CORPORATE FINANCE I ESCP-EAP European Executive MBA 21 Sept. 2005 p.m. Paris Investment Decisions-Net Present Value I. Ertürk Senior Fellow in Banking
Dec 31, 2015
CORPORATE FINANCEI
CORPORATE FINANCEI
ESCP-EAPEuropean Executive MBA21 Sept. 2005 p.m. Paris
Investment Decisions-Net Present ValueI. Ertürk
Senior Fellow in Banking
CORPORATE FINANCE
CORPORATE FINANCE
Financial
manager
Firm's
operations
Financial
markets
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
(1)(2)
(3)
(4a)
(4b)
RESPONSIBILITIES OF THE FINANCIAL MANAGER
RESPONSIBILITIES OF THE FINANCIAL MANAGER
DECISIONS IN ANY BUSINESS
WHAT LONG-TERM INVESTMENTS SHOULD YOU ACCEPT?
– CAPITAL BUDGETING DECISION
WHERE WILL YOU GET THE MONEY TO PAY FOR YOUR INVESTMENTS?
– FINANCING DECISION
VALUE OF THE FIRMVALUE OF THE FIRM
Returns generated by investments (assets) -return on assets- should be greater than the cost of liabilities (weighted average cost of capital)
ROA > WACC
Assets Liabilities
Debt
Equity
Debt
Equity
Current
Fixed
Current
Fixed
CAPITAL BUDGETINGCAPITAL BUDGETING
FINANCIAL MANAGER ATTEMPTS TO ENSURE THAT
THE PRESENT VALUE
(OR THE VALUE TODAY )
OF THE CASH FLOWS
GENERATED BY THE ASSET
IS GREATER THAN THE COST OF THE ASSET
Laurentian BakeriesLaurentian Bakeries
Should the company invest in the expansion?
TWO RULES FOR ACCEPTING OR REJECTING
PROJECTS
TWO RULES FOR ACCEPTING OR REJECTING
PROJECTS
1. INVEST IN PROJECTS WITH POSITIVE NPV –Net Present Value
2. INVEST IN PROJECTS OFFERING RETURN
GREATER THAN
OPPORTUNITY COST OF CAPITAL
11( ) r
OFTEN CALLED DISCOUNT FACTOR
DISCOUNTED CASH FLOWS -DCF
r DISCOUNT RATEHURDLE RATEOPPORTUNITY COST OF CAPITAL
Also appears as “k”
1
( )1 r
Present ValuePresent Value
1factordiscount =PV
PV=ValuePresent
C
Present ValuePresent Value
Discount Factor = DF = PV of €1
Discount Factors can be used to compute the present value of any cash flow.
DFr t
1
1( )
Present ValuesPresent Values
Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time.
t
tt r
CCDFPV
1
Discount factors: Present value of €1 to be received after t years = 1/(1+r)t
interest rate per period1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
no. ofperiods
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.8702 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.7563 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 0.693 0.675 0.6584 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 0.613 0.592 0.5725 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 0.543 0.519 0.4976 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 0.480 0.456 0.4327 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.3768 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404 0.376 0.351 0.3279 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361 0.333 0.308 0.284
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322 0.295 0.270 0.24711 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.317 0.287 0.261 0.237 0.21512 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.286 0.257 0.231 0.208 0.18713 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.258 0.229 0.204 0.182 0.16314 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.232 0.205 0.181 0.160 0.14115 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.209 0.183 0.160 0.140 0.12316 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.188 0.163 0.141 0.123 0.10717 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.170 0.146 0.125 0.108 0.09318 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.153 0.130 0.111 0.095 0.08119 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.138 0.116 0.098 0.083 0.07020 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.124 0.104 0.087 0.073 0.06121 0.811 0.660 0.538 0.439 0.359 0.294 0.242 0.199 0.164 0.135 0.112 0.093 0.077 0.064 0.05322 0.803 0.647 0.522 0.422 0.342 0.278 0.226 0.184 0.150 0.123 0.101 0.083 0.068 0.056 0.04623 0.795 0.634 0.507 0.406 0.326 0.262 0.211 0.170 0.138 0.112 0.091 0.074 0.060 0.049 0.04024 0.788 0.622 0.492 0.390 0.310 0.247 0.197 0.158 0.126 0.102 0.082 0.066 0.053 0.043 0.03525 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.074 0.059 0.047 0.038 0.03026 0.772 0.598 0.464 0.361 0.281 0.220 0.172 0.135 0.106 0.084 0.066 0.053 0.042 0.033 0.02627 0.764 0.586 0.450 0.347 0.268 0.207 0.161 0.125 0.098 0.076 0.060 0.047 0.037 0.029 0.02328 0.757 0.574 0.437 0.333 0.255 0.196 0.150 0.116 0.090 0.069 0.054 0.042 0.033 0.026 0.02029 0.749 0.563 0.424 0.321 0.243 0.185 0.141 0.107 0.082 0.063 0.048 0.037 0.029 0.022 0.01730 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.044 0.033 0.026 0.020 0.015
RATE OF RETURN RULERATE OF RETURN RULE
RETURN = PROFIT = 400 - 350 = 14.3% INVESTMENT 350
ACCEPT PROJECT BECAUSE RATE OF RETURN IS GREATER THAN THE OPPORTUNITY COST OF CAPITAL, 7%
NPV RULENPV RULE
STEP 1: FORECAST CASH FLOWSCost of building, C0 = 350Sale price in Year 1, C1 = 400
STEP 2: ESTIMATE OPPORTUNITY COST OF CAPITALIf equally risky investments in the capital marketoffer a return of 7%, then cost of capital, r = 7%
STEP 3: Discount future cash flows C1 400PV = = = 374 1 + r 1.07
STEP 4: Accept project if PV of payoff exceeds investmentNPV = -350 + 374 = +24
ONE-PERIOD PROJECT: RETURN UNCERTAIN
ONE-PERIOD PROJECT: RETURN UNCERTAIN
INVEST $1,000 NOW. RECEIVE EXPECTED UNCERTAIN CASH FLOW AFTER 1 YEAR, WHOSE EXPECTED VALUE IS $1,300
INVESTORS CAN BUY EQUALLY RISKY SECURITIES WITH 35% EXPECTED RETURN.
DECISION:1. DON'T INVEST BECAUSE 30% PROJECT RETURN IS LESS THAN 35%
OPPORTUNITY COST.2. DON'T INVEST BECAUSE NET PRESENT VALUE IS
NEGATIVE.
1,300 NET PRESENT VALUE = 1.35 - 1,000 = 963 - 1,000 = -37
VALUE OF FIRM
WILL FALL BY €37 IF WE ACCEPT THE PROJECT
PV0 == CC
r
C
r
C
r0
1
1
2
2
2
t
t
t(1 ) (1 ).......
(1 )
DISCOUNTED CASH FLOW (DCF) EQUATION
NPV =
Crt
t
t(1 )
NET PRESENT VALUE OF A PROJECTWHERE THE SUMMATION IS OVER ALL THE
CASH FLOWS GENERATED BY THE PROJECT,
INCLUDING INITIAL NEGATIVE CASH FLOWS AT THE START OF THE PROJECT, C0 ETC.
Present ValuesPresent Values
Example
Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value.
000,300000,100000,150
2Year 1Year 0Year
Present ValuesPresent Values
Example - continued
Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value.
400,18€
900,261000,300873.2
500,93000,100935.1
000,150000,1500.10Value
Present
Flow
Cash
Factor
DiscountPeriod
207.11
07.11
TotalNPV
EXAMPLEEXAMPLE
C0 = -500, C1 = +400, C2 = +400
r1 = r2 = .12
NPV = -500 + +
= -500 + 400 (.893) + 400 (.794)
= -500 + 357.20 + 318.80 = +176
400 400
1.12 (1.12)2
INTERNAL RATE OF RETURN, IRR
INTERNAL RATE OF RETURN, IRR
CC C C
01 2
2T
T(1 IRR) (1 IRR)....
(1 IRR)0
NPV
=
IRR IS THE DISCOUNT RATE FOR WHICH NPV=0
IRR = 28%
+2
0
-1
50DISCOUNTRATE (%)
NPV
NET PRESENT VALUE PROFILE
C0 = - 4
C1 = +2
C3 = +4
IRR vs. NPVIRR vs. NPV
IRR IS AN INTENSIVE MEASURE OF PROFITABILITY
NPV IS AN EXTENSIVE MEASURE OF PROFITABILITY
AT THE END OF THE DAY, WE ARE INTERESTED IN A MONETARY
(EXTENSIVE) MEASURE OF PROFITABILITY
– NOT IN THE PROFITABILITY PER EURO OF INVESTMENT
BOTH GIVE SAME RESULT IF WE’RE NOT DEALING WITH MUTUALLY
EXCLUSIVE PROJECTS OR PROJECTS WITH NONCONVENTIONAL CASH
FLOWS
Identifying Relevant Cash flows
Identifying Relevant Cash flows
Use cash flows only not accounting figures Depreciation is not a cash flow but capital expenditure is Construct “Project Appraisal Table” Use incremental cash flows only Separate investment and financing decisions Include all incidental effects. Do not forget working capital requirements. Forget sunk costs. Include opportunity costs. Beware of allocated overhead costs Use after-tax cash flows only
After-tax cash flowsAfter-tax cash flows
Incremental costs and depreciation/capital allowances reduce tax and hence increase investment cash flows by:
(cost/depreciation) X (tax rate)
Incremental income/savings increase tax and hence increase investment cash flows by:
(income/savings) X (1-tax rate)
Laurentian BakeriesRelevant Cash flowsLaurentian BakeriesRelevant Cash flows
Land value of the Winnipeg plant $250,000?Administrative staff salaries $223,000?Staff expenses and salaries
to secure the US contract $40,000?Working capital needsCost reductionsCapital cost allowance
Laurentian BakeriesLaurentian Bakeries
Investment costs (C$millions)
– Extension to the building $1.3
– Spiral freezer 1.6
– High speed processing line 1.3
– Additional warehouse space 0.6
– Contingency 0.4
TOTAL $5.2
Incremental Cash Flows (C$m) Laurentian Bakeries
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005Investment cost (5.20)Net revenue 0.58 1.10 1.52 1.58 1.64 1.71 1.78 1.85 1.92 2.00Efficiency savings 0.17 0.28 0.31 0.31 0.31 0.31 0.31 0.31 0.31 0.31Other savings 0.138 0.144 0.149 0.155 0.161 0.168 0.175 0.182 0.189 0.196
Total (before tax) 0.90 1.53 1.98 2.04 2.11 2.19 2.26 2.34 2.42 2.50
Total after-tax benefit 0.55 0.94 1.22 1.26 1.30 1.34 1.39 1.44 1.49 1.54
Tax shield 0.17 0.30 0.23 0.18 0.14 0.11 0.09 0.07 0.06 0.67
Change in working capital (0.41) (0.36) (0.29) (0.04) (0.04) (0.05) (0.05) (0.05) (0.05) (0.05)
Net working capital 1.40
Net project cash flows (5.20) 0.31 0.87 1.15 1.39 1.39 1.41 1.43 1.46 1.50 3.55
NPV (C$m) 0.09
Laurentian BakeriesLaurentian Bakeries
Need to consider hurdle rate
– Is 18% right?Sensitivity and scenario analysesNeed to consider qualitative factors
– Expansion into US
– Human resources
– Environment
INNOVATION LTDINNOVATION LTD
Project Appraisal –example 2
INNOVATION LTD.
INVESTMENT APPRAISAL SCHEDULE
Year 0 1 2 3 4 5 6
Machinery (20,000) 4,915
Grant 5,000
Sales revenue 65,000 87,500 100,000 100,000 100,000
Total cash costs (58,000) (77,000) (88,000) (88,000) (88,000)
Opportunity cost of off-cuts (3,500) (4,500) (5,000) (5,000) (5,000)
Tax paid (2,000) (4,050) (5,040) (5,232) (5,386)
Tax saved 1,750 2,250 2,500 2,500 2,500
Net benefits (20,000) 8,500 5,750 5,200 4,460 4,268 2,030
Discount factors @ 10% 1 0.909 0.826 0.751 0.683 0.621 0.564
Present values (20000) 7727 4752 3907 3046 2650 1146
Net present value @ 10% 3,228
Internal rate of return 17%
Years 0 1 2 3 4 5 6
Payback 3.14 (20,000) (11,500) (5,750) (550) 3,910Discounted payback 4.27 (20000) (12273) (7521) (3614) (568) 2083
ALTERNATIVES TO THE NPV RULEALTERNATIVES TO THE NPV RULE
SIMPLE AND DISCOUNTED PAYBACK
AVERAGE RETURN ON BOOK VALUE
INTERNAL RATE OF RETURN
PROFITABILITY INDEX
NPV
Year: 0 1 2 3 Payback At 10%
A -2 +2 1 -0.2
B -2 +1 +1 +5 2 +3.5
PROJECT A HAS SHORTER PAYBACK BUT LOWER NPV
PAYBACK RULEPAYBACK RULE
NPV
Year: 0 1 2 3 Payback At 10%
A -2 +2 1 -0.2
B -2 +1 +1 +5 2 +3.5
PROJECT A HAS SHORTER PAYBACK BUT LOWER NPV
PAYBACK RULEPAYBACK RULE
PAYBACK RULEPAYBACK RULE
IF FIRM USES 1 YEAR CUTOFF PERIOD , ACCEPT PROJECT A
IF FIRM USES 2 YEAR CUTOFF PERIOD, ACCEPT PROJECTS A & B
REGARDLESS OF CUTOFF PERIOD, PAYBACK RULE MAY GIVE DIFFERENT ANSWER THAN NPV
– PAYBACK GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE PAYBACK DATE AND NO WEIGHT TO LATER CASH FLOWS
– NO DISCOUNTING - IGNORES TIME VALUE OF MONEY
– NO GOOD RATIONALE FOR CUTOFF
CASH FLOWS (€000) NPV
Year: 0 1 2 3 Payback At 10%
B -2 +1 +1 +5 2 +3.492
C -2 +0 +2 +5 2
+3.409
D -2 +1 +1 +100 2
+74.867
PAYBACK RULEPAYBACK RULE
DISCOUNTED PAYBACK RULEDISCOUNTED PAYBACK RULE
CALCULATE LENGTH OF TIME UNTIL THE SUM OF THE DISCOUNTED CASH FLOWS IS EQUAL TO THE INITIAL INVESTMENT
ACCEPT PROJECT IF IT IS LESS THAN SOME CUTOFF VALUE
DISCOUNTED-PAYBACK RULE ASKS HOW LONG WILL IT BE UNTIL THE PROJECT HAS A POSITIVE NPV
– NO LONGER GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE PAYBACK DATE BUT STILL IGNORES CASH FLOWS AFTER CUTOFF DATE
CANNOT BE USED FOR RANKING PROJECTS
AVERAGE RETURN ON BOOK VALUEAVERAGE RETURN ON BOOK VALUE
ACCEPT OR REJECT AN INVESTMENT BASED ON ITS BOOK RATE OF RETURN – COMPARE WITH BOOK RATE OF RETURN FOR THE FIRM OR THE INDUSTRY
FITS INTO FORMAT OF ACCOUNTING STATEMENTS– INFORMATION READILY AVAILABLE
SOUNDS ATTRACTIVE BUT WRONG
AVERAGE FORECASTED NET INCOME
AVERAGE BOOK VALUE OF THE INVESTMENT
AVERAGE RETURN ON BOOK
AVERAGE RETURN ON BOOK
Year: 0 1 2 3
Book 9 6 3 0
Gross profit 6 5 4
Depreciation 3 3 3
Net income 3 2 1
Average return on book = = 44%2
4.5
ACCEPT PROJECT IF FIRM’STARGET BOOK RATE OF RETURN IS LESS THAN 44%
CAPITAL RATIONINGCAPITAL RATIONING
SOMETIMES THE FIRM CAN’T FINANCE ALL PROJECTS WHICH HAVE
A POSITIVE NPV TODAY
– AND ANTICIPATES CAPITAL RATIONING IN VARIOUS FUTURE YEARS
IDENTIFY PACKAGE OF PROJECTS WHICH SATISFY CAPITAL
CONSTRAINTS AND MAXIMIZE NPV
– IRR RULE WILL NOT WORK
– USE PROFITABILITY INDEX IN SIMPLE CASES
– LINEAR PROGRAMMING IN GENERAL CASE
CAPITAL RATIONINGCAPITAL RATIONING
0 1 2 NPV @ 10% A -10 +30 +5 21 B -5 +5 +20 16 C -5 +5 +15 12
LIMITED €10 MILLION CAPITALFIRM CAN INVEST IN PROJECT A OR
PROJECTS B AND CINDIVIDUALLY, B AND C HAVE LOWER NPV TAKEN TOGETHER, B AND C HAVE HIGHEST
NPVCHOOSE PROJECTS THAT OFFER HIGHEST
NPV PER EURO INVESTED
CAPITAL RATIONINGCAPITAL RATIONING
INITIAL INVESTMENTPROFITABILITY INDEX = NET PRESENT VALUE
PROJECT INVESTMENT NPV PROFITABILITY INDEX
A 10 21 2.1
B 5 16 3.2
C 5 12 2.4
RANK PROJECTS IN TERMS OF DECLINING PICONTINUE MAKING INVESTMENTS UNTIL
CAPITAL EXHAUSTEDACCEPT PROJECTS B AND C