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UNIT 8 Project Valuation

UNIT 8 Project Valuation. Should we build this plant?. What is capital budgeting?. Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future. Steps to capital budgeting. Estimate CFs (inflows & outflows).

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UNIT 8 Project Valuation

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  1. UNIT 8Project Valuation Should we build this plant?

  2. What is capital budgeting? • Analysis of potential additions to fixed assets. • Long-term decisions; involve large expenditures. • Very important to firm’s future.

  3. Steps to capital budgeting • Estimate CFs (inflows & outflows). • Assess riskiness of CFs. • Determine the appropriate cost of capital. • Find NPV and/or IRR. • Accept if NPV > 0 and/or IRR > WACC.

  4. What is the difference between independent and mutually exclusive projects? • Independent projects – if the cash flows of one are unaffected by the acceptance of the other. • Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.

  5. What is the difference between normal and nonnormal cash flow streams? • Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. • Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

  6. Net Present Value (NPV) • Sum of the PVs of all cash inflows and outflows of a project:

  7. What is Project L’s NPV? YearCFtPV of CFt 0 -100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPVL = $18.79 NPVS = $19.98

  8. Excel NPV Reminder You may use Excel’s NPV function to calculate NPV but be careful! Use Excel’s NPV function to find NPV of CF1-n and then subtract CF0 from this result.

  9. Rationale for the NPV method NPV = PV of inflows – Cost = Net gain in wealth • If projects are independent, accept if the project NPV > 0. • If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. • In this example, accept S if mutually exclusive (NPVs > NPVL), and accept both if independent.

  10. Internal Rate of Return (IRR) • IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0: • Use Excel’s IRR function.

  11. How is a project’s IRR similar to a bond’s YTM? • They are the same thing. • Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project. • EXAMPLE: Suppose a 10-year bond with a 9% annual coupon and $1,000 par value sells for $1,134.20. • Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

  12. Rationale for the IRR method • If IRR > WACC, the project’s return exceeds its costs and there is some return left over to boost stockholders’ returns. If IRR > WACC, accept project. If IRR < WACC, reject project. • If projects are independent, accept both projects, as both IRR > WACC = 10%. • If projects are mutually exclusive, accept S, because IRRs > IRRL.

  13. NPV Profiles • A graphical representation of project NPVs at various different costs of capital. WACC NPVLNPVS 0 $50 $40 5 33 29 10 19 20 15 7 12 20 (4) 5

  14. Drawing NPV profiles NPV ($) 60 . 50 . 40 . Crossover Point = 8.7% . 30 . . IRRL = 18.1% 20 . . S . 10 L IRRS = 23.6% . . Discount Rate (%) 0 5 15 20 23.6 10 -10

  15. Comparing the NPV and IRR methods • If projects are independent, the two methods always lead to the same accept/reject decisions. • If projects are mutually exclusive … • If WACC > crossover rate, the methods lead to the same decision and there is no conflict. • If WACC < crossover rate, the methods lead to different accept/reject decisions.

  16. Reasons why NPV profiles cross • Size (scale) differences – the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high WACC favors small projects. • Timing differences – the project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF especially good, NPVS > NPVL.

  17. Reinvestment rate assumptions • NPV method assumes CFs are reinvested at the WACC. • IRR method assumes CFs are reinvested at IRR. • Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. • Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.

  18. What is the payback period? • The number of years required to recover a project’s cost, or “How long does it take to get our money back?” • Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.

  19. Calculating payback Project L’s Payback Calculation 3 0 1 2 80 CFt-100 10 60 Cumulative -100 -90 50 -30 30 80 PaybackL = 2 + / = 2.375 years = PaybackL = 2.375 years PaybackS = 1.600 years

  20. Strengths and weaknesses of payback • Strengths • Provides an indication of a project’s risk and liquidity. • Easy to calculate and understand. • Weaknesses • Ignores the time value of money. • Ignores CFs occurring after the payback period.

  21. Proposed Project • Total depreciable cost • Equipment: $200,000 • Shipping: $10,000 • Installation: $30,000 • Changes in working capital • Inventories will rise by $25,000 • Accounts payable will rise by $5,000 • Effect on operations • New sales: 100,000 units/year @ $2/unit • Variable cost: 60% of sales

  22. Proposed Project • Life of the project • Economic life: 4 years • Depreciable life: MACRS 3-year class • Salvage value: $25,000 • Tax rate: 40% • WACC: 10%

  23. Determining project value • Estimate relevant cash flows • Calculating annual operating cash flows. • Identifying changes in working capital. • Calculating terminal cash flows. 0 1 2 3 4 Initial OCF1 OCF2 OCF3 OCF4 Costs + Terminal CFs NCF0 NCF1 NCF2 NCF3 NCF4

  24. Initial year net cash flow • Find Δ NOWC. • ⇧ in inventories of $25,000 • Funded partly by an ⇧ in A/P of $5,000 • Δ NOWC = $25,000 - $5,000 = $20,000 • Combine Δ NOWC with initial costs. Equipment -$200,000 Installation -40,000 Δ NOWC -20,000 Net CF0 -$260,000

  25. Determining annual depreciation expense Year Rate x Basis Depr 1 0.33 x $240 $ 79 2 0.45 x 240 108 3 0.15 x 240 36 4 0.07 x 240 17 1.00 $240 Due to the MACRS ½-year convention, a 3-year asset is depreciated over 4 years.

  26. Annual operating cash flows

  27. Terminal net cash flow Recovery of NOWC $20,000 Salvage value 25,000 Tax on SV (40%) -10,000 Terminal CF $35,000 Q. How is NOWC recovered? Q. Is there always a tax on SV? Q. Is the tax on SV ever a positive cash flow?

  28. Should financing effects be included in cash flows? • No, dividends and interest expense should not be included in the analysis. • Financing effects have already been taken into account by discounting cash flows at the WACC of 10%. • Deducting interest expense and dividends would be “double counting” financing costs.

  29. Should a $50,000 improvement cost from the previous year be included in the analysis? • No, the building improvement cost is a sunk cost and should not be considered. • This analysis should only include incremental investment.

  30. If the facility could be leased out for $25,000 per year, would this affect the analysis? • Yes, by accepting the project, the firm foregoes a possible annual cash flow of $25,000, which is an opportunity cost to be charged to the project. • The relevant cash flow is the annual after-tax opportunity cost. • A-T opportunity cost = $25,000 (1 – T) = $25,000(0.6) = $15,000

  31. If the new product line decreases the sales of the firm’s other lines, would this affect the analysis? • Yes. The effect on other projects’ CFs is an “externality.” • Net CF loss per year on other lines would be a cost to this project. • Externalities can be positive (in the case of complements) or negative (substitutes).

  32. Proposed project’s cash flow time line 0 1 2 3 4 -260 79.7 91.2 62.4 54.7 Terminal CF → 35.0 89.7 • Enter CFs into calculator CFLO register and enter I/YR = 10%. • NPV = -$4.03 million • IRR = 9.3% • Payback = 3.3 years

  33. What is real option analysis? • Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during the project’s life. • Real option analysis incorporates typical NPV budgeting analysis with an analysis for opportunities resulting from managers’ decisions.

  34. What are some examples of real options? • Investment timing options • Abandonment/shutdown options • Growth/expansion options • Flexibility options

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