CORPORATE FINANCE I ESCP-EAP European Executive MBA 21 Sept. 2005 p.m. Paris Investment...

CORPORATE FINANCEI

CORPORATE FINANCEI

ESCP-EAPEuropean Executive MBA21 Sept. 2005 p.m. Paris

Investment Decisions-Net Present ValueI. Ertürk

Senior Fellow in Banking

CORPORATE FINANCE

CORPORATE FINANCE

Financial

manager

Firm's

operations

Financial

markets

(1) Cash raised from investors

(2) Cash invested in firm

(3) Cash generated by operations

(4a) Cash reinvested

(4b) Cash returned to investors

(1)(2)

(3)

(4a)

(4b)

RESPONSIBILITIES OF THE FINANCIAL MANAGER

RESPONSIBILITIES OF THE FINANCIAL MANAGER

DECISIONS IN ANY BUSINESS

WHAT LONG-TERM INVESTMENTS SHOULD YOU ACCEPT?

– CAPITAL BUDGETING DECISION

WHERE WILL YOU GET THE MONEY TO PAY FOR YOUR INVESTMENTS?

– FINANCING DECISION

VALUE OF THE FIRMVALUE OF THE FIRM

Returns generated by investments (assets) -return on assets- should be greater than the cost of liabilities (weighted average cost of capital)

ROA > WACC

Assets Liabilities

Debt

Equity

Debt

Equity

Current

Fixed

Current

Fixed

CAPITAL BUDGETINGCAPITAL BUDGETING

FINANCIAL MANAGER ATTEMPTS TO ENSURE THAT

THE PRESENT VALUE

(OR THE VALUE TODAY )

OF THE CASH FLOWS

GENERATED BY THE ASSET

IS GREATER THAN THE COST OF THE ASSET

Laurentian BakeriesLaurentian Bakeries

Should the company invest in the expansion?

TWO RULES FOR ACCEPTING OR REJECTING

PROJECTS

TWO RULES FOR ACCEPTING OR REJECTING

PROJECTS

1. INVEST IN PROJECTS WITH POSITIVE NPV –Net Present Value

2. INVEST IN PROJECTS OFFERING RETURN

GREATER THAN

OPPORTUNITY COST OF CAPITAL

11( ) r

OFTEN CALLED DISCOUNT FACTOR

DISCOUNTED CASH FLOWS -DCF

r DISCOUNT RATEHURDLE RATEOPPORTUNITY COST OF CAPITAL

Also appears as “k”

1

( )1 r

Present ValuePresent Value

1factordiscount =PV

PV=ValuePresent

C

Present ValuePresent Value

Discount Factor = DF = PV of €1

Discount Factors can be used to compute the present value of any cash flow.

DFr t

1

1( )

Present ValuesPresent Values

Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time.

t

tt r

CCDFPV

1

Discount factors: Present value of €1 to be received after t years = 1/(1+r)t

interest rate per period1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

no. ofperiods

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.8702 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.7563 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 0.693 0.675 0.6584 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 0.613 0.592 0.5725 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 0.543 0.519 0.4976 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 0.480 0.456 0.4327 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.3768 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404 0.376 0.351 0.3279 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361 0.333 0.308 0.284

10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322 0.295 0.270 0.24711 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.317 0.287 0.261 0.237 0.21512 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.286 0.257 0.231 0.208 0.18713 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.258 0.229 0.204 0.182 0.16314 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.232 0.205 0.181 0.160 0.14115 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.209 0.183 0.160 0.140 0.12316 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.188 0.163 0.141 0.123 0.10717 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.170 0.146 0.125 0.108 0.09318 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.153 0.130 0.111 0.095 0.08119 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.138 0.116 0.098 0.083 0.07020 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.124 0.104 0.087 0.073 0.06121 0.811 0.660 0.538 0.439 0.359 0.294 0.242 0.199 0.164 0.135 0.112 0.093 0.077 0.064 0.05322 0.803 0.647 0.522 0.422 0.342 0.278 0.226 0.184 0.150 0.123 0.101 0.083 0.068 0.056 0.04623 0.795 0.634 0.507 0.406 0.326 0.262 0.211 0.170 0.138 0.112 0.091 0.074 0.060 0.049 0.04024 0.788 0.622 0.492 0.390 0.310 0.247 0.197 0.158 0.126 0.102 0.082 0.066 0.053 0.043 0.03525 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.074 0.059 0.047 0.038 0.03026 0.772 0.598 0.464 0.361 0.281 0.220 0.172 0.135 0.106 0.084 0.066 0.053 0.042 0.033 0.02627 0.764 0.586 0.450 0.347 0.268 0.207 0.161 0.125 0.098 0.076 0.060 0.047 0.037 0.029 0.02328 0.757 0.574 0.437 0.333 0.255 0.196 0.150 0.116 0.090 0.069 0.054 0.042 0.033 0.026 0.02029 0.749 0.563 0.424 0.321 0.243 0.185 0.141 0.107 0.082 0.063 0.048 0.037 0.029 0.022 0.01730 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.044 0.033 0.026 0.020 0.015

RATE OF RETURN RULERATE OF RETURN RULE

RETURN = PROFIT = 400 - 350 = 14.3% INVESTMENT 350

ACCEPT PROJECT BECAUSE RATE OF RETURN IS GREATER THAN THE OPPORTUNITY COST OF CAPITAL, 7%

NPV RULENPV RULE

STEP 1: FORECAST CASH FLOWSCost of building, C0 = 350Sale price in Year 1, C1 = 400

STEP 2: ESTIMATE OPPORTUNITY COST OF CAPITALIf equally risky investments in the capital marketoffer a return of 7%, then cost of capital, r = 7%

STEP 3: Discount future cash flows C1 400PV = = = 374 1 + r 1.07

STEP 4: Accept project if PV of payoff exceeds investmentNPV = -350 + 374 = +24

ONE-PERIOD PROJECT: RETURN UNCERTAIN

ONE-PERIOD PROJECT: RETURN UNCERTAIN

INVEST $1,000 NOW. RECEIVE EXPECTED UNCERTAIN CASH FLOW AFTER 1 YEAR, WHOSE EXPECTED VALUE IS $1,300

INVESTORS CAN BUY EQUALLY RISKY SECURITIES WITH 35% EXPECTED RETURN.

DECISION:1. DON'T INVEST BECAUSE 30% PROJECT RETURN IS LESS THAN 35%

OPPORTUNITY COST.2. DON'T INVEST BECAUSE NET PRESENT VALUE IS

NEGATIVE.

1,300 NET PRESENT VALUE = 1.35 - 1,000 = 963 - 1,000 = -37

VALUE OF FIRM

WILL FALL BY €37 IF WE ACCEPT THE PROJECT

PV0 == CC

r

C

r

C

r0

1

1

2

2

2

t

t

t(1 ) (1 ).......

(1 )

DISCOUNTED CASH FLOW (DCF) EQUATION

NPV =

Crt

t

t(1 )

NET PRESENT VALUE OF A PROJECTWHERE THE SUMMATION IS OVER ALL THE

CASH FLOWS GENERATED BY THE PROJECT,

INCLUDING INITIAL NEGATIVE CASH FLOWS AT THE START OF THE PROJECT, C0 ETC.


Example

Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value.

000,300000,100000,150

2Year 1Year 0Year


Example - continued

Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value.

400,18€

900,261000,300873.2

500,93000,100935.1

000,150000,1500.10Value

Present

Flow

Cash

Factor

DiscountPeriod

207.11

07.11

TotalNPV

EXAMPLEEXAMPLE

C0 = -500, C1 = +400, C2 = +400

r1 = r2 = .12

NPV = -500 + +

= -500 + 400 (.893) + 400 (.794)

= -500 + 357.20 + 318.80 = +176

400 400

1.12 (1.12)2

INTERNAL RATE OF RETURN, IRR

INTERNAL RATE OF RETURN, IRR

CC C C

01 2

2T

T(1 IRR) (1 IRR)....

(1 IRR)0

NPV

=

IRR IS THE DISCOUNT RATE FOR WHICH NPV=0

IRR = 28%

+2

0

-1

50DISCOUNTRATE (%)

NPV

NET PRESENT VALUE PROFILE

C0 = - 4

C1 = +2

C3 = +4

IRR vs. NPVIRR vs. NPV

IRR IS AN INTENSIVE MEASURE OF PROFITABILITY

NPV IS AN EXTENSIVE MEASURE OF PROFITABILITY

AT THE END OF THE DAY, WE ARE INTERESTED IN A MONETARY

(EXTENSIVE) MEASURE OF PROFITABILITY

– NOT IN THE PROFITABILITY PER EURO OF INVESTMENT

BOTH GIVE SAME RESULT IF WE’RE NOT DEALING WITH MUTUALLY

EXCLUSIVE PROJECTS OR PROJECTS WITH NONCONVENTIONAL CASH

FLOWS

Identifying Relevant Cash flows

Identifying Relevant Cash flows

Use cash flows only not accounting figures Depreciation is not a cash flow but capital expenditure is Construct “Project Appraisal Table” Use incremental cash flows only Separate investment and financing decisions Include all incidental effects. Do not forget working capital requirements. Forget sunk costs. Include opportunity costs. Beware of allocated overhead costs Use after-tax cash flows only

After-tax cash flowsAfter-tax cash flows

Incremental costs and depreciation/capital allowances reduce tax and hence increase investment cash flows by:

(cost/depreciation) X (tax rate)

Incremental income/savings increase tax and hence increase investment cash flows by:

(income/savings) X (1-tax rate)

Laurentian BakeriesRelevant Cash flowsLaurentian BakeriesRelevant Cash flows

Land value of the Winnipeg plant $250,000?Administrative staff salaries $223,000?Staff expenses and salaries

to secure the US contract $40,000?Working capital needsCost reductionsCapital cost allowance


Investment costs (C$millions)

– Extension to the building $1.3

– Spiral freezer 1.6

– High speed processing line 1.3

– Additional warehouse space 0.6

– Contingency 0.4

TOTAL $5.2

Incremental Cash Flows (C$m) Laurentian Bakeries

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005Investment cost (5.20)Net revenue 0.58 1.10 1.52 1.58 1.64 1.71 1.78 1.85 1.92 2.00Efficiency savings 0.17 0.28 0.31 0.31 0.31 0.31 0.31 0.31 0.31 0.31Other savings 0.138 0.144 0.149 0.155 0.161 0.168 0.175 0.182 0.189 0.196

Total (before tax) 0.90 1.53 1.98 2.04 2.11 2.19 2.26 2.34 2.42 2.50

Total after-tax benefit 0.55 0.94 1.22 1.26 1.30 1.34 1.39 1.44 1.49 1.54

Tax shield 0.17 0.30 0.23 0.18 0.14 0.11 0.09 0.07 0.06 0.67

Change in working capital (0.41) (0.36) (0.29) (0.04) (0.04) (0.05) (0.05) (0.05) (0.05) (0.05)

Net working capital 1.40

Net project cash flows (5.20) 0.31 0.87 1.15 1.39 1.39 1.41 1.43 1.46 1.50 3.55

NPV (C$m) 0.09


Need to consider hurdle rate

– Is 18% right?Sensitivity and scenario analysesNeed to consider qualitative factors

– Expansion into US

– Human resources

– Environment

INNOVATION LTDINNOVATION LTD

Project Appraisal –example 2

INNOVATION LTD.

INVESTMENT APPRAISAL SCHEDULE

Year 0 1 2 3 4 5 6

Machinery (20,000) 4,915

Grant 5,000

Sales revenue 65,000 87,500 100,000 100,000 100,000

Total cash costs (58,000) (77,000) (88,000) (88,000) (88,000)

Opportunity cost of off-cuts (3,500) (4,500) (5,000) (5,000) (5,000)

Tax paid (2,000) (4,050) (5,040) (5,232) (5,386)

Tax saved 1,750 2,250 2,500 2,500 2,500

Net benefits (20,000) 8,500 5,750 5,200 4,460 4,268 2,030

Discount factors @ 10% 1 0.909 0.826 0.751 0.683 0.621 0.564

Present values (20000) 7727 4752 3907 3046 2650 1146

Net present value @ 10% 3,228

Internal rate of return 17%

Years 0 1 2 3 4 5 6

Payback 3.14 (20,000) (11,500) (5,750) (550) 3,910Discounted payback 4.27 (20000) (12273) (7521) (3614) (568) 2083

ALTERNATIVES TO THE NPV RULEALTERNATIVES TO THE NPV RULE

SIMPLE AND DISCOUNTED PAYBACK

AVERAGE RETURN ON BOOK VALUE

INTERNAL RATE OF RETURN

PROFITABILITY INDEX

NPV

Year: 0 1 2 3 Payback At 10%

A -2 +2 1 -0.2

B -2 +1 +1 +5 2 +3.5

PROJECT A HAS SHORTER PAYBACK BUT LOWER NPV

PAYBACK RULEPAYBACK RULE


IF FIRM USES 1 YEAR CUTOFF PERIOD , ACCEPT PROJECT A

IF FIRM USES 2 YEAR CUTOFF PERIOD, ACCEPT PROJECTS A & B

REGARDLESS OF CUTOFF PERIOD, PAYBACK RULE MAY GIVE DIFFERENT ANSWER THAN NPV

– PAYBACK GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE PAYBACK DATE AND NO WEIGHT TO LATER CASH FLOWS

– NO DISCOUNTING - IGNORES TIME VALUE OF MONEY

– NO GOOD RATIONALE FOR CUTOFF

CASH FLOWS (€000) NPV

Year: 0 1 2 3 Payback At 10%

B -2 +1 +1 +5 2 +3.492

C -2 +0 +2 +5 2

+3.409

D -2 +1 +1 +100 2

+74.867


DISCOUNTED PAYBACK RULEDISCOUNTED PAYBACK RULE

CALCULATE LENGTH OF TIME UNTIL THE SUM OF THE DISCOUNTED CASH FLOWS IS EQUAL TO THE INITIAL INVESTMENT

ACCEPT PROJECT IF IT IS LESS THAN SOME CUTOFF VALUE

DISCOUNTED-PAYBACK RULE ASKS HOW LONG WILL IT BE UNTIL THE PROJECT HAS A POSITIVE NPV

– NO LONGER GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE PAYBACK DATE BUT STILL IGNORES CASH FLOWS AFTER CUTOFF DATE

CANNOT BE USED FOR RANKING PROJECTS

AVERAGE RETURN ON BOOK VALUEAVERAGE RETURN ON BOOK VALUE

ACCEPT OR REJECT AN INVESTMENT BASED ON ITS BOOK RATE OF RETURN – COMPARE WITH BOOK RATE OF RETURN FOR THE FIRM OR THE INDUSTRY

FITS INTO FORMAT OF ACCOUNTING STATEMENTS– INFORMATION READILY AVAILABLE

SOUNDS ATTRACTIVE BUT WRONG

AVERAGE FORECASTED NET INCOME

AVERAGE BOOK VALUE OF THE INVESTMENT

AVERAGE RETURN ON BOOK

AVERAGE RETURN ON BOOK

Year: 0 1 2 3

Book 9 6 3 0

Gross profit 6 5 4

Depreciation 3 3 3

Net income 3 2 1

Average return on book = = 44%2

4.5

ACCEPT PROJECT IF FIRM’STARGET BOOK RATE OF RETURN IS LESS THAN 44%

CAPITAL RATIONINGCAPITAL RATIONING

SOMETIMES THE FIRM CAN’T FINANCE ALL PROJECTS WHICH HAVE

A POSITIVE NPV TODAY

– AND ANTICIPATES CAPITAL RATIONING IN VARIOUS FUTURE YEARS

IDENTIFY PACKAGE OF PROJECTS WHICH SATISFY CAPITAL

CONSTRAINTS AND MAXIMIZE NPV

– IRR RULE WILL NOT WORK

– USE PROFITABILITY INDEX IN SIMPLE CASES

– LINEAR PROGRAMMING IN GENERAL CASE


0 1 2 NPV @ 10% A -10 +30 +5 21 B -5 +5 +20 16 C -5 +5 +15 12

LIMITED €10 MILLION CAPITALFIRM CAN INVEST IN PROJECT A OR

PROJECTS B AND CINDIVIDUALLY, B AND C HAVE LOWER NPV TAKEN TOGETHER, B AND C HAVE HIGHEST

NPVCHOOSE PROJECTS THAT OFFER HIGHEST

NPV PER EURO INVESTED


INITIAL INVESTMENTPROFITABILITY INDEX = NET PRESENT VALUE

PROJECT INVESTMENT NPV PROFITABILITY INDEX

A 10 21 2.1

B 5 16 3.2

C 5 12 2.4

RANK PROJECTS IN TERMS OF DECLINING PICONTINUE MAKING INVESTMENTS UNTIL

CAPITAL EXHAUSTEDACCEPT PROJECTS B AND C

CORPORATE FINANCE I ESCP-EAP European Executive MBA 21 Sept. 2005 p.m. Paris Investment...

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