Exam 3 Review. The ideal evaluation method should: a) include all cash flows that occur during the life of the project, b) consider the time value of.

Exam 3 ReviewExam 3 Review

The ideal evaluation method should:The ideal evaluation method should:

a) include a) include all cash flowsall cash flows that occur that occur during the life of the project,during the life of the project,

b) consider the b) consider the time value of moneytime value of money, and, and

c) incorporate the c) incorporate the required rate of required rate of returnreturn on the project. on the project.

Decision-making Criteria in Decision-making Criteria in Capital BudgetingCapital Budgeting

Payback PeriodPayback Period

DefinitionDefinition Decision ruleDecision rule DrawbacksDrawbacks AdvantagesAdvantages Discounted payback periodDiscounted payback period

NPV = the total PV of the annual net cash flows - the initial outlay.

NPVNPV = - IO = - IO FCFFCFtt

(1 + k)(1 + k) tt

nn

t=1t=1

Net Present ValueNet Present Value

Net Present ValueNet Present Value

Decision RuleDecision Rule:: If NPV is >=0, If NPV is >=0, acceptaccept.. If NPV is negative, If NPV is negative, rejectreject..Features of NPVFeatures of NPV

Profitability Index

PI = IO FCFt

(1 + k)

n

t=1 t

NPV = - IO FCFt

(1 + k) t

n

t=1

Decision Rule:

If PI is greater than or equal to 1, accept.

If PI is less than 1, reject.

Profitability Index

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

NPV = - IO FCFt

(1 + k) t

n

t=1

n

t=1IRR: = IO

FCFt

(1 + IRR) t

IRRIRR

Decision RuleDecision Rule::

If IRR is greater than or equal to If IRR is greater than or equal to the required rate of return, the required rate of return, acceptaccept..

If IRR is less than the required If IRR is less than the required rate of return, rate of return, rejectreject..

Modified Internal Rate of ReturnModified Internal Rate of Return(MIRR)(MIRR)

DefinitionDefinition What is the difference with IRRWhat is the difference with IRR What is the reinvestment assumptionWhat is the reinvestment assumption How to calculateHow to calculate Decision ruleDecision rule

Relationships of MethodsRelationships of Methods

All three discounted cash flow criteria are All three discounted cash flow criteria are

consistent and give similar accept-reject consistent and give similar accept-reject

decision.decision.

NPV is superior to IRRNPV is superior to IRR

Reinvestment assumptionsReinvestment assumptions

Useful GuidelinesUseful Guidelines

Use free cash flow rather than Use free cash flow rather than accounting profitsaccounting profits

Think incrementallyThink incrementally Working capital requirements are Working capital requirements are

considered a cash flow even though they considered a cash flow even though they do not leave the company. do not leave the company.

Sunk costs are not incremental cash flowSunk costs are not incremental cash flow Ignore interest payments and financing Ignore interest payments and financing

flowsflows

Capital Budgeting StepsCapital Budgeting Steps

Evaluate Cash FlowsEvaluate Cash Flows

Look at all incremental cash flows Look at all incremental cash flows occurring as a result of the project.occurring as a result of the project.

Initial outlayInitial outlay Differential Cash FlowsDifferential Cash Flows over the life over the life

of the project (also referred to as of the project (also referred to as annual cash flows).annual cash flows).

Terminal Cash FlowsTerminal Cash Flows

Evaluate Cash FlowsEvaluate Cash Flows

Initial OutlayInitial Outlay:: What is the cash flow at What is the cash flow at “time 0?”“time 0?”

(Purchase price of the asset)(Purchase price of the asset)

+ (+ (shipping and installation costs)shipping and installation costs)

(Depreciable asset)(Depreciable asset)

+ (Investment in working capital)+ (Investment in working capital)

+ + After-tax proceeds from sale of old assetAfter-tax proceeds from sale of old asset

Net Initial OutlayNet Initial Outlay

Incremental revenueIncremental revenue

- Incremental costs- Incremental costs

- - Depreciation on project Depreciation on project

Incremental earnings before taxesIncremental earnings before taxes

- - Tax on incremental EBTTax on incremental EBT

Incremental earnings after taxesIncremental earnings after taxes

+ + Depreciation reversalDepreciation reversal

Annual Cash Flow Annual Cash Flow

For Each Year, Calculate:For Each Year, Calculate:

Step 1: Evaluate Cash FlowsStep 1: Evaluate Cash Flows

Terminal Cash FlowTerminal Cash Flow:: What is the cash flow What is the cash flow at the end of the project’s life?at the end of the project’s life?

Salvage valueSalvage value

+/- Tax effects of capital gain/loss+/- Tax effects of capital gain/loss

+ + Recapture of net working capitalRecapture of net working capital

Terminal Cash FlowTerminal Cash Flow

Problems with Project RankingProblems with Project Ranking

1) Mutually exclusive projects of 1) Mutually exclusive projects of unequal unequal sizesize (the (the size disparitysize disparity problem) problem)

2)2)The The time disparitytime disparity problem with mutually problem with mutually exclusive projects.exclusive projects.

3)3)Mutually exclusive investments with Mutually exclusive investments with Unequal LivesUnequal Lives

Equivalent Annual Annuity (EAA) Equivalent Annual Annuity (EAA) method and replacement chainmethod and replacement chain

Cost of DebtCost of Debt

For the issuing firm, the For the issuing firm, the cost cost of debtof debt is: is:

the the rate of returnrate of return required required by investors,by investors,

adjusted for adjusted for flotation costsflotation costs and and

adjusted for adjusted for taxes.taxes.

Cost of Preferred StockCost of Preferred Stock

Recall:Recall:

kkpp = = = =

From the From the firm’sfirm’s point of view: point of view:

kkpp = = = =

NPo = price - flotation costs!NPo = price - flotation costs!

DPo

Dividend Price

DividendNet Price

DNPo

Cost of Common StockCost of Common Stock

There are two sources of Common Equity:There are two sources of Common Equity:

1) 1) Internal common equityInternal common equity (retained (retained earnings).earnings).

2) 2) External common equityExternal common equity (new common (new common stock issue).stock issue).

Cost of Internal EquityCost of Internal Equity

1) 1) Dividend Growth ModelDividend Growth Model

kkcc = + g = + g

2) 2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)

kkjj = k = krfrf + + jj (k (kmm - k - krf rf ))

D1

Po

Dividend Growth ModelDividend Growth Model

kkncnc = + g = + g

Cost of External EquityCost of External Equity

D1

NPo

Net proceeds to the firmafter flotation costs!

Cost of Common StockCost of Common Stock

Issues with dividend growth modelIssues with dividend growth model Issues with CAPMIssues with CAPM

Weighted Cost of CapitalWeighted Cost of Capital

The weighted cost of capital is just the The weighted cost of capital is just the weighted average cost of all of the weighted average cost of all of the financing sources.financing sources.

Use WACC for discount rate for a Use WACC for discount rate for a project only when the project has project only when the project has similar risk to the firmsimilar risk to the firm