1 Finance School of Management Objective Explain Capital Budgeting Develop Criteria for Project Evaluation Chapter 6. How to Analyze Investment Projects

2 Finance School of Management Chapter 6 Contents  The Nature of Project Analysis  Where Do Investment Ideas Come From?  The NPV Rule  Estimating a Project’s Cash Flow  Cost of Capital  Sensitivity Analysis Using Spreadsheets  Analyzing Cost- Reduction Projects  Projects with Different Lives  Ranking Mutually Exclusive Projects  Inflation and Capital Budgeting

3 Finance School of Management Capital Budget and Capital Budgeting  Once a company has decided what business it intends to be in, it must considers –proposals for investment projects –evaluating them –deciding which ones to accept and which to reject  It must prepare a plan (capital budget) for acquiring –factories, machinery, warehouses –research laboratories –showrooms, and –for training the personnel.

4 Finance School of Management The Nature of Project Analysis  Starting point: An idea for increasing shareholder wealth  Procedures of project analysis  Forecasting cash flows: Decisions and events  Flexibility of decisions in the project’s life

5 Finance School of Management Where Do Investment Ideas Come from?  Customers  R&D department  Competition  Production division  Incentive systems

6 Finance School of Management Objectives  To show how to use discounted cash flow analysis to make decisions such as: –Whether to enter a new line of business –Whether to invest in equipment to reduce costs

7 Finance School of Management NPV Rule Revisited  Invest if the proposed project’s NPV is positive.  Discount rate  Opportunity cost: The rate of return on comparable investment opportunities.  Cost of capital  NPV: The fair market value in competitive and efficient market.

8 Finance School of Management DCF Payback Do the Project

9 Finance School of Management Don’t do the Project

10 Finance School of Management Indifferent Internal Rate of Return

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12 Finance School of Management Measurement of Value Accounting ？ Market ？  Two approaches of measuring value: –Accounting: Book value—Historical cost –Financial: Market value—Discounting

13 Finance School of Management Asset = Liability + Equity The Use of Money The Source of Money The Balance Sheet

14 Finance School of Management Corporate Finance Assets Liabilities and Equity Asset 1 Asset 2 Liabilities Asset 3 · · Equity · Asset n Total Assets Liabilities & Equity Continued…… Accounting: Yes! Finance: No!

15 Finance School of Management Corporate Finance Assets Liabilities and Equity Asset 1 Asset 2 Liabilities Asset 3 · · Equity · Asset n Total Assets Liabilities & Equity NPV NPV + NPV Firm Value Capital Market Real Economy

16 Finance School of Management Example: PC1000 of Compusell Corp.

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18 Finance School of Management PC1000: Cash Flows  A seven-year coupon bond with an annual coupon payment of $1.3 million, a face value of $2.2 million, and a price of $5 million.

19 Finance School of Management Was 0%

20 Finance School of Management Was 15%

21 Finance School of Management Was 40%

22 Finance School of Management Was 0%

23 Finance School of Management Was 75%

24 Finance School of Management Was 3,100,000

25 Finance School of Management Table 6.4 Project Sensitivity to Sales Volume  3640 is the NPV break-even point. Sales UnitsNet CF OperationsNPV Project *

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27 Finance School of Management Sensitivity of Project to Sale Volume $500,000 $0 $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000 2,0002,5003,0003,5004,0004,5005,0005,5006,000 Sales (Units) Net CF from Operations

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29 Finance School of Management Cost of Capital  Risk-adjusted discount rate (k)  The risk of a particular project may be different from the risk of the firm’s existing assets.  The risk that is relevant in computing a project’s cost of capital is the risk of the project’s cash flows and not the risk of the financing instruments (e.g., stocks, bonds) the firm issues to finance the project.  The cost of capital should reflect only the market-related risk of the project (its beta).

30 Finance School of Management Illustration 1  25-year U.S. Treasury bonds paying $100 per year are selling in the market at $1,000.  A firm has the opportunity to buy $1 million worth of these bonds for $950 each.  The firm’s overall (average) cost of capital is 16%.  If discounted at 16%, the NPV of the opportunity is -$340,291.  However, no one will forgo the opportunity.  The correct cost of capital is nearly 10%.

31 Finance School of Management Illustration 2  Compusell Corporation is planning to finance the $5 million outlay required to undertake the PC1000 project by issuing bonds.  Compusell has a high credit rating because it has almost no debt outstanding and therefore can issue $5 million worth of bonds at an interest rate of 6% per year.  It would be a mistake to use 6% as the cost of capital in computing the NPV of the PC1000 project.

32 Finance School of Management Illustration 3  An all-equity financed firm with tree divisions: –An electronics division, 30% of the firm’s market value, cost of capital 22%; –A chemical division, 40% of the firm’s market value, cost of capital 17%; –A natural gas transmission division, 30% of the firm’s market value, cost of capital 14%. –The cost of capital for the firm is 0.3×22% + 0.4×17% + 0.3×14% = 17.6%.  If 17.6% is adopted as discount rate for all projects, then it is likely –to accept projects in the electronics division with negative NPV; –to pass up profitable natural gas transmission.

33 Finance School of Management Illustration 4  An all-equity financed steel company considering the acquisition of an integrated oil company that is 60% crude oil reserves and 40% refining. –The market capitalization rate on crude oil investments is 18.6% and on refining projects is 17.6%. –The market capitalization rate on the oil company shares is 18.2%. –The market capitalization rate for steel projects is 15.3%.  The market price of the oil company’s shares is “fair” ($100, expected return 18.2%).  An investment banker reports that all the shares could be acquired for a tender offer bid of $110 per share. –With 15.3%, the NPV of the acquisition is – /.153=$9. –With 18.2%, the NPV of the acquisition is – /.182=-$10.

34 Finance School of Management Example: Cost Reducing Project  A firm is considering an investment proposal to automate its production process to save on labor costs.  Invest $2 million now in equipment (an expected life of 5 years) and thereby save $700,000 per year in pretax labor costs.  The incremental cash flows due to the investment:  At the 10% discount rate, the NPV is $274,472.

35 Finance School of Management Project with Different Lives  Suppose that there are two different types of equipment with different economic lives in the previous example.  The longer-lived requires twice the initial outlay but lasts twice as long.  An easier approach is called annualized capital cost. The Shorter-lived equipment The Long-lived equipment

36 Finance School of Management Ranking Mutually Exclusive Projects  Sometimes two or more projects are mutually exclusive.  You own a parcel of land and have two alternatives: –Construct an office building; –Make a parking lot.

37 Finance School of Management Ranking Mutually Exclusive Projects  Rule: This firm should choose the project with the highest NPV at any cost of capital below 20%.

38 Finance School of Management Inflation and Capital Budgeting  Rule: There are two correct ways of computing NPV: –Use the nominal cost of capital to discount nominal cash flows. –Use the real cost of capital to discount real cash flows. –Never compare the IRR computed using real cash flow estimates to a nominal cost of capital.