,000(0.6) = $15,000

If the new product line decreases the sales of the firm’s other lines, would this affect the analysis? Yes. The effect on other projects’ CFs is an “externality.” Net CF loss per year on other lines would be a cost to this project. Externalities can be positive (in the case of complements) or negative (substitutes).

Proposed project’s cash flow time line 0 1 2 3 4 -260 79.7 91.2 62.4 54.7 Terminal CF → 35.0 89.7 Enter CFs into calculator CFLO register and enter I/YR = 10%. NPV = -$4.03 million IRR = 9.3% Payback = 3.3 years

What is real option analysis? Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during the project’s life. Real option analysis incorporates typical NPV budgeting analysis with an analysis for opportunities resulting from managers’ decisions.

What are some examples of real options? Investment timing options Abandonment/shutdown options Growth/expansion options Flexibility options