ACF-213/214 Finance I / Finance II - PowerPoint Presentation

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ACF-213/214Finance I / Finance II

Lecture 3

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Learning OutcomeApply techniques for financial valuation and rules for capital investment

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Topics Covered

A Review of The Basics

Book Rate of Return and Payback

Internal

(or Discounted Cash Flow)

Rate of Return

Choosing Capital Investments When Resources Are Limited

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Topics Covered

Applying the Net Present Value Rule

Corporate Income Taxes

Example—IM&C’s Fertilizer Project

Using the NPV Rule to Choose among Projects

The Investment Timing Decision

The Choice between Long- and Short-Lived Equipment

When to Replace an Old Machine

Cost of Excess Capacity

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Figure 5.1 A Review of the Basics

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Three Points to Remember about NPV A dollar today is worth more than a dollar tomorrow Net present value depends solely on the forecasted cash flows

from the project and the

opportunity cost of capital

Because present values are all measured in today’s dollars, you can add them up

NPV(A + B) = NPV(A) + NPV(B)

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Figure 5.2 Survey Data on CFOs’ Use of Investment Evaluation Techniques

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Book Rate of Return and PaybackBook Rate of Return

Average income divided by average book value over project life. Also called accounting rate of return.

Managers rarely use this measurement to make decisions.

The components reflect tax and accounting figures, not market values or cash flows.

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Book Rate of Return and Payback ContinuedThe payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay.The payback rule says to only accept projects that “pay back” in the desired time frame.

This method is flawed, primarily because it ignores later-year cash flows and the present value of future cash flows.

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Book Rate of Return and Payback Continued 2ExampleExamine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of two years or less.

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Book Rate of Return and Payback ConcludedExampleExamine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of two years or less.

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Internal (or Discounted Cash Flow) Rate of Return

Internal Rate of Return (IRR)

Discount rate at which NPV = 0

Internal Rate of Return Rule

Invest in any project offering a rate of return that is higher than the opportunity cost

of capital

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Internal (or Discounted Cash Flow) Rate of Return Continued

Example

You can purchase a turbo-powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

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Internal (or Discounted Cash Flow) Rate of Return Concluded

Example

You can purchase a turbo-powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

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Figure 5.3 Internal Rate of Return

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Pitfall 1—Lending or Borrowing?

With some cash flows (as noted below), the NPV of the project increases as the discount rate increases

This is contrary to the normal relationship between NPV and discount rates

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Pitfall 2—Multiple Rates of ReturnCertain cash flows can generate NPV = 0 at two different discount rates

The following cash flow in Figure 5.4 generates NPV = $A 253 million at both IRR% of +3.50% and +19.54%.

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Pitfall 2—Multiple Rates of Return ContinuedIt is possible to have a zero IRR and a positive NPV

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Pitfall 3—Mutually Exclusive ProjectsIRR sometimes ignores the magnitude of the project

The following two projects illustrate that problem

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Figure 5.5 Pitfall 3—Mutually Exclusive Projects

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Pitfall 4—What Happens When There Is More than One Opportunity Cost of CapitalTerm structure assumption

We assume that discount rates are stable during the term of the project

This assumption implies that all funds are reinvested at the IRR

This is a false assumption

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Choosing Capital Investments When Resources Are Limited

Capital Rationing

Limit set on the amount of funds available for investment

Soft Rationing

Limits on available funds imposed by management

Hard Rationing

Limits on available funds imposed by the unavailability of funds in the capital market

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An Easy Problem in Capital RationingWhen resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives

A set of limited resources and projects can yield various combinations

The highest weighted average PI can indicate which projects to select

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An Easy Problem in Capital Rationing Continued

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An Easy Problem in Capital Rationing Concluded

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Example: Profitability Index Example

We only have $300,000 to invest. Which do we select?

Project

NPV

Investment

PI

A230,000

200,0001.15B

141,250125,0001.13

C194,250

175,0001.11D

162,000150,000

1.08

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Example: Profitability Index ContinuedExample continued

Select projects with the highest weighted average PI

Project

NPV

Investment

PI

A

230,000200,0001.15

B141,250125,000

1.13C

194,250175,0001.11

D162,000150,000

1.08

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Example: Profitability Index ConcludedExample concluded

Select projects with highest weighted average PI

WAPI (BD) = 1.01

WAPI (A) = 0.77

WAPI (BC) = 1.12

ProjectNPV

InvestmentPIA

230,000200,000

1.15B141,250

125,0001.13C

194,250175,000

1.11D162,000

150,0001.08

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Applying the Net Present Value RuleRule 1: Discount Cash Flows, Not ProfitsCapital ExpensesRecord capital expenditures when they occurTo determine cash flow from income, add back depreciation and subtract capital expenditure

Working Capital

Difference between company’s short-term assets and liabilities

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Applying the Net Present Value Rule Continued

Rule 2: Discount Incremental Cash Flows

Include all incidental effects

Do not confuse average with incremental payoffs

Forecast product sales today but also recognize after-sales cash flows Include opportunity costs Forget sunk costsBeware of allocated overhead costs

Remember salvage value

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Applying the Net Present Value Rule Continued 2

Rule 3: Treat Inflation Consistently

Be consistent in how you handle inflation!!

Use nominal interest rates to discount nominal cash flows

Use real interest rates to discount real cash flows

You will get the same results, whether you use nominal or real figures

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Inflation Example

Example

You invest in a project that will produce real cash flows of

–

$100 in year zero and then $35, $50, and $30 in the three respective years. If the nominal discount rate is 15% and the inflation rate is 10%, what is the NPV of the project?

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Inflation Example Continued

Example: Nominal figures

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Inflation Example Continued 2

Example

You invest in a project that will produce real cash flows of –$100 in year zero and then $35, $50, and $30 in the three respective following years. If the nominal discount rate is 15% and the inflation rate is 10%, what is the NPV of the project?

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Inflation Concluded

Example: Real figures

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Applying the Net Present Value Rule Continued 3Rule 4: Separate Investment and Financing DecisionsQuestion: Suppose you finance a project partly with debt. How should you treat the proceeds from the debt issue and the interest and principal payments on the debt?

Answer

: You should

neither

subtract the debt proceeds from the required investment nor recognize the interest and principal payments on the debt as cash outflows.

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Applying the Net Present Value Rule ConcludedRule 5: Remember to Deduct TaxesCash flows should be estimated on after-tax basis.Subtract cash outflows for taxes from pretax cash flows and discount net amount.

Be careful to subtract cash taxes

Cash taxes paid are usually different from taxes reported on the income statement

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Table 6.1 National Corporate Tax Rates

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U.S. Corporate Income Tax ReformU.S. Tax Cuts and Jobs Act passed in December 2017 and implemented in 2018.Dropped the corporate tax rate from 35% to 21%DepreciationNew law allows companies to take bonus depreciation to write off 100% of investment immediately

It is a temporary provision and will start to phase out in 2023 and out by 2027

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U.S. Corporate Income Tax Reform ContinuedAmortization of Research ExpensesU.S. companies can now write off most outlays for R&D as immediate expensesBeginning 2022, most R&D must be depreciated over five-year periodTax Carry-Forwards

Beginning 2018, carry-backs are no longer allowed

Carry-forward losses are allowed indefinitely

Losses can offset up to 80% of future year’s income

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U.S. Corporate Income Tax Reform Continued 2Limits on Interest DeductionsU.S. tax law treats interest on debt as a tax-deductible expense2018–2021: interest deductions are limited to 30% of taxable EBITDA2022: interest deductions are limited to 30% of taxable EBIT

Restriction in interest deductions are tighter post 2021

Most companies will fall below the 30% limits

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U.S. Corporate Income Tax Reform ConcludedTerritorial versus Worldwide TaxationMost countries have territorial corporate income taxesTax income earned in their own countries but not outside their borders.U.S. switched to the territorial system in 2018

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The Three Elements of Project Cash FlowsTotal cash flow = cash flow from capital investment + operating cash flow

+ cash flow from changes in working capital

Capital investment: up-front investment in plant, equipment, research, start-up costs, and diverse other outlays

Operating cash flow: net increase in sales revenue from the new project less outlays

Investment in working capital: represents a negative cash flow

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Table 6.2 Calculating the Cash Flows and NPV of IM&C’s Guano Project Assuming Straight-Line Depreciation ($ thousands)

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Table 6.3 IM&C’s Guano Project. Revised Analysis with Immediate Expensing of Investment Expenditures

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The Investment Timing DecisionProblem 1: Investment Timing DecisionSome projects are more valuable if undertaken in the future

Examine start dates (

t

) for investment and calculate net future value for each date

Discount net values back to present 

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The Investment Timing Decision Continued

Example

You own a large tract of inaccessible timber. To harvest it, you have to invest a substantial amount in access roads and other facilities. The longer you wait, the higher the investment required. On the other hand, lumber prices may rise as you wait, and the trees will keep growing, although at a gradually decreasing rate. Given the following data and a 10% discount rate, when should you harvest?

Answer: Year 4

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The Choice between Long- and Short-Lived Equipment

Problem 2: The Choice between Long- and Short-Lived Equipment

Equivalent Annual Cash Flow :

The cash flow per period with the same present value as the actual cash flow as the project.

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Equivalent Annual Cash FlowsExample

Given the following COSTS from operating two machines and a 6% cost of capital, which machine has the lower equivalent annual cost?

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Equivalent Annual Cash Flows ContinuedExample

Given the following COSTS from operating two machines and a 6% cost of capital, which machine has the lower equivalent annual cost?

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When to Replace an Old MachineProblem 3: When to Replace an Old MachineExampleA machine is expected to produce a net inflow of $4,000 this year and $4,000 next year before breaking. You can replace it now with a machine that costs $15,000 and will produce an inflow of $8,000 per year for three years. Should you replace now or wait a year?

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When to Replace an Old Machine ContinuedProblem 3: Continued

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Cost of Excess CapacityProblem 4: Cost of Excess CapacityExample

A computer system costs $500,000 to buy and operate at a discount rate of 6% and lasts five years.

Equivalent annual cost of $118,700

Undertaking project in year 4 has a present value of 118,700/(1.06)

4, or about $94,000