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BUS650_Chapter_06.pdf
Learning Objectives
After studying this chapter, you should be able to:
• Describe the significance of corporate investments in creating value.
• Explain how identifying and classifying potential projects plays into project selection.
• Estimate project cash flows.
• Show how to select independent projects using NPV and IRR.
• Describe how to select mutually exclusive projects that maximize value.
• Identify the significance and different types of options and how to adjust for the option effect.
Imaginechina/Associated Press6
Capital Budgeting: Investing to Create Value
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CHAPTER 6Introduction
Introduction
Figure 6.0: Chapter 6 in focus
Investments made by the company
Funds from investors pay for corporate
investment (costs)
The Financial Balance Sheet
Cash generated by corporate investments (value)
In order to create value, firms must invest in projects whose value is greater than their cost. In Chapter 6, the techniques for determining whether value is greater than cost are explored.
Throughout this text we have stressed the importance of creating value for corporate shareholders. We also indicated that the greatest opportunity for creating value lay in the investing activities of companies. In the context of the financial balance sheet, these are left-hand side activities. The potential payoffs on successful investments prompt ingenious efforts to develop new products, build existing products at lower cost, improve product quality, and devise new marketing strategies. For example, the advent of e-commerce allows small companies to sell products worldwide and large companies to supplement or possibly supplant traditional distribution channels. E-commerce has, in turn, spawned companies that design and manage websites, provide Internet services and make encryp- tion software.
Some product developments create virtually new industries. Consider the spectacular growth in wireless communications that was made possible by the blending of satellite and digital technologies. In an effort to gain a competitive advantage, network providers have expanded their coverage areas, improved transmission quality, added services, and cut prices. Similarly, cell phone manufacturers embrace the latest in digital technology as they vie for market share.
In this chapter, we address the fundamentals of corporate investing. First, we discuss product market opportunities created by imperfect competition. Next, we develop some guidelines for identifying and selecting investment opportunities. We then examine the investment decision itself, paying special attention to decision criteria and discounted cash flows. Finally, we discuss options that are intrinsic to many corporate investments.
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CHAPTER 6Section 6.1 Corporate Investments and Value Creation
Pre-Test
1. Net present value measures the dollar amount that shareholder wealth will increase if a project is accepted.
a. True b. False
2. The least common strategies for exploiting market opportunities are cost leader- ship and differentiation.
a. True b. False
3. The cash flows used in NPV analysis are incremental after-tax cash flows. a. True b. False
4. A project can have just one NPV but could have more than one IRR. a. True b. False
5. The payback period is a good alternative to either NPV or IRR. a. True b. False
6. In capital budgeting, the ability to abandon a project early can add value to the project.
a. True b. False
Answers 1. a. True. The answer can be found in Section 6.1. 2. b. False. The answer can be found in Section 6.2. 3. a. True. The answer can be found in Section6.3. 4. a. True. The answer can be found in Section 6.4. 5. b. False. The answer can be found in Section 6.5. 6. a. True. The answer can be found in Section 6.6.
6.1 Corporate Investments and Value Creation
We will draw upon several important ideas covered thus far in the text in our dis-cussion of corporate investing: • It is cash flows, not income or earnings, that measure the success of a business or
investment. • The value of cash flows depends on when they are paid or received. • The effect of timing on the value of future cash flow is incorporated into the dis-
count rate.
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CHAPTER 6Section 6.1 Corporate Investments and Value Creation
• The appropriate discount rate is the investors’ required rate of return. • This required rate of return is a function of risk.
Investors buy bonds and stocks that represent claims against future corporate cash flows. Corporate investments must, therefore, generate at least enough cash flow to provide all investors with their required returns. If investments generate less than the required return, the value of the company’s securities—and, therefore, the value of the company—will decline. Of course, investments are made in the hope that they will produce enough cash to pay off creditors with enough left over to increase returns to shareholders.
Investing in Fixed Assets Depending on the industry, much corporate investment is in long-term, or fixed, assets. These assets can be classified as tangible (machinery, real estate) or intangible (copyrights, patents, contracts). Traditional capital-intensive industries invest in factories that manu- facture durable goods, such as metals, chemicals, transportation equipment, and machin- ery. However, virtually all companies, not just manufacturers, have fixed assets. Retailers either own or lease stores. R&D firms have laboratories and patents. Book and music publishers have copyrights and, perhaps, long-term contracts with writers and musicians. One of the best-known assets is the secret formula for Coca-Cola. Whether tangible or intangible, fixed assets are essential to the long-run viability of a firm.
Identifying Asset Value: NPV and IRR The ability to identify which assets are expected to add value to the firm is central to the financial management role. In this chapter, we explore this selection process (called capi- tal budgeting) in some detail. Essentially, to identify value-creating projects, businesses use either the net present value (NPV) or internal rate of return (IRR) criteria.
Net present value measures the dollar value added to the firm by the investment. The NPV of an investment is the present value of the future cash flows minus the initial investment.
Net present value 5 Present value of future cash flows – Initial investment
NPV directly measures the present value of the cash flows a project is expected to gen- erate. It then compares this value to the project’s cost. If the project value is expected to exceed the cost, the project should be pursued.
The IRR criteria compares the IRR (expected return) for a project to the required return for investors, given the project’s risk. If the expected return exceeds that requirement, then the project should be pursued.
We will look at the equations for finding NPV and IRR later in this chapter. For now, it is important to know that companies can add value to the business and increase owners’ wealth by pursuing positive NPV projects, or project’s whose IRR exceeds its required return. With this objective in mind, we will begin our discussion of corporate investments.
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CHAPTER 6Section 6.1 Corporate Investments and Value Creation
Product Market Opportunities The financial model of the corporation is based on the premise that product markets provide valuable investment opportunities for firms. Firms that identify and exploit these opportunities create value because they do what their shareholders individually cannot do. The search for investment opportunities occurs within the overall mission and strategic plan of the corporation.
Investment opportunities are often short-lived because suc- cessful products attract compet- itors. For example, the success of Starbuck’s coffee spawned many purveyors of specialty coffees and espresso, and Black- Berry was supplanted by the iPhone after a few years of mar- ket dominance.
Competition, or the threat of competition, means that firms must not only remain alert for new opportunities but also try to protect their existing mar- kets. For example, major air- lines on occasion have used sometimes illegal predatory pricing to discourage low-cost “no-frills” airlines from serv- ing their hub cities. Even seem- ingly entrenched firms may be vulnerable to competition. Before Japanese autos entered the market, the United States was the nearly exclusive turf of the big three American automakers.
Firms have a number of weapons with which to fend off competitors. Patents and copy- rights protect, for a time, valuable intellectual property, such as inventions, publications, and computer software. Sometimes protecting a competitive position requires invest- ment. For example, McDonald’s attempted to forestall competition by being the first to buy choice restaurant locations. Investing in a modern plant may lower production costs or increase product quality. Some industries invest heavily in promotion. Athletic apparel manufacturers engage in a frenzied competition to sign hot sports stars to expensive long- term contracts.
Seeking out and successfully pursuing valuable investments places great demands on management. There are many potential hazards. Managers may fail to recognize oppor- tunities, or they may chase opportunities that do not exist. For example, a market may appear to be attractive because it produces extraordinarily high profits. Yet a closer exami- nation reveals that existing producers hold patents on key technologies or may control supply sources or distribution channels.
Shareholders must pay attention to the product market when deciding on investment opportunities because competitors can quickly overshadow a leading product as demonstrated by iPhone’s dominance over BlackBerry.
Associated Press
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CHAPTER 6Section 6.2 Project Selection
High-end retailers like Neiman Marcus focus on a differentiation strategy that emphasizes style, quality, and service.
Associated Press
When an apparent investment opportunity reveals itself, managers should ask the follow- ing questions:
• If this is a genuine opportunity, why is there not greater competition in this market?
• Are competing products on the horizon that may reduce market demand? • Are there costly barriers to entry? • Is the current competitive posture likely to remain over the long haul? • Are market forces already at work to increase competition? • Will the corporation be able to protect its investment by keeping competitors at
bay?
Taking reasonable precautions should actually encourage investing by making poor investments less likely. Companies that have a record of successful investing may be more aggressive in searching for new opportunities than those that have experienced recent or costly failures.
6.2 Project Selection
Each firm must develop a competitive strategy for exploiting market oppor- tunities. The most common of these strategies are cost leader- ship and differentiation. Low- cost producers can undercut their competitor’s prices; Wal- Mart, for example, uses this strategy. On the other hand, a differentiation strategy may take many forms. A company may offer higher quality, a function- ally distinct product, or better service. Among clothing retail- ers, there are Nordstrom and Neiman Marcus (quality and service) and L. L. Bean (func- tionally distinct). Differentiation frequently prompts large invest- ments in advertising. In 1999 CNET, Inc. launched a $100 million ad campaign to promote their technology website, even though the investment would wipe out their positive cash flows. A firm’s competitive strategy determines where it looks for market opportunities. For example, Wal-Mart would not be likely to focus on product quality and service if that jeopardized its position as a cost leader.
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CHAPTER 6Section 6.2 Project Selection
A firm’s competitive strategy guides its strategic planning. These strategic plans are then translated into investments. The process of translating plans into investments begins with identifying a set of potential projects. This requires the following steps:
Step 1: Identify possible projects that fit into the corporate strategic plan or mission.
Step 2: Classify projects by size and purpose so that management attention can be directed to those that are most important.
Step 3: Eliminate or integrate projects that are in some way dependent on other projects.
Let’s look at these more closely.
Identifying Potential Projects Ideally, a company’s search for investment opportunities would transcend its traditional products and markets. For example, a company doing business in the United States may consider overseas markets. A bank might consider providing computer services. A manu- facturer of industrial equipment might also consider making consumer products.
Classifying Projects Companies often find it useful to categorize potential projects by their size and the com- pany’s experience with such projects. Large projects, with which the company has little experience, require careful scrutiny. An example of such a project would be an American company investing for the first time in a less-developed country. At the other extreme are routine investments such as replacing a worn-out machine. Management resources are finite. By confining the search to projects that fit the company’s mission and then classify- ing them, management can direct its attention to a relatively few, crucial projects.
Projects that may seem risky and deserving of great management scrutiny must be judged in the context of existing company operations. Table 6.1 provides a representative scheme for classifying projects according to the amount of management attention required.
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CHAPTER 6Section 6.2 Project Selection
Table 6.1: Project types and management oversight
Project type Description Management attention required
Example
Replacement projects
• Update or upgrade existing capacity.
• Senior management typically does not make decisions on these relatively routine investments.
• Replacing worn-out or obsolete machinery and equipment.
Expansion projects
• Used to expand existing capacity, such as adding new machinery or equipment to increase output.
• Require only moderate management scrutiny because capacity expansion is a response to increased or anticipated demand.
• Retailers lease larger facilities or open additional stores.
Diversification, or dispersion, projects
• Add new products or new regions to a company’s operations.
• Demands on management may vary, depending on how related the new products or regions are to existing ones.
• Initial overseas expansion of a domestic corporation (high level of management attention).
• Investing in freight cars to lease to private carriers (lower level of management attention).
There are two other investment categories that don’t fit neatly into a risk classification. One is investment mandated by law, such as pollution control equipment to comply with environmental regulations and plant improvements to conform to occupational safety and health codes. The other is investment in other companies. Mergers and acquisitions are risky in part because they combine corporate cultures. Most mergers expand existing capacity, diversify product lines, or extend operations to new regions.
Eliminating Project Dependencies When we first identify potential investments, we may include projects that are either com- plementary or mutually exclusive. Pipelines to bring crude oil to the refinery and trans- port refined petroleum to ports or markets must accompany a new oil refinery. It makes little sense to evaluate the refinery separately from the pipelines. These are complemen- tary projects and should be considered a single investment.
Mutually exclusive projects are substitutes for each other, requiring either/or decisions. There may be alternative types of pipelines that can be built to serve the oil refinery, or rail cars or barges may be used in place of pipelines. The company must select the best option for each task and discard the others.
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CHAPTER 6Section 6.3 Estimating Project Cash Flows
Once the company’s financial analysts have combined com- plementary projects and cho- sen among mutually exclusive projects, those that remain are independent projects. Indepen- dent projects all have equal status, meaning that the com- pany may invest in all, none, or any combination of projects, knowing that each investment decision does not affect the oth- ers. This greatly simplifies the analysis and allows manage- ment to focus on the process of creating wealth. As is usual in business, even though simplify- ing assumptions aids our analy- sis, we must deal at some point with less simple realities. In truth, individual projects must be viewed in the context of the portfolio of investments.
6.3 Estimating Project Cash Flows
O nce a company’s financial analysts have identified an array of independent proj-ects, they must evaluate each as a potential investment. First, they must estimate cash flows that are associated with the project. These include the initial invest- ment, operating income and expenses spread over the life of the project, and project ter- mination. Operating and termination cash flows are discounted, and their present value is then compared to the initial investment. If the present value of the future cash flows is greater than the initial investment, the investment has a positive net present value. A posi- tive net present value indicates that the investment will add value to the company.
Recall from Section 6.1 that
Net present value 5 Present value of future cash flows – Initial investment
In order to calculate net present value, we must estimate the amount and timing of the investment’s cash flows. In this section, we provide some ground rules for estimating cash flows and then show how they are used in a discounted cash flow model.
Consider Only Incremental Cash Flows The most difficult part of project analysis is identifying and quantifying cash flows related to the project. Here, the guiding principle is to include only incremental cash
Purchasing new pipelines for a new oil refinery is an example of a complementary project because they are interconnected. Can you think of any other examples of complementary projects?
Digital Vision/ Getty Images
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CHAPTER 6Section 6.3 Estimating Project Cash Flows
flows, defined as the change in corporate cash flows attributable to the project. This seems simple enough, but these cash flows can be elusive. Even the cost of some projects may be impossible to pin down. Consider how difficult it is to estimate the completed cost of an office building or plant that may take years to complete. Some cash flows may escape attention altogether, such as the effect of one project on another project’s cash flows. Here are a few guidelines for identifying incremental cash flows:
• Beware of allocated costs, such as corporate overhead. Usually allocated costs do not change as a result of taking on projects. For example, a new project may use existing idle capacity on the company’s computer network. Assuming that there is no alternative use for the network capacity and support staff, there is no incremental cost. So nothing should be allocated to the new project. On the other hand, the project’s demand for network services may compel the company to add capacity. In this case, the cost incurred is incremental and should be included in the project.
• Consider the opportunity costs of currently owned resources. Take for example, a plant built on land owned by the company. The land entails no out-of-pocket costs; however, it is not a free resource because it has alternative uses. The analyst must consider, as the cost of the land, the income that could be produced from its next-best use. Perhaps it could become a parking lot, be sold, be leased, or be used for growing tomatoes.
• Ignore sunk costs. A sunk cost is money that has already been spent and cannot be recovered. However, it can be difficult (on many levels) to abandon projects on which a great deal of money has been spent. Abandonment has its own costs, and sometimes finishing a project that may have been unwise to begin with is the only way to recover at least some of its costs. The analyst must consider the incremental costs and revenues of completing a project.
• Consider incidental effects of the project. A new product may reduce sales of other company products. For example, a retailer that opens a second location in the same town will lose some customers to the new store. There may be positive inci- dental effects as well. For instance, large airlines subsidize small feeder airlines to deliver passengers to and from their hub airports. For the feeder airlines, these incidental effects make them viable. Identifying and costing all incidental effects of a project is easier said than done. Projects that depend on incidental effects may be very risky and should be taken on with caution.
Cash Flow Categories It is convenient to categorize project cash flows by their timing, that is, when they occur. The initial investment occurs at the beginning of the project’s life, operating income and expense are annual cash flows occurring during the project’s life, and termination cash flows occur when the project ends. Each category includes cash flows from different sources. Figure 6.1 outlines these categories, and they are discussed in further detail below.
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CHAPTER 6Section 6.3 Estimating Project Cash Flows
Figure 6.1: Cash flow categories over a project’s lifetime
Initial investment
• Project cost
• Investment tax credits
• Change in net working capital
• Sale of existing asset
• Tax effect of asset sale
Operating income and expense
• Cash revenues
• Cash expenses
• Depreciation
Project termination
• Income from project sale
• Tax effect on project sale
• Recovery of net working capital
Project cash flows can be categorized across the life of the project. Initial investment cash flows occur at the beginning of the project’s life, operating income and expense flows occur during the project, and termination cash flows occur at the end of the project.
Initial Investment Project cost (cash outflow) may include transportation, insurance, setup, employee train- ing, and prepaid maintenance. For some projects, it may also include infrastructure costs such as roads and utilities. Also included may be planning and design costs such as archi- tectural fees. Be careful to not include sunk infrastructure, planning, and design costs. For simple projects, the outflow occurs at the present time (t 5 0). However, large projects, such as plant construction, may take several years to complete.
Investment tax credits (cash inflow) reduce taxes paid in some proportion to the project cost. From time to time, governments provide tax credits for certain kinds of investments. Currently, there is no general investment tax credit ( ITC) in the United States, but there are ITCs in other countries.
Change in net working capital (cash outflow or inflow) may be required by expansion, diver- sification, and dispersion projects. Increased inventories and receivables may be needed to support increased production. These current assets are tied to the investment and are therefore incremental costs. Generally, we assume that this increased working capital is
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CHAPTER 6Section 6.3 Estimating Project Cash Flows
Wages for employees are a cash outflow operating expense. What additional examples of operating expenses can you think of?
Justin Guariglia/National Geographic Stock
reduced to its prior level on termination of the project, resulting in a decrease, or recovery of net working capital. Some investments may actually reduce the need for net working capital. For example, a new production facility may employ just-in-time inventory con- trol, reducing the need for inventory stocks.
Sale of existing asset (cash inflow) generally occurs only for replacement projects.
Tax effect of asset sale (cash inflow or outflow) must be considered when the sale price of the asset is greater than its depreciated book value and the company owes tax on the dif- ference. If the sale price is less than the book value, the loss reduces the company’s taxable income.
Operating Income and Expense Operating income and expense are annual rev- enues and expenses occurring during the operat- ing life of the project. Of the three categories, the incremental cash flows associated with opera- tions are the most difficult to identify.
Cash revenues (cash inflow) include sales and other incidental income. These cash flows are usually not an annuity because unit sales and prices will not be constant from year to year.
Cash expenses (cash outflow) include materials, labor, fuel or power, maintenance, rents, con- tract services, and any number of other incre- mental costs. As with sales, they normally vary from period to period. Replacement projects may reduce expenses, producing cash savings. These are all operating expenses and do not include interest or other capital costs. Costs of capital are included in the discount rate.
Depreciation (cash inflow) of fixed assets is non- cash, tax deductible expense. The tax saving is the only cash flow resulting from depreciation. For a replacement project, only the change in deprecia- tion between the new and old projects is relevant.
Project Termination Income from project sale (cash inflow) results from assets that have economic value beyond the life of the project. They may be sold intact, in parts, or as scrap. Companies often plan to resell assets after a specified period. Their resale or terminal value may add signifi- cantly to a project’s value.
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CHAPTER 6Section 6.3 Estimating Project Cash Flows
Tax effect of project sale (cash inflow or outflow) is treated in the same way as that on the sale of an existing asset.
Recovery of net working capital (cash inflow or outflow) occurs at the termination of a proj- ect, when the initial change in net working capital is reversed in order to return to the original net working capital position.
Cash Flow Calculations Now, we look at specific calculations for two types of project cash flows.
The Tax Effect of Asset Sales If an asset is sold for more than its depreciated book value, the difference between the sale price and book value is a taxable capital gain. The tax that must be paid equals the gain times the marginal corporate tax rate. A capital loss resulting from a sale price less than book value reduces the company’s tax, assuming that it has other taxable income. The tax treatment of asset sales applies to both initial investment and termination cash flows. To illustrate, consider a project in which existing equipment is to be replaced by new equip- ment costing $10,000 (shown in Table 6.2). The existing equipment may be sold for $3,000, but it has a depreciated book value of $2,500, creating a $500 taxable gain on the sale. The tax rate is 34%. Cash flows are starred (*).
Table 6.2: Tax effect of asset sale
Data Category Value
*Project cost ($10,000)
*Sales price of existing asset $3,000
Book value of existing asset $2,500
Gain (Loss) $500
Tax effect of sale (gain x tax rate) ($170)
To determine the initial cash flow, we add the tax effect to the project cost and sale price:
Initial cash flow 5 Project cost 1 Sale price 1 Tax effect
Initial cash flow 5 (10,000) 1 3,000 1 (170) 5 ($7,170)
Some or all of the gain on an asset sale actually represents the recapture of depreciation. If the tax rate on capital gains and losses is the same as the tax rate on income, the source of the gain is immaterial. However, if the capital gain tax rate is less than that on ordi- nary income, then depreciation recapture must be calculated and the appropriate tax rate applied.
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CHAPTER 6Section 6.3 Estimating Project Cash Flows
Operating Cash Flows The estimates of annual operating income and expenses must be converted to operating cash flows. This is done using the net income approach to calculating cash flows.
Step 1: Calculate taxable income. Earnings before tax (EBT) equal cash revenues minus oper- ating expenses and depreciation.
EBT 5 S – E – dep
Step 2: Calculate corporate income tax. Corporate tax is the product of EBT and the marginal corporate tax rate (tx).
Step 3: Calculate net income or earnings after tax (EAT) by subtracting the tax from the EBT. The final step is to calculate operating cash flow (OCF) by adding depreciation to net income.
OCF 5 EAT 1 dep
Project cash flows and the calculation of operating cash flow are summarized in Table 6.3.
Table 6.3: Classifying project cash flows
Cash flow Classification
Initial investment
Project cost Outflow
Investment tax credit Inflow
Change in net working capital Outflow/inflow
Sale of asset Inflow
Tax effect of sale Outflow/inflow
Operating cash flows
Cash revenues (S) Inflow
Cash expenses (E) Outflow
Depreciation (dep) Noncash expense
Tax Outflow
Calculations for operating cash flows
Earnings before tax (EBT) S – E – dep
Corporate tax EBT 3 tx
Earnings after tax
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CHAPTER 6Section 6.4 Selecting Independent Projects
The Challenge of Estimating Project Cash Flows These guidelines for estimating project cash flows do not capture the difficulty of actually gathering information and producing estimates. A single independent project may include building a plant, installing production equipment, buying trucks, and training workers. Such a project involves gathering and sifting large quantities of information. Incomplete or inaccurate information may lead to an incorrect decision. The large amounts of capital required by many projects make the cost of incorrect decisions that much greater.
Some cash flows, such as equipment costs and taxes, are relatively easy to estimate because their costs are explicit. Future cash flows that are dependent on the success of the project require more sophisticated and time-consuming estimates. Table 6.4 divides project cash flows into two categories: those that are fairly easy to estimate and those that are more difficult. Keep in mind that these categories are guidelines only, not absolutes.
Table 6.4: Estimating project cash flows
Step in project life cycle Less difficult to estimate More difficult to estimate
Initial investment • Project cost • Investment tax credit • Sale of existing asset • Tax effect of asset sale
Change in net working capital
Operating cash flows Depreciation • Cash revenues • Expenses
Project termination • Income from sale of project • Tax effect of project sale • Recovery of net working
capital
6.4 Selecting Independent Projects
As discussed earlier, independent projects are those that do not affect a company’s other projects. Once an independent project has been identified, we must deter-mine whether or not it is a worthwhile endeavor. Recall that net present value plays a key role in project selection by determining expected cash flows.
An independent project should be taken if its NPV is positive (NPV . 0). NPV is a direct measure of the project’s contribution to firm value. Even projects with small NPVs should be taken, at least in principle. Any positive NPV project is expected to produce a cash flow in excess of that needed to provide investors with their required rates of return. Cash flow from a project whose NPV 5 0 should provide these required returns; however, it would produce no residual cash flow to increase shareholder wealth. Therefore, shareholders would be indifferent toward the project.
Next we will examine the equations used to calculate net present value and internal rate of return for an independent project.
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CHAPTER 6Section 6.4 Selecting Independent Projects
Calculating NPV and IRR for Independent Projects Recall that net present value is equal to present value of future cash flows minus the ini- tial investment (NPV 5 PV – II). Present value (PV) is the summation of the discounted operating cash flows (OCF) plus the discounted terminal cash flows (TCF). The formula for calculating NPV is
(6.1) NPV 5 2II 1 a nt 5 1 OCFt
11 1 R1r2 2 t 1 TCFn
11 1 R1r2 2 n
Table 6.5 breaks down the components of Equation (6.1) and Equation (6.2).
Table 6.5: Variables in NPV and IRR equations
Variable Value
II Initial investment
OCFt Operating cash flows in year t
TCF Terminal cash flows
t Year
N Life span (in years) of the project
R(r) Project required rate of return
Remember that internal rate of return is the expected rate of return on a project. IRR is found by solving for the discount rate that equates the present value of future cash inflows to the project cost. To calculate IRR, we use trial and error to find the discount rate that satisfies the condition PV 5 II, which is equivalent to NPV 5 0. Solving for a project’s IRR is the functional equivalent of solving for a bond’s yield to maturity.
For a single future cash flow or a multiple period annuity cash flow, IRR can be solved algebraically. However, project cash flows are seldom annuities, leaving us no choice but to find IRR through trial and error. This is a tedious process without the assistance of a calculator or computer.
The formula for IRR is
(6.2) II 1 a nt 5 1 OCFt
11 1 IRR2 t 1 TCFn
11 1 IRR2 n
Comparing NPV and IRR Results on Independent Projects If a project is found to have a positive net present value, it will also have an internal rate of return greater than its required rate. On the other hand, if the project NPV is found to
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CHAPTER 6Section 6.4 Selecting Independent Projects
be negative (less than 0), then the IRR would also be less than the required rate of return. Symbolically, the relationship between NPV and IRR may be stated
If NPV . 0, then IRR . R(r).
If NPV 5 0, then IRR 5 R(r).
If NPV , 0, then IRR , R(r).
Although IRR does not directly measure the project’s contribution to firm wealth, we see the equivalency of NPV and IRR decision rules (if NPV . 0, then IRR . R(r), etc.). This equivalency leads to an important point: For independent projects, both NPV and IRR analyses will cause us to accept and reject the same projects. Therefore, it does not matter which method of analysis we choose. Both use discounted cash flows and the required rate of return in the investment decision. Net present value uses the required rate of return as a discount rate and produces a dollar value for the project; IRR uses the required return as a hurdle rate, or reference point against which to compare the project’s internal rate of return.
Now, let’s apply what we have learned about determining project value.
Application: The Pogo Harness Project Nine years ago, engineer Paula Bauer founded Pacific Offshore Ltd. (POL) as a supplier of high- quality hardware and gear for sailboats. Five years ago, a suc- cessful initial public offering of stock provided the capital POL needed to meet demand and expand its product line. Paula is most directly involved in prod- uct development and is always looking for ideas that can be turned into new products for the sailor. She often sails with her dog Pogo. After having to fish Pogo out of the water on several occasions, Paula recog- nized the need for a harness that would keep Pogo on board yet give the dog some freedom to move about the boat. Paula and her vice president, Sonny Wheeler, designed and tested a harness that met with Pogo’s approval.
Paula and Sonny calculate that they can produce the harness and associated hardware with an investment of $57,000 in tools and equipment. Alternatively, they could invest about $225,000 in automated, high-speed machine tools that would greatly reduce unit
While the Pogo harness could be considered a product sailors will use, it is essentially an independent project as POL’s investment in it does not affect any other company product.
ZUMA Press/Corbis
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CHAPTER 6Section 6.4 Selecting Independent Projects
production costs at higher production volume. Because the Pogo harness is an untested product, they opt for the lower investment. It will cost an additional $11,000 to slightly alter their manufacturing facility to handle this new product. Increased sales from the Pogo harness project should increase average receivables and inventory from $23,000 to $25,000. Distribution will be handled through normal catalog and chandlery sales, but they also plan to market through pet supply stores, and the Pogo harness will be featured on POL’s new website. Paula and Sonny agree that they will push ahead with the website even if they decide to not produce the Pogo harness. The reconfiguration of the manufac- turing facility will allow POL to sell some older equipment for an estimated $7,800.
Paula estimates that the Pogo harness will produce cash flows for five years. After five years, if demand warrants, she will invest in automated equipment to cut production costs. If there is insufficient demand or if lower-cost competitors have flooded the market, she will cease production. Either way, POL will no longer need the existing tools. Paula’s production manager estimates that the rather specialized tools will bring no more than $12,000 when they are sold in five years. Tools, equipment, and reconfiguration costs are depreciated on a seven-year accelerated cost-recovery schedule. Pacific Offshore’s effec- tive tax rate on income is 34%, and its tax rate on capital gains is 28%. The projected cash flows for the Pogo harness project are shown in Table 6.6 and Table 6.7.
Table 6.6 presents data on the sale of the existing equipment and the sale in Year 5 of the tools of the Pogo harness project. All project cash flows, including operating cash flows, are shown in Table 6.7.
Table 6.6: Pogo harness project: Calculating the tax effect of asset sales
Data Category Cash Value
Sale of existing equipment (Year 0)
Book value (book) $0
Sale price (sale)* 7,800
Capital gain or loss (gain) 7,800
Tax effect of sale (gain) 3 (tax)* 2,184
Sale of Pogo harness project tools (Year 5)
Original purchase price $57,000
Book value (book)** 12,717
Sale price (sale)* 12,000
Capital gain or loss (gain) (717)
Tax effect of sale (gain) 3 (tax)* (201)
* Designates cash flow ** At the end of Year 5, accumulated depreciation totals 77.69% Book value 5 $57,000 x (1 – 0.07769) 5 $12,717 Capital gain tax rate 5 28%
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CHAPTER 6Section 6.4 Selecting Independent Projects
Table 6.7: Pogo harness project: Cash flows
Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Initial investment
Tools and equipment
($57,000)
Plant reconfiguration
($11,000)
Added net working capital
($2,000)
Sale of asset $7,800
Tax effect of sale $2,184
Total ($64,384)
Operating cash flows
Cash revenues (S) $42,500 $49,300 $55,216 $60,185 $65,602
Expenses (E) $29,750 $29,580 $33,130 $30,093 $32,801
Depreciation (Dep) $9,717 $16,653 $11,893 $8,493 $6,072
Earnings before tax (EBT 5 S – E – Dep)
$3,033 $3,067 $10,193 $21,600 $26,729
Tax (tax50.34) (EBT x tax)
$1,031 $1,043 $3,466 $7,344 $9,088
Earnings after tax (EAT 5 EBT – tax)
$2,002 $2,024 $6,728 $14,256 $17,641
Add back depreciation (EAT 1 Dep)
$11,719 $18,677 $18,621 $22,749 $23,713
Project termination cash flow
Income from sale $12,000
Tax effect of sale $201
Recovering net working capital
$2,000
Total $14,201
Annual depreciation rate
14.29% 24.49% 17.49% 12.49% 8.93%
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CHAPTER 6Section 6.4 Selecting Independent Projects
Calculating the NPV and IRR for the Pogo Harness Project The Pogo harness project’s cash flows are summarized in Table 6.8. Pacific Offshore’s required rate of return on investments is 12.5%. For our analysis, this required return (R(r)) is given. In Chapter 7 we will show how to estimate the required rate of return for a project.
Table 6.8: Pogo harness project cash flow summary
Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Initial investment ($64,384)
Operating cash flows $11,719 $18,677 $18,621 $22,749 $23,713
Ending cash flows $14,201
Cash flows ($64,384) $11,719 $18,677 $18,621 $22,749 $37,914
Present value ($64,384) $10,417 $14,757 $13,078 $14,202 $21,040
NPV $9,110
IRR 17.2%
Required rate of return
12.5%
Using the data given, we can expand Equation (6.1) to determine the project’s NPV:
NPV 5 2II 1 a nt 5 1 OCFt
11 1 R1r2 2 t 1 TCFn
11 1 R1r2 2 n
NPV 5 2II 1 OCF1
1 1 R1r2 1 OCF2
11 1 R1r2 2 2 1 OCF3
11 1 R1r2 2 3 1 OCF4
11 1 R1r2 2 4 1 OCF5
11 1 R1r2 2 5
NPV 5 2$64,384 1 $11,719
1.125 1
$18,677 1.1252
1 $18,621 1.1253
1 $22,749 1.1254
1 $37,914 1.1255
NPV 5 $9,110
The NPV indicates that the harness project will add $9,110 in value to the company if our cash flow estimates are correct and if 12.5% is the appropriate required rate of return. Note that the cash flow in Year 5 is the sum of the operating cash flow and termination cash flow ($23,713 1 $14,201).
Now, let’s solve for the IRR for this project.
II 5 a nt 5 1 OCFt
11 1 IRR2 t 1 TCFn
11 1 IRR2 n
$64,384 5 a nt 5 1 $11,719 1 1 IRR
1 $18,677
11 1 IRR2 2 1 $18,621
11 1 IRR2 3 1 $22,749
11 1 IRR2 4 1 $37,914
11 1 IRR2 5
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CHAPTER 6Section 6.4 Selecting Independent Projects
Solving for the discount rate, the IRR for the Pogo harness project is 17.2%. This is the rate that equates the present value of the cash flows in Years 1 through 5 to $64,384.
Comparing NPV and IRR Results for the Pogo Harness Project As we discovered in our calculations above, the IRR for the Pogo harness project is greater than its required rate of return (17.2% . 12.5%), making it a worthwhile project for the company to pursue. If Pacific Offshore Ltd. chooses to invest in the project, it will add $9,110 to the value of the company. Stated another way, if it does not take on the project, it will have missed an opportunity to increase firm value by that amount.
The relationship between NPV and the discount rate is worth exploring further. Figure 6.2 plots the NPV of the Pogo harness project at various discount rates. One of the discount rates is the IRR, which is 17.2%. The IRR of 17.2% is the point at which NPV 5 0. (This is where the line crosses the x-axis.) Note that at discount rates less than 17.2%, NPV is posi- tive, while rates above 17.2% yield negative NPVs.
Figure 6.2: Pogo harness project NPV at various discount rates
IRR $0
$20,000
$50,000 $45,296
$37,960
$31,314
$25,279
$40,000
$30,000
$10,000
$0
Discount rate
N P
V
20%18%16%14%12%10%8%6%4%2%0
($10,000)
$19,786
$14,775
$10,193 $5,996
$2,144
−$4,665
−$1,400
NPV at required return $9,110
The NPV of a project declines if the project has a higher required return.
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CHAPTER 6Section 6.5 Selecting Mutually Exclusive Projects
A city that wants an upgraded stadium must decide whether to renovate or build anew. This is an example of a mutually exclusive project.
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6.5 Selecting Mutually Exclusive Projects
With the Pogo harness project, we saw that both NPV and IRR will lead to the cor-rect accept or reject decision. The harmony between NPV and IRR exists because the Pogo harness project is independent. When projects are not independent, the harmony between NPV and IRR breaks down. There are primarily two types of project dependency: mutually exclusive projects and limited capital budget (capital rationing). In each case, acceptable projects (i.e., those with NPV . 0 and IRR . R(r)) must compete against one another. This implies that some acceptable projects will not be taken. In this section we deal with mutually exclusive projects.
Mutually exclusive projects com- pete with others, all of which are acceptable using NPV and IRR decision rules. The analyst must choose the best of these projects and discard the rest. In most cases, both NPV and IRR will identify the same best project; that is, the project with the high- est NPV will also have the high- est IRR. However, the analyst watches for conditions under which NPV and IRR disagree:
• The timing of cash flows differs substantially between projects. For example, most cash flows for one project occur early in its life, while those for another project occur late in its life.
• Projects are of substantially different size, meaning that one requires a much larger investment than the other.
Timing of Project Cash Flows Let’s look at four mutually exclusive projects to see how timing of cash flows impacts the accord between IRR and NPV.
Table 6.9 shows cash flows, IRR, and NPV for mutually exclusive projects A–D. The required rate of return, R(r), equals 10%. The timing of cash flows differ over the six-year period.
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CHAPTER 6Section 6.5 Selecting Mutually Exclusive Projects
Table 6.9: Mutually exclusive projects with different timing of cash flows
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 NPV at 10%
IRR
A ($9,000) $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $1,453 15.3%
B ($9,000) $500 $500 $2,000 $2,000 $6,000 $6,000 $1,849 14.6%
C ($9,000) $1,700 $1,700 $1,700 $1,700 $1,700 $1,700 ($1,596) 3.4%
D ($9,000) $5,000 $5,000 $1,000 $1,000 $300 $300 $1,468 19.4%
Both NPV and IRR indicate that project C is not acceptable; therefore, we can concentrate on the remaining three projects. Project A is an annuity, project B’s cash flows occur mostly in the later years, and project D’s cash flows occur mostly in the early years. Notice that the project with the late cash flows (B) has the highest NPV, and the project with the early cash flows (D) has the highest IRR. Project A, the annuity, has neither the highest NPV nor the highest IRR. Projects A, C, and D all have IRR greater than the R(r) of 10%; this means that they could all be considered acceptable projects, because their IRR . R(r).
Why does timing of cash flows lead to conflicts between NPV and IRR? Because, for acceptable projects, NPV discounts cash flows at a lower rate, R(r), than does IRR. This affects project selection because discount rates are also compounding rates of return.
In general, IRR favors projects whose cash flows occur mostly in the early years. NPV, which is less affected by compounding because of its lower discount rate, does not favor projects with early cash flows. NPV favors project B with its greater dollar cash flows, even though they occur in the later years. Although this may seem like a technical trivial- ity, it is not if it causes disagreement between NPV and IRR.
Differences in Size of the Initial Investment Now, let us look at four mutually exclusive projects to see how a different size in initial investment disrupts the harmony between IRR and NPV.
Table 6.10 shows the initial investment, cash flows, NPV, and IRR for mutually exclusive projects E–H. As in the previous example, the required rate of return, R(r), equals 10%.
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CHAPTER 6Section 6.5 Selecting Mutually Exclusive Projects
Table 6.10: Mutually exclusive projects with different initial investments
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 NPV at 10%
IRR
E ($5,000) $1,800 $1,800 $1,800 $1,800 $1,800 $1,800 $2,839 27.7%
F ($10,000) $3,300 $3,300 $3,300 $3,300 $3,300 $3,300 $4,372 23.9%
G ($15,000) $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,599 19.9%
H ($20,000) $5,700 $5,700 $5,700 $5,700 $5,700 $5,700 $4,825 17.9%
We see that the largest project (H) has the largest NPV. We expect larger projects to produce greater value. Conversely, the smallest project (E) has the highest IRR. In general, lower- cost investments tend to have higher IRR. If two investments have equal cash flows, the investment that costs the least must have the highest rate of return.
Resolving the Conflict: Choosing NPV Over IRR Most of the time, an analyst will not be faced with having to resolve a conflict between NPV and IRR. Conflicts are irrelevant if projects are independent. For mutually exclusive projects, conflicts are likely only when there are substantial differences in timing of cash flows or differences in project size. When conflicts arise, there are three reasons for choos- ing NPV.
Reason 1: The Rate of Return. For acceptable projects, NPV assumes that project cash flows are compounded at the required rate of return, whereas IRR assumes that cash flows are compounded at a higher rate [IRR . R(r)]. Consider project D in Table 6.8 with its IRR of 19.4%. This project generates a $5,000 cash flow in Year 1 of a six-year life. The IRR method implicitly assumes that this $5,000 is invested at 19.4% for the remaining five years. The NPV method, on the other hand, assumes that the $5,000 is invested at 10% over the same period. Unless the company has other investment opportunities that yield close to 19.4%, it is more prudent to assume that the project cash flows will earn about 10%, which repre- sents the company’s opportunity cost.
Reason 2: Value Creation. NPV is a direct measure of value. For example, project H in Table 6.9 is expected to add $4,825 in value to the company, whereas project E, which has the highest IRR, will add only $2,839 in value.
Reason 3: Multiple IRRs. The cash flows for all investments follow the same basic pat- tern: An initial investment is followed by cash inflows, usually over a number of years. Sometimes the initial investment may last for a number of years before the cash inflows begin. For most projects, once the cash inflows begin, they continue until the project is terminated. However, there are cases where a project may require a midlife investment. A planned upgrade of a plant or equipment would be an example. The cash flow pattern of such an investment is shown in Table 6.11.
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CHAPTER 6Section 6.5 Selecting Mutually Exclusive Projects
Table 6.11: Sample cash flow for project with midlife investment
Year Cash flow (1 or –)
1 –
2 1
3 1
4 1
5 –
6 1
7 1
With this or any similar cash flow pattern involving more than one sign change, there is more than one discount rate that renders NPV 5 0. Therefore, the project has more than one IRR. For such projects, the calculated IRR is unreliable, and IRR should be abandoned in favor of NPV.
Payback as an Alternative to NPV and IRR Before electronics gave us a hand in making complex calculations, payback was the most common means of evaluating a project. Payback period is simply a measure of how many years it takes a project to recoup its initial investment. Table 6.12 compares the payback period for projects A–D from Table 6.9 with their NPV and IRR.
Table 6.12: Comparing payback to NPV and IRR for mutually exclusive projects
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Payback Years
NPV at 10%
IRR
A ($9,000) $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 3.75 $1,453 15.3%
B ($9,000) $500 $500 $2,000 $2,000 $6,000 $6,000 4.67 $1,849 14.6%
C ($9,000) $1,700 $1,700 $1,700 $1,700 $1,700 $1,700 5.29 ($1,596) 3.4%
D ($9,000) $5,000 $5,000 $1,000 $1,000 $300 $300 1.8 $1,468 19.4%
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CHAPTER 6Section 6.5 Selecting Mutually Exclusive Projects
The benefit of simple calculation is no longer a viable reason to use payback rather than NPV and IRR as advanced software and calculators now do the work for you.
PR Newswire/Associated Press
The calculation of payback is quite simple. Project A in has an initial investment of $9,000, and its inflows are outlined in Table 6.13.
Table 6.13: Project A cash inflows
Year Cash inflow Cumulative cash inflow
1 $2400 $2400
2 $2400 $4800
3 $2400 $7200
4 $2400 $9600
5 $2400 $12000
6 $2400 $14400
From the cumulative cash flow column, we see that the $9,000 will be returned sometime during the fourth year. Through interpolation, we deter- mine that payback occurs three-quarters of the way through the fourth year, making the payback period 3.75 years. Payback periods for projects B–D are similarly calculated.
Payback’s single virtue is that it is easily calcu- lated. However, payback has some serious short- comings. First, we have not discounted future cash flows, so the time value of money is ignored. This flaw could be overcome by calculating a pay- back period using discounted annual cash flows. Discounting complicates the calculation, elimi- nating payback’s most basic virtue. Payback also disregards cash flows occurring after the payback period. Project D’s payback is 1.8 years, yet the project produces cash flows for 4 more years. If the last 4 years of Project D’s cash flows were to disappear, its payback would remain at 1.8 years although the project’s value would have diminished.
Notice in Table 6.12 that projects with the lowest payback period are those with the highest IRR. This is because both payback and IRR favor proj- ects with large early cash flows. If we are seeking projects with the greatest NPV, payback leads us down the wrong path. Notice also that we cannot automatically exclude project C, which has a payback of 5.29 years. Project C is unacceptable because of its negative NPV and IRR, which is less than the 10% required return. However, we do not know whether 5.29 years is an unacceptably long payback
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CHAPTER 6Section 6.6 Options in Capital Projects
period. This absence of a definitive criterion for accepting or rejecting a project is yet another failing of payback. Ease of calculation is not a compelling enough reason to use payback in the age of electronics.
6.6 Options in Capital Projects
To most people, options are synonymous with stock options, which are contracts that investors buy and sell in the options market. Stock options have become big news in recent years because they are often a major part of the compensation of executives and employees. In this section, we describe options, explain why they are valuable, and identify options that are associated with capital projects.
Characteristics of Options All options have certain features in common. First, they give the holder the right to buy or sell valuable assets at some future time. Some, like call options, specify the price and time period in which the asset can be purchased. Other options give the holder the right to perform a certain action. For example, a company may contract with a labor union for an option to lay off factory workers temporarily during cyclical reductions in demand for its product. The company holds a put option, which is the right to sell or rid itself of unneeded labor (an asset). In return, the union may extract concessions from the company in the form of job security or compensation. A second feature of options is that they do not bind the holder to buy or sell. The holder will only exercise the option when it is in his or her interest (i.e., it is profitable to do so). A third feature of options is that the seller must honor the terms of the option when the holder chooses to exercise it. Many options, how- ever, carry specific expiration dates. Once the date has passed, the option has no more value than an expired lottery ticket, and the seller is no longer required to honor the terms.
There are two prices associated with options. The first is the price paid by the buyer. This could be in the form of cash, concessions, or some other form. The second is the price paid when the holder exercises an option to buy an asset. It may also be the price received when the holder of a put option exercises an option to sell. The price paid on a call option or received on a put option is called the exercise price.
An Option Example You may be more familiar with options than you realize. Consider a pizza coupon. Sup- pose The Pizza Company offers a coupon that gives you the right to buy their famous Kitchen Sink pizza that normally sells for $13.99 for $9.99, however, you must use it by November 15. This coupon is an example of a call option contract. The valuable asset is the pizza, the exercise price is $9.99, and the expiration date is November 15.
Another familiar example involves buying a house. A buyer makes an offer on a house for $200,000. The buyer accompanies the offer with an earnest money check for $2,000. This earnest money is the price of a call option on the house, effectively taking the house off the market and giving the buyer a few days to reconsider and arrange financing. The
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CHAPTER 6Section 6.6 Options in Capital Projects
Options are more familiar than you would think, as coupons are a type of option. Can you think of any other examples of everyday options?
PR Newswire/Associated Press
buyer may then exercise her option to buy the house for the exercise price of $200,000. If she chooses not to buy, she loses her earnest money.
The cost of the option on the home is explicit, $2,000. The pizza coupon is nominally free, but there is a cost (at least The Pizza Company hopes there is a cost). If you were going to buy a Kitchen Sink pizza without the coupon, then The Pizza Company has lost the difference between the regular price and the coupon price. On the other hand, you may be tempted to visit The Pizza Company instead of your regular pizza parlor and try a Kitchen Sink pizza. If you like it, you could become a regular customer of The Pizza Com- pany. If you don’t, you paid only $9.99 for the pizza.
We exercise a call option when the value or price of the asset exceeds the exercise price. Obviously, the pizza coupon would be worthless if you could buy the pizza for $9.99 or less without the cou- pon. Conversely, we exercise a put option (to sell) if the exercise price exceeds the value of the asset. Often a put option can be thought of as the oppo- site of a call option. For example, if The Pizza Company thought that it could sell all the pizzas it could make at $13.99, it would not offer the cou- pon. It offers the coupon because selling pizza for $9.99 is better than selling it for a lower price, giv- ing away free pizza, or losing inventory through spoilage.
It is important to note that, because options do not have to be exercised, they can never have a nega- tive value. Options are exercised only when they have value to the holder; otherwise, they simply expire. This is not to say that an investor cannot lose money by buying an option. If you pay $100 for an option that ultimately proves to be worth- less, you will not exercise the option, and you will have lost $100. If the option has a value of $50,
you will exercise it, losing only $50. This is an important point. If the option has any value at all, it should be exercised. Doing so will at least cut your loss. Next, we examine the five factors that make options valuable.
Factors That Affect the Value of an Option Let’s begin by examining two of the factors that make options valuable. The first is the value of the optioned asset. The second is the exercise price. Options gain value as the difference between the asset value and exercise price widens. For a call option, this will occur if the asset value rises or the exercise price falls. Returning to The Pizza Company example, if the normal price of the pizza rises to $15.99 from $13.99, the coupon rises in value by $2.00. At $13.99, the $9.99 coupon saves you $4.00. At $15.99, it saves you $6.00. If The Pizza Company offers another coupon for a Kitchen Sink pizza at $8.99, this coupon would be worth $1.00 more than the $9.99 coupon because the savings on a $13.99 pizza
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CHAPTER 6Section 6.6 Options in Capital Projects
would rise from $4.00 to $5.00. If there were a market for pizza coupons, their minimum value would equal the amount of the savings, which is the market price minus the exer- cise price. It is possible that the value could be greater, depending on whether pizza prices were expected to rise.
Summarizing the first two factors that affect option value:
1. All else being equal, as an option’s exercise price goes down, the value of a call option increases.
2. All else being equal, the higher the price of the underlying asset is, the higher the value of a call option will be.
Note as well that the coupon might have value even if the current promotional price of a pizza were less than the coupon price. The coupon has value, for example, if it does not expire for a month, during which time there is a reasonable chance that the price of pizza will rise above the coupon price. Now, suppose that the coupon will expire tomorrow. It is unlikely that the promotion will end by tomorrow. In that case, the coupon is essentially valueless. Time to expiration, therefore, is another factor affecting option value:
3. All else being equal, as the time to expiration increases, the value of a call option increases.
Consider a situation in which pizza prices are highly variable because of a shortage of mozzarella cheese. When The Pizza Company has to pay a premium for cheese, the price of the Kitchen Sink pizza may rise to as much as $19.99. The possibility of prices greater than $13.99 makes the coupon even more valuable. People will conserve their coupons when the price is $13.99 to use when the price is $19.99. At prices above the exercise price, the savings—and hence the value of the coupon—increases dollar for dollar. At $19.99, the coupon is worth $10.00 ($19.99 – $9.99). When the price is $13.99, the coupon is nominally worth $4.00; however, with the price of pizza almost certain to rise above $13.99, people are willing to pay more than $4.00 for a coupon. Price volatility of the asset, therefore, is another factor affecting option value.
4. All else being equal, the more volatile the price of the underlying asset is, the more valuable the option will be.
The final factor that affects option value relates to the time value of money lessons we learned earlier in this text. In effect, options allow us to defer payment, and because money has time value, this deferred payment adds value to the option. The time value of the deferred payment increases with the interest rate.
5. All else being equal, as interest rates rise, the value of option contracts will also increase.
Table 6.14 summarizes the five factors that affect the value of options.
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CHAPTER 6Section 6.6 Options in Capital Projects
Table 6.14: Factors affecting the value of call options
Factor 1 As an option’s exercise price goes down, the value of a call option increases.
Factor 2 The higher the price or the underlying asset, the higher the value of a call option.
Factor 3 As the time to expiration increases, the value of a call option increases.
Factor 4 Higher volatility of the price of the underlying asset increases the value of the option.
Factor 5 As interest rates rise, the value of option contracts also increases.
Real Options Options associated with capital projects are known as real options. These are called real options, to distinguish them from options contracts on stocks and other securities. Real options are important attributes of many projects, although they are often difficult to identify and value. Here, we look more closely at different types of real options, and why the valuation of real options is often problematic.
Many companies have learned that taking into account the options in projects significantly affects their investing decisions. This options approach has become a partial substitute for long-range planning, which relies on forecasts of future events. By contrast, options thrive on uncertainty. Rather than relying on forecasts to select projects, companies may seed a number of projects, recognizing that many will never be developed. They expect that those that are developed will be very profitable. By seeding a number of projects, a company is giving itself the option to develop the projects that are most promising as time goes by and markets develop.
Options as a Strategic Investment. Options are ideal hedges against an uncertain future, such as unforeseen changes in product demand. For example, a car company could opt to pay an extra $3 million in design and manufacturing costs for a plant that can quickly change production from one model to another. This would allow the manufacturer to change over production in just a few days, as opposed to the industry standard of several weeks. This changeover option represents a hedge against unforeseen changes in demand for certain car models. It allows the company to reduce the risk associated with an unclear future, but the option does come with a price (in this case, the price is $3 million).
Options to Close Down and Start Up. The option to close a project down and then start it back up at a later time can be valuable. This option can be particularly profitable when dealing with products whose market prices are subject to great volatility, such as electricity.
The Option to Abandon a Project. In NPV analysis, we estimate the life of the project. How- ever, as mentioned earlier in this chapter, there are times when the project should be aban- doned or terminated prior to the end of its expected life. To determine whether the project should be abandoned in any particular year, we compare the salvage value in that year to the discounted value of the project’s remaining cash flows. If the salvage value exceeds the discounted value of the remaining cash flows, then the project should be immediately terminated. In effect, we are determining whether the project is worth more dead than alive.
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CHAPTER 6Section 6.6 Options in Capital Projects
To understand the abandonment option, consider the printing press project in Table 6.15. The press initially costs $60,000 and will be used to print a weekly newspaper. Revenues are generated from advertising and subscriptions. The expected life of the project is six years. The project’s after-tax cash flows follow a typical life cycle pattern. They rise as sales build and then flatten and decline as competing newspapers enter the market or as demand for weekly newspapers wanes. Because the printing press has many alternative uses, its salvage value initially declines slowly, reflecting wear and tear rather than obso- lescence. At a discount rate of 12%, the six-year project has a positive NPV of $14,410, so the project is accepted.
Table 6.15: Cash flows for printing press project
Data Category Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Operating cash flows
$12,000 $16,000 $18,000 $18,000 $14,000 $10,000
Salvage value $56,000 $52,000 $48,000 $44,000 $34,000 $27,000
To determine the optimal termination date, we compute the NPV, including salvage value, for each year. For example, if we abandon after the first year, we receive the operating cash flow of $12,000 for Year 1 plus the salvage value of $56,000. Discounting at 12% results in an NPV (abandon after year 1) of $714.29
NPV 5 PV 2 Initial investment
NPV (Year 1) 5 12,000 1 56,000
1.12 2 60,000 5 $714
Using this approach, the NPV of abandonment at Years 2 through 5, are
NPV (Year 2) 5 12,000
1.12 1
16,000 1 52,000 1.122
– 60,000 5 $4,923
NPV (Year 3) 5 12,000
1.12 1
16,000 1.122
1 18,000 1 48,000
1.123 – 60,000 5 $10,447
NPV (Year 4) 5 12,000
1.12 1
16,000 1.122
1 18,000 1.123
1 18,000 1 44,000
1.124 – 60,000 5 $15,684
NPV (year 5) 5 12,000
1.12 1
16,000 1.122
1 18,000 1.123
1 18,000 1.124
1 14,000 1 34,000
1.125 2 60,000 5 $14,957
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CHAPTER 6Section 6.6 Options in Capital Projects
This analysis shows that the highest NPV occurs when the project ends after Year 4. Beyond Year 4, the present value of the additional operating cash flows do not compensate for the loss in the asset’s salvage value. In other words, the cost of continuing exceeds the benefits of continuing to receive operating cash flows. Being able to abandon the project early, in Year 4, raises project value by $1,274, which is the value of the project if it is sold in Year 4 minus its value if it is sold in Year 6 (15,684 – 14,410). If the company had to buy the option to terminate the project before Year 6, it could pay up to this amount and shareholders would still benefit. Thus, the abandonment option is worth $1,274.
The value of the abandonment option increases with the salvage value of the asset. A primary determinant of salvage value is the number of alternative uses for the asset. A generic asset that can be used in many applications is generally more valuable than a highly specialized asset with few uses. Specialized assets—machines and equipment— tend to be productively more efficient. Quite often a company must consider the tradeoff between a specialized asset that increases operating cash flows by lowering production costs and a generic asset that increases salvage value.
Adjusting NPV for the Option Effect Computing a precise value for real options is difficult because the amount and timing of payoffs is uncertain and, in some cases, not measurable. In some situations there is no need to make the computation. For example, suppose that a project has a positive NPV before consideration of an abandonment option. In this case, the option merely adds value to an already acceptable project. Unless you are faced with pursuing capital rationing or choosing between mutually exclusive investments, where the option may change a proj- ect’s relative standing among competing projects, there is no reason to calculate the option value. Remember that for an independent project the only requirement for acceptance is that it has a positive NPV.
When a project has a slightly negative NPV before consideration of potentially value- enhancing options, we must estimate the option’s value, using the five factors that affect option value as a guide. A sufficiently valuable option could cause us to accept a project that may otherwise be rejected. Any analysis must begin by determining whether or not the option might ever be used. For example, if we know we will continue with a project through its entire economic life, then the abandonment option has no value and no further consideration is needed. Of course, not all options are imbedded in projects. Some must be purchased. Other options, even though they may be attached to projects, may add cost to the project. In these cases, the decision must be made on whether to buy the option, and this requires us to estimate the option’s value.
Ignoring options that are attached to investment projects means ignoring some of the projects’ potential value, implying that some profitable projects will be rejected. Valu- ing real options remains elusive, but the five factors that affect option value can serve as a framework for making estimates. Considering these options, even in this rough way, helps managers identify profitable investments.
A final word of caution: We must be careful when we modify rigorous analyses with edu- cated guesses. It is possible for a manager to use such hasty analysis to make any project look profitable. If a project is accepted because of the value of its attached options, then
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CHAPTER 6Post-Test
those options and the source of their value must be carefully considered. The presence of options, real or imagined, should not be used as a pretext for taking on ill-advised projects.
Conclusion
The decision to invest in long-term assets is crucial to the long-run success of a corpo-ration. This investment represents the implementation of the corporate mission and goals. If the company does not have a clear sense of where it is going, it may invest its resources in inappropriate product markets. In this chapter, we outlined a process for translating a corporate strategic plan into identification of specific projects. We also sug- gested a method of classifying projects according to the amount of management attention required.
We then showed how to distill dependent projects down to an array of independent proj- ects, which can be evaluated using either NPV or IRR. We showed that NPV and IRR methods of analysis are entirely consistent with each other for independent projects but may give conflicting accept/reject signals when used to choose from among mutually exclusive projects. If such conflicts arise, we should opt to select projects on the basis of NPV rather than IRR. In the final analysis, NPV gives us a direct measure of the value added to the company by an investment project.
Finally, we showed that many investment projects also contain call options on future investment opportunities and put options on projects that may be terminated. Although these options may be difficult to value explicitly, they may nonetheless be useful enough to influence the investment decision.
Post-Test
1. Net present value measures the dollar amount that shareholder wealth will increase if a project is accepted.
a. True b. False
2. The least common strategies for exploiting market opportunities are cost leader- ship and differentiation.
a. True b. False
3. The cash flows used in NPV analysis are incremental after-tax cash flows. a. True b. False
4. A project can have just one NPV but could have more than one IRR. a. True b. False
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CHAPTER 6Post-Test
5. The payback period is a good alternative to either NPV or IRR. a. True b. False
6. In capital budgeting, the ability to abandon a project early can add value to the project.
a. True b. False
7. How does NPV determine asset value? a. It determines the dollar value an investment adds to the firm. b. It compares the expected return to the required return. c. It measures how many years it will take to make up for the project’s
investment. d. It determines operating income and expense.
8. Which of the following would NOT be considered an expansion project? a. An ice cream franchise opens a new store in the mall. b. A small paper retailer leases the building next door to add warehouse space. c. An artisan baker opens an artisan cheese shop next door to the flagship
location. d. A small dairy farmer purchases additional land for grazing.
9. Cash flows for NPV analysis would probably NOT include a. the initial working capital investment. b. the cost of new equipment. c. the tax shield benefits of depreciation. d. an allocation for overhead fixed costs.
10. Advanced Valves Inc. seeks to upgrade a machine. The old machine was pur- chased five years ago for $96,000. It is being depreciated over eight years to zero book value using the straight-line method. Its current book value is $36,000. Its current market value is $30,000. The new machine costs $140,000. It will be depre- ciated over seven years to zero book value using the straight-line method. After its useful life of 10 years it is expected to have a scrap value of $30,000. The new machine will increase earnings before depreciation and taxes by $30,000 per year for 10 years. The company’s tax rate is 30%, and the appropriate discount rate for this project is 10%. Compute the IRR and payback for this project.
a. IRR 5 8.4%, Payback 5 5.97 years b. IRR 5 8.4%, Payback 5 4.97 years c. IRR 5 19.3%, Payback 5 4.97 years d. IRR 5 19.3%, Payback 5 3.41 years
11. Capital rationing implies that a company has a fixed investment budget so it must choose among its positive NPV projects, and some good projects will not be funded. What are the criteria for choosing the set of projects to be funded?
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CHAPTER 6Key Ideas
a. Rank the projects by their NPV, highest to lowest, and fund the highest NPVs until all the funds are used.
b. Rank the projects by their IRR, highest to lowest, and fund the highest IRRs until all the funds are used.
c. Rank the projects by cost, lowest to highest, and fund the least expensive proj- ects until all the funds are used.
d. Choose the set of projects that have the highest aggregate NPV within the allowed budget.
12. Which of the following is NOT true regarding options? a. They are useful in volatile pricing markets. b. They require stable market conditions. c. Their valuation can be difficult to determine. d. They may add cost to a project.
Answers 1. a. True. The answer can be found in Section 6.1. 2. b. False. The answer can be found in Section 6.2. 3. a. True. The answer can be found in Section 6.3. 4. a. True. The answer can be found in Section 6.4. 5. b. False. The answer can be found in Section 6.5. 6. a. True. The answer can be found in Section 6.6. 7. a. It determines the dollar value an investment adds to the firm. The answer can be found in Section 6.1. 8. c. An artisan baker opens an artisan cheese shop next door to the flagship location. The answer can be
found in Section 6.2. 9. d. An allocation for overhead fixed costs. The answer can be found in Section 6.3. 10. d. IRR 5 19.3%, Payback 5 3.41 years. The answer can be found in Section 6.4. 11. d. Choose the set of projects that have the highest aggregate NPV within the allowed budget. The
answer can be found in Section 6.5. 12. b. They require stable market conditions. The answer can be found in Section 6.6.
Key Ideas
• Fixed assets can be classified as tangible (machinery, real estate) or intangible (copyrights, patents, contracts).
• Net present value measures the value added to the firm by an investment. The NPV of an investment is the present value of the future cash flows minus the initial investment.
• The IRR criteria compares the expected return for a project to the required return for investors, given the project’s risk. If the expected return exceeds that require- ment, then the project should be pursued.
• Companies may choose to undertake three types of projects: replacement, expan- sion, and diversification.
• Mutually exclusive projects are substitutes for each other, requiring either/or decisions.
• Independent projects all have equal status, meaning that the company may invest in any knowing that each investment decision does not affect the others.
• When estimating cash flows, consider only incremental cash flows by remem- bering to beware of allocated costs, consider the opportunity costs of currently owned resources, ignore sunk costs, and consider incidental effects of the project.
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CHAPTER 6Key Terms
Critical Thinking Questions
1. Individuals and families, like corporations, have long-term investments. What are two investments that most families have?
2. Some companies, such as Motorola, spend millions of dollars each year on employee training. The cost of this training is treated as an accounting expense, but it may really be an investment. Why might training be an investment?
3. Apple is now the highest valued company in the world at over $600 billion. Apple earned this position by producing products with very high profit margins. Think about Apple’s products and explain what Apple does to maintain such high profit margins (much higher than competitors). High profit margins almost always imply products with large positive NPVs. What is the source of Apple’s huge positive NPVs?
4. Over the past few years, we have seen film cameras and video rental stores disappear, many book stores close, and much discussion about whether print newspapers will survive this decade. What does this imply about project propos- als that assume 10 or 15 years of high cash flows?
5. In July 2011, Nortel Networks, a now closed Canadian telecommunications com- pany, auctioned off its patents. The auction brought in $4.5 billion from bidders that included Apple, Microsoft, and four other companies. Google was among the companies that were outbid. Why would these companies spend so much on patents? See Web Resources at the end of Chapter 6 for more details about this auction.
Key Terms
abandonment The option to terminate or sell a project before the end of its func- tional life.
after-tax cash flows The amount of cash flow remaining after taxes have been deducted.
allocated costs Costs, such as overhead costs, that do not necessarily change as a result of taking on a project.
call option The right, but not the obliga- tion, to buy an asset at a specified price within a specified time period.
capital budgeting The process in which a business determines whether projects are worth pursuing.
complementary projects Investment proj- ects that are related such that all or none must be taken.
dispersion projects Investments that add new geographic regions, including other countries, to a company’s operations.
diversification projects Investments that add new products or product lines to a company’s operations.
exercise a call option The purchase of an asset under the terms of an option contract.
exercise price Price at which an asset may be bought or sold by the owner of an option.
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CHAPTER 6Key Formulas
Key Formulas
Net Present Value
(6.1) NPV 5 a nt 5 1 OCFt
11 1 R1r2 2 t 1 TCFn
11 1 R1r2 2 n
Internal Rate of Return
(6.2) II 1 a nt 5 1 OCFt
11 1 IRR2 t 1 TCFn
11 1 IRR2 n
expansion projects Investments that expand existing capacity, such as adding new machinery or equipment to increase output.
expiration date The date that an option to buy or sell an asset lapses.
fixed assets Long-term investments. They may be tangible, such as machinery and equipment, or intangible, such as patents and employee training.
hurdle rate A required rate of return, or reference point, against which to compare a project’s internal rate of return.
incidental effects Indirect effects of an investment. Costs or revenues not nor- mally associated with the investment.
incremental cash flows The change in cor- porate cash flows attributable to a project.
independent projects The decision to invest in any project has no impact on the decision to invest in any other project.
internal rate of return (IRR) The discount rate that equates the present value of an investment’s future cash flows with the investment’s cost.
mutually exclusive projects Investment projects that are related such that only one can be taken.
net present value (NPV) The present value of future cash flows minus the initial investment. NPV is the present value of all cash flows connected to an investment.
opportunity costs The amount of the highest valued forgone alternative.
payback period A measure of how many years it takes to recoup the initial invest- ment in a project.
put option The right, but not the obliga- tion, to sell an asset at a specified price within a specified time period.
real options Options associated with capi- tal projects.
recovery of net working capital The reduction in net working capital associated with the termination of an investment.
replacement projects Investments that update or upgrade existing capacity; such as replacing worn out or obsolete machin- ery and equipment.
sunk costs A cost that has already been incurred. The cost is irretrievable. Sunk costs are not relevant in decision making.
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CHAPTER 6Web Resources
Web Resources
A Business Week article from July 19, 2011 discusses the importance of patents to leading technology companies: http://www.bloomberg.com/news/2011-07-20/patents-are-very-valuable-tech-giants- discover-nathan-myhrvold.html
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