Foundations of Business Finance Section 5

Companies can take three major steps to reduce the potential loss from expropriation:

(1) Finance the subsidiary with local capital. (2) Structure operations such that the subsidiary has value only as a part of the integrated corporate system. (3) Obtain insurance against economic losses from expropriation from a source such as the Overseas Private Investment Corporation (OPIC). If the third step is taken, insurance premiums would have to be added to the project's cost.

The three most popular methods used by businesses to evaluate capital budgeting projects are

(1) net present value, (2) internal rate of return and (3) payback period

A long packsack means

(1) that the investment dollars will be locked up for many years, hence the project is relatively illiquid, and (2) that the project's cash flows must be forecast far out into the future, hence the project is probably quite risky.

Capital budgeting involves the same steps used in general asset valuation. These steps can be summarized as follows:

1. Determine the relevant components of the initial investment outlay for the asset or project. 2. Estimate the future cash flows expected to be generated by the asset or project. 3. Evaluate the riskiness of the projected cash flows to determine the appropriate rate of return to use for computing the present value of the estimated cash flows. 4. Compute the discounted present value of the expected cash flows using the firm's cost of capital as the discount rate. 5. Compare the discounted present value of the expected future cash flows with the initial investment, or cost, that is required to acquire the asset. Alternatively, the expected rate of return on the project can be calculated and compared with the firm's required rate of return.

Tow cardinal rules can help financial analysts avoid making mistakes:

1. capital budgeting decisions must be based on after tax cash flows and not accepting income 2. only incremental cash flows are relevant to the analysis to accept or reject a project

We can classify a project's incremental cash flows into one of three categories:

1. cash flows that occur only at the start of the project's life 2. Cash flows that continue through the project's life 3. Cash flows that occur only at the end, or the extermination, of the project

To reinvest at the internal rate of return associated with a capital project, the firm must be able to reinvest the project's cash flows in another project with an identical Internal rate of return.

Such projects generally do not continue to exist or it is not feasible to reinvest in such projects because competition in the investment markets drives their prices up and their internal rates of returns down.

How useful is it to generate cash flows earlier rather than later?

The value of early cash flows depends on the rate at which we can reinvest these cash flows. The NPV method implicitly assumes that the rate at which cash flows can be reinvested is the required rate of return, r, whereas the IRR method implies that the firm has the opportunity to reinvest at the project's IRR.

Corporate risk is measured by

a project's effect not he firm's earnings variability while it is being held with all of the other projects and assets of the firm

Scenario Analysis

a risk analysis technique that helps decision makers get an idea of the range of possible outcomes when a project is purchased. In a scenario analysis, the financial analyst asks operating managers to pick a bad set of circumstances and a good set. The NPVs under the bad and good conditions are then calculated and compared to the expected or able case, NPB

The Net present value shows

by how much a firm's value and thus stockholders' wealth, will increase if a capital budgeting project is purchased.

The modified internal rate of return has significant advantage over the traditional internal rate of return measure. MIRR assumes that

cash flows are reinvested at the required rate of return, whereas the traditional IRR measure assumes that cash flows are reinvented at the project's own IRR. Because reinvestment at the required rate of return generally is more correct, the MIRR is a better indicator of a project's true profitability. MIRR also solves the multiple IRR problem.

a project has a conventional cash flow pattern if it has

cash outflows in one or more consecutive periods at the beginning of its life followed by a series of cash inflows during its life

Incremental operating =

change in cash revenues - change in cash expenses - change in taxes

The difference between the required increase in current assets and the increase in current liabilities is the

change in net working capital. If this change is positive then additional financing over and above the cost of the project is needed to fund the increase

We include the change in depreciation expense when

computing incremental operating cash flows because when depreciation changes, both taxable income and hence the amount of income taxes paid change and the amount of taxes paid is a cash flow

We can determine the acceptability of a capital budgeting project by

computing its value and comparing the result to the purchase price.

The value of an asset can be determined by

computing the discounted present value of the cash flows it is expected to generate during its life.

Replacement decisions involve

deterring whether capital projects should be purchased to take the place of existing assets that might be worn out, damaged, or obsolete. Replacement projects are necessary to maintain or improve profitable operating using existing of production levels.

The major problem with evaluating beta risk is that it is

difficult to measure betas for capital budgeting projects

Internal rate of return is defined as the

discount rate at which a project's net present value equals $0

A higher risk could arise from two primary sources:

exchange rate risk and poetical risk. A lower risk might result from international diversification

Identifying the incremental cash flows is more complicated with a replacement project than with an

expansion project because the cash flows from both the new asset and old asset must be considered

We can use the results of the scenario analysis to determine the

expected NPV, the standard deviation of NPV and the coefficient of variation.

Shipping and Installation Costs

fo project components are important to include in the project cost because they require cash payments.

PV of cash outflows =

future value of cash inflows / (1 + modified internal rate of return)^n

When a project's discounted payback is less than its life, the present value of the future cash flows the project is expected to

generate exceeds the initial cost of the asset, that is NPV > 0, and the project will create value for the firm and its shareholders

Risk adjusted discount rate approach

he required rate of return used to evaluate a project is adjusted if its risk differs substantially from the firm's average risk.

That is, average-risk projects would require an "average" rate of return (the firm's WACC); above-average-risk projects would require a

higher-than-average rate; and below-average-risk projects would require a lower-than-average rate.

Another important caveat covering internal rate of return is that it

implies a constant reinvestment rate for the cash flows of the project. The IRR for a project will be its average annual rate of return over its life only if all of its cash flows can be reinvested in other projects that on average have the same IRRs. If a project has a particularly high IRR, it will be difficult to find other projects with high IRRs to fulfill this reinvestment rate assumption. If a project has a particularly low IRR, it will be easy to find other projects with higher IRRs for the reinvestment of cash flows

If a firm invests in a project with a present value greater than its cost, the value of the firm will

increase. A very direct link therefore exists between capital budgeting and stock values; the most effective the firm's capital budget procedures, the higher the price of its stock

The initial investment outlay refers to the

incremental cash flows that occur only at the start of a project's life. IT includes such cash flows as the purchase price of the new project and shipping and installation costs.

Some capital budgeting decisions involve

independent projects, whereas others involve mutually exclusive projects.

It is easy to avoid inflation bias: simply build inflationary expectations into the cash flows used int he capital budgeting analysis. The firm does not have to adjust its required rate of return to account for inflation expectations because

investors include such expectations when establishing the rate at which they are willing to permit the firm to use their funds.

Budget

is a plan that details projected cash inflows and cash outflows during som future period

Capital budget

is an outline of planned exprnfituries on fixed assets

discounted payback period

is the length of time it takes for a project's discounted cash flows to repay the cost of the investment. This does considers the time value of peony.

Capital budgeting

is the process of analyzing projects and deciding which are acceptable investments and which acceptable investments should be purchased

The internal rate of return

is the rate of return the firm expects to earn if a project is purchased and held for its economic life. IT is defined as the discount rate that equates the present value of a project's expected cash flows to the initial amount invested

A stand alone risk

is the risk an asset would have if it were a firm's only asset. It is measured by the variability of the asset's expected returns.

Net present value is important because

it gives a direct measure of the dollar benefit to the firm's shareholders, so we regard the NPV as the best single measure of profitability

The process of cash flow estimation is problematic because

it is difficult to accurately forecast the costs and revenues associated with large, complex projects or projects that are expected to affect operation for long periods of time

Logic suggest that the NPV method is better because

it selects the project that adds more to shareholder wealth

A project is considered acceptable if its payback is

less than the maximum cost recovery time established by the firm

A number of factors combine to make capital budgeting decisions perhaps the most important ones that financial mangers must make. Capital budgeting has

long term effects so the firm loses some decision making flexibility when it purchases capital projects

Bond's riskiness is influenced by its

maturity

We can modify the internal rate of return and make it a better indicator of relative profitability and hence a better evaluation tool for use inc optical budgeting. This modified return is called the

modified internal rate of return or MIRR

Projects with unconventional cash flow patterns present unique difficulties when the IRR method is used, including the possibility of

multiple Internal rate of returns.

IF we subtract the purchase price of the asset from the discounted present value of its expected future cash flows, the result is the

net dollar value to net benefit that accrues to the firm if the asset is purchased. This net benefit is called the asset's net present value.

Depreciation is a

non cash expense

Incremental cash flows are those that

occur as direct result of accepting rah project. To determine whether a specific cash flow is considered relevant, we must determine whether it is affected by the purchase of the project

Timing is also important in capital budgeting. Capital assets must be ready to come

on line when they are needed, otherwise opportunities could be lost. A firm that forecasts its needs for capital assets in advance will have an opportunity to purchase and install the assets before they are needed.

If two projects are mutually exclusive rather than independent then

only one project can be purchased

Guess is an

optional estimate of the internal rate of return. The guess input is a holdover from the early days off spreadsheets when computing power was low and the quest was needed to speed up the calculation.

A graph that shows a project's net present value at various discount rate is termed the

project's net present value profile

Independant projects are

projects whose cash flows are not affected by any other projects, so the acceptance of one project does not affect the acceptance of other projects. As a result, all independent projects can be purchased if they all are acceptable

Values is the

range of cells that contain the cash flows with the first cell being the negative initial outlay

Political risk

refers to any action by a host government that reduces the value of a company's investment.

Capital

refers to fixed asserts used in production

Exchange rate risk

reflects the inherent uncertainty about the home currency value of cash flows sent back to the parent. In other words, foreign projects have an dded risk element that relates to what the basic cash flows will one worth in the parent company's home currency, because actual exchange rates might differ substantially from expectations

Internal rate of return < rate of return =

reject (firm value will decrease)

Capital budgeting decisions generally are termed either

replacement decisions or expansion decisions

Because we assume that the firm returns to the operating level that existed prior to the acceptance of the project, any changes in net working capital that occurred at the beginning of the project's life will be

reversed at the end of its life.

Most firms incorporate project risk in capital budgeting decisions by using the

risk adjusted discount rate approach

risk adjusted required rate of return =

risk free rate + (expected rate of return on the market + rvRF)risk o the project relative to the other projects of the firm

The relevant risk of a stock is the

risk that remains when it is held with other stocks in a diversified portfolio because firm specific risk can be reduced significantly or eliminated through diversification.

Internal rate of return also measures profitability, but it is expressed as a percentage rate of return which many decision makers

seem to prefer. It also contains information concerning a project's safety margins, which is not inherent in net present value

Inflation

should be recognized in capital budgeting decisions. IF expected inflation is not built into the determination of expected cash flows, then the asset's calculated value and expected rate of return will be incorrect. That is, both of these values will be artificially low.

capital budgeting is important because the acquisition of fixed assets typically involves

substantial expenditures.

Notable problems in determining incremental cash flows include:

sunk costs, opportunity costs, externalities, shipping and installation costs, and inflation

TO measure corporate or within firm risk we must determine how

the capital budgeting project is related to the firm's existing assets

An expansion project calls for

the firm to invest in new assets in an effort to increase sales. The first step in the analysis is to summarize the initial investment outlays required for the project. The next step is to estimate the cash flows that will occur once production begins. The final cash flow comment that must be computed is the terminal cash flow

IF the capital budgeting decision is a replacement decision, then

the initial investment also must take into account the cash flows associated with the disposal of the old, or replace, asset; this amount includes any cash received or paid to scrap the old asset and any tax effects associated with its disposal

When all of the information about a project is collected, financial managers use these data to create estimates of its cash flows-

the investment outlays and the net cash flows exited after the project is purchased

One important caveat covering internal rate of return is that

the project's cash flows out only change sign one time during its life. If the sign of the cash flows changes more than once during the project's life, then the IRR is not unique, and there are in fact multiple IRRs for the project − one for each sign change.

The terminal cash flow incldues

the salvage value

cash flows that occur only at the start of the project's life

time Period 0 - which represent the amounts that are initially invested in the project.

Cash flows that occur only at the end, or the extermination, of the project

time Period n - which represent the amounts that are associated with the disposal, or termination, of the project at the end of its life.

Cash flows that continue through the project's life

time Periods 1 through n - which represent changes in the firm's operating cash flows that are associated with investing in the project.

traditional payback method does not consider the

time value of money

One way that a firm can try to measure the beta risk of a project is

to find single product companies in the same line of business as the project sign evaluated and then use the average of the betas of those companies to determine the required rate of return for the proposed project. This technique it termed the Prue play method and the single product companies that are used for comparisons are called pure play firms

Due to the constant reinvestment rate assumption, internal rate return tends to

understate the relative worth of low internal rate of return projects and it tends to overstate and relative worth of high internal rate of return projects.

payback period

which is defined as the expected number of years required to recover the original investment (the cost of the asset)

The addition or replacement of a capital asset also affects the firm's short term assets and liabilities, which are known as the

working capital accounts

three types of project risk need to be considered to determine whether the required rate of return used to evaluate a project should be different than the firm's WACC:

(1) the project's own stand alone risk the risk it exhibits when evaluated alone rather than as part of a combination or portfolio of assets (2) the corporate or within firm risk which is the effect a project has on the total riskiness of the company (3) the beta or market risk which is the project's risk assessed from the standpoint of a stockholder who holds a well diversified portfolio

Two basic conditions can cause NPV profiles to cross and thus lead to conflicts between NPV and IRR:

(1) when project size (or scale) differences exist, meaning that the cost of one project is much larger than that of the other or (2) when timing differences exist, meaning that the timing of cash flows from the two projects differs such that most of the cash flows from one project come in the early years and most of the cash flows from the other project come in the later years

Payback period =

(number of years before the year of full recovery of initial investment) + (amount of the initial investment that is unrecovered at the start of the recovery year / total cash flows generated during the recovery year)

AS long as the projects internal rate of return is greater than the rate of return required by the firm for such an investment, then the project is acceptable.

An Internal rate of return greater than rate of return also means that Net present value is positive so the two measures will produce the same decision to accept.

why is a project acceptable if its internal rate of return is greater than its required rate of return?

Because the internal rate of return on a project is the rate of return that the project is expected to generate and if this return exceeds the cost of the funds used to finance the project, a surplus remains after paying the funds. This surplus accrues to the firm's stockholders. Therefore, taking on a project whose IRR exceeds its required rate of return, or cost of funds, increases stockholders' wealth. On the other hand, if the IRR is less than the cost of funds, then taking on the project imposes a cost on current stockholders that decreases wealth.

Net present value =

Cash flow 0 + cash flow 1/(1+rate pf return)^1 + cash flow 2/(1+rate of return)^2 + so forth.

As a general rule, the impact of an increase in the discount rate is much greater on distant cash flows than on near-term cash flows.

Consequently, if most of its cash flows come in the early years, a project's NPV will not be lowered very much if the required rate of return increases.

Generally, political risk premiums are not added to the required rate of return to adjust for this risk.

If a company's management is seriously concerned that a given country might expropriate foreign assets, it simply will not make significant investments in that country.

Mathematically, the NPV and IRR methods will always lead to the same accept/reject decisions for independent projects:

If a project's NPV is positive, its IRR will exceed r; if NPV is negative, r will exceed the IRR.

If the estimated NPV for a project is positive, then it is an acceptable investment because the value of the company will be increased.

If the NPV is negative, then the project should be rejected because it will decrease the value of the company if it is undertaken. An NPV of zero would indicate that the project will have no effect on the value of the company.

Is MIRR as good as NPV for choosing between mutually exclusive projects?

If two projects are of equal size and have the same life, then NPV and MIRR will always lead to the same project selection decision

All capital budgeting methods that consider the time value of money include

NPV, IRR, MIRR and discounted payback

Internal rate of return > rate of return =

accept (firm value will increase)

To compute a project's payback period, simply

add up the expected cash flows for each year until the cumulative value equals the amount that is initially invested. The total amount of time that it takes to recapture the original amount invested is the payback period

Capital budgeting analysis relies on

after tax cash flows rather than accounting profits because it is cash that pays the bills and can be invested in capital projects, not profits

Cash flow estimation is the most important and perhaps the most difficult step in the

analysis of a capital project.

Externalities

are effects that a project will have on other parts of the firm. aLthough they often are diffcult let to quantify, externalities must be estimated so they are not mistakenly included as new cash flows int eh capital budgeting analysis.

Sunk costs

are outlays that have been committed or that already have occurred which will not change if the project is purchased. They cannot be recovered regardless of whether the project is accepted or rejected

Cash flows must be converted into the currency of the parent company, and thus

are subject to future exchange rate changes

Opportunity costs

are the cash flows that could be generated form assets that the firm already owns if they are not used for the project in question

Incremental operating cash flows

are the changes in day to day operating cash flows that result from the purchase of a capital project. They occur throughout the life o fate project, continuing to affect the firm's cash flows until the firm disposes of the asset.

Terminal cash flow occurs

at the end of the life of the project. It is associated with (1) the final disposal of the project and (2) the return of the firm's operations to their state prior to the project's acceptance.