Project evaluation
What does the required rate of return at the company level depends on?
It depend on the perceived impact on the company and the financial risks. It also depends on the company's capital structure which is the relationship between debt and equity.
What does the required rate of return for each project depend on?
It depends on geographical differences i.e differences in inflation and risk in different countries. But also differences in risk between different type of projects (project differences)
What is the annuity method?
It is comparisons of projects with different economic lifetimes. It shows the value created per year and not for an entire project like NPV does. It implies that all cash flows are converted to annual amounts of equal size = annuities.
What is inflation?
It is the general rise in the price level in an economy over time which result in a depreciation of purchasing power of money. = you need more money to buy the same products. The higher the inflation, the less will a future payment be worth at today's price level
Pros of NPV ratios
It makes it possible to rank projects in situations of temporary capital shortage
How can you deal with the difficulties in comparing projects with different economic lives correctly?
Make the evaluation on the basis of the life of the shorter project. For the longer project, use a residual value at the end of the shorter project. Assume that when the first project ends, the company reinvests in a new identical project (only works if the timelines matches afterwards, otherwise you still have the same problem) Use the Annuity method which is the most common way to do it.
How is NPV calculated?
NPV is calculated by calculating the value of all present an future cash flows to the same point in time (the present), using a determined interest rate (rate of return) for the project (discounting). Thereafter all negative values are subtracted from the positive values.
What is the NPV ratio?
NPV/ initial investment. It tells us which projects that generates the highest NPV per invested euro. One project might have a higher NPV while another has better NPV ratio and in cases where capital is limited the option that generates the highest NPV ratio is the best one.
Most interest rates are expressed in ...
Nominal terms
Which are the three methods to evaluate whether a project is valuable?
Payback method, NPV, IRR
What is the difference between NPV and IRR (internal rate of return)
The NPV method requires you to specify a rate of return to calculate NPV, while the IRR method seeks to calculate the rate of return that will give you NPV=0
What is the cons of payback method?
- Ignores the impact of time - Ignores all cash flow consequences that happens after the payback period. It might seem like a good investment if it has been payed back during the payback goal however it might not be a good investment because it might generate negative cash flows the remaining years. It is a useful method for projects with short life-time and small initial investments, but for all other projects you need to look at the project over its whole life time, and consider the impact of when cash flows occur.
What is the pros of payback method?
- simple and easy to calculate - Immediate/intuitive logic - prfioritize projects that generates cash quickly - Good for liquidity - simplified way of taking risk because early cash flows are more certain (less risky) than later cash flows.
What changes when you include taxes in the NPV calculation?
1. the projected pre tax cash inflows and outflows need to be converted to after tax cash flows 2. We need to include any additional cash flow consequences like depreciation and realised gains or loses from sales of assets 3. We need to adjust a pre tax RRR to a post tax RRR.
What are the pros with IRR?
A rate of return expressed in % is easier to communicate than NPV which is expressed in amount.
What is the real approach?
All future cash flow consequences are stated at todays price level (real terms) A real interest rate is used to calculate the present value. That is a interest rate that does not include inflation.
What is the nominal approach?
All future cash flow consequences are stated in the price level prevailing at the time when cash flows will occur (nominal terms) A nominal interest rate is used to calculate the present value
What are the pros of NPV?
All future cash flows consequences are considered. Also, time value of money is considered by discounting future cash flows using an interest rate. It is also the theoretical correct way of measuring economic value.
How do we know if we should invest in a project or not?
All projects with a net present value of > or same than 0 should be accepted. All projects with a net present value of <0 should be rejected.
Why do many prefer NPV over IRR?
Although using IRR gives us a mathematically correct answer the economic assumptions of company management is not dealt with acceptably using IRR. NPV allows us to make one decision at a time without feeling that we are compromising profitability too much. Also a problem is that there could be multiple or no IRR at all. If there are irregular cash flow patterns with positive and negative values there will be multiple IRR. It will cause issues and in those cases it would be preferred to use NPV.
Why do we consider taxes when doing project evaluation?
Because the tax effects of a project affects the value of the project for the company.
Why is it difficult to compare projects with different economic lives correctly?
Because we need to consider what happens after the first project ends
Cons of NPV ratios
Can produce wrong ranking if there is no capital shortage because then you can think that you should choose the highest NPV ratio and not the NPV.
What is capital budgeting?
Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. It tells us which projects are the best to invest in. This tells us something about what is at stake here: Capital is limited, so we have to make sure that we use it wisely
What is included in working capital?
Cash, accounts receivables, customer unpaid invoices, inventories of raw materials and finished goods
... need to be included in our NPV calculations because it reduces our tax payment otherwise.
Depreciation
TRUE OR FALSE: if you use IRR you don't need to determine a required rate of return.
False
What is the decision rule for IRR?
If IRR> required rate of return = accept project
What is an exception for the decision rule for NVP?
If a company is experiencing a temporary capital shortage, it might need to prioritise between projects with a positive NPV using the NPV ratio. Instead of accepting all projects where NPV > 0
How do we know if a project is valuable to do?
If the economic benefit outweigh the investment
Every project has two parts which? and what do they mean?
Investment and harvesting: Investment = all will have negative cash flow consequences. New machines, going into a new market etc. Harvesting = when the operation generates positive net cash flow.
What are the two perspectives on value creation? and why do we have different perspectives?
Projects vs period We generally do business in projects and use project perspective for project evaluations to see if the project is good enough or to see which project we should invest in. However, shareholders and stakeholders request information for periods. Which means that all projects are added together and allocated to periods. And they ask questions like what profit did they earn and how can we increase profit next yerar?
How can the real interest rate be seen?
Since most interest rates are expressed in nominal terms, real interest rate can be seen as a nominal rate that has been adjusted for inflation.
What does required rate of return (interest rate) depend on?
Since you do no have access to the money now and only later It depends on compensation for waiting to use the money. It also takes inflation into account, you will need more money later to buy the same products. Thirdly it also takes the risk that you may lose some or all of you money into account.
What are the cons of NPV?
Since you don't really know how much cash flow each year will generate the method is sensitive To assumptions about future cash flows. In the same way it is sensitive to determination of the required rate of return. The decision rule is that all projects with positive NPV are value creating (and should be pursued). But if we have limited capital, how should we choose between NPV positive projects?
There are two ways of dealing with inflation in project evaluation calculation, what are those called?
The nominal approach and the real approach
What does the decision rule say?
The project is favorable if the project's payback time is shorter than the payback time target (usually expressed in years, e.g. no more than 3 years)
What is a true for the real and nominal approach calculations?
The result will be the same, given that the adjustments for inflation are done correctly for both cash flows and the interest rate
What does management control stand for?
Using the numbers internally
How do we grow our company?
We do that by taking on positive NPV projects. That will give us long term growth of the company. We also have to think about what capital structure (mix of debt and equity) that will maximize firm value or minimize the cost of capital. Either (1) decrease debt to equity ratio (d/e). That can be done by issuing new shares and we can take that money to pay off some debt. Thereby we are simultaneously increasing equity and decreasing debt. or (2) increase debt to equity ratio. By borrowing more money to repurchase shares. (paying back shareholders)
The highest IRR doesn't necessarily mean the best project, why?
You can not use IRR to rank projects because it depends on the required rate of return and different projects may look better at different RRR.
Decision makers often see today's price levels as ...
reference points
When including taxes it is easier to use the ... approach. Why?
nominal approach. Because taxes are paid on nominal income
Taxes are paid on...
nominal taxable income
What is payback method?
the part in time when the capital invested is earned back from the cash flows generated by the project.
When do capital shortage often occur?
when the investors don't share your view of a project's (or the company's) risks and prospects - > change the required rate of return
