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Part II Capital Investment Choice Chapter 5 Measuring Investment Value:

Part II Capital Investment Choice Chapter 5 Measuring Investment Value: You Can Trust NPV. Definition and Illustration of NPV An investment’s net present value is the sum of the present values of its expected benefits,

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Part II Capital Investment Choice Chapter 5 Measuring Investment Value:

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  1. Part II Capital Investment Choice Chapter 5 Measuring Investment Value: You Can Trust NPV ALSALEH- Fin 421: Chapter 5

  2. Definition and Illustration of NPV An investment’s net present value is the sum of the present values of its expected benefits, minus the present value of cash Outlays. NPV = CF1 CF2 CFn 1 + (5-1) + (1+k)1 (1+k)2 (1+k)n The arbitrage pricing principal requires that the value of an investment is the sum of the present value of all future cash flows. ALSALEH- Fin 421: Chapter 5

  3. NPV Example: Y0 Y1 Y2 ($1500) $1,000 $1,000 At k =10 percent NPV = ($1,000 x PVIFA12yr,10%) - $1,500 = $1,735.50 - $1,500 = $235.50 ALSALEH- Fin 421: Chapter 5

  4. Complex Cash Flows • Cash flows are typically not even over the life of a capital investment, and there may be outlays in more than one period. • There is no requirement that all future cash flows are positive Table 5-1- page141 10% $-1,000 1,000 -2,000 3,000 ALSALEH- Fin 421: Chapter 5

  5. Perpetuities The NPV of a perpetuity with a constant cash flow is: NPV = CF1 /(k - g) - I0 (5-2) Example:$5.1 billion is paid for perpetual cash flows of $700 million at the end of each year. What is investment’s NPV at 15 percent required Return. NPV = $700/(.15 – 0) - $5,100 = -$433m NPV@ g=4%= $700/(.15-.04) -$5,100 = $1,264m ALSALEH- Fin 421: Chapter 5

  6. Forms of Computing NPV • PV value of cash benefits, minus the present value of cash costs other than financing costs, discounted at average cost of debt and equity funds • PV of cash flows to stockholders, discounted at the stockholders’ opportunity cost. • PV of economic profits, discounted at the stockholders’ opportunity cost ALSALEH- Fin 421: Chapter 5

  7. Net Present Value and Wealth Creation Perfect Financial Markets • All-Equity Financing • Cash flow from an investment is available to distribute to the stockholders or reinvest on their behalf. • The value of an investment opportunity is the same whether the equity portion of its funding came from retention of earnings or the sale of new stock. ALSALEH- Fin 421: Chapter 5

  8. Example- Table 5-2. Berner Corporation Page 144 Year 0 1 2 CF (1,500.00) 1,200.00 800.00 PV@12% (1,500.00) 1,071.43 637.75 Total PV 1,709.18 NPV = 209.18 ALSALEH- Fin 421: Chapter 5

  9. b. Debt-Equity Mix and NPV • NPV measures wealth creation for shareholders when debt is included in the financing and maintained at a constant percentage of present value of future cash Flows. • When investment is financed with a combination of debt and equity, the average opportunity cost is referred to as the weighted average cost of capital (WACC). ALSALEH- Fin 421: Chapter 5

  10. WACC = Wd Kd + (1-Wd)Ke (5-3) Wd = 50% of value of investment, Kd , Interest creditors expect to earn on assets of similar risk, Ke= return required by stockholders If Kd = 10%, Ke = 14%, (taxes=0) then WACC= 0.5 x 0.10 + (1- 0.5) x 0.14 = 12% ALSALEH- Fin 421: Chapter 5

  11. Table 5-3 YEAR0 1 2 CF from investment (1,500.00) 1,200.00 800.00 PV of remaining CF(12%) 1,709.18 714.29 0.00 Debt (50% of PV of rem. CF) 854.59 357.14 0.00 Borrow (repay) 854.59 (497.45) (357.14) CF from investment (1,500.00) 1,200.00 800.00 Interest expense 85.46 35.71 Borrow (repay) 854.59 (497.45) (357.14) CF to (from) equity (645.41) 617.09 407.15 PV (14%) (645.41) 541/30 313.29 PV 845.59 NPV 209.18 ALSALEH- Fin 421: Chapter 5

  12. Market Imperfection • Income Taxes, NPV, and Wealth Creation With or without taxes, and with or without debt, the net present value is the amount by which an investment increases the wealth of the shareholders. Tax consideration • Cost of capital asset is expensed over the useful life of the asset (depreciation). • Interest on debt is tax deductible ALSALEH- Fin 421: Chapter 5

  13. Example- Berner Corporation- Page 146-147 • Purchase price of the asset = $1,500 • The asset has a useful life of 2 years • First years depreciation = $900 • Second year depreciation = $600 Tax rate = 40 percent Year 1 tax : ($1,200 -$900) x 0.4 = $120 Year 2 tax: ($800 -$600) x 0.4 = $80 ALSALEH- Fin 421: Chapter 5

  14. Table 5-4 0 1 2 CF from investment (1,500.00) 1,200.00 800.00 -Tax 120.0080.00 After tax flow from investment Without interest expense (1,500.00) 1,080.00 720.00 PV of rem.CF at WACC of 10% 1,576.86 654.55 0.00 Debt (50% of PV of rem. CF) 788.43 327.28 0.00 Borrow (repay) 788.43 (461.15) (327.28) After tax CF from investment (1,500.00) 1,080.00 720.00 Interest expense ( 78.84) ( 32.73) Interest savings 31.54 13.09 Borrow (repay) 788.43 (461.15) (327.28) CF to (from) equity (711.57) 571.55 373.08 PV (14%) (711.57) 501.36 287.07 PV 788.43 NPV 76.86 ALSALEH- Fin 421: Chapter 5

  15. Tax deductibility of interest Interest before tax , Kd= 10%, K=14%e Tax rate = 40 % Cost of debt after tax = 10%( 1-Tax rate) = 10%(1-0.4) = 10% (0.6) = 6% Savings = 4% =10%x 0.4 Tax savings = (cost before tax) x Tax rate WACC = .06x 0.5 + .14 x.50 = 10% ALSALEH- Fin 421: Chapter 5

  16. Net present value of the investment (NPV) can be calculated by: • discounting future cash flows from investment at the cost of capital Minus 2. the cost of the investment NPV = $1,080/(1.101) + $720/(1.102) - $1,500 = $76.86 ALSALEH- Fin 421: Chapter 5

  17. Wealth gain to the stockholders, based on an analysis of the cash flows to and from the stockholders, considering the stockholders’ opportunity cost. NPV after tax cash flows from investment, after considering the impact of financing choice, discounted at the weighted average cost of capital ALSALEH- Fin 421: Chapter 5

  18. Three Methods of Computing NPV • PV value of cash benefits, minus the present value of cash costs discounted at average cost of capital (Page 148). • PV of cash flows to stockholders, discounted at the stockholders’ opportunity cost ( Figure 5-4, page 147) • PV of economic profits, discounted at the stockholders’ opportunity cost (Figure 5-5- page 149) ALSALEH- Fin 421: Chapter 5

  19. Uninformed Investors and NPV Represent a serious problem • The market value of the stock may be different from its intrinsic value • Lead to the rejection of attractive investments However • Investor’s mistaken view is temporary • Investors become informed over time as cash flows come in ALSALEH- Fin 421: Chapter 5

  20. The impact of a new investment on Intrinsic Value if the stockholders are misinformed: Given NPVi = the intrinsic value of a Proposed capital investment NPVi = IEn ( So / Sn) – IEo ---------------- 5-7 ALSALEH- Fin 421: Chapter 5

  21. NPVi = intrinsic net present value of a proposed capital investment IEn = intrinsic value of the equity with the proposed capital investment IEo = intrinsic value of the equity without the proposed capital investment Sn = number of shares of stock if the new investment is made So = number of shares of stock outstanding ALSALEH- Fin 421: Chapter 5

  22. Example: Albers Corporation • The Corp. generates cash flow of $1million a year • The company has 100,000 shares of stock Outstanding. • Cash flow per share is $10 • The company’s cost of capital is 10 percent • Stockholders are misinformed and expect cash flow of only $8 a share ALSALEH- Fin 421: Chapter 5

  23. Per shareT. Equity Intrinsic $10/0.10=$100 $100x100,000 =$10,000,000 value Actual $ 8/0.10= $ 80 $ 80x100,000 = $80,000,000 Price • The company has an attractive investment opportunity that requires $2 million of additional equity • PV of the cash inflows from investment is $2.4 • $2 million of needed equity will be obtained by selling new shares = $2,000,000/ $8 = 25,000 shares • Sn = 100,000 + 25,000 = 125,000 shares NPVi = $12,400,000 (100,000/125,000) -$10,000,000 = ($80,000) ALSALEH- Fin 421: Chapter 5

  24. The best solution to the problem of misinformed investors: • Make extra efforts to make good estimates of future benefits. • Communicate honestly with the investors to keep them well informed about their company and its future investment opportunities. ALSALEH- Fin 421: Chapter 5

  25. NPV = (1,080 –D1 - 0.10 X 1500)/1.10 + [720 – (1,500 –D1 ) - 0.10 (1,500 –D1)]/(1.10)2 Rearranging terms NPV = (1,080 - 0.10 X 1500)/1.10 + (720 -1,500 - 0.10 X 1,500)/(1.10 )2 - D1 /1.10 +1.10 D1 /(1.10)2 NPV = (720 -1,500 - 0.10 X 1,500)/(1.10 )2 ALSALEH- Fin 421: Chapter 5

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