CF III InvestmentManagemt PreRead

8/3/2019 CF III InvestmentManagemt PreRead

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Winter Term 2009 1Markus Neuhaus I Corporate Finance I [email protected]

Corporate Finance

Investment management

Dr. Markus R. NeuhausPatrick Schwendener, CFA


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Corporate Finance: Course overview

18.09. Fundamentals (4 hours) M. Neuhaus & M.Schmidli

25.09 Investment Management M. Neuhaus & P. Schwendener

02.10. Investment Management M. Neuhaus & M. Bucher

09.10. No Lecture No Lecture

16.10. Value Management M. Neuhaus, R. Schmid & F. Monti 23.10. No Lecture No Lecture 30.10. No Lecture No Lecture

06.11. No lecture No Lecture

13.11. Mergers & Acquisitions I&II (4 hours) M. Neuhaus & D. Villiger

20.11 Tax and Corporate Finance (4 hours) Markus Neuhaus

27.11. Legal Aspects R. Watter

04.12. Financial Reporting M. Neuhaus & M. Jeger

11.12. Turnaround Management M. Neuhaus & Markus Koch

18.12. Summary, repetition M. Neuhaus


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Markus R. Neuhaus

PricewaterhouseCoopers AG, ZrichPWC

Phone: +41 58 792 4000Email: [email protected]

Grade CEO

Qualification Doctor of Law (University of Zurich), Certified Tax Expert

Career Development Joined PwC in 1985 and became Partner in 1992.

Subject-related Exp. Corporate Tax

Mergers + Acquisitions

Lecturing SFIT: Corporate Finance, University of St. Gallen: Tax Law

Multiple speeches on leadership, business, governance, commercial

and tax law Published Literature Author of commentary on the Swiss accounting rules

Publisher of book on transfer pricingAuthor of multiple articles on tax and commercial law, M+A,IPO, etc.

Other professional roles: Member of the board of conomiesuisse, member of the boardand chairman of the tax chapter of the Swiss Institute of

Certified Accountants and Tax Consultants


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Patrick Schwendener

PricewaterhouseCoopers AG, ZrichPWC

Phone: +41 58 792 15 08Email: [email protected]

Grade Advisory Manager

Qualification lic. oec. HSG, CFA

Career Development Corporate Finance PricewaterhouseCoopers sinceOctober 2004

Subject-related Exp. Various projects in the field of valuation Lecturing Treuhandkammer - Business valuations using DCF technique

KV Zurich Business School - Capital budgeting

Published Literature Several articles on valuation topics


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Contents

Learning targets

Pre-course reading

Lecture Investment management

Case study

Solution to case study


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Learning targets

Know the discipline of investment management and its relevant stakeholders andunderstand their contributions and responsibilities

Understand the strategic importance of investing and the various types of investments

Distinguish between static and dynamic methods and know the characteristics of thevarious analysis methods in each category and their similarities

Know when to apply which methods and be able to make a qualified judgment whetheran investment opportunity should be undertaken or not

Know potential limitations and shortcomings of quantitative capital budgeting methods


7/59Winter Term 2009 7Markus Neuhaus I Corporate Finance I [email protected]

Contents

Learning targets

Pre-course reading


Case study




Pre-course reading

Books

Mandatory reading

Brealey, Myers, Allen (2008): chapter 2 (pp.13 - 23)

Brealey, Myers, Allen (2008): chapter 6 (pp.115 - 135) Optional reading



Volkart (2008): chapter 4 (pp. 296 - 306)

Presentation slides

Structure of lecture (pp. 1 - 11)

Case study (pp. 46 - 59)



Contents

Learning targets

Pre-course reading


Case study




Agenda (1/2)

1. Introduction

Investment process

Nature of investment opportunities

Need for investment management Overview of capital budgeting methods

2. Static methods

Static methods

Cost and profit comparison method

Simple payback period method

Average rate of return method (Return on investment method)

Conclusion on static methods



Agenda (2/2)

3. Dynamic methods

Compounding and discounting

Opportunity cost of capital

Dynamic methods Net present value method (NPV)

Internal rate of return method (IRR)

Dynamic payback period method

Annuity method

Conclusion on dynamic methods

4. Case study

Circuit AG

5. Solution to case study

6. Q&A and discussion



Agenda: Introduction

Investment process

Nature of investment opportunities

Need for investment management

Overview of capital budgeting methods



Investment process (1/2)

Shareholders prefer to be rich rather than poor. Therefore, they want the firm to investavailable cash in every project that is worth more than it costs (circle of cash)

If the firm is perceived to fall short of that goal, shareholders prefer to invest their capitalthemselves more profitably outside the company on their own

Investment

opportunities Firm Shareholders

Investment

opportunities

Cash

Option 2:The firm pays dividendto its shareholders

Option 1:The firm makes

investment decision

Source: Brealy, Myers, Allen (2008), p. 117.



Investment process (2/2)

Most organisations have developed special procedures and methods for dealing withinvestment management, involving

the formulation of long-term goals as part of the overall strategy process

the search for and identification of new investment opportunities

the estimation and forecasting of relevant parameters

the development of decision rules

the controlling and monitoring of investment projects

Consequently, investment management has many different stakeholder groups. Forinstance, engineering manpower is indispensable as it

helps translate technical talk into financial talk

provides relevant data for financial models


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Nature of investment opportunities (2/2)

In practice, capital investments can be grouped using various characteristics

By categories of investment projects (not exhaustive):

New investments

Expansion investments Replacement investments

Productivity investments

Infrastructure investments

By degree of dependence:

Mutually exclusive investments

Complementary investments

Substitute investments



Need for investment management

Capital investments can be huge and have a significant impact on the future financialperformance and the value of the firm

When analyzing capital investment opportunities, companies are usually confronted witha series of challenges

Limited capital resources

Limited predictability of relevant data

Relevant data partly insufficiently quantifiable

The tools and methods of investment management help overcome the complexity ofinvesting by providing a sound basis for decision making

Investment

Financing

Profitability /excess return

Future valueof the firm



Overview of capital budgeting methods

The term capital budgeting refers to a firms entire process of analyzing investment

opportunities and determining opportunities that are worth being pursued and realized

Several methods of analyzing investment opportunities have evolved which can bedivided into static and dynamic methods

Historically, static methods were developed first. Today, professionals typically makeuse of the dynamic methods and apply static methods as 'rules of thumb' at best

Static methods Dynamic methods

Cost comparison method

Profit comparison method


Average rate of return method(Return on investment method)

Net present value method (NPV)



Annuity method



Agenda: Static methods

Static methods



Average rate of return method (Return on investment method) Conclusion on static methods




Most easily understood methods

Analysis of average per year or average per produced unit if capacities are different

Cost comparison method: Choice of investment opportunity with lowest costs:

Cost comparison method = min (average annual costs) or min (average costs per unit) Profit comparison method: Choice of investment opportunity with highest profits:

Profit comparison method = max (average annual profit) or min (average profit per unit)



Simple payback period method (1/2)

The simple payback period method (SPP) considers the initial investment and theresulting annual cash flows and tells the investor the time it takes to recover the initialinvestment

Decision rule: Accept an investment opportunity when its payback period is shorterthan the expected useful life, i.e. when total cumulative cash flows exceed the requiredinvestment

In case of uneven cash flows, cumulate actual annual cash flows Use return-flow-figure to compare investment opportunities with differing useful lives

(return-flow-figure = expected useful life / payback period)

Simple payback period = Required investmentAverage annual cash flow



Simple payback period method (2/2)

Example 1: Even cash flow pattern

Investment sum: 100

annual cash flow: 20

Expected useful life: 10 years

Accept project as payback < 10 years

Example 2: Uneven cash flow pattern (useful life: 5 years)

Accept project as payback < 5 years

YearNominal

cash flow

Cumulated

cash flow

0 (today) -100 -1001 30 -70

2 35 -35

3 35 0

4 40 40

5 40 80

SPP =Required investment

annual cash flow= 5 years


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Average rate of return method (Return on investment

method) (1/2) The average rate of return (ARR) or Return on investment (ROI) can be calculated by

dividing the benefit of an investment, i.e. earnings before interest payments, by theaverage capital tie-up

Decision rule: ARR is usually compared to some firm-specific threshold called hurdlerate, opportunity cost of capital, cost of capital or minimum rate of return. Projects withan ARR above the threshold should be realized

ARR is a popular metric due to its versatility (can be defined differently) and simplicity.The downside of this is that it is prone to manipulation

Practitioners often use ARR as a means of relative performance measurement

ARR is also known as return on investment, accounting rate of return or book rate ofreturn

ARR = Average profit + Average interest Capital tie-up (= Inv. capital)

= Earnings before interest Capital tie-up (= Inv. capital)


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Average rate of return method (Return on investment

method) (2/2) Example

Initial investment outlay: 300 Annual net profit: 30

Depreciation period (years): 10 Imputed interest rate: 10%

Liquidation value: 60 Hurdle rate: 15%

Accept project as ARR > 15%

ARR =Average profit + Average interest

Average capital tie-up=

30 + 18

180= 26.7%

interest = capital tie-up * Imputed interest rate = 180 * 10.0% = 18.0

capital tie-up =Initial outlay + Liquidation value

2=

300 + 60

2= 180


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Conclusion on static methods

Pros

Static methods are easy to understand

Time and effort for data collection is manageable

Cons

Static methods only consider "average periods"

Time value of money not considered

Potential risk of oversimplification

Use static methods as rules of thumb at best


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Agenda: Dynamic methods

Compounding and discounting

Opportunity cost of capital

Dynamic methods

Net present value method (NPV)



Annuity method



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Compounding and discounting (1/3)

Time value of moneyInvestors prefer to receive a payment of a fixed amount of money today rather than theequal amount of money at a point of time in the future, all other circumstances beingequal. In other words, to forego the use of money today, investors must receive somecompensation in the future

Compounding interestDescribes the process of adding accumulated interest to the principal, so that interest isearned on interest from that moment on. In other words, it helps determine the futurevalue of a principal

Discounting interest

Describes the inverse process, i.e. finding the present value (today) of an amount ofcash at some future date. The future value is reduced by applying an appropriatediscount rate for each unit of time


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PV FV1 FV2 FV3

Compound

interest

t

Compounding:

FV3 = PV * (1+r)3

Discounting:

PV = FV3 *

General:

FVn = PV * (1+r)n

PV = FVn *

1

(1+r)n

1

(1+r)3


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Example applying an interest rate of 10%

Compounding and discounting are very sensitive to changes in the discount rate

YearNominal

cash flow

Compound

factor @ 10%

Compound

cash flow (FV)

Nominal

cash flow

Discount

factor @ 10%

Discounted

cash flow (PV)

1 100 1.611 161 100 0.909 912 100 1.464 146 100 0.826 83

3 100 1.331 133 100 0.751 75

4 100 1.210 121 100 0.683 68

5 100 1.100 110 100 0.621 62

Total 500.0 671.6 500.0 379.1

Compounding Discounting

YearNominal

cash flow

Compound

factor @ 15%

Compound

cash flow (FV)

Nominal

cash flow

Discount

factor @ 15%

Discounted

cash flow (PV)

Total 500.0 775.4 500.0 335.2


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Opportunity cost of capital (1/2)

The opportunity cost of capital for an investment project is the expected rate of returndemanded by investors in common stocks or other securities subject to the same risksas the project

Therefore, determining the opportunity cost of capital for an investment project involves

Searching for securities with identical risk profiles (perfect match) and

Determining the expected return of these securities

Discounting the investment project's expected cash flow at its opportunity cost of capitalwill result in the price that investors would be willing to pay for the project

In practice, it is usually difficult to find such securities. A companys weighted averagecost of capital (WACC) is often taken as a convenient approximation for the opportunity

cost of capital

Company WACC needs to be adjusted for projects whose risk profile is different fromcompany risk profile


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Opportunity cost of capital (2/2)

The riskier a project, the higher the return required by investors. Factors that need to beconsidered include:

Inflation

Entrepreneurial business risk

Industry / sector risk

Project-specific risks

Cheap debt financing will not lower the opportunity cost of capital of an investmentproject

The terms opportunity cost of capital, weighted average cost of capital, discount factor,hurdle rate are often used interchangeably


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Net present value method (1/3)

The net present value (NPV) is defined as the total present value of a time series offuture cash flows less an initially required investment

Decision rule: Accept investment opportunities offering a positive net present value

Required input parameters:

Required investment (C0)

Expected payoffs/cash flows (Ct)

Number of years (t)

Discount rate/hurdle rate/opportunity cost of capital (r)

t

1it

t0

r1

CCNPV

T

T2

21

10

r1

C

r1

C

r1

CCNPV


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C0


PV

C1C2 C3

C4 Cnt

0 1 n32 4

NPV

Example: Discount rate 10%

Year 0 1 2 3 4 5 Total

Income 0 30 35 35 40 40 180

Capital investment -100 0 -100

Cash flow -100 30 35 35 40 40 80Discount factor 1.000 0.909 0.826 0.751 0.683 0.621

Discounted cash flow -100 27 29 26 27 25

Cum discounted cash flow -100 -73 -44 -18 10 35

NPV 35

C5

5

Some numbers are rounded.


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Cash flows pattern Flat Increasing Decreasing

Discount rate 10% 15% 10% 15% 10% 15%

NPV 36 21 35 18 38 23


Sound estimation of discount rate and cash flows is crucial as NPV is very sensitive tothese parameters

Distribution and timing of the cash flows impact the NPV as more distant cash flows arediscounted to a greater extent than earlier cash flows

Among mutually exclusive projects the one with the highest NPV should be chosen

1 The following table shows the detailed cash flows underlying the three scenarios defined above.

Year 1 2 3 4 5 Total

Flat cash flows 36 36 36 36 36 180

Increasing cash flows 30 35 35 40 40 180

Decreasing cash flows 40 40 35 35 30 180

1


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Internal rate of return method (1/4)

The internal rate of return (IRR) is defined as the rate of return that makes the netpresent value equal to zero, i.e. the rate at which the present value of the expectedcash flows equals the required investment (or the NPV is zero after a defined number ofyears)

Decision rule: Accept investment opportunities offering rates of return in excess of theiropportunity cost of capital (hurdle rate)

Required input parameters: Required investment (C0)


Number of years (t)

0

IRR1

CCNPV

t

1it

t0

0

IRR1

C

IRR1

C

IRR1

CCNPV

TT

22

11

0


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=C0 PV

0

YearCash

flows22% PV 23% PV

0 -100 1.000 -100.0 1.000 -100.0

1 30 0.820 24.6 0.813 24.4

2 35 0.672 23.5 0.661 23.1

3 35 0.551 19.3 0.537 18.8

4 40 0.451 18.1 0.437 17.5

5 40 0.370 14.8 0.355 14.2

NPV 0.2 -2.0

Example: Interpolation of IRR

IRR = 22%+ 1% * (0.2/2.2)

= 22.1%

C1C2 C3

C4 Cnt

1 n32 4

C5

5

Discount rate = ?


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Provides relative values compared with the absolute results of the NPV method

Results can be misleading when compared without considering required investment

IRR assumes that a project's cash flows can be reinvested at the same rate of return,which can be a doubtful assumption

IRR is widely used in workday life and many alternative applications have beendeveloped

The later a project's cash flows will occur, the lower the IRR will be (provided totalnominal cash flow is equal), i.e. IRR (decreasing) > IRR (flat) > IRR (increasing)

Cash flows pattern Flat Increasing DecreasingDiscount rate 10% 15% 10% 15% 10% 15%

NPV 36 21 35 18 38 23

IRR 23.4% 22.1% 24.8%

1 See page 34 for detailed cash flow pattern assumptions.

1


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The IRR rule contains several pitfalls:

Conflicting results for mutually exclusive projects

Multiple rates of return (change in the sign of the cash flow stream, referred to as"Descartes' rule of signs")

Lending vs. borrowing

Multiple opportunity costs


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NPV vs. IRR

Investment opportunities with discount rates below IRR will yield positive NPV andshould be accepted and vice versa

IRR and NPV analyses result in the same answer when applied properly, but NPV iseasier to use and less prone to wrong decisions

Only IRR is based on the reinvestment assumption but not NPV

NPV is superior - in case of conflicting results, go with NPV!

Discount

rate

IRRNPV

NPV > 0

NPV < 0Discount rate < IRR

Discount rate > IRR


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Dynamic payback period method (1/3)

The dynamic payback period method (DPP) determines the length of time required foran investments cash flows, discounted at its opportunity cost of capital, to recover its

initial required investment

Decision rule: Accept an investment opportunity when its payback duration is shorter

than the expected useful life (same as for static payback method) Required input parameters:

Required investment (C0)


Expected useful life (t)

Discount rate/hurdle rate/opportunity cost of capital (r)


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t

CF1 CF5CF3CF2 CF4

Payback period = ?

PVC0

Example: DPP using a discount rate of 10%

DPP = 3.0

+ (18/28)= 3.6

SPP = 3.0

YearNominal

cash flow

Cumulated

cash flow

Discount

factor

Discounted

cash flow

Cumulated

cash flow

0 (today) -100 -100 1.000 -100 -100

1 30 -70 0.909 27 -73

2 35 -35 0.826 29 -44

3 35 0 0.751 26 -18

4 40 40 0.683 27 10

5 40 80 0.621 25 35

Static payback (SP) Dynamic payback (DP)

Some numbers are rounded.


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DPP provides useful results and is often applied as a complementary method to NPVbut should not be used as the sole investment decision criterion

NPV and DPP can lead to different results depending on

the distribution of cash flows over the investment's useful life

the designated time limit of the investment

DPP omits all cash flows after the investment sum is recovered, which may beinadequate for long-running investments

In practice, both simple and dynamic payback durations are often used as simplemeasures of risk since short payback durations are generally considered safer than

longer periods (liquidity aspect)


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Annuity method (1/2)

An annuity is a series of equal annual cash flows over a given period. The sum of thesecash flows is equal to a project's NPV

Decision rule: Accept investment opportunities with annuities greater than zero

The annuity method is similar to NPV but somewhat more difficult to calculate

Based on the initial investment outlay, the rate of return and the project's time horizon,the required cash flow is calculated (equals IRR or NPV of zero). This required cashflow is then subtracted from the project's actual cash flow. The difference represents the

annuity, which in sum must be equal to the project's NPV

The use of annuities is often unnecessary as NPV analyses will come to identical results

Only two arguments support the use of the annuity method:

Annuities help to calculate the NPV for perpetual cash flows (e.g. terminal valuecalculation in business valuation)

As a one-period measure annuities can be interpreted more easily than NPV

Annuity (finite) = NPV *(1 + r)T * r

(1 + r)T - 1Annuity (infinite) = NPV * r


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Present value interestfactor for annuity

Annuity method (2/2)

Calculation of future and present values of ordinary annuity and annuity due:

Future value interestfactor for annuity

Ordinary =(1+r)n -1

r1

r

Due = (1+r)n -1

r* (1+r)

r*(1+r)n1

-Ordinary =

Due = 1r r*(1+r)n1 - * (1+r)

YearNominal

cash flow

Compound

factor @ 10%

Compound

cash flow (FV)

Nominal

cash flow

Discount

factor @ 10%

Discounted

cash flow (PV)

1 100 1.611 161 100 0.909 91

2 100 1.464 146 100 0.826 83

3 100 1.331 133 100 0.751 75

4 100 1.210 121 100 0.683 68

5 100 1.100 110 100 0.621 62

Total 500.0 6.716 671.6 500.0 3.791 379.1

Compounding Discounting


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Pros

Consideration of time value of money

Consideration of effective cash flows instead of average values

Enable detailed analysis of the investment project

Cons

Time and effort for data collection can be overwhelming

Sensitivity of results to changes of some parameters (e.g. WACC)

Risk of neglecting aspects of non-monetary nature Calculations are more complex, prone to error and time-consuming

Uncertainty of future projections

Dynamic methods are preferred over static methods


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Agenda: Case study

Circuit AG


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Circuit AG

The Swiss Circuit AG (Circuit) was founded in 1975 and is a wellestablished producer of medium and high quality printed circuit boards(PCB)

Circuit produces only in Switzerland at four plants

Since 2005, domestic and European demand has been significantlydeclining. However, Circuit faces only slightly weaker demand in thearea of high-quality circuit boards and only a moderate slowdown in themedium quality sector

The latest industry outlook is very solid and Circuit is expected toexperience above-average growth

Given these circumstances, Circuit is now examining potentialinvestment opportunities in the field of high-quality multi-layer circuitboards


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Circuit AG: High-speed milling (1/4)

The product manager of Circuit's high-frequency PCB department has proposed twoalternative investments in the field of high-speed milling. The following data have beengathered

Alternative A Alternative B

Expected useful life (in years) 6.0 6.0

Sales volume (units per year) 14'000 18'000

Sales price (CHF per unit) 10.0 10.0

Initial investment outlay 200'000 250'000

Construction costs 18'000 28'000

Freigth costs 2'000 2'000

Liquidation value after 8 years 16'000 0

Fixed operating costs (per year) 6'000 22'000

Variable unit costs (CHF per unit) 4.6 3.9

Tax rate (% per year) 20.0% 20.0%

Imputed interest rate (% per year) 6.0% 6.0%


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Identify the preferred investment using

the profit comparison method

the average rate of return method

the static payback method

Discuss and justify your overall decision


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Profit comparison method


Revenue

./. Variable costs

./. Fixed costs

EBITDA

./. Depreciation

EBIT

./. Average interest

EBT

./. Tax

Average profit

Rank


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Average rate of return method

Static payback period method


Average profit

Average interest

Average capital tie-up

Average rate of return

Rank


Average profit

+ Average depreciation

Average cash flow

Total investment outlay

Static payback period in years

Rank


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Circuit AG: Etching technology (1/6)

In early 2009, Mr. Sell, Chief Strategy Officer in Circuit's high-frequency PCBdepartment, has proposed to venture into the field of plasma etching. However, basedon preliminary studies, Mr. Sell currently still favors two different etching technologies,wet etching and plasma etching. While wet etching is expected to be an expiringtechnology, the market is not sure whether plasma etching will advance to the state of

the art technology. Circuit can invest only in one technology

Mr. Sell has told you that he favors IRR, because the results of NPV can be misleading.He has already assessed plasma etching and determined its IRR to be 23.3%. He asksyou to calculate the IRR for the potential investment in wet etching and hand in areasonable proposal in which technology to invest

Use the following pages to determine the IRR by interpolation


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IRR calculation for wet etching technology (low IRR bound)

Cash flow Discount rate Present value

Capital outlay year 0 -150

Cash flow year 1 80

Cash flow year 2 75

Cash flow year 3 55

Cash flow year 4 20

Cash flow year 5 10 0.3277

Net present value

Wet etching @ %


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IRR calculation for wet etching technology (high IRR bound)

Cash flow Discount rate Present value

Capital outlay year 0 -150

Cash flow year 1 80

Cash flow year 2 75

Cash flow year 3 55

Cash flow year 4 20

Cash flow year 5 10 0.3149

Net present value

Wet etching @ %


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As part of your investment proposal, you have also produced the following chart.Describe its information value and comment on the impact on your investment appraisal

-40

-200

20

40

60

80

100

120140

160

0% 3% 6% 9% 12%

15%

18%

21%

24%

27%

30%

Plasma etchingWet etching

r

NPV


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As part of the investment appraisal, Mr. Sell also asks for a net present valuecalculation for both technologies. The appropriate discount rate has been determined toamount to 15%

Compare the results obtained by the different methods and formulate a final investment

recommendation

Cash flow Discount factor Present value

Capital outlay year 0 -150 1.000 -150

Cash flow year 1 30 0.870 26


Cash flow year 3 60

Cash flow year 4 75

Cash flow year 5 90

Net present value

Rank

Plasma etching


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Cash flow Discount factor Present value

Capital outlay year 0 -150 1.000 -150



Cash flow year 3 55

Cash flow year 4 20

Cash flow year 5 10

Net present value

Rank

Wet etching


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Contents

Learning targets

Pre-course reading


Case study

Solution to cases


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Solution to cases

Solutions will be distributed after the lecture (download)

CF III InvestmentManagemt PreRead

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