Fin 620 Chapter 10 and 11
Rationale for the NPV Method
If projects are independent, accept if the project NPV > 0 If projects are mutually exclusive, accept project with the highest positive NPV, one that adds the most value NPV = PV inflows − PV of the outflows (Cost) This is net gain in wealth, so accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher positive NPV. Adds most value.
What types of projects require the least detailed and the most detailed analysis in the capital budgeting process?
Projects requiring greater investments or that have greater risk should be given detailed analysis the capital budgeting process.
Why is it important to include inflation when estimating cash flows? (
Nominal r > real r. The cost of capital, r, includes a premium for inflation. Nominal CF > real CF. This is because nominal cash flows incorporate inflation. If you discount real CF with the higher nominal r, then your NPV estimate is too low. Nominal CF should be discounted with nominal r, and real CF should be discounted with real r. It is more realistic to find the nominal CF (i.e., increase cash flow estimates with inflation) than it is to reduce the nominal r to a real r.
Nonnormal cash flows projects
___________________________have a large cash outflow either sometime during or at the end of their lives. A common problem encountered when evaluating projects with ________________________ is multiple IRRs. •Two or more changes of signs. •Most common: Cost (negative CF), then string of positive CFs, then cost to close project. •For example, nuclear power plant or strip mine.
Stand-alone risk
is the risk a project would have if it was held in isolation(one project). Ignores both firm and shareholders diversification. Measured by the σ or CV of NPV, IRR
Explain why sunk cost should not be included in a capital budgeting analysis but opportunity and externalities should be included.
Capital budgeting analysis should only include those cash flows which will be affected by the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm taking on this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis.
MIRR (Modified Internal Rate of Return)
assumes that cash flows from all projects are reinvested at the cost of capital as opposed to the project's own IRR. This makes the modified internal rate of return a better indicator of a project's true profitability. the discount rate that causes the PV of a project's terminal value(TV) to equal the PV of costs. TV is found by compounding inflows at WACC. Thus ________assumes cash inflows are reinvested at WACC. TV is found by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC
opportunity cost
an _____________________is a cash flow that a firm must forgo to accept a project. For example, if the project requires the use of a building that could otherwise be sold, the market value of the building is an____________________ of the project
mutually exclusive projects
cannot be performed at the same time. We can choose either Project 1 or Project 2, or we can reject both, but we cannot accept both projects because they are related by both trying to accomplish the same thing so only one can be accepted. if the cashflows of one cand be adversely impacted by the acceptance of the other Accept the project with the highest positive NVP, if none have a positive NVP, reject both.
Normal cash flow projects
if one or more cash outflows (costs) are followed by a series of cash inflows. •Cost (negative CF) followed by a series of positive cash inflows. •One change of signs. Non-normal Cash Flow
Capital Rationing
occurs when a firm's management limits its capital expenditures to an amount less than would be required to fund the optimal capital budget.
Independent Projects
projects whose cash flows are unrelated to (or independent of) one another; the acceptance of one does not eliminate the others from further consideration CAsh flows are not affected by other projects. If both positive NVP's accept both projects because one does not affect the other.
Accounting Income
reports accounting data as defined by Generally Accepted Accounting Principles (GAAP).
Steps in Capital Budgeting
• Estimate cash flows (inflows & outflows), chapter 11. • Assess risk (fluctuations) of cash flows, chapter 11. • Determine risk-adjusted r =WACC for project. • Evaluate cash flows using capital budgeting techniques: NPV, PI, IRR, Multiple IRRs, Modified IRR (MIRR), Payback Period (nondiscounted PBP), Discounted PBP.
Assessing stand alone risk via scenario analysis
• Examines several possible situations, usually worst case, most likely case, and best case. • Provides a range of possible outcome * What does scenerio analysis do? Unlike the sensitivity analysis which concentrates onthe change in ONE variable at a time, scenerio analysis is useful to know what would happen to the project's NPV if SEVERAL of the input variable turn out to ne better or worse that expected for possible situations: worst case, most likely case, and best case.
Incremental Cash Flow for a Project: Key Concepts
* Purchase of assets represents negative CF's * Depreciation is a non-cash expense. Depreciation shelters income from taxation(depreciationis tax deductible), affecting net CF's **For capital budgeting purposes, it is the projects net cash flow, not its accounting income, that is relevant. We use the cash flows, not aqccounting income, to estimate the value of the stock. * Payables and accrurals reduce CF's(liabilities) ** THe difference between the required increase in operating current assets and the increase in operating curent liabilities is the change in net operating working capital. **Interest is a cash expense but mot included in projects cash flow. It is part of the WACC so no double counting.
Steps in Capital Budgeting
*Estimate cash flows (inflows & outflows), chapter 11. • Assess risk (fluctuations) of cash flows, chapter 11. • Determine risk-adjusted r = WACC for project. • Evaluate cash flows using capital budgeting techniques: NPV, PI, IRR, Multiple IRRs, Modified IRR (MIRR), Payback Period (nondiscounted PBP), Discounted PBP ((Know how to calculate each of these and know the criteron if you would accept the project or not))
Capital Budgeting Project Categories
1. Replacement to continue profitable operations 2. Replacement to reduce costs 3. Expansion of existing products or markets 4. Expansion into new products/markets 5. Contraction decisions (abandon project) 6. Safety and/or environmental projects 7. Mergers 8. Other
THe three types of risk analysis and the objective
1. Stand-alone risk 2. corporate/diversifiable risk 3. Market risk/beta risk Objective: is to determine whether a project's risk differs from that of an average project at the company. If so, the projects cash flows should be discounted at the projects risk-adjusted cost of capital instead of a company's overall weighted average cost of capital (WACC).
Distinquish among beta(market)risk, within firm (or corporate) risk, and stand -alone risk for a project being considered for inclusion in a firm's capital budgeting.
11-10 Stand-alone risk is the project's risk if it is held as a lone asset. It disregards the fact that it is but one asset within the firm's portfolio of assets and that the firm is but one stock in a typical investor's portfolio of stocks. Stand-alone risk is measured by the variability of the project's expected returns. Corporate, or within-firm, risk is the project's risk to the corporation, giving consideration to the fact that the project represents only one in the firm's portfolio of assets, hence some of its risk will be eliminated by diversification within the firm. Corporate risk is measured by the project's impact on uncertainty about the firm's future earnings. Market, or beta, risk is the riskiness of the project as seen by well-diversified stockholders who recognize that the project is only one of the firm's assets and that the firm's stock is but one small part of their total portfolios. Market risk is measured by the project's effect on the firm's beta coefficient.
In theory, market risk should be the only "relevant risk. However, companies focus as much on stand-alone risk as on market risk. What are the reasons for the focus on stand-alone risk?
11-11 It is often difficult to quantify market risk. On the other hand, we can usually get a good idea of a project's stand-alone risk, and that risk is normally correlated with market risk: The higher the stand-alone risk, the higher the market risk is likely to be. Therefore, firms tend to focus on stand-alone risk, then deal with corporate and market risk by making subjective, judgmental modifications to the calculated stand-alone risk.
why is it true, in general, that a failure to adjust expected cash flows for expected inflation biases the calculated NPV downward?
11-3 Since the cost of capital includes a premium for expected inflation, failure to adjust cash flows means that the denominator, but not the numerator, rises with inflation, and this lowers the calculated NPV.
Expalin how net operating working capital is recovered at the end of a project's life and why it is included in a capital budgeting analysis?
11-5 When a firm takes on a new capital budgeting project, it typically must increase its investment in receivables and inventories, over and above the increase in payables and accruals, thus increasing its net operating working capital. Since this increase must be financed, it is included as an outflow in Year 0 of the analysis. At the end of the project's life, inventories are depleted and receivables are collected. Thus, there is a decrease in NOWC, which is treated as an inflow.
Why are interest charges not deducted when a project's cash flows are calculated for use in a capital budgeting analysis?
11-7 The costs associated with financing are reflected in the weighted average cost of capital. To include interest expense in the capital budgeting analysis would "double count" the cost of debt financing.
Most firms generate cash inflows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows and then using them in the analysis? If we do not, are our results biased? If so, would the NPV be biased up or down? Explain.
11-8 Daily cash flows would be theoretically best, but they would be costly to estimate and probably no more accurate than annual estimates because we simply cannot forecast accurately at a daily level. Therefore, in most cases we simply assume that all cash flows occur at the end of the year. However, for some projects it might be useful to assume that cash flows occur at mid-year, or even quarterly or monthly. There is no clear upward or downward bias on NPV since both revenues and costs are being recognized at the end of the year. Unless revenues and costs are distributed radically different throughout the year, there should be no bias.
What are some differences in the analysis for a replacement project versusthst of a new expansion project?
11-9 In replacement projects, the benefits are generally cost savings, although the new machinery may also permit additional output. The data for replacement analysis are generally easier to obtain than for new products, but the analysis itself is somewhat more complicated because almost all of the cash flows are incremental, found by subtracting the new cost numbers from the old numbers. Similarly, differences in depreciation and any other factor that affects cash flows must also be determined.
Sunk cost
A _______________ is one that has already occurred and is not affected by the capital project decision. ________________ are not relevant to capital budgeting decisions. Happened in the past and related to the project but you do noy use it.
eplacement project
A _______________________ is one in which an existing machine is replaced with a more efficient one—new sales might not be created, but cash flows improve because of the more efficient machine.
Replacement Chain Approach
A _________________________ is a method of comparing mutually exclusive projects that have unequal lives. Each project is replicated such that they will both terminate in a common year. If projects with lives of 3 years and 5 years are being evaluated, the 3year project would be replicated 5 times and the 5-year project replicated 3 times; thus, both projects would terminate in 15 years. Not all projects maximize their NPV if operated over their engineering lives and therefore it may be best to terminate a project prior to its potential life.
risk-adjusted discount rate
A ________________________________________incorporates the risk of the project's cash flows. The cost of capital to the firm reflects the average risk of the firm's existing projects. Thus, new projects that are riskier than existing projects should have a higher risk-adjusted discount rate. Conversely, projects with less risk should have a lower risk-adjusted discount rate. This adjustment process also applies to a firm's divisions. Risk differences are difficult to quantify, thus risk adjustments are often subjective in nature. A project's cost of capital is its risk-adjusted discount rate for that project.
decision tree
A______________________ is a way of structuring a set of sequential decisions that depend on the outcomes at specific points in time. A staged decision tree analysis divides the analysis into different phases. At each phase a decision is made either to proceed or to stop the project. These decisions are represented on the ________________ by circles and are called decision nodes. Each path that depends on a decision is called a branch.
Externality
An ________________ is something that is external to the project but occurs because of the project. For example, cannibalization occurs when a project's product reduces the company's sales of similar product If the new product line would decrease sales of the firm's other products by $50,000 per year, would this affect the analysis? Yes. The effects on the other projects' CFs are "externalities." Net CF loss per year on other lines would be a cost to this project. Externalities will be positive if new projects are complements to existing assets. Will be negative if new projects substitute the old one (cannibalization).
expansion project
An ________________________ is one in which new sales are generated
What are the weaknesses of sensitivity analysis?
Does not reflect diversification. Says nothing about the likelihood of change in a variable, i.e. a steep sales line is not a problem if sales won't fall. Ignores relationships among variables
Suppose a firm is considering two mutually exclusive projects. One has a life of 6 years and the other a life of 10 years. Would the failure to employ some type of replacement chain analysis bias an NPV analysis against one of the projects? Explain>
Generally, the failure to employ common-life analysis in such situations will bias the NPV against the shorter project because it "gets no credit" for profits beyond its initial life, even though it could possibly be "renewed" and thus provide additional NPV.
Which risk type is theoretically the most relevant? wHY
Market risk is theoretically the most relevant because ot is the one that, according to CAPM, is reflected in stock prices. Unfortunetely, market risk is also the most difficult to measure, primarily because new projects don't have "market prices" that can be related to stock market returns.
Describe a process that firms often use to determine a projects risk adjusted cost of capital.
Most decision makers: * first conduct primary analysis and estimate the projects value using a risk-adjusted cost of capital tht is based on thier experience with similar past projects. * Second, they conduct a quantitative analysis of the projects stand alone risk using sensitivity analysis, scenerio analysis, or mnte carlo simulation. *Third, they consider corporate and market risk in the qualitative manner. *Fourth, theu assign a risk-adjusted cost of capital to the project based on the risk assesment.
Normal vs. Non-normal Cash Flows
Normal Cash Flow Project: • Cost (negative CF) followed by a series of positive cash inflows. • One change of signs. Non-normal Cash Flow Project: • Two or more changes of signs. • Most common: Cost (negative CF), then string of positive CFs, then cost to close project. • For example, nuclear power plant or strip mine
11-2Operating cash flows, rather than accounting profits, are used in project analysis. What is the basis for this emphasis on cash flows opposed to net income?
Only cash can be spent or reinvested, and since accounting profits do not represent cash, they are of less fundamental importance than cash flows for investment analysis. Recall that in the stock valuation chapters we focused on dividends and free cash flows, which represent cash flows, rather than on earnings per share, which represent accounting profits.
How do simulation analysis and scenerio analysis differ in the wau they treat very bad and very good outcomes? What does this imply about using each technique to evaluate project riskiness?
Scenario analysis analyzes a limited number of outcomes. Although the base case scenario may be the most likely, or expected outcome, the bad and good scenarios are frequently worst case and best case scenarios, that is, when everything goes bad together, or everything goes right together. It is unlikely that everything will go wrong all at once, or everything will go right all at once and so scenario analysis can tend to overestimate the riskiness of a project. Simulation analysis, on the other hand, allows the variables being simulated to either vary together or independently, as the modeler sees fit. With enough runs of the simulation, this procedure should provide a reasonably accurate description of the possible outcomes. Note, however, that if the project is big and its failure could threaten the viability of the firm, then evaluating a worst case scenario may very well be important! A simulation may only identify that worst case outcome infrequently and with a scenario analysis you can specify the worst case and see if it drags the company down.
Assessing stand alone risk via sensitivity analysis (know how this works)
Shows how changes in a variable such as unit sales affect NPV or IRR. Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. It begins with a base-case scenario in which the project's NPV is found using the base case value for each input variable. So, it answers "what if" questions, e.g. "What if sales decline by 30%?
Results of Sensitivity Analysis
Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV. Unit sales line is steeper than salvage value or r, so for this project, should worry most about accuracy of sales forecast.
Strengths and Weaknesses of Payback
Strengths: • Provides an indication of a project's risk and liquidity. • Easy to calculate and understand. Many companies, especially multinationals, use PBP because it is easy. Weaknesses: • Does not take into account the time value of money (no discounting) • Ignores CFs occurring after the payback period. • No specification of acceptable payback.
10-3 Explain why the NPV of a relatively long-term project, defined as one for which a high percentage of its cash flows are expected in the distant future, is more sensitive to changes in the cost of capital than the NPV of a short-term project.
The NPV is obtained by discounting future cash flows, and the discounting process actually compounds the interest rate over time. Thus, an increase in the discount rate has a much greater impact on a cash flow in Year 5 than on a cash flow in Year 1.
reinvestment rate assumption
The assumption that cash flows from a project can be reinvested (1) at the cost of capital, if using the NPV method or (2) at the internal rate of return, if using the IRR method. The mathematics of the NPV method imply that project cash flows are reinvested at the cost of capital while the IRR method assumes reinvestment at the IRR. Since project cash flows can be replaced by new external capital that costs r, the proper reinvestment rate assumption is the cost of capital, and thus the best capital budget decision rule is NPV.
What is the payback period?
The number of years required to recover a project's cost, or how long does it take to get the business's money back? Decision Criterion: Generally, the shorter the PBP the better. However, compare the calculated PBP to a maximum number determined by the management taking into account the industry norms. To accept the project, your calculated PBP should not exceed that maximum.
10-4 When two mutually exclusive projects are being compared, explain why the short-term project might be ranked higher under the NPV criterion if the cost of capital is high whereas the long-term project might be deemed better if the cost of capital is low. would changes in the cost of capital ever cause a change in the IRR ranking of two such projects? Why or Why not?
This question is related to Question 10-3 and the same rationale applies. With regard to the second part of the question, the answer is no; the IRR rankings are constant and independent of the firm's cost of capital.
NPV(Net Present Value Method)
______________________ is the present value of the project's expected future cash flows (both inflows and outflows), discounted at the appropriate cost of capital. It is a direct measure of the value of the project to shareholders.
Sensitivity analysis
_______________________ indicates exactly how much NPV or other output variables such as IRR or MIRR will change in response to a given change in an input variable, other things held constant. ___________________ is sometimes called "what if" analysis because it answers this type of question.
Monte Carlo
_______________________ simulation analysis is a risk analysis technique in which a computer is used to simulate probable future events and thus to estimate the profitability and risk of a project.
Scenario analysis
_________________________ is a shorter version of simulation analysis that uses only a few outcomes. Often the outcomes considered are optimistic, pessimistic and most likely.
Incremental cash flows
_________________ are those cash flows that arise solely from the asset that is being evaluated. For example, assume an existing machine generates revenues of $1,000 per year and expenses of $600 per year. A machine being considered as a replacement would generate revenues of $1,000 per year and expenses of $400 per year. On an incremental basis, the new machine would not increase revenues at all, but would decrease expenses by $200 per year. Thus, the annual incremental cash flow is a before-tax savings of $200.
Project cash flow
_________________, which is the relevant cash flow for project analysis, represents the actual flow of cash, which includes investments in capital and working capital, but does not include interest expenses or noncash charges like depreciation (except to the extent that depreciation affects taxes). In other words,_____________________is the free cash flow generated by the project.
Capital budgeting
____________________ is the whole process of analyzing projects and deciding whether they should be included in the capital budget. This process is of fundamental importance to the success or failure of the firm as the fixed asset investment decisions chart the course of a company for many years into the future. (deciding to invest in this project or not. Deals with real assets. long-term decisions;involve large expenditures;)
Growth options
______________________ allow a company to expand if market demand is higher than expected. This includes the opportunity to expand into different geographic markets and the opportunity to introduce complementary or second-generation products. It also includes the option to abandon a project if market conditions deteriorate too much.
Salvage value
______________________ is the market value of an asset after its useful life. ____________________ and their tax effects must be included in project cash flow estimation
Corporate (within-firm) risk
_________________________ is the risk that a project contributes to a company after taking into consideration the cash flows of the company's other projects; because projects are not perfectly correlated, ____________________usually will be less than stand-alone risk. **also known as "within-firm" risk, is variability a project contributes to a corporation's stock returns, considering that the project is only one of many. Therefore, some of the project's risk is eliminated by diversification if it is not perfectly correlated with the other projects
IRR(internal rate of return)
______________________________ is the discount rate that equates the present value of the expected future cash inflows and outflows. It measures the rate of return on a project, but it assumes that all cash flows can be reinvested at the IRR rate. _____ is the discount rate that forces PV inflows = initial cost. This is the same as forcing NPV = 0. Or, it is the discount rate that EQUATES the PV of outflows to PV of inflows ________ is an estimate of the project's rate of return, so it is comparable to the YTM on a bond. When there are multiple _____ use the NPV IT IS NOT DEPENDENT ON THE COST OF CAPITAL USED!!
Net operating working capital changes
_____________________________________ are the increases in current operating assets resulting from accepting a project less the resulting increases in current operating liabilities, or accruals and accounts payable. A _______________________________ must be financed just as a firm must finance its increases in fixed assets.
Investment timing options
___________________________________give companies the option to delay a project rather than implement it immediately. This option to wait allows a company to reduce the uncertainty of market conditions before it decides to implement the project.
The discounted payback method
___________________________corrects this fault in the regular payback method. Cash flows are discounted at WACC and then those discounted cash flows are used to find the payback.
The regular payback method The discounted payback method corrects this fault.
_________________________is deficient in that it does not take account of cash flows beyond the payback period. 1. Time value of money ignored 2. CAsh flows beyond the payback period are given no consideration 3. merely states how long it takes to payback investment
Market (beta) risk
_________________________is the risk that a company contributes to a well diversified portfolio. *also known as beta risk. It is the risk that emanates from the project's effect on the firm's beta coefficient.
Capacity options
_______________________allow a company to change the capacity of their output in response to changing market conditions. This includes the option to contract or expand production.
Real options
_______________________occur when managers can influence the size and risk of a project's cash flows by taking different actions during the project's life. They are referred to as real options because they deal with real as opposed to financial assets. They are also called managerial options because they give opportunities to managers to respond to changing market conditions. Sometimes they are called strategic options because they often deal with strategic issues. Finally, they are also called embedded options because they are a part of another project.
crossover rate
is the cost of capital at which the NPV profiles for two projects intersect indicating that at that point their NPVs are equal.
Economic Life
is the number of years a project should be operated to maximize its NPV, and is often less than the maximum potential life.
Payback Period
is the number of years it takes a firm to recover its project investment. Payback may be calculated with either raw cash flows (regular payback) or discounted cash flows (discounted payback). In either case, payback does not capture a project's entire cash flow stream and is thus not the preferred evaluation method. Note, however, that the payback does measure a project's liquidity, and hence many firms use it as a risk measure. We start with the project's cost, which is negative, and then add the cash inflow for each year until the cumulative cash flow turns positive. The payback year is the year prior to full recovery, plus a fraction equal to the shortfall at the end of the prior year divided by the cash flow during the year when full recovery Decision Criterion:Generally, the shorter the PBP the better. However, compare the calculated PBP to a maximum number determined by the management taking into account the industry norms. To accept the project, your calculated PBP should not exceed that maximum. Payback = Number of yrs prior to full recovery + Uncovered cost at start of year/cash flow during full recovery year
NPV profile
is the plot of a project's NPV versus its cost of capital.
scenerio analysis
mean= E(NPV)= 101.6 to find E(NPV) $279 X 0.25 + $88 X 0.50 + $-49 X 0.25 = $101.6 Standard deviation= 116.6 to find σ(NPV) take the square root of : ($279-101.6)^2 x 0.25 + ($88-101.6)^2x0.50 + ($-49-101.6)^2x0.25 CV(NPV) = σ(NPV)/E(NPV) = 116.6/101.6
Equivalent Annual Annuity
method is an alternative method of comparing mutually exclusive projects that have unequal lives. This method converts the annual cash flows under the alternative investments into a constant cash flow stream whose NPV is equal to the NPV of the initial stream.
PI (profitability index)
the present value of an investment's future cash flows divided by its initial cost is the ratio of the present value of future cash flows to the project's initial cost. It shows the relative profitability of any project. A profitability index greater than 1 is equivalent to a positive NPV project. It measures the "bang for the buck." When PI > 1 accept the project. If it is independent accept both. If mutually exclusive, accept the higher one.
