OM FINAL

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

CHAPTER TWO: CAPITAL BUDGETING

Yi Zhou

Associate Professor Department of Finance

College of Business San Francisco State University

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

NET PRESENT VALUE NPV EXAMPLES NPV’S ADVANTAGES & DISADVANTAGES

NET PRESENT VALUE

Net present value (NPV ): the difference between an investment’s market value and its cost.

NPV is a measure of how much value is created or added today by undertaking an investment, and how well the project will meet the goal of increasing shareholder wealth.

The capital budgeting process can be viewed as a search for investments with positive net present values.

NPV > 0: Project is expected to add value to the firm will increase the wealth of the owners. NPV = 0: Project’s inflows are exactly sufficient to repay the invested capital.

We estimate NPV by using discounted cash flow, or DCF, valuation.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

NET PRESENT VALUE NPV EXAMPLES NPV’S ADVANTAGES & DISADVANTAGES

NPV EXAMPLE 1

Suppose we are asked to decide whether or not a new consumer product should be launched. Based on projected sales and costs, we expect that the cash flows over the five-year life of the project will be $2,000 in the first two years, $4,000 in the next two, and $5,000 in the last year. It will cost about $10,000 to begin production. We use a 10 percent discount rate to evaluate new products. What should we do here?

NPV = −10, 000 + 2, 000 1.10

+ 2, 000 1.102

+ 4, 000 1.103

+ 4, 000 1.104

+ 5, 000 1.105

(1)

= −10, 000 + 1, 818 + 1, 653 + 3, 005 + 2, 732 + 3, 105 (2) = 2, 313 (3)

This is positive; we should take on the project.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

NET PRESENT VALUE NPV EXAMPLES NPV’S ADVANTAGES & DISADVANTAGES

NPV EXAMPLE 2

Assume that Gerhardt Corporation is considering an investment of $50 million in a capital project that will return after-tax cash flows of $16 million per year for the next four years plus another $20 million in year five. The required rate of return is 10 percent.

NPV = −50 + 16

1.101 +

16 1.102

+ 16

1.103 +

16 1.104

+ 20

1.105 (4)

= −50 + 14.545 + 13.223 + 12.021 + 10.928 + 12.418 (5) = 13.136 (6)

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

NET PRESENT VALUE NPV EXAMPLES NPV’S ADVANTAGES & DISADVANTAGES

NPV EXAMPLE 3

Consider the Hoofdstad Project, which requires an investment of $1 billion initially, with subsequent cash flows of $200 million, $300 million, $400 million, and $500 million. What is the net present value of the Hoofdstad Project if the required rate of return of this project is 5%?

NPV = −1, 000 + 200

1.051 +

300 1.052

+ 400

1.053 +

500 1.054

(7)

= −1, 000 + 190.48 + 272.11 + 345.54 + 411.35 (8) = 219.46 (9)

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

NET PRESENT VALUE NPV EXAMPLES NPV’S ADVANTAGES & DISADVANTAGES

NPV’S ADVANTAGES & DISADVANTAGES

Advantages

Easy to understand (i.e., value added).

Considers the time value of money.

Considers all project cash flows.

Disadvantages

Result is a monetary amount, not a return.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

PAYBACK PERIOD

PAYBACK PERIOD

The payback period is the length of time it takes to recover the initial cash outlay of a project from future incremental cash flows. In the following example, the payback occurs in the last year, Year 4:

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

PAYBACK PERIOD

PAYBACK PERIOD: IGNORING CASH FLOWS

The payback period for both Project X and Y is three years, even through Project X provides more value through its Year 4 cash flow:

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INTERNAL RATE OF RETURN (IRR) IRR’S ADVANTAGES & DISADVANTAGES

INTERNAL RATE OF RETURN (IRR)

Consider the following Project, which requires an investment of $1 billion initially, with subsequent cash flows of $200 million, $300 million, $400 million, and $500 million. What is the IRR?

0 = −1, 000 + 200

(1 + IRR)1 +

300 (1 + IRR)2

+ 400

(1 + IRR)3 +

500 (1 + IRR)4

(10)

After several rounds of trials and errors

IRR = 12.826%

You will NOT be tested on how to calculate IRR in the final exam of FIN 351.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INTERNAL RATE OF RETURN (IRR) IRR’S ADVANTAGES & DISADVANTAGES

IRR’S ADVANTAGES & DISADVANTAGES

Solved iteratively. The problem is that we cannot solve directly for IRR, but rather must either iterate (trying different values of IRR until the NPV is zero) or use a financial calculator or spreadsheet program to solve for IRR.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS EXAMPLE: RANKING CONFLICTS THE MULTIPLE IRR PROBLEM

INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS

When evaluating more than one project at a time, it is important to identify whether the projects are independent or mutually exclusive. This makes a difference when selecting the tools to evaluate the projects.

Independent projects are projects in which the acceptance of one project does not preclude the acceptance of the other(s). Example: A large conglomerate is introducing a new soup and a new peanut butter substitute.

Mutually exclusive projects are projects in which the acceptance of one project precludes the acceptance of another or others. Example: An airline requires a single jet for a new route. The airline can buy a jet from Boeing or Airbus, but cannot buy one from each.

If projects are independent, accept if NPV > 0 produces the same result as when IRR > r. If projects are mutually exclusive, accept if NPV > 0 may produce a different result than when IRR > r.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS EXAMPLE: RANKING CONFLICTS THE MULTIPLE IRR PROBLEM

EXAMPLE: RANKING CONFLICTS

Consider two mutually exclusive projects, Project P and Project Q: Which project is preferred and why?

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS EXAMPLE: RANKING CONFLICTS THE MULTIPLE IRR PROBLEM

EXAMPLE: PROJECT P AND PROJECT Q

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS EXAMPLE: RANKING CONFLICTS THE MULTIPLE IRR PROBLEM

NPV PROFILES: PROJECT P AND PROJECT Q

From IRR only, Project Q is preferred. However, from NPV, the choice is more complicated.

For required rates of return less than 4.89%, Project P is preferred (that is, higher NPV).

For required rates of return between 4.89% and 12.11%, Project Q is preferred.

For required rates of return above 12.11%, both projects are rejected.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS EXAMPLE: RANKING CONFLICTS THE MULTIPLE IRR PROBLEM

THE MULTIPLE IRR PROBLEM

If cash flows change sign more than once during the life of the project, there may be more than one rate that can force the present value of the cash flows to be equal to zero. This scenario is called the “multiple IRR problem."

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS EXAMPLE: RANKING CONFLICTS THE MULTIPLE IRR PROBLEM

EXAMPLE: THE MULTIPLE IRR PROBLEM

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

BEGINNING: INVESTMENT OUTLAY AFTER-TAX OPERATING CASH FLOW (OCF) TERMINAL YEAR MACRS SCHEDULE

CASH FLOW PROJECTIONS

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

BEGINNING: INVESTMENT OUTLAY AFTER-TAX OPERATING CASH FLOW (OCF) TERMINAL YEAR MACRS SCHEDULE

BEGINNING: INVESTMENT OUTLAY

Investment Outlay = FCInv + NWCInv − (1 − T)Sal0 − TB0

FCInv = Investment in new fixed capital

NWCInv = Investment in net working capital

Sal0(1 − T) = After-tax salvage value from sale of old fixed capital if applicable.

T = Tax rate

B0 = Book value of old fixed capital if applicable.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

BEGINNING: INVESTMENT OUTLAY AFTER-TAX OPERATING CASH FLOW (OCF) TERMINAL YEAR MACRS SCHEDULE

AFTER-TAX OPERATING CASH FLOW (OCF)

After-tax Operating Cash Flow =

OCF = (S − C − D)(1 − T) + D = (S − C)(1 − T) + TD.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

BEGINNING: INVESTMENT OUTLAY AFTER-TAX OPERATING CASH FLOW (OCF) TERMINAL YEAR MACRS SCHEDULE

TERMINAL YEAR

Terminal Year OCF = OCFT + SalT (1 − T) + NWCInv + TBT

SalT (1 − T) = After-tax salvage value.

NWCInv = Investment in working capital.

BT = Book value of fixed capital on termination date if applicable.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

BEGINNING: INVESTMENT OUTLAY AFTER-TAX OPERATING CASH FLOW (OCF) TERMINAL YEAR MACRS SCHEDULE

MACRS SCHEDULE

Will be Provided at All Tests.

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

EXAMPLE: CASH FLOW ANALYSIS

EXAMPLE: CASH FLOW ANALYSIS

Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The

initial cost of the assets is $95 million, and the company’s working capital would increase by

$13 million during the life of the new product. The new product is estimated to have a useful

life of four years, at which time the assets would be sold for $16 million. Management expects

company sales to increase by $140 million the first year, $175 million the second year, $155

million the third year, and then trailing to $65 million by the fourth year because competitors

have fully launched competitive products. Operating expenses are expected to be 70% of sales,

and depreciation is based on an asset life of three years under MACRS (modified accelerated

cost recovery system). Year 1: 33.33%, Year 2: 44.45%, Year 3: 14.81% and Year 4: 7.41%.If

the required rate of return on the Vitamin-Burger project is 8% and the company’s tax rate is

30%, should the company invest in this new product?

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

EXAMPLE: CASH FLOW ANALYSIS

EXAMPLE: CASH FLOW ANALYSIS

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS PESSIMISTIC SCENARIO MOST LIKELY SCENARIO OPTIMISTIC SCENARIO

INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS PESSIMISTIC SCENARIO MOST LIKELY SCENARIO OPTIMISTIC SCENARIO

PESSIMISTIC SCENARIO

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS PESSIMISTIC SCENARIO MOST LIKELY SCENARIO OPTIMISTIC SCENARIO

MOST LIKELY SCENARIO

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING

NET PRESENT VALUE PAYBACK PERIOD

INTERNAL RATE OF RETURN (IRR) RANKING CONFLICTS: NPV VS. IRR

CASH FLOW PROJECTIONS EXAMPLE: CASH FLOW ANALYSIS

SCENARIO ANALYSIS

INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS PESSIMISTIC SCENARIO MOST LIKELY SCENARIO OPTIMISTIC SCENARIO

OPTIMISTIC SCENARIO

YI ZHOU CHAPTER TWO: CAPITAL BUDGETING