1 Finance School of Management Objective Explain Capital
Budgeting Develop Criteria for Project Evaluation Chapter 6. How to
Analyze Investment Projects
Slide 3
2 Finance School of Management Chapter 6 Contents The Nature of
Project Analysis Where Do Investment Ideas Come From? The NPV Rule
Estimating a Projects Cash Flow Cost of Capital Sensitivity
Analysis Using Spreadsheets Analyzing Cost- Reduction Projects
Projects with Different Lives Ranking Mutually Exclusive Projects
Inflation and Capital Budgeting
Slide 4
3 Finance School of Management Capital Budget and Capital
Budgeting Once a company has decided what business it intends to be
in, it must considers proposals for investment projects evaluating
them deciding which ones to accept and which to reject It must
prepare a plan (capital budget) for acquiring factories, machinery,
warehouses research laboratories showrooms, and for training the
personnel.
Slide 5
4 Finance School of Management The Nature of Project Analysis
Starting point: An idea for increasing shareholder wealth
Procedures of project analysis Forecasting cash flows: Decisions
and events Flexibility of decisions in the projects life
Slide 6
5 Finance School of Management Where Do Investment Ideas Come
from? Customers R&D department Competition Production division
Incentive systems
Slide 7
6 Finance School of Management Objectives To show how to use
discounted cash flow analysis to make decisions such as: Whether to
enter a new line of business Whether to invest in equipment to
reduce costs
Slide 8
7 Finance School of Management NPV Rule Revisited Invest if the
proposed projects NPV is positive. Discount rate Opportunity cost:
The rate of return on comparable investment opportunities. Cost of
capital NPV: The fair market value in competitive and efficient
market.
Slide 9
8 Finance School of Management DCF Payback Do the Project
Slide 10
9 Finance School of Management Dont do the Project
Slide 11
10 Finance School of Management Indifferent Internal Rate of
Return
Slide 12
11 Finance School of Management
Slide 13
12 Finance School of Management Measurement of Value Accounting
Market Two approaches of measuring value: Accounting: Book
valueHistorical cost Financial: Market valueDiscounting
Slide 14
13 Finance School of Management Asset = Liability + Equity The
Use of Money The Source of Money The Balance Sheet
Slide 15
14 Finance School of Management Corporate Finance Assets
Liabilities and Equity Asset 1 Asset 2 Liabilities Asset 3 Equity
Asset n Total Assets Liabilities & Equity Continued Accounting:
Yes! Finance: No!
Slide 16
15 Finance School of Management Corporate Finance Assets
Liabilities and Equity Asset 1 Asset 2 Liabilities Asset 3 Equity
Asset n Total Assets Liabilities & Equity NPV NPV + NPV Firm
Value Capital Market Real Economy
Slide 17
16 Finance School of Management Example: PC1000 of Compusell
Corp.
Slide 18
17 Finance School of Management
Slide 19
18 Finance School of Management PC1000: Cash Flows 2.2 1.3 -5
1.3 A seven-year coupon bond with an annual coupon payment of $1.3
million, a face value of $2.2 million, and a price of $5
million.
Slide 20
19 Finance School of Management Was 0%
Slide 21
20 Finance School of Management Was 15%
Slide 22
21 Finance School of Management Was 40%
Slide 23
22 Finance School of Management Was 0%
Slide 24
23 Finance School of Management Was 75%
Slide 25
24 Finance School of Management Was 3,100,000
Slide 26
25 Finance School of Management Table 6.4 Project Sensitivity
to Sales Volume 3640 is the NPV break-even point. Sales UnitsNet CF
OperationsNPV Project 20002000005005022 30005500001884708 3604 *
10030090 400013000001235607 500020500004355922
600028000007476237
Slide 27
26 Finance School of Management
Slide 28
27 Finance School of Management Sensitivity of Project to Sale
Volume $500,000 $0 $500,000 $1,000,000 $1,500,000 $2,000,000
$2,500,000 $3,000,000 2,0002,5003,0003,5004,0004,5005,0005,5006,000
Sales (Units) Net CF from Operations
Slide 29
28 Finance School of Management
Slide 30
29 Finance School of Management Cost of Capital Risk-adjusted
discount rate (k) The risk of a particular project may be different
from the risk of the firms existing assets. The risk that is
relevant in computing a projects cost of capital is the risk of the
projects cash flows and not the risk of the financing instruments
(e.g., stocks, bonds) the firm issues to finance the project. The
cost of capital should reflect only the market-related risk of the
project (its beta).
Slide 31
30 Finance School of Management Illustration 1 25-year U.S.
Treasury bonds paying $100 per year are selling in the market at
$1,000. A firm has the opportunity to buy $1 million worth of these
bonds for $950 each. The firms overall (average) cost of capital is
16%. If discounted at 16%, the NPV of the opportunity is -$340,291.
However, no one will forgo the opportunity. The correct cost of
capital is nearly 10%.
Slide 32
31 Finance School of Management Illustration 2 Compusell
Corporation is planning to finance the $5 million outlay required
to undertake the PC1000 project by issuing bonds. Compusell has a
high credit rating because it has almost no debt outstanding and
therefore can issue $5 million worth of bonds at an interest rate
of 6% per year. It would be a mistake to use 6% as the cost of
capital in computing the NPV of the PC1000 project.
Slide 33
32 Finance School of Management Illustration 3 An all-equity
financed firm with tree divisions: An electronics division, 30% of
the firms market value, cost of capital 22%; A chemical division,
40% of the firms market value, cost of capital 17%; A natural gas
transmission division, 30% of the firms market value, cost of
capital 14%. The cost of capital for the firm is 0.322% + 0.417% +
0.314% = 17.6%. If 17.6% is adopted as discount rate for all
projects, then it is likely to accept projects in the electronics
division with negative NPV; to pass up profitable natural gas
transmission.
Slide 34
33 Finance School of Management Illustration 4 An all-equity
financed steel company considering the acquisition of an integrated
oil company that is 60% crude oil reserves and 40% refining. The
market capitalization rate on crude oil investments is 18.6% and on
refining projects is 17.6%. The market capitalization rate on the
oil company shares is 18.2%. The market capitalization rate for
steel projects is 15.3%. The market price of the oil companys
shares is fair ($100, expected return 18.2%). An investment banker
reports that all the shares could be acquired for a tender offer
bid of $110 per share. With 15.3%, the NPV of the acquisition is
110+18.2/.153=$9. With 18.2%, the NPV of the acquisition is
110+18.2/.182=-$10.
Slide 35
34 Finance School of Management Example: Cost Reducing Project
A firm is considering an investment proposal to automate its
production process to save on labor costs. Invest $2 million now in
equipment (an expected life of 5 years) and thereby save $700,000
per year in pretax labor costs. The incremental cash flows due to
the investment: At the 10% discount rate, the NPV is $274,472.
Slide 36
35 Finance School of Management Project with Different Lives
Suppose that there are two different types of equipment with
different economic lives in the previous example. The longer-lived
requires twice the initial outlay but lasts twice as long. An
easier approach is called annualized capital cost. The
Shorter-lived equipment The Long-lived equipment
Slide 37
36 Finance School of Management Ranking Mutually Exclusive
Projects Sometimes two or more projects are mutually exclusive. You
own a parcel of land and have two alternatives: Construct an office
building; Make a parking lot.
Slide 38
37 Finance School of Management Ranking Mutually Exclusive
Projects Rule: This firm should choose the project with the highest
NPV at any cost of capital below 20%.
Slide 39
38 Finance School of Management Inflation and Capital Budgeting
Rule: There are two correct ways of computing NPV: Use the nominal
cost of capital to discount nominal cash flows. Use the real cost
of capital to discount real cash flows. Never compare the IRR
computed using real cash flow estimates to a nominal cost of
capital.