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Other Investment Criteria and discounted Cash Flow Analysis

This lecture discusses Net Present Value (NPV), other investment rules, calculating free cash flows, and provides specific examples for better understanding.

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Other Investment Criteria and discounted Cash Flow Analysis

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  1. Other Investment Criteria and discounted Cash Flow Analysis Capital Budgeting Decision Fin351: lecture 4

  2. Today’s agenda • Net Present Value (revisit) • Other two investment rules • Some points in calculating free cash flows • Free cash flows calculation • A specific example Fin351: lecture 4

  3. Net Present Value rule (NPV) • NPV is the present value of a project minus its cost • If NPV is greater than zero, the firm should go ahead to invest; otherwise forget about this project • A hidden assumption: there is no budget constraint or money constraint. Fin351: lecture 4

  4. NPV (continue) In other words: Managers can increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value if there is no budget constraint. Fin351: lecture 4

  5. A: Profit = - $50 + $60 = $10 $10 Added Value $50 Initial Investment Net Present Value Example Q: Suppose we can invest $50 today & receive $60 later today. What is the profit? Fin351: lecture 4

  6. Net Present Value Example Suppose we can invest $50 today and receive $60 in one year. What is our increase in value given a 10% expected return? This is the definition of NPV $4.55 Added Value $50 Initial Investment Fin351: lecture 4

  7. Net Present Value NPV = PV - required investment Fin351: lecture 4

  8. Net Present Value Terminology C = Cash Flow t = time period r = “opportunity cost of capital” or discount rate • The Cash Flow could be positive or negative at any time period. Fin351: lecture 4

  9. Net Present Value Example You have the opportunity to purchase an office building. You have a tenant lined up that will generate $16,000 per year in cash flows for three years. At the end of three years you anticipate selling the building for $450,000. How much would you be willing to pay for the building? Fin351: lecture 4

  10. Net Present Value $466,000 Example - continued $450,000 $16,000 $16,000 $16,000 0 1 2 3 Fin351: lecture 4

  11. Net Present Value $466,000 $450,000 Example - continued $16,000 $16,000 $16,000 0 1 2 3 Present Value 14,953 14,953 380,395 $409,323 Fin351: lecture 4

  12. Net Present Value Example - continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building? Fin351: lecture 4

  13. Net Present Value Example - continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building? Fin351: lecture 4

  14. Another example about NPV • An oil well, if explored, can now produce 100,000 barrels per year. The well will produce forever, but production will decline by 4% per year. Oil prices, however, will increase by 2% per year. The discount rate is 8%. Suppose that the price of oil now is $14 for barrel. • If the cost of oil exploration is $12.8 million, do you want to take this project? Fin351: lecture 4

  15. Solution • Visualize the cash flow patterns • C0=1.4, C1=1.37, C2=1.34, C3=1.31 • What is the pattern of the cash flow? • g=C1/C0 -1 =-0.0208=-2.1% • PV( the project) =C0+C1/(r-g)=15 • NPV=PV( the project ) -12.8>0 • What’s your decision? Fin351: lecture 4

  16. Two other investment rules • IRR rule • Payback period rule Fin351: lecture 4

  17. IRR rule Internal Rate of Return (IRR) - Discount rate at which NPV = 0. IRR rule - Invest in any project offering a IRR that is higher than the opportunity cost of capital or the discount rate. Fin351: lecture 4

  18. IRR rule Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment? Fin351: lecture 4

  19. Internal Rate of Return Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment? Fin351: lecture 4

  20. Internal Rate of Return Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment? IRR = 12.96% Fin351: lecture 4

  21. Internal Rate of Return IRR=12.96% Fin351: lecture 4

  22. What’s wrong with IRR? Pitfall 1 - Mutually Exclusive Projects • IRR sometimes ignores the magnitude of the project. • The following two projects illustrate that problem. Example You have two proposals to choose between. The initial proposal (H) has a cash flow that is different from the revised proposal (I). Using IRR, which do you prefer? Fin351: lecture 4

  23. Internal Rate of Return (1) Example You have two proposals to choose between. The initial proposal (H) has a cash flow that is different from the revised proposal (I). Using IRR, which do you prefer? Fin351: lecture 4

  24. Internal Rate of Return Fin351: lecture 4

  25. What’s wrong with IRR (2)? Pitfall 2 - Lending or Borrowing? Example project C0 C1 IRR (%) NPV at 10% +150 +50 +$36.4 -100 J K -150 +50 -$36.4 +100 Fin351: lecture 4

  26. What’s wrong with IRR (3)? Pitfall 3 - Multiple Rates of Return • Certain cash flows can generate NPV=0 at two different discount rates. • The following cash flow generates NPV=0 at both (-50%) and 15.2%. • Example • A project costs $1000 and produces a cash flow of $800 in year 1, a cash flow of $150 every year from year 2 to year 5, and a cash flow of -150 in year 6. Fin351: lecture 4

  27. Payback period rule • Payback period is the number of periods such that cash flows recover the initial investment of the project. • The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period. The following example will demonstrate the absurdity of this rule. Fin351: lecture 4

  28. Payback period rule The following example shows that all the three projects have a payback period of 2. If the payback period used by the firm is 2, the firm can take project C and lose money. Cash Flows Prj.C0C1C2C3Payback NPV@10% A -2000 +1000 +1000 +10000 2 7,429 B -2000 +1000 +1000 0 2 -264 C -2000 0 +2000 0 2 - 347 Fin351: lecture 4

  29. Some points to remember in calculating cash flows • Depreciation and accounting profit • Incremental cash flows • Change in working capital requirements • Sunk costs • Opportunity costs • Forget about financing Fin351: lecture 4

  30. Cash flows, accounting profit and depreciation • Discount actual cash flows • Using accounting income, rather than cash flows, could lead to wrong investment decisions • Don’t treat depreciation as real cash flows Fin351: lecture 4

  31. Example • A project costs $2,000 and is expected to last 2 years, producing cash income of $1,500 and $500 respectively. The cost of the project can be depreciated at $1,000 per year. Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income. Fin351: lecture 4

  32. Solution (using accounting profit) Fin351: lecture 4

  33. Solution (using cash flows) Fin351: lecture 4

  34. Forget about financing • When valuing a project, ignore how the project is financed. • You can assume that the firm is financed by issuing only stocks; or the firm has no debt but just equity Fin351: lecture 4

  35. Incremental Cash Flow cash flow with project cash flow without project - = Incremental cash flows • Incremental cash flows are the increased cash flows due to investment • Do not get confused about the average cost or total cost? • Do you have examples about incremental costs? Fin351: lecture 4

  36. Working capital • Working capital is the difference between a firm’s short-term assets and liabilities. • The principal short-term assets are cash, accounts receivable, and inventories of raw materials and finished goods. • The principal short-term liabilities are accounts payable. • The change in working capital represents real cash flows and must be considered in the cash flow calculation Fin351: lecture 4

  37. Example • We know that inventory is working capital. Suppose that inventory at year 1 is $10 m, and inventory at year 2 is $15. What is the change in working capital? Why does this change represent real cash flows? Fin351: lecture 4

  38. Sunk costs • The sunk cost is past cost and has nothing to do with your investment decision • Is your education cost so far at SFSU is sunk cost? Fin351: lecture 4

  39. Opportunity cost • The cost of a resource may be relevant to the investment decision even when no cash changes hands. • Give me an example about the opportunity cost of studying at SFSU? Fin351: lecture 4

  40. Inflation rule • Be consistent in how you handle inflation!! • Use nominal interest rates to discount nominal cash flows. • Use real interest rates to discount real cash flows. • You will get the same results, whether you use nominal or real figures Fin351: lecture 4

  41. Example 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 discount rates are 10% what is the present value cost of the lease? Fin351: lecture 4

  42. Inflation Example - nominal figures Fin351: lecture 4

  43. Inflation Example - real figures Fin351: lecture 4

  44. How to calculate free cash flows? • Free cash flows = cash flows from operations + cash flows from the change in working capital + cash flows from capital investment and disposal • We can have three methods to calculate cash flows from operations, but they are the exactly same, although they have different forms. Fin351: lecture 4

  45. How to calculate cash flows from operations? • Method 1 • Cash flows from operations =revenue –cost (cash expenses) – tax payment • Method 2 • Cash flows from operations = accounting profit + depreciation • Method 3 • Cash flows from operations =(revenue –cost)*(1-tax rate) + depreciation *tax rate Fin351: lecture 4

  46. Example • revenue 1,000 • Cost 600 • Depreciation 200 • Profit before tax 200 • Tax at 35% 70 • Net income 130 Given information above, please use three methods to calculate Cash flows Fin351: lecture 4

  47. Solution: • Method 1 • Cash flows=1000-600-70=330 • Method 2 • Cash flows =130+200=330 • Method 3 • Cash flows =(1000-600)*(1-0.35)+200*0.35 =330 Fin351: lecture 4

  48. A summary example ( Blooper) • Now we can apply what we have learned about how to calculate cash flows to the Blooper example, whose information is given in the following slide. Fin351: lecture 4

  49. Blooper Industries (,000s) Fin351: lecture 4

  50. Cash flows from operations for the first year or $3,950,000 Fin351: lecture 4

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