Class Coverage Final Exam – Friday August 11, 7 p.m. Long Term Investment Decisions Why capital budgeting is important to corporate strategy The payback technique The return on investment technique The net present value technique The weighted average cost of capital The role of uncertainty

Final Exam Part 1 (17%) Finance only – 1 hour – multiple choice like mid-terms. Part 2 (33%) Entire course content – 2 hours. Stress is on understanding. Bring calculator but extensive calculations not required. Examples of types of questions will be given next week. Part marks will be awardable even if answer is incorrect. Communication skills will be rewarded. ed feedback on individual answers will be available.

Class Coverage Long Term Investment Decisions Why capital budgeting is important to corporate strategy The payback technique The return on investment technique The net present value technique The weighted average cost of capital The role of uncertainty

Long-term Decisions: Capital Budgeting: Introduction: Short-term decisions affect the organization for a short period. Short-term decisions usually involve small amounts of money. Short-term decisions can be reversed at little cost. Therefore a short-term decision that was unwise is a temporary and inexpensive problem. Long-term decisions affect the organization over a long period. Long-term decisions usually involve a large amount of money. Long-term decisions cannot be reversed, except at great cost. Therefore it is vitally important that long-term decisions be taken correctly.

Capital Budgeting Decision Process: 1: The process should be standardized throughout the organization. 2: The proposal should be a good fit with the organization’s strategy. 3: Economic analysis of the proposal should be based on forecasts of the following information : i:additional cash inflows from revenues; ii:additional cash outflows from expenses; iii:additional non-cash expenses; iv:weighted average cost of capital; v:risk assessment. 4: Forecast information should be analyzed through: i:payback; ii:return on investment; iii:net present value iv:risk analysis

Strategic Analysis: Exxon Mobil: 2001: Strategy includes “functional and geographic diversity”. A proposal that increases functional diversity is a good fit with the strategy; A proposal that increases geographical diversity is a good fit with the strategy; A proposal that increases the range of products produced in its Australian subsidiary is a very good fit with the strategy. Such a proposal would be further investigated through economic analysis.

Strategic Analysis: Exxon Mobil: 2001: Strategy includes “functional and geographic diversity”. A proposal that aims to reduce distribution costs in its US operations does not pursue the organizational strategy. It may still be a good idea, as operational efficiency is also important, and it does not harm the strategy. It would be considered on its merits as a cost saving proposal. A proposal to take over a rival US oil company does not make any contribution to the strategy, and potentially exposes Exxon to “anti-trust” (monopoly) accusations. It should be rejected without further consideration.

A Capital Budgeting Proposal: Purchase of patent: Cost:$300,000 Increased sales revenue:$500,000 per year for 6 years Increased cash expenses:$425,000 per year for 6 years Depreciation: $300,00/6:$ 50,000 per year for 6 years Ignore increases in working capital (such as inventory and receivables changes) resulting from the investment. Question: Is this proposal economically justified?

Payback method: Initial investment:$300,000 (one time only) Increased sales revenue:$500,000 per year for 6 years Increased cash expenses:$425,000 per year for 6 years Increased cash flow:$ 75,000 per year for 6 years Year 0: Cash outflow: Investment:$300,000 Year 1: Cash inflow:$ 75,000 End of year 1: unrecovered investment:$225,000 Year 2: Cash inflow:$ 75,000 End of year 2: unrecovered investment:$150,000 Year 3: Cash inflow:$ 75,000 End of year 3: unrecovered investment:$ 75,000 Year 4: Cash inflow:$ 75,000 End of year 4: unrecovered investment:$ nil By the end of year 4 the investment should be “paid back”

Payback method: Payback: Initial investment-cumulative cash flow = 0 $300,000 - $75,000 – $75,000 - $75,000 - $75,000 = 0 (4 years) For cash flows that are the same amount each year: Payback = investment/annual cash flow $300,000/$75,000 = 4 years

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Economic Analysis: 1: Payback: Deficiencies: 1: Payback fails to consider all the cash flows: All three proposals have a 4 year payback, Therefore each is equally valuable in terms of payback. Are you indifferent between receiving: Nothing, or: $75,000 in year 5 and 6, or: $75,000 per year from year 6 forever. Clearly not! 2: Payback fails to consider the pattern of cash flows within the payback period: Would you be indifferent between: Year 1: $99,000: Year 2: $ 1,000, and Year 1: $ 1,000: Year 2: $99,000Clearly not!

Economic Analysis: Return on Investment: ROI = Operating income/total assets (for the whole company) ROI for a capital budgeting proposal: Operating income arising from the investment/investment Or, for the return on the average investment: Operating income arising from the investment/ Average investment Adding investments that have a good individual ROIs will improve the ROI of the whole organization.

Economic Analysis: Return on Investment: Increased sales revenue:$500,000 per year for 6 years Increased cash expenses:$425,000 per year for 6 years Depreciation: $300,000/6:$ 50,000 per year for 6 years Total expense:$475,000 Increased operating income:$ 25,000 ROI: operating income/investment: $25,000/$300,000 = 8.33% RO Average I:operating income/average investment: $25,000/($300,000/2) = 16.67% ROI is better than payback because in considers all the cash flows (not just those up to payback date).

Economic Analysis: Return on Investment: Deficiencies: ROI is deficient: it fails to consider the pattern of cash flows. Two proposals each require an investment of $600,000. Year:0123 Cash flows: Proposal 1:($600,000)$340,000$220,000$220,000 Proposal 2:($600,000)$220,000$220,000$340,000 Depreciation is $200,000 per year ($600,000/3 years) Operating income: Proposal 1:$140,000$ 20,000$ 20,000 Proposal 2:$ 20,000$ 20,000$140,000 Both proposals have the same average income: ($140,000 + $20,000 + $20,000)/3 = $60,000 per year

Economic Analysis: Return on Investment: Deficiencies: The two proposals have equal operating income: $ 60,000 The two proposals have equal investments: $600,000 The two proposals have equal ROIs: 10% ($60,000/$600,000 = 10%) However, when would you prefer your cash: $120,000 at the end of year 1, or $120,000 at the end of year 3? Clearly the “time value of money” would cause you to prefer the cash sooner, rather than later. Only “present value” techniques bring the time value of money into the assessment of proposals (i.e. NOT payback and NOT ROI).

Interest: An amount invested will grow due to interest: The higher the rate of interest, the more the growth: Interest rate:5%10%15%20% Present value: $100 Future value in 1 year:$105$110$115$120 FV = PV * (1 + i%) In compound interest it is assumed that the interest is reinvested, so that interest is earned on the interest as well as on the principal: if 10% is the interest rate: $100 grows to $110 at the end of year 1 ($100 * 1.10) $110 grows to $121 at the end of year 2 ($110 * 1.10) $121 grows to $ at the end of year 3 ($121 * 1.10) $ grows to $ at the end of year 4 ($ * 1.10) $ grows to $ at the end of year 5 ($ * 1.10) FV = PV * (1 + I%) n

Compound Interest: The growth of an amount invested depends on a combination of the interest rate and the number of years: Future value of $100: Interest rate (i%)5%10%15% Year 0(n=0)$100$100$100 Year 1(n=1) Year 2(n=2) Year 3(n=3) Year 4(n=4) Year 5(n=5) Year 10 (n=10) Year 20 (n=20) , FV = PV * (1+i) n

Discounting: Whereas compounding adds interest to a present value, Discounting removes the interest opportunity from a future value: $100 is 10% interest for 1 year: FV = $110. $110 one year from today is worth $100 in present value. $100 is 10% interest fro 2 years: FV = $121 $121 two years from today is worth $100 in present value. Compounding formula:FV = PV * (1 + i) n Discounting formula:PV = FV * 1/(1 + i) n

Discounting: (see table 10-8: p. 225) Present value of $100: Interest rate (i%)5%10%15% Year 0(n=0)$100.00$100.00$ Year 1(n=1) Year 2(n=2) Year 3(n=3) Year 4(n=4) Year 5(n=5) Year 10 (n=10) Year 20(n=20) PV = FV * 1/(1+i) n

Net present Value: With discounting cash flows that arise at different points in time can be validly compared: Cash flowDiscountPresent factor(12%)value Year 0: ($300,000)1($300,000.00) Year 1:$ 75, $ 66, Year 2:$ 75, , Year 3:$ 75, , Year 4:$ 75, , Year 5:$ 75, , Year 6:$ 75, , Total present value of cash inflows: $308, Net present value of proposal: $ 8, As the NPV is positive, the proposal is acceptable.

Net Present Value: Any future cash flow can be multiplied by its appropriate discount factor to get its “net present value” The discount factors are in table 10-9: (page 225) A cash flow of $100,000 arising 8 years from now, where the relevant interest rate is 14% has a present value of: $100,000 * = $35,060 If each yearly cash inflow is identical in amount, the stream of cash flows is referred to as an “annuity”. Any annual amount can be multiplied by its appropriate annuity discount factor to get its net present value. A six year annuity of $75,000, where 12% is the relevant interest rate has a present value of: $75,000 * = $308,355 And if it cost $300,000, has a net present value of $8,355

Weighted Average Cost of Capital: It is essential to know the relevant interest rate at which the future cash flows are to be discounted: Cost of debt is 10% interest Marginal tax rate is 40% After tax cost of debt interest is 10% * (1-.40) = 6% Cost of equity = 15% Assume the company is financed 50% by debt, 50% by equity Weighted Average Cost of Capital: (Cost of debt * proportion of debt) + (cost of equity * proportion of equity) ((10% * (1-.4)) * 50%) + (15% * 50%) = 10.5%

Steps in Net Present Value Calculation: Estimate the amount of the cash investment; Estimate the amount and timing of the cash flows caused by the investment; Decide on an appropriate discount (interest) rate (e.g. WACC); Discount each future cash flow to its present value; Add the present values of all the inflows; Deduct the investment (leaving the net present value); If the NPV is positive: consider the proposal (compare with other proposals); If the NPV is negative: reject the proposal; If the NPV = 0: you are indifferent to accepting or rejecting. Worry about risk!

Risk & Uncertainty: The future is always uncertain. The further into the future we try to forecast, the less the precision of the estimates. Therefore assessing long-term proposals is inherently uncertain. Ways of dealing with uncertainty include: Managerial assessment of the riskiness of proposals; Buying additional precision through research; Avoiding risk through long-term contracts; Using a higher discount rate for high risk projects; Using sensitivity analysis to identify the risk factors