IESEG Financial Management

8/18/2019 IESEG Financial Management

1/48

IESEG – FINANCIAL MANAGEMENT – S2-2014/2015

FINANCIAL MANAGEMENT

Valuing Projects and Firms

Final Exam (03/04/15)

Preparation – Key elements


2/48


COURSE PRESENTATION - AIMS

• To get an overview on investment decisions in

a company

• To understand the company’s investment

decision (NPV, IRR, Payback Investment Rules)

• To understand the fundamentals of capital

budgeting


3/48


COURSE PRESENTATION - AIMS

• To understand the fundamentals of stock

valuation

• To link financial management decisions with

the company’s global strategy


4/48

Chapter 3

Financial Decision

Making and the Lawof One Price


5/48


Using Market Prices to Determine Cash

Values – General Principle

“Whenever a good trades in a competitive

market – by which we mean a market in which it

can be bought and sold at the same price – that

price determines the cash value of the good. As

long as a competitive market exists, the value of

the good will not depend on the views orpreferences of the decision maker”


6/48


The Interest Rate: An Exchange Rate

Across Time

Present Versus Future Value

When we express the value in terms of dollars

today, we call it the present value (PV) of theinvestment.

If we express it in terms of dollars in the future,

we call it the future value of the investment.


7/48


Present Value

and the NPV Decision Rule

The net present value (NPV) of a project or

investment is the difference between the

present value of its benefits and the present

value of its costs.

Net Present Value

(Benefits) (Costs) NPV PV PV

(All project cash flows) NPV PV


8/48


The NPV Decision Rule

When making an investment decision, take the

alternative with the highest NPV.

Choosing this alternative is equivalent to

receiving its NPV in cash today.


9/48


The NPV Decision Rule

Accepting or Rejecting a Project

• Accept those projects with positive NPV

because accepting them is equivalent toreceiving their NPV in cash today.

• Reject those projects with negative NPV

because accepting them would reduce thewealth of investors.


10/48


Choosing Among Alternatives

We can also use the NPV decision rule to choose

among projects. To do so, we must compute the

NPV of each alternative, and then select the one

with the highest NPV. This alternative is the onewhich will lead to the largest increase in the

value of the firm.


11/48


NPV and Cash Needs

Regardless of our preferences for cash today

versus cash in the future, we should always

maximize NPV first. We can then borrow or lend

to shift cash flows through time and find our

most preferred pattern of cash flows.


12/48


Arbitrage and the Law of

One Price

Law of One Price

If equivalent investment opportunities trade

simultaneously in different competitive markets,

then they must trade for the same price in both

markets.=> Any competitive price can be used to determine a cashvalue, without checking the price in all possible markets


13/48


The NPV of Trading Securities and Firm Decision Making

Separation Principle

We can evaluate the NPV of an investment decision

separately from the decision the firm makes

regarding how to finance the investment or any

other security transactions the firm is considering.

=> We can separate the firm’s investment decision

from its financing choice


14/48

Chapter 4

The Time Value

of Money


15/48


The Timeline

• A timeline is a linear representation of the

timing of potential cash flows.

•It can be used to represent a series of cashflows lasting several periods (= stream of cash

flows).

• Drawing a timeline of the cash flows will helpyou visualize the financial problem.


16/48


The Timeline

Differentiate between two types of cash flows

– Inflows are positive cash flows.

– Outflows are negative cash flows, which areindicated with a – (minus) sign.


17/48


The Timeline

• Assume that you are lending $10,000 today and that the loan will berepaid in two annual $6,000 payments.

• The first cash flow at date 0 (today) is represented as a negative sumbecause it is an outflow (vs the 2 inflows of + $6000)

• Timelines can represent cash flows that take place at the end of any timeperiod – a month, a week, a day, etc.


18/48


Three Rules of Time Travel

• Financial decisions often require combining

cash flows or comparing values. Three rules

govern these processes.The Three Rules of Time Travel


19/48


• Most investment opportunities have multiple

cash flows that occur at different point in time

• Based on the first rule of time travel we can

derive a general formula for valuing a stream

of cash flows:

If we want to find the present value of a stream

of cash flows, we simply add up the present

values of each.

Valuing a Stream of Cash Flows


20/48


The Internal Rate of Return

In some situations, you know the present value

and cash flows of an investment opportunity but

you do not know the internal rate of return

(IRR), the interest rate that sets the net present

value of the cash flows equal to zero.


21/48

Chapter 7

InvestmentDecision Rules


22/48


The NPV Decision Rule (reminder)

When making an investment decision, take the

alternative with the highest NPV.Choosing this alternative is equivalent to receiving

its NPV in cash today.

=> Compare the project’s NPV to zero and acceptthe project if its NPV is positive

NPV and Stand-Alone Projects


23/48


Alternative Rules Versus the NPV Rule

• Sometimes alternative investment rules may

give the same answer as the NPV rule, but at

other times they may disagree.

• When the rules conflict, the NPV decision rule

should be followed => in these cases, the

alternative rules lead to bad decisions that

reduce wealth


24/48


The Internal Rate of Return Rule

• Internal Rate of Return (IRR) Investment Rule

Take any investment where the IRR exceeds the cost

of capital. Turn down any investment whose IRR is

less than the cost of capital.

• Project cost of capital : return on other

alternatives in the market with equivalent riskand maturity


25/48


The Internal Rate of Return Rule

• The IRR Investment Rule will give the same answer as the NPV rulein many, but not all, situations.

• In general, the IRR rule works for a stand-alone project if all of theproject’s negative cash flows precede its positive cash flows.

• In other cases, the IRR rule may disagree with the NPV rule andthus be incorrect.

•

Situations where the IRR rule and NPV rule may be in conflict:• Delayed Investments

• Nonexistent IRR

• Multiple IRRs


26/48


The Payback Rule

• The payback period is amount of time it takes to recover or payback the initial investment. If the payback period is less than a pre-specified length of time, you accept the project. Otherwise, youreject the project.

• The payback rule is used by many companies because of itssimplicity.

• Pitfalls:

– Ignores the project’s cost of capital and time value of money.

– Ignores cash flows after the payback period.

– Relies on an ad hoc decision criterion.


27/48


Mutually Exclusive Projects :

• When you must choose only one project

among several possible projects, the choice ismutually exclusive.

• NPV Rule

• Select the project with the highest NPV.• It leads to the greatest increase in wealth

Choosing Between Projects


28/48


• Mutually Exclusive Projects :

– IRR Rule :

• Selecting the project with the highest IRR

• But, it may lead to mistakes :

– When projects differ in scales of investment

– When projects differ in the timing of their cash flows

– When projects differ in their riskiness

=> Then their IRRs cannot be meaningfhully compared

Choosing Between Projects


29/48


The Incremental IRR Rule

Incremental IRR Investment Rule

• Apply the IRR rule to the difference between thecash flows of the two mutually exclusive

alternatives (the increment to the cash flows ofone investment over the other)

• The incremental IRR tells the discount rate atwhich it becomes profitable to switch from one

project to the other => we don’t compare theprojects directly, we evaluate the decision toswitch from one to the other using the IRR rule


30/48


The Incremental IRR Rule

• Shortcomings of the Incremental IRR Rule (sameas for IRR Rule) :

– The incremental IRR may not exist.

– Multiple incremental IRRs could exist.

– The fact that the IRR exceeds the cost of capital forboth projects does not imply that either project has apositive NPV.

– When individual projects have different costs ofcapital, it is not obvious which cost of capital theincremental IRR should be compared to.


31/48


Project Selection

with Resource Constraints

• Evaluation of Projects with Different Resource

Constraints

• The profitability index can be used to identify theoptimal combination of projects to undertake.

Value Created NPVProfitability IndexResource Consumed Resource Consumed


32/48


Shortcomings of the Profitability Index

• In some situations the profitability Index doesnot give an accurate answer.

• Two Conditions of the Profitability Index :

– The set of projects taken following the

profitability index ranking completely exhausts the

available ressource

–

There is only a single relevant ressource constraint => With multiple resource constraints, the

profitability index can break down completely.


33/48

Chapter 8

Fundamentals of

Capital Budgeting


34/48


Forecasting Earnings

• Capital Budget

Lists the investments that a company plans

to undertake

• Capital Budgeting

Process used to analyze alternate investments and

decide which ones to accept


35/48


Forecasting Earnings

• Incremental Earnings

The amount by which the firm’s earnings are

expected to change as a result of the investment

decision

• Earnings are not actual cash flow. However, as

a practical matter, to derive the forecasted

cash flow of a project, financial managersoften begin by forecasting earnings.


36/48


Interest Expense

• In capital budgeting decisions, interest

expense is typically not included . The rationale

is that the project should be judged on its

own, not on how it will be financed.

• For this reason, we refer to the net income we

compute as the unlevered net income


37/48


Taxes

• Marginal Corporate Tax Rate

The tax rate on the marginal or incremental dollar of

pre-tax income. Note: A negative tax is equal to a

tax credit.Income Tax EBIT

c


38/48


Unlevered Net Income

Unlevered Net Income Calculation

Unlevered Net Income EBIT (1 ) (Revenues Costs Depreciation) (1 )

c

c


39/48


Incremental Earnings Forecast

Spreadsheet Incremental Earnings Forecast


40/48


Sunk Costs and Incremental Earnings

• Sunk costs are costs that have been or will be paid regardless of thedecision whether or not the investment is undertaken.

• Sunk costs should not be included in the incremental earningsanalysis.

•

Typically overhead costs are fixed and not incremental to theproject and should not be included in the calculation of incrementalearnings (except the additional overhead expenses that arisebecause of the decision to take the project).

•

Past Research and Development Expenditures :Money that hasalready been spent on R&D is a sunk cost and therefore irrelevant.The decision to continue or abandon a project should be based onlyon the incremental costs and benefits of the product going forward.


41/48


Determining Free Cash Flow and NPV

• Earnings are an accounting measure of the

firm’s performance.

• To evaluate a capital budgeting decision, we

must determine its consequences for the

firm’s available cash.

• The incremental effect of a project on a firm’s

available cash is its free cash flow.


42/48


Calculating the Free Cash Flow

from Earnings

• Net Working Capital (NWC)

– Most projects will require an investment in net

working capital.

• Trade credit is the difference between receivables

and payables.

– The increase in net working capital is defined as:

Net Working Capital Current Assets Current Liabilities

Cash Inventory Receivables Payables

1 t t t NWC NWC NWC


43/48


Calculating the Free Cash Flow

from Earnings

Spreadsheet Calculation of Free Cash


44/48


Calculating Free Cash Flow Directly

• Free Cash Flow

– The term c × Depreciation is called the depreciation taxshield (tax savings resulting from the ability to deductdepreciation => depreciation expenses have a positiveimpact on the free cash flow)

Unlevered Net Income

Free Cash Flow (Revenues Costs Depreciation) (1 )

Depreciation CapEx

c

NWC

Free Cash Flow (Revenues Costs) (1 ) CapEx

Depreciation

c

c

NWC


45/48


Calculating the NPV

year discount factor

1( )

(1 ) (1 )

t

t t t t

t

FCF PV FCF FCF

r r

Spreadsheet Computing NPV


46/48


Analyzing the Project

Break-Even Analysis

• The break-even level of an input is the level

that causes the NPV of the investment to

equal zero.

• In a break-even analysis, for each parameter,

we calculate the value at which the NPV is

zero.


47/48


Sensitivity Analysis

• Sensitivity Analysis shows how the NPV varies

with a change in one of the assumptions,

holding the other assumptions constant.

• Which aspects of the project are more critical

when managing the project


48/48

Chapter 9

Valuing Stocks

IESEG Financial Management

Documents

Transcript of IESEG Financial Management