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1、Chapter 6: The Analysis of Investment ProjectsObjectiveExplain Capital BudgetingDevelop Criteria1金融学教学bodie2e-cha1Objectives To show how to use discounted cash flow To show how to use discounted cash flow analysis to make decisions for business firms analysis to make decisions for business firms suc
2、h as:such as: Whether to enter a Whether to enter a new line of businessnew line of business Whether to invest in equipment to Whether to invest in equipment to reduce costsreduce costs Recall chapter 1, the process of analyzing such Recall chapter 1, the process of analyzing such decisions is calle
3、ddecisions is called capital budgetingcapital budgeting. .2金融学教学bodie2e-cha1Three Elements of Capital Budgetingcoming up with proposals for investment projectsevaluating themdeciding which ones to accept and which to reject3金融学教学bodie2e-cha1The criteria of capital budgetingRecall the objective of a
4、firm Maximization of the market value of Maximization of the market value of shareholders equityshareholders equityThe theory of how to do this was provided in the prior two chapters Compute the net present value of the Compute the net present value of the projects expected cash flows, and undertake
5、 projects expected cash flows, and undertake only those with only those with positive NPVpositive NPV4金融学教学bodie2e-cha1Chapter 6 Contents 6.1 The Nature of Project Analysis6.1 The Nature of Project Analysis 6.2 Where do Investment Ideas 6.2 Where do Investment Ideas come from?come from? 6.3 The Net
6、Present Value 6.3 The Net Present Value Investment RuleInvestment Rule 6.4 Estimating a Projects Cash 6.4 Estimating a Projects Cash FlowsFlows 6.5 Cost of Capital6.5 Cost of Capital 6.6 Sensitivity Analysis Using 6.6 Sensitivity Analysis Using SpreadsheetsSpreadsheets 6.7 Analyzing Cost-6.7 Analyzi
7、ng Cost-Reducing ProjectsReducing Projects 6.8 Projects with 6.8 Projects with Different LivesDifferent Lives 6.9 Ranking Mutually 6.9 Ranking Mutually Exclusive ProjectsExclusive Projects 6.10 Inflation & 6.10 Inflation & Capital BudgetingCapital Budgeting5金融学教学bodie2e-cha16.1 The Nature of Project
8、 Analysis Basic unit of analysisBasic unit of analysis the individual investment projectthe individual investment project Procedural OutlineProcedural Outline Form ideas on how to increase shareholders equityForm ideas on how to increase shareholders equity Plan how to implement the ideasPlan how to
9、 implement the ideas Gather information on timing and magnitude of costs Gather information on timing and magnitude of costs and benefitsand benefits Apply NPV criterionApply NPV criterion6金融学教学bodie2e-cha16.2 Where do Investment Ideas Come From? monitor existing & potential customers needsmonitor e
10、xisting & potential customers needs monitor existing & potential technological monitor existing & potential technological capacity of the firmcapacity of the firm monitor the competitions marketing, monitor the competitions marketing, investment, patents, and technical recruitinginvestment, patents,
11、 and technical recruiting monitor production & distribution functions monitor production & distribution functions for revenue enhancement / cost savingsfor revenue enhancement / cost savings reward employees for innovative ideasreward employees for innovative ideas7金融学教学bodie2e-cha16.3 Net Present V
12、alue Investment RuleA projects net present value is the amount by which the project is expected the amount by which the project is expected to increase the wealth of the firms current to increase the wealth of the firms current shareholdersshareholdersAs a criterion Invest in proposed projects with
13、positive NPVInvest in proposed projects with positive NPV8金融学教学bodie2e-cha1IllustrationThe following tables show the computation of NPV To show the effect of the discount rate, three To show the effect of the discount rate, three tables are shown based on different ratestables are shown based on dif
14、ferent rates9金融学教学bodie2e-cha1 Do Project10金融学教学bodie2e-cha1 Dont Do Project11金融学教学bodie2e-cha1 Indifferent Internal Rate of Return12金融学教学bodie2e-cha1SummaryThe discount rate in the first scenario it was assumed to be in the first scenario it was assumed to be 10%, and the resulting NPV was $2010%,
15、and the resulting NPV was $20 In the second scenario it was assumed to be In the second scenario it was assumed to be 15%, and the NPV was -$6915%, and the NPV was -$69 In the third scenario, the discount rate that In the third scenario, the discount rate that resulted in a zero NPV was found result
16、ed in a zero NPV was found 13金融学教学bodie2e-cha114金融学教学bodie2e-cha16.4 Estimating a Projects Cash FlowsIt is important to remember that when making financial decisions only timed cash flows are used depreciationdepreciation is an expense, but is is an expense, but is notnot a cash a cash expense, and
17、must be expense, and must be excludedexcluded the tax benefit of depreciation, however, is a the tax benefit of depreciation, however, is a cash flow, and must be cash flow, and must be includedincluded15金融学教学bodie2e-cha1Working Capital & Cash FlowsSome cash flows do not occur on the income statemen
18、t, but involve timing working capitalworking capital additions and reductions are additions and reductions are cash flowscash flows at the end of a project, the sum of the at the end of a project, the sum of the nominal changes in working capital is zeronominal changes in working capital is zero16金融
19、学教学bodie2e-cha1Accruals & DeferralsTake extra care if you are provided with net income information by an accountant the flows forming net income may includethe flows forming net income may include accrualsaccruals deferralsdeferrals these are typically small, and may some-these are typically small,
20、and may some-times be ignoredtimes be ignored17金融学教学bodie2e-cha1Incremental Cash FlowsOnly the incremental cash flows should form part of an investment decision Evaluate the projected cash flows, by Evaluate the projected cash flows, by (category and) timing, both with and without (category and) tim
21、ing, both with and without the project, and find the differencethe project, and find the difference This difference is a collection of timed cash This difference is a collection of timed cash flows, and this is what affects the wealth of flows, and this is what affects the wealth of the shareholders
22、the shareholders18金融学教学bodie2e-cha1IllustrationA proposed project will generate $10,000 in revenue, but will causes another product line to lose $3,000 in revenuesThe incremental cash flow is only $7,00019金融学教学bodie2e-cha1Sunk CostsShareholders are interested in the timing and magnitude of cash flow
23、s From an investors vantage, a project gives From an investors vantage, a project gives rise to an alternative cash flowrise to an alternative cash flow If If (alternative cash flows) - (original cash (alternative cash flows) - (original cash flows)flows) is valuable to shareholders, do project is v
24、aluable to shareholders, do project A sunk cost has no impact on future cash A sunk cost has no impact on future cash flows: it is irrelevant to shareholdersflows: it is irrelevant to shareholders20金融学教学bodie2e-cha1IllustrationR&D expenses are $10,000 to-date for your project, and you plan to spend
25、another $20,000, making $30,000 in all The $10,000 is a sunk cost. The decision The $10,000 is a sunk cost. The decision whether to undertake the project will not whether to undertake the project will not change this expenditurechange this expenditure Only the $20,000 is an incremental cost, and Onl
26、y the $20,000 is an incremental cost, and the $10,000 should the $10,000 should be excludedbe excluded21金融学教学bodie2e-cha1Example 1P174-17522金融学教学bodie2e-cha1Example 2 PCs Forever is a company that produces personal computers. It has PCs Forever is a company that produces personal computers. It has b
27、een in operation for two years and is at capacity. It is considering an been in operation for two years and is at capacity. It is considering an investment project to expand its production capacity. investment project to expand its production capacity. The project requires an initial outlay of $1,00
28、0,000: $800,000 for new The project requires an initial outlay of $1,000,000: $800,000 for new equipment with an expected life of four years and $200,000 for equipment with an expected life of four years and $200,000 for additional working capital. additional working capital. The selling price of it
29、s PCs is $1,800 per unit, and annual sales are The selling price of its PCs is $1,800 per unit, and annual sales are expected to increase by 1,000 units as a result of the proposed expected to increase by 1,000 units as a result of the proposed expansion. Annual fixed costs (excluding depreciation o
30、f the new expansion. Annual fixed costs (excluding depreciation of the new equipment) will increase by $100,000, and variable costs are $1,400 per equipment) will increase by $100,000, and variable costs are $1,400 per unit. unit. The new equipment will be depreciated over four years using the The n
31、ew equipment will be depreciated over four years using the straight line method with a zero salvage value. straight line method with a zero salvage value. The hurdle rate for the project is 12% per year, and the company pays The hurdle rate for the project is 12% per year, and the company pays incom
32、e tax at the rate of 40%. income tax at the rate of 40%. 23金融学教学bodie2e-cha1Example 2 What is the accounting break-even point for this What is the accounting break-even point for this project? project? What is the projects What is the projects NPVNPV? ? At what volume of sales would the At what volu
33、me of sales would the NPVNPV be zero? be zero? 24金融学教学bodie2e-cha16.5 The Cost of Capital Cost of capital is the risk-adjusted discount rate Cost of capital is the risk-adjusted discount rate (k) to use in computing a projects NPV. The (k) to use in computing a projects NPV. The standard way of deal
34、ing with uncertainty about standard way of dealing with uncertainty about future cash flows is to use a larger discount future cash flows is to use a larger discount rate.rate. When determining the cost of capitalWhen determining the cost of capital the risk of the project is, in general, different
35、from the risk of the project is, in general, different from the risk of the firms existing assetsthe risk of the firms existing assets only the market-related risk is relevantonly the market-related risk is relevant only the risk from a projects only the risk from a projects cash flowscash flows is
36、relevant is relevant (not that of financing instruments)(not that of financing instruments)25金融学教学bodie2e-cha1Illustration of point 1 A firm whose average cost of capital for its existing A firm whose average cost of capital for its existing assets is 16% per year gets an opportunity to assets is 16
37、% per year gets an opportunity to purchase riskless U.S. T-bonds at below-market prices. purchase riskless U.S. T-bonds at below-market prices. Suppose that 25-year U.S. T-bonds paying $100 per Suppose that 25-year U.S. T-bonds paying $100 per year are selling in the market at $1000, and the firm ye
38、ar are selling in the market at $1000, and the firm could buy $1 million worth of these bonds for $950 could buy $1 million worth of these bonds for $950 each.each. If these cash flows are discounted at the firms cost of If these cash flows are discounted at the firms cost of capital 16% per year, t
39、he present value of each bond capital 16% per year, the present value of each bond is $634, and the NPV of the project would be is $634, and the NPV of the project would be -$315,830, which means it should be rejected.-$315,830, which means it should be rejected. Common sense: you can buy something
40、for $950 and Common sense: you can buy something for $950 and sell it immediately for $1,000, would you do it?sell it immediately for $1,000, would you do it?26金融学教学bodie2e-cha1Illustration of point 3 Dell is planning to finance the $10 million outlay to Dell is planning to finance the $10 million o
41、utlay to undertake the PC1000 project by issuing bonds, and Dell undertake the PC1000 project by issuing bonds, and Dell can issue $10 million worth of bonds at an interest rate can issue $10 million worth of bonds at an interest rate of 6% per year.of 6% per year. Could we use 6% as the cost of cap
42、ital in computing the Could we use 6% as the cost of capital in computing the NPV of the PC1000 project? NPV of the PC1000 project? If could, Dell would actually be able to do almost any If could, Dell would actually be able to do almost any projects, because of a super-low cost of capital; and all
43、projects, because of a super-low cost of capital; and all these projects cost of capital would be identically 6%!these projects cost of capital would be identically 6%!27金融学教学bodie2e-cha16.6 Sensitivity Analysis Using SpreadsheetsWill the project still be economical if some of the underlying variabl
44、es are inaccurate, or astray from estimation? Spreadsheets are an excellent tool for Spreadsheets are an excellent tool for exploring the influence of estimation errors exploring the influence of estimation errors on financial decisionson financial decisions28金融学教学bodie2e-cha1 Base CaseThe following
45、 is an embedded Excel worksheet for the cash flow of a firm It is generally a good practice to divide the It is generally a good practice to divide the worksheet into two segments, one worksheet into two segments, one containing only data, and the other containing only data, and the other containing
46、 only formulaecontaining only formulae This practice increases flexibility & reduces This practice increases flexibility & reduces the chance of errorthe chance of error It is also a good practice to name variables It is also a good practice to name variables using Insert:Name:Create in Excelusing I
47、nsert:Name:Create in Excel29金融学教学bodie2e-cha130金融学教学bodie2e-cha1A Modified Scenario In this case the cash is piling up (Watch out In this case the cash is piling up (Watch out for IRS penalties in this case!)for IRS penalties in this case!) The assumption is now made that sales units The assumption
48、is now made that sales units grow by +2%, unit prices by -3%, and fixed grow by +2%, unit prices by -3%, and fixed costs by +8% (No, Victor: Fixed costs may costs by +8% (No, Victor: Fixed costs may vary with time. Yes, Valerie: Fixed costs do vary with time. Yes, Valerie: Fixed costs do not vary wi
49、th sales.)not vary with sales.) Assume a dividend of $1,000,000/yearAssume a dividend of $1,000,000/year31金融学教学bodie2e-cha132金融学教学bodie2e-cha1Additional Scenarios The following graphs are variations from the basic model constructed by changing one variable at a time:33金融学教学bodie2e-cha1Was 15%34金融学教学
50、bodie2e-cha1Was 40%35金融学教学bodie2e-cha1Was 0%36金融学教学bodie2e-cha1Was 75%37金融学教学bodie2e-cha1Was $3,100,00038金融学教学bodie2e-cha1ConsequencesNotice that the reduced long-term viability of the product, together with the dividend for demands, will cause: a cash flow crisis early in year 5, a cash flow crisis
51、 early in year 5, negative accounting profits in year 6, negative accounting profits in year 6, and a serious negative operating cash flow in and a serious negative operating cash flow in year 8 when the tax benefits of depreciation year 8 when the tax benefits of depreciation are finally consumed.a
52、re finally consumed.39金融学教学bodie2e-cha1Graphs Graphs are a useful supplement to Graphs are a useful supplement to spreadsheets as they may illustrate behavior spreadsheets as they may illustrate behavior of the model to continuing changes in a of the model to continuing changes in a selected indepen
53、dent variableselected independent variable The following graphs explore a modelThe following graphs explore a model40金融学教学bodie2e-cha1Table 6.4 Project Sensitivity to Sales VolumeTable 6.4 Project Sensitivity to Sales Volume41金融学教学bodie2e-cha142金融学教学bodie2e-cha143金融学教学bodie2e-cha1Sensitivity Analysi
54、sExample 3: House Inc. has purchased a building for $1 million dollars. The economic life of the building is thirty years and it will be fully depreciated over thirty years using the straight-line depreciation method. The discount rate is 14% and the corporate tax rate is 35%. Assume there is no inf
55、lation. What is the minimum lease payment the company should ask for? 44金融学教学bodie2e-cha16.7 Analyzing Cost-Reducing ProjectsBreak-even point is number of sales resulting in a NPV = 0IRR is discount rate resulting in NPV = 0Price B/E is unit price resulting in NPV= 0Payback period is the project lif
56、e resulting in NPV = 045金融学教学bodie2e-cha1Analyzing Cost-Reducing Projects Example 4Example 4: Suppose a firm is considering a cost : Suppose a firm is considering a cost saving project. It can invest $2 million now in saving project. It can invest $2 million now in equipment and thereby save $700,00
57、0 per year in equipment and thereby save $700,000 per year in pretax labor costs. If the equipment has an pretax labor costs. If the equipment has an expected life of five years and if the firm pays expected life of five years and if the firm pays income tax at the rate of 33.3%, is this a income ta
58、x at the rate of 33.3%, is this a worthwhile investment? Assume the discount rate worthwhile investment? Assume the discount rate is 10%.is 10%.46金融学教学bodie2e-cha1Analyzing Cost-Reducing Projects Example 5: Example 5: A firm is considering investing $10 A firm is considering investing $10 million in
59、 equipment which is expected to million in equipment which is expected to have a useful life of four years and is have a useful life of four years and is expected to reduce the firms labor costs by expected to reduce the firms labor costs by $4 million per year. Assume the firm pays a $4 million per
60、 year. Assume the firm pays a 40% tax rate on accounting profits and uses 40% tax rate on accounting profits and uses the straight line depreciation method. What the straight line depreciation method. What is the after-tax cash flow from the is the after-tax cash flow from the investment in years 1
61、through 4? If the firms investment in years 1 through 4? If the firms hurdle rate for this investment is 15% per hurdle rate for this investment is 15% per year, is it worthwhile? What are the year, is it worthwhile? What are the investments investments IRRIRR and and NPVNPV? ? 47金融学教学bodie2e-cha16.
62、8 Projects with Different LivesSuppose in the example 4 there are two different types of equipment with different economic lives: Long-lived equipment: $4 million initial capital Long-lived equipment: $4 million initial capital outlay, can last for 10 yearsoutlay, can last for 10 years Short-lived e
63、quipment: $2 million initial capital Short-lived equipment: $2 million initial capital outlay, can last for 5 yearsoutlay, can last for 5 years Assume the discount rate is 15%. Which one Assume the discount rate is 15%. Which one should you choose?should you choose?48金融学教学bodie2e-cha1Projects with D
64、ifferent Lives Example 6Example 6: Electricity, Inc. is choosing between two : Electricity, Inc. is choosing between two pieces of equipment. The first choice costs $500,000 pieces of equipment. The first choice costs $500,000 and will last five years. It will be depreciated using the and will last
65、five years. It will be depreciated using the straight line depreciation method and will have no straight line depreciation method and will have no salvage value. It will have an annual maintenance cost salvage value. It will have an annual maintenance cost of $50,000. The second choice will cost $60
66、0,000 and of $50,000. The second choice will cost $600,000 and will last eight years. It will also be depreciated using will last eight years. It will also be depreciated using the straight line depreciation method and will have no the straight line depreciation method and will have no salvage value
67、. It will have an annual maintenance cost salvage value. It will have an annual maintenance cost of $55,000. The discount rate is 11% and the tax rate is of $55,000. The discount rate is 11% and the tax rate is 35%. Which machine should be chosen and what 35%. Which machine should be chosen and what
68、 assumptions underlie that choice?assumptions underlie that choice? 49金融学教学bodie2e-cha16.9 Ranking Mutually Exclusive ProjectsUsing the NPV method, you are unlikely to encounter any serious problemsSome managers, particularly those with an engineering background, prefer to use the IRR method The IRR
69、 method may be The IRR method may be mademade to give the to give the correct answer, correct answer, but this requires but this requires considerable skillconsiderable skill. Avoid it (unless your . Avoid it (unless your boss an engineer)boss an engineer)50金融学教学bodie2e-cha1Ranking Mutually Exclusiv
70、e Projects Example 7Example 7: You own a parcel of land and have : You own a parcel of land and have two alternatives for developing it. You can two alternatives for developing it. You can construct an office building, requiring an initial construct an office building, requiring an initial outlay of
71、 $20 million, or you can make a parking outlay of $20 million, or you can make a parking lot, requiring an initial outlay of $10,000. If you lot, requiring an initial outlay of $10,000. If you build an office building, you estimate that you will build an office building, you estimate that you will b
72、e able to sell it in one year for $24 million. If you be able to sell it in one year for $24 million. If you make it into a parking lot, you estimate that you make it into a parking lot, you estimate that you will have a cash flow of $10,000 per year forever. will have a cash flow of $10,000 per yea
73、r forever. Which project should you choose?Which project should you choose?51金融学教学bodie2e-cha1NPV as a Function of the Discount Rate52金融学教学bodie2e-cha16.10 Inflation and Capital BudgetingWhen computing NPV Use the nominal cost of capital to discount Use the nominal cost of capital to discount nomina
74、l cash flowsnominal cash flows (Nominal cash flows are rarely constant)(Nominal cash flows are rarely constant) Use the real cost of capital to discount real Use the real cost of capital to discount real cash flowscash flows53金融学教学bodie2e-cha1Inflation and Capital Budgeting Example 8Example 8: Finne
75、rtys Brew Pub is considering buying : Finnertys Brew Pub is considering buying more machinery that will allow the pub to increase its more machinery that will allow the pub to increase its portfolio of beers on tap. The new machinery will cost portfolio of beers on tap. The new machinery will cost $
76、65,000 and will be depreciated on a 10 year basis. It $65,000 and will be depreciated on a 10 year basis. It is expected to have no value after 10 years. The is expected to have no value after 10 years. The improved selection is anticipated to increase sales by improved selection is anticipated to i
77、ncrease sales by $30,000 for the first year and increase at the rate of $30,000 for the first year and increase at the rate of inflation of 3% for each year after that. Production inflation of 3% for each year after that. Production costs are expected to be $15,000 for the first year and costs are e
78、xpected to be $15,000 for the first year and are also expected to increase at the rate of inflation. are also expected to increase at the rate of inflation. The real discount rate is 12% and the nominal riskfree The real discount rate is 12% and the nominal riskfree interest rate is 6%. The corporate tax rate is 34%. interest rate is 6%. The corporate tax rate is 34%. Should Mr. Finnerty buy the machinery?Should Mr. Finnerty buy the machinery?54金融学教学bodie2e-cha1
