Finance Test 2

IRR General Investment Rule

- Accept the project if the IRR is greater than the discount rate. Reject the project if the IRR is less than the discount rate. Also known as the "basic IRR rule." - NPV is positive for discount rates below the IRR and negative for discount rates above the IRR. If you accept projects when the discount rate is less than the IRR, you will be accepting positive NPV projects.

-NPV; +NPV

- Decreases value of the firm and increases the value of the firm by the NPV amount (value additivity) - Uses the correct discount rate

Discounted Payback Period Method

- First discount the cash flows. Then ask how long it takes for the discounted cash flows to equal the initial investment. - As long as the cash flows and discount rate are positive, the discounted payback period will never be smaller than the payback period because discounting reduces the value of the cash flows. - Like payback, discounted payback first requires us to choose an arbitrary cutoff period, and then it ignores all cash flows after that date. - A poor compromise between the payback method and NPV

Investments of Unequal Lives: The Equivalent Annual Cost Method

- NPV rule suggests taking the machine whose costs have the lower present value. This choice might be a mistake, however, because the lower-cost machine may need to be replaced before the other one. - Calculate the "equivalent annual cost" of each machine; this approach puts cost on a per-year basis. - Equate single payment at Date 0 with n#year annuity = "Equivalent Annual Cost"

Depreciation Tax Shield

- depreciation deduction multiplied by the tax rate - depreciation is a noncash expense - only cash flow effect of deducting depreciation is to reduce our taxes

Modified IRR (MIRR)

- handles the multiple IRR problem by combining cash flows until only one change in sign remains - by discounting and then combining cash flows until only one change in sign. - MIRR is a function of the discount rate

Internal Rate of Return (IRR)

- provides a single number summarizing the merits of a project that does not depend on the interest rate prevailing in the capital market (depends only on the cash flows of the project). - IRR is the rate that causes the NPV of the project to be zero.

Incremental Cash Flows

1. Cash Flows-Not Accounting Income: Always discount cash flows, not earnings, when performing a capital budgeting calculation. Earnings do not represent real money. - Only cash flows that are incremental to the project should be used. - These cash flows are the changes in the firm's cash flows that occur as a direct consequence of accepting the project. 2. Sunk Costs: A cost that has already occurred. Since they are in the past, they cannot be changed by the decision to accept or reject the project. (Not incremental cash flows) 3. Opportunity Costs: By taking the project, the firm forgoes other opportunities for using the assets. - An asset that is being considered for selling, leasing, or employing elsewhere. If the asset is used in a new project, potential revenues from alternative uses are lost. 4. Side Effects: Classified as erosion or synergy. - Erosion occurs when a new product reduces the sales and, hence, the cash flows of existing products. - Synergy occurs when a new project increases the cash flows of existing projects. 5. Allocated Costs: a cash outflow of a project only if it is an incremental cost of the project. - Frequently a particular expenditure benefits a number of projects. Accountants allocate this cost across the different projects when determining income.

Problems with IRR approach affecting both independent and mutually exclusive

1. Investing or financing? - Investing: a firm initially pays out money. Financing: a firm initially receives money, where the basic IRR rules is flipped. 2. Multiple rates of return - where a project's cash flows exhibit two changes of sign, the number of "flip-flops" equals the number of IRR's. Since there is no good reason to use one over the other, IRR simply cannot be used.

Problems with IRR only affecting mutually exclusive

1. The scale problem - IRR ignores the issue of scale. Although opportunity 1 has a greater IRR, the investment is much smaller. - Incremental IRR is the IRR on the incremental investment from choosing the large project instead of the small project. - To handle mutually exclusive - compare the NPVs of the two choices. - Calculate in the incremental NPV from making the large-budget picture instead of the small-budget picture. - Compare the incremental IRR to the discount rate. 2. The Timing Problem

Three Problems with Payback Method

1. Timing of Cash Flows within the Payback Period - it does not consider the timing of the cash flows within the payback period. 2. Payments after the Payback Period - it ignores all cash flows occurring after the payback period. Because of the short-term orientation of the payback method, some valuable long-term projects are likely to be rejected. 3. Arbitrary Standard for Payback Period - no comparable guide for choosing the payback cutoff date, so the choice is somewhat arbitrary.

A Test

1. True - You must know the discount rate to compute the NPV of a project, but you compute the IRR without referring to the discount rate. 2. False - Hense, the IRR rule is easier to apply than the NPV rule because you don't use the discount rate when applying IRR. The discount rate is needed for making a decision under either the NPV or IRR approach.

Three attributes of NPV

1. Uses cash flows 2. Uses all the cash flows of the project 3. Discounts the cash flows properly

Payback Period Method

A particular cutoff date, say two years, is selected. All investment projects that have payback periods of two years or less are accepted, and all of those that pay off in more than two years - if at all - are rejected.

Special Cases of Discounted Cash Flow Analysis

After tax OCF = EBIT+Deprec-Taxes ->Taxes = EBIT*Tax% Setting the Bid Price: - the winner is whoever submits the lowest bid - goal is to determine the lowest price we can profitably charge. 1. Look at capital spending and NWC investment 2. After tax salvage value 3. Determine OCF -> NPV=0=Period 0 CF +OCFxPVIA or ->OCF=Net Income + Deprec PVIA = [1-(1+r)^-2]/r pg. 192

Net Working Capital

An investment in NWC arises whenever (1) inventory is purchased, (2) cash is kept in the project as a buffer against unexpected expenditures, and (3) sales are made on credit, generating accounts receivable rather than cash.

Break-Even Analysis

Approach determines the sales needed to break even (a complement to sensitivity analysis because it also sheds light on the severity of incorrect forecasts). Calculate using accounting profit and PV. Break even occurs where Rev - Costs = 0 CALCULATING BREAK-EVEN POINT 1. Sales Price - Varibale Cost = Contribution Margin (each additional product contributes this amount to pretax profit) 2. Fixed Costs + Depreciation 3. Accounting Profit Break-Even Point = (2)/(1) PV 1. Equivalent Annual Cost (EAC) = Initial Investment / (# yr Annuity Factor @ r% = PVIA) 2. After tax costs = EAC + Fixed Costs*(1-tax)-Depr(tax) 3. PV Break-Even Point = (2)/(1) ***When we use accounting profit as the bases for the break-even calculation, we subtract depreciation, which understates the true costs of recovering the initial investment. ***Companies that accounting basis are really losing money. They are losing the opportunity cost of the initial investment.

Interest Expense

Assuming no debt financing is accurate. Firms typically calculate a project's cash flows under the assumption that the project is financed only with equity. We want to determine NPV of the project independent of financing decisions. Adjustments for debt financing are reflected in the discount rate, not the cash flows.

Sensitivity Analysis and Scenario Analysis

Examines how sensitive a particular NPV calculation is to changes in underlying assumptions. Also known as "what-if analysis" and "bop" (best, optimistic, and pessimistic). Revenue estimates depend on 3 assumptions: 1 . Market Share 2. Size of product market 3. Price per product # of Prod sold/year = Market share * Size of product market Annual sales revenue = # of products sold * price per prod. Costs include - Variable costs - change as the output changes, and they are zero when production is zero. Costs of direct labor and raw materials are usually variable cost. CONSTANT PER UNIT OF OUTPUT, implying that total variable costs are proportional to the level of production. - Fixed costs - not dependent on the amount of goods or services produced during the period. Fixed costs are usually measured as costs per unit of time, such as rent per month or salaries per year. Fixed over a predetermined time period. Variab cost/year = variab cost/unit * # of prod sold/year Total cost before tax/year = Variab cost/year * fixed cost/yr bop used for # of purposes: 1. Table can indicate whether NPV analysis should be trusted. 2. shows where more information is needed (an error in the estimate of investment appears to be relatively unimportant because even under the pessimistic scenario, the NPV is still highly positive). Drawbacks: 1. Unwittingly increase the false sense of security among managers. 2. Sensitivity analysis treats each variable in isolation when, in reality, the different variables are likely to be related. Scenario Analysis: Examines a number of different likely scenarios, where each scenario involves a confluence of factors.

Making Capital Investment Decisions

Networking Capital (NWC): the investment in working capital is to be completely recovered by the end of the project's life. Initial cash outflow = ending cash inflow - Decreases in working capital in the later years are viewed as cash inflows Investments: machine, opportunity cost, investment in working capital Income and Taxes: Need income incalculation to determine taxes pg. 175. Salvage Value: When selling an asset, one must pay taxes on the difference between the asset's sales price and its book value. Cash Flow: -> from operations = sales - operating costs - taxes -> from total investments -> Total = operations + total investments cash flows NPV

Independent Project

One whose acceptance or rejection is independent of the acceptance or rejection of other projects.

Interest Rates and Inflation

Real Interest Rate = (1+Nominal)/(1+inflation)-1 Real Interest Rate Approximation = Nominal - inflation Approximation becomes poor when rates are higher.

NPV Rule

Tells us to accept the project if the appropriate discount rate lies within a certain range and to reject if the discount rate lies outside the range.

Net Present Value (NPV)

The difference between the sum of the present values of the project's future cash flows and the initial cost of the project.

Mutually Exclusive Investments

Two projects A and B are mutually exclusive: You can accept A or you can accept B or you can reject both of them, but you cannot accept both of them.

More on Payback Method

Used when making relatively small decisions. Under the NPV method, a long time may pass before one decides whether a decision was correct. With the payback method we know in two years whether the manager's assessment of the cash flows was correct. As the decisions grow in importance, which is to say when firms look at bigger projects, NPV becomes the order of the day.

Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis

When a high NPV appears at the bottom, one's temptation is to say yes immediately. Nevertheless, the projected CF often goes unmet in practice, and the firm ends up with a money loser.