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Long-Term Investment Analysis Chapter 11

Long-Term Investment Analysis Chapter 11. Budgeting is a form of planning Operational Budgeting -- revenues & expenses Capital Budgeting – is the planning and evaluation capital expenditures (which are assets that last more than a year)

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Long-Term Investment Analysis Chapter 11

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  1. Long-Term Investment AnalysisChapter 11 Budgeting is a form of planning Operational Budgeting -- revenues & expenses Capital Budgeting– is the planning and evaluation capital expenditures (which are assets that last more than a year) even more significant, since capital projects will impact the firm for many years to come Problem of Limits: Every manager wants more equipment, more supplies, more buildings, more employees The issue is to accept good projects, and forego others 2005 South-Western Publishing

  2. What Went Right and Wrong With Nokia? • Nokia (a Finnish company) makes cell phones • The cell phone market took off in the 1990s • Nokia surpassed Motorola in worldwide market share • Then in 2001, Nokia’s share price tumbled as the packet-switching technology (3G) using the Internet, disrupted Nokia’s dominance • The future of Internet 3G cell phones may be great, but is uncertain. How much should Nokia invest?

  3. The Capital Budgeting Process • Generate alternative capital investment project proposals • Often each department head offers several proposals • Estimate cast flows for each project proposal • Be sure to include all the costs and revenue impacts • Evaluate and choose from these alternatives the projects to implement • NPV, IRR, payback methods discussed later • Review the investment projects after they have been implemented. • The hope is that we learn from our past mistakes

  4. Estimating Cash Flows • Estimate initial costs, called NINV or the net investment of the project • Information comes from actual bids, “request for proposals” (RFPs), estimates, and some guesses • Then also estimate net cash flows (NCFs) for the future depends of life of asset • Spreadsheet programs of Excel or Lotus are helpful NCF = ( R - C - D)·( 1 - t ) + D [18.5] • whereDR is change in revenues, t is the tax rates,DC is change in costs, andDD is change in depreciation

  5. Evaluating and Choosing the Investment Projects 1. Internal Rates of Return (IRR) • Using your estimates of NINV and NCFs, find r that solves equation [18.6] S (NCFt / (1 + r)t ) = NINV • This r is the IRR, or the rate of return of the project • If r > k, the firm’s required cost of capital, then you should do that project • For example, if the project earns an IRR of 20%, but the firm’s borrowing cost is 8%, then it is a profitable project.

  6. Evaluating and Choosing 2. Net Present Value (NPV) • More often, firms use their estimates of NINV and NCFs to solve equation [18.7] NPV = St=1 (NCFt / (1 + k)t ) - NINV • NPV has two parts. It is the present value of future net cash flows discounted at k, the firm’s required cost of capital. Subtract from that its initial cost (NINV) to find the NPV • All projects with NPV > 0 increase the value of the firm and should be undertaken!

  7. Table 18.1 IRR versus NPV: Mutually Exclusive Projects Tennessee Missouri Project Project NINV $1,000 $1,000 NCF’s yr 1 667 0 yr 2 667 1,400 NPV(5%) $240 $270 IRR 21.5% 18.3% Even though the IRR of the Tennessee project is higher, Pick Missouri for its better NPV. • Suppose that you are going to expand production in Tennessee or in Missouri, but not in both places. These are mutually exclusive choices • It may be that both have IRRs higher than the required return (say 5%) and that both have NPVs above zero. • The ranking of the two projects may conflict. • Pick the project with the higher NPV.

  8. Reviewing and ImplementingProjects after Implementation • Often a neglected step, but reviewing helps to reveal where mistakes were made in the past • Forecasts are rarely perfect, but large mistakes may occur in: • Over estimating the impact on revenue • Under estimating the impact on costs • Forgetting to include spillover impacts on other projects within the firm • Errors in estimating the firm’s cost of capital

  9. Estimating the Firm’s Cost of Capital • Cost of Debt Capitalis after-tax interest cost of debt at the marginal firm tax rate ki = kd ( 1 - t ) [18.9] • Small firms typically borrow from a bank, and they know the interest rate, kd, which is interest rate on debt • Larger firms can sell bonds or corporate paper. When they sell new bonds close to par value, they know what interest rate they are paying. • If kd = 9%, and t = .40 tax rate, ki = 5.4%

  10. Estimating the Firm’s Cost of Capital • Cost of Equity Capitalis the cost if raised internally through retained earnings or borrowed externally from new issues of stock. • From the dividend discount model, assuming a constant-growth in dividends at rate g, ke = D1/P + gdiv. yield + growth rate [18.13] 2.Or using the capital asset pricing model (CAPM) ke = rf + ( km - rf )[18.14] where rfis the risk free rate, is a regression coefficient found between the monthly returns of the stock and the market, and kmis the return on the market. 3. Or the cost of external capital ke’ = D1/Vnet + gwhere Vnet is net of the floatation costs of new stock

  11. Estimating the Firm’s Cost of Capital • Weighted Cost of Capital ka = (equity fraction)•ke + (debt fraction)•kd • Let D be the amount of debt and E be the amount of equity ka = [E/(D+E)]•ke+ [D/(D+E)]•kd[18.16] • If we know the debt-equity structure and the cost of equity and of debt capital, we can calculate the weighted cost of capital • Example: 75% of financing is equity and the rest is with debt, and the cost of equity capital is 12%, the interest rate on debt before taxes is 8%, with a 40% marginal tax rate. Find ka: • ka = .75•.12 + .25•.08(1-.40) = 10.2%

  12. Cost-Benefit Analysis • Many organizations don’t have a clear-cut cost of financing, such as public and not-for-profit (NFP) organizations. • For personal decisions and NFP, often cost-benefit analysis is a useful tool. • Like listing the pros and cons to any decision, it is best to list all the positive and negative inflows and outflows from a decision. • For projects that last several years, the discount rate is said to be the social discount rate. • Benefit-Cost Ratio = (Present Value of Benefits)/Cost • If the Benefit-Cost Ratio > 1, then the project should be undertaken

  13. Steps in Cost-Benefit Analysis • Determine the objective to be maximized • Some projects involve health, others retention in school, others economic growth. The objective matters. • Consider the constraints on the decision • What costs and what benefits should be included in the analysis • Select a criterion to determine whether the project should be accepted or rejected • Select an appropriate discount rate • A low social discount rate will tend to make projects, such as Head-Start for preschoolers more likely to be accepted, since the payoff is many years down the road

  14. Objectives and Welfare Economics • Pareto Optimality - all projects that help someone without hurting anyone should be accepted • But almost all projects require some money from someone, so it is hard to find many projects that would meet the Pareto Criterion • Kaldor-Hicks Criterion – weaker notion that project that help some so much that they could potentially compensate the losers into agreeing should be accepted • A family with limited money has two kids. The academically gifted one is sent to college. The added income earned by the one kid could potentially compensate the kid who didn’t go to college. This would meet the Kaldor-Hicks Criterion as a good family decision.

  15. Constraints on Cost-Benefit Analysis • Physical constraints. Limited by the state of technology. • Legal constraints. Laws on property rights. • Administrative constraints. Hire qualified administrators. • Distributional constraints. Must not harm. • Political constraints. What is possible vs best. • Financial or budget constraints. • Social and religious constraints. Cultural and religious considerations.

  16. The Appropriate Rate of Discount • The social rate of discount is used for capital projects. • Proponents of projects WANT to use a low rate • Opponents of projects WANT to use a high rate • The economist William Baumol notes that projects in the public sector draw money away from the private sector • If 10% is earned in the private sector, then that would be a good social rate to use • Alternatively, if a public project has an IRR of 25%, it is very likely that the project should be undertaken, since it is very hard to earn 25% in the private sector

  17. Cost Effectiveness Analysis Cost-effectiveness analysisasks what are the costs of alternative means for reaching a goal? • We know we must fight crime, but what is the cheapest way to do it? • Constant-cost studies specify the output for a given cost from alternative programs. • Least-cost studies alternative programs to achieve a given goal are examined in terms of cost. • Objective-level studies estimate the cost of achieving several performance levels of the same objective.

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