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FINE 3010-01 Financial Management

FINE 3010-01 Financial Management. Instructor: Rogério Mazali Lecture 10: 10/24/2011. FINE 3010-01 Instructor: Rogério Mazali. Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin. Chapter 8:

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FINE 3010-01 Financial Management

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  1. FINE 3010-01Financial Management Instructor: RogérioMazali Lecture 10: 10/24/2011

  2. FINE 3010-01Instructor: RogérioMazali Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin Chapter 8: Net Present Value and Other Investment Criteria

  3. Introduction • Definition: A set of comprehensive principles and rules used to value real investments • Questions we will address: • Should we take this project? • Which project should we choose?

  4. Agenda • Net Present Value • A Comment on risk and Present Value • Valuing Long-Lived Securities • Using the NPV Rule to Choose • Payback • Internal Rate of Return • A Closer Look at the Rate of Return • Calculating the Rate of Return of Long-Lived Projects • A Word of Caution • Some Pitfalls with the Internal Rate of Return

  5. NPV Method Definition: The NPV of a project is the PV of all the future inflows of the project minus the cost of implementing the project Data requirements: • Cash flows of the project (both present and future) • Discount rate (the opportunity cost of capital) NPV Rule: If NPV > 0 => Accept the project If NPV < 0 => Reject the project Opportunity Cost of Capital - Expected rate of return given up by investing in the project

  6. 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 our increase in value?

  7. $4.55 Added Value $50 Initial Investment 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?

  8. Net Present Value • Chapter 5: discounted cash flows and PVs • Example: Construction of an office Block • Land costs $50,000.00 • Construction costs: $300,000 • After 1 year, you expect to sell it for $400,000

  9. Net Present Value Step 1: Forecast cash flows Cost of building = C0 = 350,000 Sale price in Year 1 = C1 = 400,000 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 7%, then Cost of capital = r = 7%

  10. Net Present Value Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment • NPV rule: take the project whenever NPV > 0.

  11. Valuing Long-Lived Projects • The NPV rule works for projects of any length Terminology C = Cash Flow T = number of periods project will last r = “opportunity cost of capital” • The Cash Flow could be positive or negative at any time period.

  12. Valuing Long-Lived Projects 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? Assume a 7% opportunity cost of capital

  13. Valuing Long-Lived Projects • 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? • NPV = $409,300 – $350,000 = $59,300

  14. Using Financial Calculators to Find NPV

  15. NPV Method - Example Cash Inflows 30,000 20,000 10,000 0 1 2 3 Equally risky investments in the capital market offer a return of 10% Cash Outflows: -50,000

  16. Risk and Present Value • Higher risk projects require a higher rate of return • Higher required rates of return cause lower PVs

  17. Using the NPV rule to choose between projects • So far, take-it-or-leave-it decisions. • Most real world decisions are either-or. • Example 1: 7-story building vs. 10-story building • Example 2: Oil heating vs. natural gas heating • Example 3: build it today or wait a year to start construction • These choices are said to be mutually exclusive.

  18. NPV Method - Properties • PVs are all measured in today’s dollars, you can sum them up! • Value additivity: The NPV of a sum of projects is equal to the sum of the values of the individual projects NPV (A+B) = NPV (A) + NPV (B) • The best of a set of projects is the one with the highest NPV

  19. Using the NPV rule to choose between projects • Example 8.3: Choosing Between Two Projects • It has been several years since your office last upgraded its office networking software. Two competing systems have been proposed. Both have an expected useful life of 3 years, at which point it will be time for another upgrade. One proposal is for an expensive, cutting-edge system, which will cost $800,000 and increase firm cash flows by $350,000 a year through increased productivity. The other proposal is for a cheaper, somewhat slower system, that will cost only $700,000 but would increase cash flows by only $300,000 a year. If the cost of capital is 7%, which is the better option?

  20. NPV Method - Summary Net Present Value Rule Managers 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. • NPV rules recognizes a dollar today worth more than a dollar tomorrow • It uses all the forecast cash flows of the project • It discounts the cash flows of the project with its discount rate

  21. Other Investment Criteria: Payback Payback Period- Time until 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 statement.

  22. + 7,249 • 264 • 347 Other Investment Criteria: Payback Example The three project below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact our decision. Cash Flows Project C0 C1 C2 C3 Payback NPV@10% A -2,000 +1,000 +1,000 +10,000 B -2,000 +1,000 +1,000 0 C -2,000 0 +2,000 0 2 2 2

  23. Internal Rate of Return Definition: It is the discount rate, r IRR , that equates NPV to zero. Data requirements: • Cash flows of the project (both present and future) • Hurdle rate IRR Rule: If IRR > Hurdle rate => Accept the project If IRR < Hurdle rate => Reject the project

  24. Other Investment Criteria: 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%

  25. Using Financial Calculators to Find IRR

  26. NPV/IRR Graph: Building Example

  27. Internal Rate of Return - Example Cash Inflows 30,000 20,000 10,000 0 1 2 3 Solution: IRR = 11.787% Cash Outflows: -50,000

  28. Internal Rate of Return – Example The NPV is decreasing in the discount rate IRR = 0.11787

  29. Pitfalls with the IRR • Pitfall 1: Lending or Borrowing • Consider the following two projects:

  30. Pitfalls with the IRR

  31. Pitfalls with the IRR • Pitfall 2: Multiple Rates of Return: • Example: King Coal Corp. is considering a project to strip-mine coal. The project requires an investment of $22 million and is expected to produce a cash inflow of $15 million in each of years 1 through 4. However, the company is obliged in year 5 to reclaim the land at a cost of $40 million. At a 10% OCC, the project has an NPV of $0.7 million > $0.00. • There are 2 IRRs for this project:

  32. Pitfalls with the IRR

  33. Pitfalls with the IRR • Solution to this problem: Modified IRR (MIRR) • MIRR: combine cash flows so that there is only ONE flip in sign of CFs.

  34. Pitfalls with the IRR

  35. Pitfalls with the IRR • Pitfall 3: Mutually Exclusive Projects • Back to our office Block Examples: • Initial Proposal: Build Office Block for $350K, sell 1 year later for $400K • Revised Proposal: Build Office Block for $350K, rent it for 3 years for $16K, and then sell it for $450K

  36. Pitfalls with the IRR

  37. Examples of Mutually Exclusive Projects • IRR can be misleading • NPV, “in principle”, can always be used, as long as at least one project has a NPV > 0. • In some cases, though, using NPV to compare mutually exclusive projects can be tricky: • The investment timing decision • The choice between long-and short-lived equipment • The replacement decision

  38. Investment Timing • Return to Example 8.1 (Obsolete Technologies): New computer system • Costs $50K, lasts 4 years, generates $22K a year • NPV, at 10%, is close to $20K, but fin. Manager is not convinced, and reasons that: • Computer prices are continuously falling • NPV will be higher next year • Proposes postponing the purchase for 1 year • FM has been making the same argument for 10 years.

  39. Investment Timing

  40. Long- vs. Short-Lived Equipment • Choice between two machines, F and G: • Machine F: • price is $15K • lasts for 3 years • costs $4K/year to run. • Machine G: • price is $10K • lasts for 2 years • costs $6K/year to run. • Opportunity Cost of Capital: 6%

  41. Long- vs. Short-Lived Equipment • NPV (G) > NPV(F) => choose G, right? • A: Not so fast. Problem: machines have different useful lives. You would replace G in year 3 and have this extra cost of more constant replacements. • How to go around this problem? • A: calculate annual costs, using the Equivalent Annual Annuity

  42. Long vs. Short-Lived Equipment • Equivalent Annual Annuity: Annuity, i.e., stream of constant CFs that generates the same PV as the original stream of CFs.

  43. Long vs. Short-Lived Equipment

  44. Replacing an Old Machine • Comparison above assumes lives of machines are fixed • In practice, replacement is an economic decision • Managers decide when to replace machinery • Common problem: old machine replacement • Old machine: lasts 2 years, costs $12K/year to operate • New machine: lasts 5 years, costs $8K/year to operate, price is $25K • Should you replace your old machine? • A: No. New machine costs $13.93K/year overall, old machine costs $12K a year.

  45. Capital Rationing • Soft Rationing: limits imposed by top management to middle management to give incentives to middle managers to choose their best ideas; • Hard Rationing: limits imposed by investors. Firm cannot obtain financing beyond a certain limit. • Whatever case, firm would be forced to pass up positive NPV projects, and choose the best ones.

  46. Capital Rationing • Example: suppose OCC = 10%, firm resources are $20 million • If no rationing, take all projects. • Q: Which projects to choose?

  47. Capital Rationing • You would like to pick projects that give highest PV per dollar invested • You would pick projects with the highest profitability index (PI).

  48. Capital Rationing • In our example: • Pick projects J, L, M, N, leave project K • Pitfall: sometimes people use PI to choose between investments in any situation. This only makes sense in the context of Capital Rationing

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