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1、Principles of FinanceLecture 03How to Analyze Investment Projects ObjectivesTo show how to use discounted cash flow analysis to make decisions such as- Whether to enter a new line of business- Whether to invest in equipment to reduce costsContentsThe NPV ruleEstimating a projects cash flowsCost of c
2、apitalSensitivity AnalysisCost-reducing projectsProjects with different livesMutually exclusive projectsInflation and capital budgetingThe Nature of Project AnalysisBasic unit of analysis-Individual investment projectThe criterion used- Find the present value of all future cash flows, and subtract t
3、he initial investment to obtain the net present value (NPV)- Invest in proposed project with positive NPV- The wealth of the firms shareholders will increase by NPVNPV of a ProjectDiscount rate(cost of capital)10%YearCash FlowPVCum_PV0-1000-1000-10001450409-5912350289-3023250188-1144150102-115503120
4、Project NPV20Decision: Accept the projectNPV of a ProjectDiscount rate(cost of capital)15%YearCash FlowPVCum_PV0-1000-1000-10001450391-6092350265-3443250164-180415086-9455025-69Project NPV-69Decision: Reject the projectNPV of a ProjectDiscount rate(cost of capital)11.04%YearCash FlowPVCum_PV0-1000-1
5、000-10001450405-5952350284-3113250183-128415099-30550300Project NPV0Where Do Investment Ideas Come From? Monitor existing and customer needsMonitor existing and potential technological capacity of the firmMonitor main competitors marketing, investment, patent, and technical recruitmentMonitor produc
6、tion and distribution functions for revenue enhancement/cost savings Reward employees for innovative ideasExamples of Investment IdeasLaunch a new line of business Replace existing equipment with more efficient oneClose a loss making subsidiaryEstimating A Projects Cash FlowsEstimate the cash flows
7、without the investmentEstimate the cash flows with the investmentTake the difference This will yield only future incremental cash flows to the investmentDepreciation and Cash FlowsIt is important to remember that when making financial decisions only timed cash flows are used- Depreciation is an expe
8、nse, but not a cash flow, and must be excluded-The tax benefit of depreciation, however, is cash flow, and must be included.Working Capital and Cash FlowsSome cash flows do not occur on the income statement, but involve timing.- Working capital additions and reductions are cash flows-At the end of t
9、he project, the sum of nominal changes in working capital is zero Incremental Cash Flows: Illustration 1A proposed project will generate $10 million in revenue, but will causes another product line to lose $3 million in revenuesThe incremental cash flow is only $7 millionIncremental Cash Flows: Illu
10、stration 2R&D expenses are $10,000 to-date for your project, and you plan to spend another $20,000, making $30,000 in all- The $10,000 is a sunk cost. The decision whether to undertake the project will not change this expenditure-A sunk cost has no impact on future cash flows-Only $20,000 is an incr
11、emental cost, and the $10,000 should be excludedIncremental Cash Flows: Illustration 3- A proposed project uses an existing (non-cancelable) leased warehouse with total annual rent of $100,000-The warehouse is projected to remain 50% utilized, unless the project is undertaken- The lease prohibits su
12、b-leasing- The proposed project will use 25% of the warehouse- The current market rate will be $150,000 to rent the warehouse- How should the project be charged?Incremental Cash Flows: Illustration 3 The project should be charged nothing- The warehouse expenditure will occur whether the project is u
13、ndertaken or not. It is therefore not an incremental cash flow- With different assumptions, e.g. alternative usage or lease renegotiation, the answer would be different.The Cost of CapitalThe risk of the project is, in general, different from the risk of the existing projects/assetsOnly the market-r
14、elated risk is relevantOnly the risk from a projects cash flow is relevant (not that of financing instruments)Estimating Cash Flows: PC1000Capital investment of $2.8 millions, and the equipment will be depreciated over 7 years using the straight-line method with a zero salvage valueRevenue: 4000 units $5000 per unit = $20 millionFixed costs inc. depreciation: $3.5 millionVariable costs: 4000 units $3750 per unit = $15 millionWor
