Projects may look attractive for two reasons:1) There are some errors in forecast 2)The company genuinely expects to earn excess profits.
So increase odds in your favor by moving in areas of competitive advantages.
Look at economic rents and where even advantage is absent or entry of competitors will push prices down or costs up, don’t enter .
When you have the market value of an asset use it..rather then over analysis…gold, real estate..airplanes etc…
PV calculations may vary and subject to error …that’s life!!!!!
3. INTRODUCTION TO CORPORATE FINANCE
First Principles of Corporate Finance
Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and should reflect the financing
mix used-either owners’ funds (equity) or borrowed money (debt).
• Returns on projects should be measured on the basis of cash flows generated
and the timing of these cash flows; they should also take into account both
positive and negative side effects of these projects.
Choose a financing mix that maximizes the value of the firm and matches the assets being
financed.
If there are not enough investments that earn the hurdle rate, return the cash to the owners of
the firm. The form of returns - dividends and stock buybacks - will depend on the stockholders
characteristics.
Objective : Maximize the Value of the firm.
4. WHAT ARE CAPITAL BUDGETING DECISIONS ?
The basic characteristic of capital budgeting (also referred
to as capital expenditure) is that it involves a current outlay
of funds in the hope of receiving a stream of benefits in
future.
5. WHY ARE CAPITAL BUDGETING DECISIONS IMPORTANT ?
• They have long term consequences.
• It is difficult to reverse capital budgeting decisions.
• It involves substantial outlays.
6. ASSEMBLING OF INVESTMENT PROPOSALS
• Modernisation and Replacement Decisions
• Expansion and Diversification
• New Product Investments
• Obligatory and Welfare Investments
7. Steps in Investment Analysis
• Estimate a hurdle rate for the project, based upon the riskiness of the
investment
• Estimate revenues and accounting earnings on the investment.
• Measure the accounting return to see if the investment measures up to the
hurdle rate.
• Operating income = EBIT = Reve – exp (SGA +COGS) – DEP= EBIT
• Convert accounting earnings (EBIT) into cash flows
• Use the cash flows to evaluate whether the investment is a good investment.
• Time weight the cash flows ( Investment Criterias)
• Use the time-weighted cash flows to evaluate whether the investment is a
good investment.
9. NET PRESENT VALUE
• Net Benefit over and above the compensation for time and risk and
confirms to objective of Finance.
• Sum of the Present Values of all cash flows discounted at an appropriate
discount rate.
• It takes into account the time value of money
• It considers the cash flow stream in entirety.
• It follows the principle of value additivity.
• It is consistent with shareholders value maximisation.
• Problem in Mutually exclusive projects
• Its an absolute not a relative measure. You cannot rank projects.
10. BENEFIT COST RATIO
• This is the Net Present Value per Rupee of outlay.
• Therefore it can differentiate between large and
small projects.
• It is recommended in cases of Constrained capital
budgets.
11. INTERNAL RATE OF RETURN
• The Discount Rate that makes the Net Present
Value equal to zero.
• Makes sense to business men who think in terms
of rate of return.
• However if the cash flow stream changes sign
there may be multiple returns.
• Projects of different scales cannot be ranked.
12. PAY BACK PERIOD
• It is the length of time required to recover the initial cash outlay.
• It is a rough and ready method for dealing with risk. And short
paybacks mean quick profits and Easier to communicate
• It emphasizes early cash inflows , so good for firms hard pressed
for liquidity.
• Ignores all cash flows after the cut off date
• Equal weights to all cash flows before cut off dates.
• Discounted Payback simply means the number of years that the
project must last in order for it to make sense in terms of net
present value.
13. Book RATE OF RETURN
• It is the average rate of return given by Profit After Tax
divided by Book value of Investment.
• It is based on accounting information.
• Book rate of return is an average across all activities
and not an ideal benchmark for all new projects.
15. Measures of return: Accounting Earnings
• Principles Governing Accounting Earnings Measurement
• Accrual Accounting: Show revenues when products and
services are sold or provided, not when they are paid for.
Show expenses associated with these revenues rather than
cash expenses.
• Operating versus Capital Expenditures: Only expenses
associated with creating revenues in the current period
should be treated as operating expenses. Expenses that
create benefits over several periods are written off over
multiple periods (as depreciation or amortization)
16. From Forecasts to Accounting Earnings
Measure only Incremental cash flow
Separate projected expenses into operating and capital expenses: Operating expenses, in
accounting, are expenses designed to generate benefits only in the current period, while
capital expenses generate benefits over multiple periods.
Depreciate or amortize the capital expenses over time: Once expenses have been
categorized as capital expenses, they have to be depreciated or amortized over time.
Allocate fixed expenses that cannot be traced to specific projects: Expenses that are not
directly traceable to a project get allocated to projects, based upon a measure such as
revenues generated by the project; projects that are expected to make more revenues
will have proportionately more of the expense allocated to them.
Consider the tax effect: Consider the tax liability that would be created by the operating
income we have estimated
Consider the duration for which projected
17. From Earnings to Cash Flows
• To get from accounting earnings to cash flows:
• you have to add back non-cash expenses (like depreciation and amortization)
• you have to subtract out cash outflows which are not expensed (such as
capital expenditures)
• you have to make accrual revenues and expenses into cash revenues and
expenses (by considering changes in working capital).
• Free cash Flow to FIRM = EBIT(1-T) +Depreciation/amortization – capex –
change in NWC
• FCFF WILL BE DISCOUNTED AT WACC (POST TAX)
18. Sunk Costs
• Any expenditure that has already been incurred, and cannot be recovered (even
if a project is rejected) is called a sunk cost
• When analyzing a project, sunk costs should not be considered since they are not
incremental
• By this definition, market testing expenses and R&D expenses are both likely to
be sunk costs before the projects that are based upon them are analyzed. If sunk
costs are not considered in project analysis, how can a firm ensure that these
costs are covered?
• Remember Cannibalization costs, if any.
19. Allocated Costs
• Firms allocate costs to individual projects from a centralized pool
(such as general and administrative expenses) based upon some
characteristic of the project (sales is a common choice)
• For large firms, these allocated costs can result in the rejection of
projects
• To the degree that these costs are not incremental (and would exist
anyway), this makes the firm worse off.
• Thus, it is only the incremental component of allocated costs that should
show up in project analysis.
• How, looking at these pooled expenses, do we know how much of the
costs are fixed and how much are variable?
20. Closure on Cash Flows
• In a project with a finite and short life, you would need to compute a salvage
value, which is the expected proceeds from selling all of the investment in the
project at the end of the project life. It is usually set equal to book value of fixed
assets and working capital (Don’t forget to recover working capital)
• In a project with an infinite or very long life, we compute cash flows for a
reasonable period, and then compute a terminal value for this project, which is
the present value of all cash flows that occur after the estimation period ends..
21. COMPONENTS OF CASH FLOW STREAM
• Initial Flow
Outlay on Plant & Machinery and F.A. + Outlay on Net Working
Capital
• Operational Flow
EBIT (1-T) + Depreciation
• Terminal Flow
P.T. Salvage value of F.A. & NWC.
22. Complex Investment Decisions
• How shall choice be made between investments with different lives?
• How shall choice be made between investments under capital rationing?
23. COMPLEX DECISIONS
• Annual Equivalent Value Method
Assume that each machinery is replaced in the last year of life with an
identical asset.
Calculate the AEV by using the formula,
AEV = NPV / Annuity Factor
• Investment Timing and Duration
Undertake the project at that point of time which maximises NPV.
• AEV can be used to find
• BCR/PI may be used for Capital Rationing – Multi Prd. Constraints and
Indivisibility
24. Risk Analysis in Capital Budgeting
• Conventional Techniques for Risk Analysis
--Payback -- Risk Adjusted Discount Rate
• Techniques
Sensitivity and Scenario Analysis
25. The proportion of proposed projects having positive NPVs at
the corporate hurdle rate is independent of the hurdle rate.
!!!
Its all about forecasts
26. Where does positive NPV come from?
• Projects may look attractive for two reasons:1) There are some
errors in forecast 2)The company genuinely expects to earn
excess profits.
• So increase odds in your favor by moving in areas of
competitive advantages.
• Look at economic rents and where even advantage is absent or
entry of competitors will push prices down or costs up, don’t
enter .
• When you have the market value of an asset use it..rather then
over analysis…gold, real estate..airplanes etc…
• PV calculations may vary and subject to error …that’s life!!!!!
Editor's Notes
Lays out the basic steps in analyzing an investment.
Accrual accounting income is designed to measure the “income” made by an entity during a period, on sales made during the period. Thus, accrual accounting draws lines between operating expenses (that create income in the current period) and capital expenditures (which create income over multiple periods).
It is not always consistent. R&D, for instance, is treated as an operating expense.
Accrual accounting also tries to allocate the cost of materials to current period revenues, leading to inventory, and give the company credit for sales made during the period, even if cash has not been received, giving rise to accounts receivable.
Most of these decisions are determined by accounting standards. In some cases, however, firms may adopt different accounting standards for project analysis than for preparing financing statements.
The adjustments can lead to cash flows that are very different from accounting income, especially for firms with significant capital expenditures and depreciation charges.
Sunk costs should not be considered an investment analysis, but a healthy firm has to figure out a way to recover sunk costs from on-going projects. The only way to ensure that this happens is to have a process where costs are examined before they become sunk. For instance, pharmaceutical firms need to be able to ask whether a specified expenditure in R&D is worth it (given expectations for products that might emerge from the R&D, and the size of the market) before the expenditure is made.
This is likely to be far more difficult if the research is basic research without a specific product in mind.
Allocation is the accountant’s mechanism for fairness.
If the allocation is of an expense that would be incurred anyway, whether the project is taken or not, it is not incremental.
It is difficult to figure out what allocated expenses are fixed and what are incremental. One approach that works reasonably well for firms with a history is to look at the expense (say, G&A) over time and compare it with some base variable (revenues or number of units). If the expense is fixed, it should not vary with the base variable. If it is variable, it will, and the nature of the variation will help define how much is fixed and how much is variable.
G & A Expense = a + b (Revenues) across time
The coefficient on revenues will be the amount G& A will increase by for a dollar change in revenues. This can then be used in conjunction with the revenues on the new project, to specify the G&A that the new project should carry.
When you stop estimating cash flows on a project, you have to either estimate salvage value or terminal value. For projects with finite lives (such as buying a plant or equipment), estimating salvage value is appropriate. For projects with very long lives, estimating a terminal value is more reasonable.
If you assume that the project is liquidated, any investments in working capital have to be salvaged. This does not necessarily mean that you will get 100% back.
A terminal value can also be thought off as the value that you would get by selling this project (as an on-going project) to someone else at the end of the analysis. In this case, we are estimating that the theme park in Bangkok will be worth $ 8,821 million at the end of year 9. (The perpetual growth model gives the value of the asset at the beginning of the year of the cash flow)
