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Chapter 7 Investment Decision Rules Chapter 7 Investment Decision Rules

7. 1 NPV and Stand-Alone Projects • Researchers at Fredrick’s Feed and Farm have 7. 1 NPV and Stand-Alone Projects • Researchers at Fredrick’s Feed and Farm have made a breakthrough. • They believe that they can produce a new, environmentally friendly fertilizer at a substantial cost savings over the company’s existing line of fertilizer. • The fertilizer will require a new plant that can be built immediately at a cost of $250 million. • Financial managers estimate that the benefits of the new fertilizer will be $35 million per year, starting at the end of the first year and lasting forever • A take-it-or-leave-it investment decision involving a single, standalone project Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -2

NPV Rule • The NPV of the project is calculated as: • he financial NPV Rule • The NPV of the project is calculated as: • he financial managers responsible for this project estimate a cost of capital of 10% per year. • Using this cost of capital the NPV is $100 million, which is positive. • The NPV investment rule indicates that by making the investment, the value of the firm will increase by $100 million today, so Fredrick’s should undertake this project. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -3

NPV Rule • The NPV of the project depends on the appropriate cost of NPV Rule • The NPV of the project depends on the appropriate cost of capital. • Often, there may be some uncertainty regarding the project’s cost of capital. • In that case, it is helpful to compute an NPV profile: a graph of the project’s NPV over a range of discount rates. • Figure 7. 1 plots the NPV of the fertilizer project as a function of the discount rate, r. • Notice that the NPV is positive only for discount rates that are less than 14%. • When r = 14%, the NPV is zero. • Recall from Chapter 4 that the internal rate of return (IRR) of an investment is the discount rate that sets the NPV of the project’s cash flows equal to zero. • Thus, the fertilizer project has an IRR of 14%. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -4

Figure 7. 1 NPV of Fredrick’s Fertilizer Project • If FFF’s cost of capital Figure 7. 1 NPV of Fredrick’s Fertilizer Project • If FFF’s cost of capital is 10%, the NPV is $100 million and they should undertake the investment. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -5

Alternative Rules Versus the NPV Rule • The IRR of a project provides useful Alternative Rules Versus the NPV Rule • The IRR of a project provides useful information regarding the sensitivity of the project’s NPV to errors in the estimate of its cost of capital. • Sometimes alternative investment rules may give the same answer as the NPV rule, but at other times they may disagree. – When the rules conflict, the NPV decision rule should be followed. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -6

7. 2 The Internal Rate of Return Rule(IRR) Investment Rule • One interpretation of 7. 2 The Internal Rate of Return Rule(IRR) Investment Rule • One interpretation of the internal rate of return is the average return earned by taking on the investment opportunity. • The internal rate of return (IRR) investment rule is based on this idea: If the average return on the investment opportunity (i. e. , the IRR) is greater than the return on other alternatives in the market with equivalent risk and maturity (i. e. , the project’s cost of capital), you should undertake the investment opportunity. • We state the rule formally as follows: IRR Investment Rule: Take any investment opportunity where the IRR exceeds the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -7

The Internal Rate of Return Rule (cont'd) • The IRR Investment Rule will give The Internal Rate of Return Rule (cont'd) • The IRR Investment Rule will give the same answer as the NPV rule in many, but not all, situations. • In general, the IRR rule works for a standalone project if all of the project’s negative cash flows precede its positive cash flows. – In Figure 7. 1, whenever the cost of capital is below the IRR of 14%, the project has a positive NPV and you should undertake the investment. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -8

Applying The IRR Rule • In other cases, the IRR rule may disagree with Applying The IRR Rule • In other cases, the IRR rule may disagree with the NPV rule and thus be incorrect. – Situations where the IRR rule and NPV rule may be in conflict: • Delayed Investments • Nonexistent IRR • Multiple IRRs Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -9

Applying The IRR Rule (cont'd) • Delayed Investments – Assume you have just retired Applying The IRR Rule (cont'd) • Delayed Investments – Assume you have just retired as the CEO of a successful company. – A major publisher has offered you a book deal. The publisher will pay you $1 million upfront if you agree to write a book about your experiences. – You estimate that it will take three years to write the book. – The time you spend writing will cause you to give up speaking engagements amounting to $500, 000 per year. – You estimate your opportunity cost to be 10%. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -10

Applying The IRR Rule (cont'd) • Delayed Investments – Should you accept the deal? Applying The IRR Rule (cont'd) • Delayed Investments – Should you accept the deal? – Since the NPV is negative, the NPV rule indicates you should reject the deal. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -11

Figure 7. 2 NPV of Star’s $1 Million Book Deal • When the benefits Figure 7. 2 NPV of Star’s $1 Million Book Deal • When the benefits of an investment occur before the costs, the NPV is an increasing function of the discount rate. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -12

Applying The IRR Rule (cont'd) • For most investment opportunities, expenses occur initially and Applying The IRR Rule (cont'd) • For most investment opportunities, expenses occur initially and cash is received later. • In this case, Star gets cash upfront and incurs the costs of producing the book later. • It is as if Star borrowed money—receiving cash today in exchange for a future liability—and when you borrow money you prefer as low a rate as possible. • In this case the IRR is best interpreted as the rate Star is paying rather than earning, and so Star’s optimal rule is to borrow money so long as this rate is less than his cost of capital. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -13

Applying The IRR Rule (cont'd) • Multiple IRRs – Suppose Star informs the publisher Applying The IRR Rule (cont'd) • Multiple IRRs – Suppose Star informs the publisher that it needs to sweeten the deal before he will accept it. – The publisher offers $550, 000 advance and $1, 000 in four years when the book is published. – Should he accept or reject the new offer? Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -14

Applying The IRR Rule (cont'd) • Multiple IRRs – The cash flows would now Applying The IRR Rule (cont'd) • Multiple IRRs – The cash flows would now look like: – The NPV is calculated as: Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -15

Applying The IRR Rule (cont'd) • Multiple IRRs – By setting the NPV equal Applying The IRR Rule (cont'd) • Multiple IRRs – By setting the NPV equal to zero and solving for r, we find the IRR. – In this case, there are two IRRs: 7. 164% and 33. 673%. – Because there is more than one IRR, the IRR rule cannot be applied. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -16

Figure 7. 3 NPV of Star’s Book Deal with Royalties Copyright © 2014 Pearson Figure 7. 3 NPV of Star’s Book Deal with Royalties Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -17

Applying The IRR Rule (cont'd) • Multiple IRRs – Between 7. 164% and 33. Applying The IRR Rule (cont'd) • Multiple IRRs – Between 7. 164% and 33. 673%, the book deal has a negative NPV. – Since your opportunity cost of capital is 10%, you should reject the deal. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -18

Applying The IRR Rule (cont'd) • Nonexistent IRR – Finally, Star is able to Applying The IRR Rule (cont'd) • Nonexistent IRR – Finally, Star is able to get the publisher to increase his advance to $750, 000, in addition to the $1 million when the book is published in four years. – With these cash flows, no IRR exists; there is no discount rate that makes NPV equal to zero. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -19

Figure 7. 4 NPV of Star’s Final Offer • No IRR exists because the Figure 7. 4 NPV of Star’s Final Offer • No IRR exists because the NPV is positive for all values of the discount rate. Thus the IRR rule cannot be used. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -20

Applying The IRR Rule (cont'd) • IRR Versus the IRR Rule – While the Applying The IRR Rule (cont'd) • IRR Versus the IRR Rule – While the IRR rule has shortcomings for making investment decisions, the IRR itself remains useful. – IRR measures the average return of the investment and the sensitivity of the NPV to any estimation error in the cost of capital. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -21

Textbook Example 7. 1 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 Textbook Example 7. 1 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -22

Textbook Example 7. 1 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 7. 1 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -23

Figure 7. 5 NPV Profiles for Example 7. 1 While the IRR Rule works Figure 7. 5 NPV Profiles for Example 7. 1 While the IRR Rule works for project A, it fails for each of the other projects. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -24

7. 3 The Payback Rule • The payback period is amount of time it 7. 3 The Payback Rule • The payback period is amount of time it takes to recover or pay back the initial investment. • If the payback period is less than a prespecified length of time, you accept the project. • Otherwise, you reject the project. – The payback rule is used by many companies because of its simplicity. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -25

Textbook Example 7. 2 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 Textbook Example 7. 2 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -26

Textbook Example 7. 2 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 7. 2 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -27

Alternative Example 7. 2 • Problem – Projects A, B, and C each have Alternative Example 7. 2 • Problem – Projects A, B, and C each have an expected life of 5 years. – Given the initial cost and annual cash flow information below, what is the payback period for each project? A B C Cost $80 $120 $150 Cash Flow $25 $30 $35 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -28

Alternative Example 7. 2 • Solution – Payback A • $80 ÷ $25 = Alternative Example 7. 2 • Solution – Payback A • $80 ÷ $25 = 3. 2 years – Project B • $120 ÷ $30 = 4. 0 years – Project C • $150 ÷ $35 = 4. 29 years Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -29

The Payback Rule (cont’d) • Pitfalls: – Ignores the project’s cost of capital and The Payback Rule (cont’d) • Pitfalls: – Ignores the project’s cost of capital and time value of money. – Ignores cash flows after the payback period. – Relies on an ad hoc decision criterion. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -30

7. 4 Choosing Between Projects • Mutually Exclusive Projects – When you must choose 7. 4 Choosing Between Projects • Mutually Exclusive Projects – When you must choose only one project among several possible projects, the choice is mutually exclusive. – NPV Rule • Select the project with the highest NPV. – IRR Rule • Selecting the project with the highest IRR may lead to mistakes. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -31

Textbook Example 7. 3 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 Textbook Example 7. 3 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -32

Textbook Example 7. 3 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 7. 3 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -33

Alternative Example 7. 3 • Problem – A small commercial property is for sale Alternative Example 7. 3 • Problem – A small commercial property is for sale near your university. Given its location, you believe a student-oriented business would be very successful there. You have researched several possibilities and come up with the following cash flow estimates (including the cost of purchasing the property). Which investment should you choose? Project Initial Investment First-Year Cash Flow Growth Rate Cost of Capital Used Book Store $250, 000 $55, 000 4% 7% Sandwich Shop $350, 000 $75, 000 4% 8% Hair Salon $400, 000 $120, 000 5% 8% Clothing Store $500, 000 $125, 000 8% 12% Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -34

Alternative Example 7. 3 (cont’d) • Solution – Assuming each business lasts indefinitely, we Alternative Example 7. 3 (cont’d) • Solution – Assuming each business lasts indefinitely, we can compute the present value of the cash flows from each as a constant growth perpetuity. The NPV of each project is – Thus, all of the alternatives have a positive NPV. But because we can only choose one, the clothing store is the best alternative. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -35

IRR Rule and Mutually Exclusive Investments: Differences in Scale • If a project’s size IRR Rule and Mutually Exclusive Investments: Differences in Scale • If a project’s size is doubled, its NPV will double. • This is not the case with IRR. • Thus, the IRR rule cannot be used to compare projects of different scales. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -36

IRR Rule and Mutually Exclusive Investments: Differences in Scale • Would you prefer a IRR Rule and Mutually Exclusive Investments: Differences in Scale • Would you prefer a 500% return on $1, or a 20% return on $1 million? • While a 500% return certainly sounds impressive, at the end of the day you will only make $5. • The latter return sounds much more mundane, but you will make $200, 000. • This comparison illustrates an important shortcoming of IRR: Because it is a return, you cannot tell how much value will actually be created without knowing the scale of the investment. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -37

IRR Rule and Mutually Exclusive Investments: Differences in Scale (cont’d) – Consider two of IRR Rule and Mutually Exclusive Investments: Differences in Scale (cont’d) – Consider two of the projects from Example 7. 3 Bookstore Coffee Shop Initial Investment Cash Flow. Year 1 $300, 000 $63, 000 $400, 000 $80, 000 Annual Growth Rate Cost of Capital IRR NPV 3% 8% 24% $960, 000 3% 8% 23% $1, 200, 000 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -38

IRR Rule and Mutually Exclusive Investments: Timing of Cash Flows • Another problem with IRR Rule and Mutually Exclusive Investments: Timing of Cash Flows • Another problem with the IRR is that it can be affected by changing the timing of the cash flows, even when the scale is the same. – IRR is a return, but the dollar value of earning a given return depends on how long the return is earned. • Consider again the coffee shop and the music store investment in Example 7. 3. • Both have the same initial scale and the same horizon. • The coffee shop has a lower IRR, but a higher NPV because of its higher growth rate. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -39

IRR Rule and Mutually Exclusive Investments: Differences in Risk • An IRR that is IRR Rule and Mutually Exclusive Investments: Differences in Risk • An IRR that is attractive for a safe project need not be attractive for a riskier project. • Consider the investment in the electronics store from Example 7. 3. • The IRR is higher than those of the other investment opportunities, yet the NPV is the lowest. • The higher cost of capital means a higher IRR is necessary to make the project attractive. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -40

The Incremental IRR Rule • When choosing between two projects, an alternative to comparing The Incremental IRR Rule • When choosing between two projects, an alternative to comparing their IRRs is to compute the incremental IRR, which is the IRR of the incremental cash flows that would result from replacing one project with the other. • The incremental IRR tells us the discount rate at which it becomes profitable to switch from one project to the other. • Then, rather than compare the projects directly, we can evaluate the decision to switch from one to the other using the IRR rule • Incremental IRR Investment Rule – Apply the IRR rule to the difference between the cash flows of the two mutually exclusive alternatives (the increment to the cash flows of one investment over the other). Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -41

Textbook Example 7. 4 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 Textbook Example 7. 4 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -42

Textbook Example 7. 4 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 7. 4 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -43

Textbook Example 7. 4 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 7. 4 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -44

The Incremental IRR Rule (cont'd) • Shortcomings of the Incremental IRR Rule – The The Incremental IRR Rule (cont'd) • Shortcomings of the Incremental IRR Rule – The incremental IRR may not exist. – Multiple incremental IRRs could exist. – The fact that the IRR exceeds the cost of capital for both projects does not imply that either project has a positive NPV. – When individual projects have different costs of capital, it is not obvious which cost of capital the incremental IRR should be compared to. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -45

7. 5 Project Selection with Resource Constraints • In practice, there are often limitations 7. 5 Project Selection with Resource Constraints • In practice, there are often limitations on the number of projects the firm can undertake. • For example, when projects are mutually exclusive, the firm can only take on one of the projects even if many of them are attractive. • Often this limitation is due to resource constraints— for example, there is only one property available in which to open either a coffee shop, or book store, and so on. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -46

7. 5 Project Selection with Resource Constraints • Evaluation of Projects with Different Resource 7. 5 Project Selection with Resource Constraints • Evaluation of Projects with Different Resource Constraints – Consider three possible projects with a $100 million budget constraint – Practitioners often use the profitability index to identify the optimal combination of projects to undertake in such situations Table 7. 1 Possible Projects for Copyright © 2014 Pearson Education, Inc. All rights reserved. a $100 Million Budget 7 -47

Profitability Index • The profitability index can be used to identify the optimal combination Profitability Index • The profitability index can be used to identify the optimal combination of projects to undertake. – From Table 7. 1, we can see it is better to take projects II & III together and forego project I. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -48

Textbook Example 7. 5 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 Textbook Example 7. 5 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -49

Textbook Example 7. 5 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 7. 5 (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -50

Alternative Example 7. 5 • Problem – Suppose your firm has the following five Alternative Example 7. 5 • Problem – Suppose your firm has the following five positive NPV projects to choose from. However, there is not enough manufacturing space in your plant to select all of the projects. – Use the profitability index to choose among the projects, given that you only have 105, 000 square feet of unused space. Project NPV Square feet needed Project 1 100, 000 40, 000 Project 2 88, 000 30, 000 Project 3 80, 000 38, 000 Project 4 50, 000 24, 000 Project 5 12, 000 1, 000 330, 000 133, 000 Total Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -51

Alternative Example 7. 5 (cont’d) • Solution – Compute the PI for each project. Alternative Example 7. 5 (cont’d) • Solution – Compute the PI for each project. Project NPV Square feet needed Profitability Index (NPV/Sq. Ft) Project 1 100, 000 40, 000 2. 5 Project 2 88, 000 30, 000 2. 93 Project 3 80, 000 38, 000 2. 10 Project 4 50, 000 24, 000 2. 08 Project 5 12, 000 12. 0 Total 330, 000 Copyright © 2014 Pearson Education, Inc. All rights reserved. 133, 000 7 -52

Alternative Example 7. 5 (cont’d) • Solution – Rank order them by PI and Alternative Example 7. 5 (cont’d) • Solution – Rank order them by PI and see how many projects you can have before you run out of space. Project NPV Square feet needed Profitability Index (NPV/Sq. Ft) Cumulative total space used Project 5 12, 000 1, 000 2. 5 1, 000 Project 2 88, 000 30, 000 2. 93 31, 000 Project 1 100, 000 40, 000 2. 5 71, 000 Project 3 80, 000 38, 000 2. 11 Project 4 50, 000 24, 000 2. 08 Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -53

Shortcomings of the Profitability Index • In some situations the profitability Index does not Shortcomings of the Profitability Index • In some situations the profitability Index does not give an accurate answer. – Suppose in Example 7. 5 that Net. It has an additional small project with a NPV of only $120, 000 that requires 3 engineers. – The profitability index in this case is 0. 1 2/ 3 = 0. 04, so this project would appear at the bottom of the ranking. – However, 3 of the 190 employees are not being used after the first four projects are selected. – As a result, it would make sense to take on this project even though it would be ranked last. Copyright © 2014 Pearson Education, Inc. All rights reserved. 7 -54

Chapter 8 Fundamentals of Capital Budgeting Chapter 8 Fundamentals of Capital Budgeting

8. 1 Forecasting Earnings • Capital Budget – Lists the investments that a company 8. 1 Forecasting Earnings • Capital Budget – Lists the investments that a company plans to undertake • Capital Budgeting – Process used to analyze alternate investments and decide which ones to accept • Incremental Earnings – The amount by which the firm’s earnings are expected to change as a result of the investment decision Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -56

Revenue and Cost Estimates • Home. Net’s target market is upscale residential “smart” homes Revenue and Cost Estimates • Home. Net’s target market is upscale residential “smart” homes and home offices. • Based on extensive marketing surveys, the sales forecast for Home. Net is 100, 000 units per year. • Given the pace of technological change, Linksys expects the product will have a four-year life. • It will be sold through high-end electronics stores for a retail price of $375, with an expected wholesale price of $260. • Linksys has completed a $300, 000 feasibility study to assess the attractiveness of a new product, Home. Net. – Revenue Estimates • Sales = 100, 000 units/year, Per Unit Price = $260 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -57

Revenue and Cost Estimates (cont'd) • Developing the new hardware will be relatively inexpensive, Revenue and Cost Estimates (cont'd) • Developing the new hardware will be relatively inexpensive, as existing technologies can be simply repackaged in a newly designed, home-friendly box. • Linksys expects total engineering and design costs to amount to $5 million. • Once the design is finalized, actual production will be outsourced at a cost (including packaging) of $110 per unit. • Cost Estimates • Up-Front R&D = $15, 000 • Up-Front New Equipment = $7, 500, 000 – Expected life of the new equipment is 5 years – Housed in existing lab • Annual Overhead = $2, 800, 000 • Per Unit Cost = $110 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -58

Incremental Earnings Forecast Table 8. 1 Spreadsheet Home. Net’s Incremental Earnings Forecast Copyright © Incremental Earnings Forecast Table 8. 1 Spreadsheet Home. Net’s Incremental Earnings Forecast Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -59

Capital Expenditures and Depreciation • The $7. 5 million in new equipment is a Capital Expenditures and Depreciation • The $7. 5 million in new equipment is a cash expense, but it is not directly listed as an expense when calculating earnings. • Instead, the firm deducts a fraction of the cost of these items each year as depreciation. • Straight Line Depreciation – The asset’s cost is divided equally over its life. Annual Depreciation = $7. 5 million ÷ 5 years = $1. 5 million/year Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -60

Interest Expense • In capital budgeting decisions, interest expense is typically not included. • Interest Expense • In capital budgeting decisions, interest expense is typically not included. • The rationale is that the project should be judged on its own, not on how it will be financed. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -61

Taxes • Marginal Corporate Tax Rate – The tax rate on the marginal or Taxes • Marginal Corporate Tax Rate – The tax rate on the marginal or incremental dollar of pre-tax income. – Note: A negative tax is equal to a tax credit. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -62

Taxes (cont'd) • Unlevered Net Income Calculation Copyright © 2014 Pearson Education, Inc. All Taxes (cont'd) • Unlevered Net Income Calculation Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -63

Indirect Effects on Incremental Earnings • Opportunity Cost – The value a resource could Indirect Effects on Incremental Earnings • Opportunity Cost – The value a resource could have provided in its best alternative use – In the Home. Net project example, space will be required for the investment. – Even though the equipment will be housed in an existing lab, the opportunity cost of not using the space in an alternative way (e. g. , renting it out) must be considered. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -64

Textbook Example 8. 2 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 Textbook Example 8. 2 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -65

Textbook Example 8. 2 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 8. 2 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -66

Indirect Effects on Incremental Earnings (cont'd) • Project Externalities – Indirect effects of the Indirect Effects on Incremental Earnings (cont'd) • Project Externalities – Indirect effects of the project that may affect the profits of other business activities of the firm. – Cannibalization is when sales of a new product displaces sales of an existing product. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -67

Indirect Effects on Incremental Earnings (cont'd) • Project Externalities – In the Home. Net Indirect Effects on Incremental Earnings (cont'd) • Project Externalities – In the Home. Net project example, 25% of sales come from customers who would have purchased an existing Linksys wireless router if Home. Net were not available. – Because this reduction in sales of the existing wireless router is a consequence of the decision to develop Home. Net, we must include it when calculating Home. Net’s incremental earnings. – For the cannibalization, suppose that the existing router wholesales for $100 – ($25% * 100, 000 units * $100/unit = $2. 5 million) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -68

Indirect Effects on Incremental Earnings (cont'd) Table 8. 2 Spreadsheet Home. Net’s Incremental Earnings Indirect Effects on Incremental Earnings (cont'd) Table 8. 2 Spreadsheet Home. Net’s Incremental Earnings Forecast Including Cannibalization and Lost Rent Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -69

Sunk Costs and Incremental Earnings • Sunk costs are costs that have been or Sunk Costs and Incremental Earnings • Sunk costs are costs that have been or will be paid regardless of the decision whether or not the investment is undertaken. – Sunk costs should not be included in the incremental earnings analysis. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -70

Sunk Costs and Incremental Earnings (cont'd) • Fixed Overhead Expenses – Typically overhead costs Sunk Costs and Incremental Earnings (cont'd) • Fixed Overhead Expenses – Typically overhead costs are fixed and not incremental to the project and should not be included in the calculation of incremental earnings. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -71

Sunk Costs and Incremental Earnings (cont'd) • Past R&D Expenditures – Money that has Sunk Costs and Incremental Earnings (cont'd) • Past R&D Expenditures – Money that has already been spent on R&D is a sunk cost and therefore irrelevant. – The decision to continue or abandon a project should be based only on the incremental costs and benefits of the product going forward. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -72

Sunk Costs and Incremental Earnings (cont'd) • Unavoidable Competitive Effects – When developing a Sunk Costs and Incremental Earnings (cont'd) • Unavoidable Competitive Effects – When developing a new product, firms may be concerned about the cannibalization of existing products. – However, if sales are likely to decline in any case as a result of new products introduced by competitors, then these lost sales should be considered a sunk cost. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -73

Real-World Complexities • Typically, – sales will change from year to year. – the Real-World Complexities • Typically, – sales will change from year to year. – the average selling price will vary over time. – the average cost per unit will change over time. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -74

Textbook Example 8. 3 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 Textbook Example 8. 3 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -75

Textbook Example 8. 3 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 8. 3 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -76

8. 2 Determining Free Cash Flow and NPV • The incremental effect of a 8. 2 Determining Free Cash Flow and NPV • The incremental effect of a project on a firm’s available cash is its free cash flow. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -77

Calculating the Free Cash Flow from Earnings • Capital Expenditures and Depreciation – Capital Calculating the Free Cash Flow from Earnings • Capital Expenditures and Depreciation – Capital Expenditures are the actual cash outflows when an asset is purchased. – These cash outflows are included in calculating free cash flow. – Depreciation is a non-cash expense. – The free cash flow estimate is adjusted for this non-cash expense. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -78

Net Working Capital • Most projects will require the firm to invest in net Net Working Capital • Most projects will require the firm to invest in net working capital. • Firms may need to maintain a minimum cash balance to meet unexpected expenditures, and inventories of raw materials and finished product to accommodate production uncertainties and demand fluctuations. • Also, customers may not pay for the goods they purchase immediately. • While sales are immediately counted as part of earnings, the firm does not receive any cash until the customers actually pay. • In the interim, the firm includes the amount that customers owe in its receivables. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -79

Net Working Capital • Thus, the firm’s receivables measure the total credit that the Net Working Capital • Thus, the firm’s receivables measure the total credit that the firm has extended to its customers. • In the same way, payables measure the credit the firm has received from its suppliers. • The difference between receivables and payables is the net amount of the firm’s capital that is consumed as a result of these credit transactions, known as trade credit. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -80

Net Working Capital • Suppose that Home. Net will have no incremental cash or Net Working Capital • Suppose that Home. Net will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to customers). • However, receivables related to Home. Net are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of goods sold (COGS). • Home. Net’s net working capital requirements are shown in the spreadsheet in Table 8. 4. • Table 8. 4 shows that the Home. Net project will require no net working capital in year 0, $2. 1 million in net working capital in years 1– 4, and no net working capital in year 5. • How does this requirement affect the project’s free cash flow? • Any increases in net working capital represent an investment that reduces the cash available to the firm and so reduces free cash flow. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -81

Calculating the Free Cash Flow from Earnings (cont'd) Table 8. 4 Spreadsheet Home. Net’s Calculating the Free Cash Flow from Earnings (cont'd) Table 8. 4 Spreadsheet Home. Net’s Net Working Capital Requirements Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -82

Calculating the Free Cash Flow from Earnings (cont'd) • Net Working Capital (NWC) – Calculating the Free Cash Flow from Earnings (cont'd) • Net Working Capital (NWC) – Most projects will require an investment in net working capital. • Trade credit is the difference between receivables and payables. – The increase in net working capital is defined as: Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -83

Calculating the Free Cash Flow from Earnings (cont'd) • Capital Expenditures and Depreciation Table Calculating the Free Cash Flow from Earnings (cont'd) • Capital Expenditures and Depreciation Table 8. 3 Spreadsheet Calculation of Home. Net’s Free Cash Flow (Including Cannibalization and Lost Rent) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -84

Textbook Example 8. 4 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 Textbook Example 8. 4 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -85

Textbook Example 8. 4 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 8. 4 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -86

Calculating Free Cash Flow Directly • Free Cash Flow – The term tc × Calculating Free Cash Flow Directly • Free Cash Flow – The term tc × Depreciation is called the depreciation tax shield. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -87

Calculating the NPV • Home. Net NPV (WACC = 12%) Table 8. 5 Spreadsheet Calculating the NPV • Home. Net NPV (WACC = 12%) Table 8. 5 Spreadsheet Computing Home. Net’s NPV Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -88

Calculating the NPV • Launching the Home. Net project produces a positive NPV, while Calculating the NPV • Launching the Home. Net project produces a positive NPV, while not launching the project produces a 0 NPV. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -89

8. 3 Choosing Among Alternatives (cont'd) • Evaluating Manufacturing Alternatives – In the Home. 8. 3 Choosing Among Alternatives (cont'd) • Evaluating Manufacturing Alternatives – In the Home. Net example, assume the company could produce each unit in-house for $95 if it spends $5 million upfront to change the assembly facility (versus $110 per unit if outsourced). – The in-house manufacturing method would also require an additional investment in inventory equal to one month’s worth of production. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -90

8. 3 Choosing Among Alternatives (cont'd) • Evaluating Manufacturing Alternatives – Outsource • Cost 8. 3 Choosing Among Alternatives (cont'd) • Evaluating Manufacturing Alternatives – Outsource • Cost per unit = $110 • Investment in A/P = 15% of COGS – COGS = 100, 000 units × $110 = $11 million – Investment in A/P = 15% × $11 million = $1. 65 million » ΔNWC = –$1. 65 million in Year 1 and will increase by $1. 65 million in Year 5 » NWC falls since this A/P is financed by suppliers Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -91

8. 3 Choosing Among Alternatives (cont'd) • Evaluating Manufacturing Alternatives – In-House • Cost 8. 3 Choosing Among Alternatives (cont'd) • Evaluating Manufacturing Alternatives – In-House • Cost per unit = $95 • Up-front cost of $5, 000 • Investment in A/P = 15% of COGS – COGS = 100, 000 units × $95 = $9. 5 million – Investment in A/P = 15% × $9. 5 million = $1. 425 million – Investment in Inventory = $9. 5 million / 12 = $0. 792 million – ΔNWC in Year 1 = $0. 792 million – $1. 425 million = –$0. 633 million » NWC will fall by $0. 633 million in Year 1 and increase by $0. 633 million in Year 5 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -92

8. 3 Choosing Among Alternatives (cont'd) • Evaluating Manufacturing Alternatives Table 8. 6 Spreadsheet 8. 3 Choosing Among Alternatives (cont'd) • Evaluating Manufacturing Alternatives Table 8. 6 Spreadsheet NPV Cost of Outsourced Versus In-House Assembly of Home. Net Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -93

8. 3 Choosing Among Alternatives (cont'd) • Comparing Free Cash Flows Cisco’s Alternatives – 8. 3 Choosing Among Alternatives (cont'd) • Comparing Free Cash Flows Cisco’s Alternatives – Outsourcing is the less expensive alternative. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -94

8. 4 Further Adjustments to Free Cash Flow • Other Non-cash Items (In general, 8. 4 Further Adjustments to Free Cash Flow • Other Non-cash Items (In general, other non-cash items (e. g. amortization) that appear as part of incremental earnings should not be included in the project’s free cash flow. The firm should include only actual cash revenues or expenses) • Timing of Cash Flows (For simplicity, we have treated the cash flows for Home. Net as if they occur at the end of each year. In reality, cash flows will be spread throughout the year. We can forecast free cash flow on a quarterly, monthly, or even continuous basis when greater accuracy is required. ) • Accelerated Depreciation (With MACRS (Modified Accelerated Cost Recovery System) depreciation, the firm first categorizes assets according to their recovery period. Based on the recovery period, MACRS depreciation tables assign a fraction of the purchase price that the firm can recover each year) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -95

Further Adjustments to Free Cash Flow (cont'd) • We consider a number of complications Further Adjustments to Free Cash Flow (cont'd) • We consider a number of complications that can arise when estimating a project’s free cash flow, such as non-cash charges, alternative depreciation methods, liquidation or continuation values, and tax loss carryforwards. • Liquidation or Salvage Value (Assets that are no longer needed often have a resale value, or some salvage value if the parts are sold for scrap) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -96

Textbook Example 8. 6 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 Textbook Example 8. 6 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -97

Textbook Example 8. 6 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 8. 6 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -98

Further Adjustments to Free Cash Flow (cont'd) • Sometimes the firm explicitly forecasts free Further Adjustments to Free Cash Flow (cont'd) • Sometimes the firm explicitly forecasts free cash flow over a shorter horizon than the full horizon of the project or investment. This is necessarily true for investments with an indefinite life, such as an expansion of the firm. • In this case, we estimate the value of the remaining free cash flow beyond the forecast horizon by including an additional, one-time cash flow at the end of the forecast horizon called the terminal or continuation value of the project. • Terminal or Continuation Value – This amount represents the market value of the free cash flow from the project at all future dates. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -99

Textbook Example 8. 7 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 Textbook Example 8. 7 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -100

Textbook Example 8. 7 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 8. 7 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -101

Further Adjustments to Free Cash Flow (cont'd) • Tax Carryforwards – Tax loss carryforwards Further Adjustments to Free Cash Flow (cont'd) • Tax Carryforwards – Tax loss carryforwards and carrybacks allow corporations to take losses during its current year and offset them against gains in nearby years. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -102

Textbook Example 8. 8 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 Textbook Example 8. 8 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -103

Textbook Example 8. 8 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 8. 8 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -104

8. 5 Analyzing the Project • Break-Even Analysis – The break-even level of an 8. 5 Analyzing the Project • Break-Even Analysis – The break-even level of an input is the level that causes the NPV of the investment to equal zero. – Home. Net IRR Calculation Table 8. 7 Spreadsheet Home. Net IRR Calculation Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -105

8. 5 Analyzing the Project (cont'd) • In a break-even analysis, for each parameter, 8. 5 Analyzing the Project (cont'd) • In a break-even analysis, for each parameter, we calculate the value at which the NPV of the project is zero. – Break-Even Levels for Home. Net Table 8. 8 Break-Even Levels for Home. Net – EBIT Break-Even of Sales – Level of sales where EBIT equals zero Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -106

Sensitivity Analysis • Sensitivity Analysis shows how the NPV varies with a change in Sensitivity Analysis • Sensitivity Analysis shows how the NPV varies with a change in one of the assumptions, holding the other assumptions constant. Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -107

Sensitivity Analysis (cont'd) Table 8. 9 Best- and Worst-Case Parameter Assumptions for Home. Net Sensitivity Analysis (cont'd) Table 8. 9 Best- and Worst-Case Parameter Assumptions for Home. Net Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -108

Figure 8. 1 Home. Net’s NPV Under Bestand Worst-Case Parameter Assumptions Copyright © 2014 Figure 8. 1 Home. Net’s NPV Under Bestand Worst-Case Parameter Assumptions Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -109

Textbook Example 8. 9 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 Textbook Example 8. 9 Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -110

Textbook Example 8. 9 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. Textbook Example 8. 9 (cont'd) Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -111

Scenario Analysis • Scenario Analysis considers the effect on the NPV of simultaneously changing Scenario Analysis • Scenario Analysis considers the effect on the NPV of simultaneously changing multiple assumptions. Table 8. 10 Scenario Analysis of Alternative Pricing Strategies Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -112

Figure 8. 2 Price and Volume Combinations for Home. Net with Equivalent NPV Copyright Figure 8. 2 Price and Volume Combinations for Home. Net with Equivalent NPV Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -113

Table 8 A. 1 MACRS Depreciation Table Showing the Percentage of the Asset’s Cost Table 8 A. 1 MACRS Depreciation Table Showing the Percentage of the Asset’s Cost That May Be Depreciated Each Year Based on Its Recovery Period Copyright © 2014 Pearson Education, Inc. All rights reserved. 8 -114