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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 1 Project Decision Making Learning Objectives: Explain the Cost-Benefit Analysis Concept Compute the NPV of a Project Conduct NPV Analysis of Projects With Unequal Lengths Compute the NPV of a Project Using Risk Adjusted Discount Rate Compute the IRR of a Project Compute the Payback Period of a Project Compute the Discounted Payback Period of a Project Compute the MIRR of a Project Use the Above Methods to Make a Project Investment Decision Understand the Limitations of the Above Methods Interpret NPV Profiles Explain Why WACC is Used as the Discount Rate For NPV Calculations

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 2 Project Decision Making The process of planning and evaluating expenditures of capital for assets whose resulting cash flows are expected to extend beyond one year Theis decision process is also called “Capital Budgeting” Used to decide which projects to adopt Involves Long-term / Strategic Decisions Project duration of several years Errors in forecasting requirements have long lasting effects Projects in question typically involves large capital expenditures The larger the firm, the larger the expenditures Typically involves the purchase of fixed assets (i.e. plant & equipment) that will produce some sort of future cash flow stream However, the capital budgeting process can be applied to any outflow of cash that produces a series of future cash flows transportation, automation/MIS, R&D, etc. costs of market expansion efforts, new product lines, etc. outsourcing marketing Used to evaluate a single project or choose between 2 or more projects Importance of Capital Budgeting: Since the results of capital budgeting decisions last many years… the firm loses some financial flexibility they are strategic decisions Erroneous forecasts of requirements can have serious consequences if too much is invested the firm will incur unnecessarily high depreciation and other expenses if not enough is invested: purchased equipment may not be modern enough to enable the firm to be competitive if capacity is in adequate, the firm may lose market share Timing is important; the firm must acquire and bring into operation assets when needed; must be pro-active

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 3 Project (Decision) Types: Replacement Projects: whether to purchase capital assets to take the place of existing assets to maintain or improve existing operations. maintenance of business: replacement of equipment necessary to continue current business operations cost reduction: includes replacement of serviceable but obsolete equipment with more cost effective equipment Expansion Projects: whether to purchase capital projects and add them to existing assets to increase existing operations. existing products or markets new products or markets Safety and/or Environmental Projects Research & Development Projects future cash flows very uncertain the norm is to add very subjective estimates to more “solid” cash flows Long-term contracts Other: office buildings, parking lots, executive aircraft, etc. Project Categories: Independent Projects: Projects whose cash flows are not affected by decisions made about other projects; i.e. you can do as many of the projects as you can afford Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted Five Techniques: Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR)

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 4 Net Present Value (NPV) Method Definition: The sum of all project cash flows is the Net Present Value The value of any financial asset is determined by discounting all future cash flows to the present (i.e. find the PV @ t = 0) and adding them up Process: Discount all future expected cash flows to time zero (t = 0) then add them to any initial investments Rationale: An NPV > 0 means you make money; the profit is greater than the cost An NPV < 0 means you lose money; the cost is greater than the profit An NPV of 0 means you break even Accept only projects with NPV > 0 When comparing mutually exclusive projects, the one with the highest NPV is the one with the highest potential benefit to the firm. If all the cash flows of mutually exclusive projects are negative, they will have negative NPVs. Still, you choose the project with the hichest NPV Formula: The discount rate r for computing NPV is usually the Weighted Average Cost of Capital (WACC) (from Ch 12) The discount rate can be the Opportunity Cost of Capital (from Ch 5)

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 5 Net Present Value (NPV) Method (continued) Example (Uneven CFs): What is the NPV of a project with the following annual cash flows if the firm’s WACC =10%? 1,500 8001,200-3,000 1,363.64 991.74 601.05 204.90 161.33 300 01234 Financial Calculator: I/Y=10, CF 0 =-3000, CF 1 =1500, CF 2 =1200, CF 3 =800, CF 4 =300; NPV = 161.33 Is this project acceptable? Example (Uniform CFs): What is the NPV of a project with the following annual cash flows if the firm’s WACC =10%? discount @ 10% 1 per. discount @ 10% 2per. discount @ 10% 3 per. discount @ 10% 4 per. 01234 500 1,500 500 NPV = -1500 + [P/Y=1, N=4, I/Y=10, PMT=500; CPT, PV] = -1500 + 1584.93 = 84.93

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CE 350 Project Decison Making 6 Net Present Value (NPV) Method (continued) Example: What is the NPV of a project with the following monthly cash flows if the firm’s WACC =6.0000%? 0456123 $350$390$480$660$820$940-$2,000 x $1,000

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CE 350 Project Decison Making 7 Net Present Value (NPV) Method (continued) Example: What is the NPV of a project with the following quarterly cash flows if the firm’s WACC = 8.0000%? $ x $1,000 1 2 343536 $500 0 $11,000.00

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CE 350 Project Decison Making 8 Payback Period Payback Period (PB): The length of time it takes to recover the original costs (of the project) from expected cash flows Rationale: The sooner investment costs are recovered, the better Process: Simply add up the expected cash flows until they equal (or exceed) the original investment. The number of years it take to do this is the payback period. PB = Number of years before full recovery of original investment Uncovered cost at start of full-recovery year Total cash flow during full-recovery year + Cash Flow Cumulative Net CF 1,500 8001,200-3,000300 PB 01234 Example: Find the payback period for a project which has the following cash flows PB = 2 + 300/800 = 2.38 years Full-recovery year -3,000 + 1,500 -1,500 + 1,200 -300 + 800 500

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 9 Payback Period (continued) Payback Period Decision Rule: When evaluating a single project, the project is acceptable if the Payback Period is less than any pre-specified time limit When evaluating 2 or more mutually exclusive projects, the one with the shortest Payback Period is preferrable, assuming that it is less than any pre-specified time limit Strengths & Weaknesses of the Payback Method: Strengths Provides an indication of a project’s liquidity risk (how long will invested capital be tied up) Weaknesses Ignores the Time Value of Money Ignores the CFs occurring after the payback period Example: Consider two projects who’s annual cash flows are shown below: 450 100 0234156 Project A Project B PB = 4.5 yrs 450 200 90 0234156 PB = 5 yrs Project A has a shorter PB period but is it really the more preferable project? Compute NPV of each project (assume WACC = 8%): NPV A =12.28 NPV B = 35.38

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CE 350 Project Decison Making 10 Discounted Payback Period (not covered in your textbook) Similar to Payback Period Method Expected future cash flows are discounted by the project’s cost of capital Thus the discounted payback period is defined as the number of years required to recover the investment from discounted net cash flows Example: A project has the following annual cash flows. Find the discounted payback period 10 80 60 0 1 2 3 -100 r =10% PVCF t=0 -1009.0949.5960.11 Cum. NET Discounted Cash Flows Discounted Payback = 2 + 41.32/60.11 = 2.69 yrs Strengths & Weaknesses of the Discounted Payback Method: Strengths Provides an indication of a project’s liquidity risk Recognizes time value of money Recognizes WACC Weaknesses Ignores the CFs occurring after the payback period -100 + 9.09 -90.91 + 49.59 -41.32 + 60.11 18.79

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CE 350 Project Decison Making 11 Discounted Payback Period (not covered in your textbook) Example: A project has the following quarterly cash flows. Find the discounted payback period. WACC = 6.0000% 10 30 25 -70 r per = 1.5% 0 123 4 20

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 12 Internal Rate of Return Definition: The discount rate that forces the PV of a project’s expected cash flows to equal its initial cost It is also the discount rate that forces the project’s NPV to equal 0 (do some algebra; subtract the initial cost form both sides of the equation and you get an NPV equation) The IRR is the ROR of the project A project is internal to a firm; it is an internal investment Rationale: Projects that have an IRR greater than r (the opportunity cost) are acceptable investments The project produces returns in excess of that which is required 1,500 8001,200-3,000300 01234 Example: What is the IRR of a project with the following cash flows? 3000 = 1,500 + 1,200 + 800 + 300 (1+IRR) (1+IRR) 2 (1+IRR) 3 (1+IRR) 4 NPV = 0 = -3000 + 1,500 + 1,200 + 800 + 300 (1+IRR) (1+IRR) 2 (1+IRR) 3 (1+IRR) 4 Solve for IRR (the discount rate that satisfies (results in, fits) either of above equations CF, 2nd CLR WORK (Clear cash flow worksheet) -3000, ENTER ↓, 1500, ENTER ↓, ↓, 1200, ENTER ↓, ↓, 800, ENTER ↓, ↓, 300, ENTER IRR, CPT: 13.1140%

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 13 Internal Rate of Return (continued) 3000 = 1,500 + 1,200 + 800 + 300 (1+IRR) (1+IRR) 2 (1+IRR) 3 (1+IRR) 4 IRR is similar in concept to the Yield to Maturity of a bond If IRR = 13.114% then: $3000 = $1,326.10 + $937.88 + $552.77 + $183.25 If the initial cost of the project is $3,000 and it produces a 13.114% ROR, then the firm will break even (the initial investment is matched by the sum of the discounted future cash flows) If each of the discounted CFs are compounded at IRR (13.114%) for the respected number of periods, it produces the project’s CF stream: 1,500 8001,200-3,000300 01234

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 14 Internal Rate of Return (continued) If a project’s IRR exceeds the WACC (or opportunity cost of capital), the firm makes money If a project’s IRR is less than the WACC (or opportunity cost of capital), the firm will lose money If a project’s IRR equals the WACC (or opportunity cost of capital), the firm “breaks even” Thus the project’s required ROR is the firm’s WACC When comparing two mutually exclusive projects, the one with the higher IRR is preferred Some notes on using NPV and IRR methods 1. Reinvestment Rate Assumption Which one of these methods (NPV or IRR) is a safer bet? (i.e. more reliable and predictable) The answer depends on the interest rate at which cash flows can be reinvested the NPV method assumes that they can be reinvested at r, the IRR implies that they can be reinvested at a rate equal to a project’s IRR both methods rely on expected (thus estimated) future cash flows however with NPV, we know what rate these CFs will be reinvested at; it’s the opportunity cost of capital we create the IRR by forcing the NPV of the expected cash flows to equal zero thus the IRR we come up may be much greater than the opportunity cost of capital, thus establishing an unrealistic reinvestment rate for project CFs

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 15 Some notes on using NPV and IRR methods (continued) 2. The IRR method is not suitable when a project has “unconventional” cash flows A conventional CF has a large outflow of cash at the beginning of the life span and several inflows of cash throughout the rest of the project An unconventional CF has an initial negative CF, followed by a series of positive CFs which are interrupted by a negative CF. This will produce 2 or more IRRs (one for each period in which the sign of the CF changes) (trust me on this; you don’t want to see the math)(you can use a calculator but the IRR will be meaningless) Which IRR will you use? 0456123 $50k $370k $89k $130k $145k $170k $94k Unconventional Cash Flows: What to do? Answer: Modify the cash flows so that there is only one negative cash flow then do IRR. This is the Modified IRR method. 0456123 $50k $89k $130k $145k $170k $94k WACC = 9.5000% P/Y=1, N=1, I/Y=9.5, FV=50; CPT PV; PV = 45.66k CF0=-370, C01=130, C02=43.34, C03=0, C04=145, C05=170, CO6=94; IRR = 13.4800% $45.66k $370k = $89K - $45.66k

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 16 Notes on NPV and IRR (continued) Why use IRR? Answer: It suits those who want to directly express the benefits of a project as a rate of return (Corporate operation types selling a project to non- finance guys) It gives some indication of safety if future cash flows fall short of expectations: WACC is only an estimate of the of a firm’s true cost of capital What if WACC is too low of an estimate of a firm’s cost of capital? Projects with relatively high IRR have greater margins of safety the than projects whose IRRs barely exceed a firm’s WACC Conclusions: When evaluating which of 2 or more mutually exclusive projects, NPV is preferred over IRR Prof. Jim’s Recommendations: Always use NPV first Use IRR and Discounted Payback Period as tie breakers

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 17 NPV Profiles Let’s examine two projects with differing cash flows Project S Project L If we plot NPVs of each project against various values for r, we can see how the NPVs will change when r changes 600 300 400200 01234 -1,000 5 100 200 400 200400 01234 -1,000 5 600 Key Points: The crossover point is the r that produces equal NPVs. At r greater than 9.55%, Proj S has higher NPV. At r less than 9.55%, Proj L has higher NPV. Note: IRR suggests Proj S is always superior If the profiles don’t cross, one project dominates the other Crossover Point: NPV S = NPV L @ r = 9.55% IRR L = 18.9% IRR S = 25.7% NPV Discount Rate (r) PROJ L PROJ S

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 18 NPV Profiles (continued) Two reasons why profiles cross: Size (scale) differences. Smaller projects demand less funds at t = 0 thus leave more funds available for other investments. The higher the opportunity cost, the more valuable these funds are, so high r favors small projects. Cash Flow Timing differences. Project with faster payback provides more CF in early years for reinvestment. Use both methods (NPV & IRR) to determine sensitivity to r Find NPV and IRR of both projects. Construct NPV profiles and find the crossover point Accept the project that has the highest NPV with respect to r

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MGT 326 Ch 8:Investment Decision Rules (bdh2e) 19 Comparison of Projects with Unequal Lives Example: A company is planning to modernize its production facilities and is considering either a conveyor system (Proj C) or some forklift trucks (Proj F) 7,00012,00013,000 0123 -20,000 0123456 -40,000 8,00013,00014,00012,00010,00011,000 Proj F Proj C r =11.5% NPV C = $7,165, IRR = 17.5% NPV F = $5,391, IRR = 25.2% The NPV results hide the fact that Proj F affords the opportunity to make a similar investment at t =3, thus producing another 3 years of cash flows To compensate for this we must use the replacement chain or common life approach this simply means extending the cash flows of the shorter project out to the life of the longer project and then computing NPV of the shorter project 7,00012,00013,000 -20,000 Proj F Replacement Chain NPV F = $9,281 0123456 7,00012,00013,000 -20,000 This is only an issue for mutually exclusive projects Ignore the Equivalent Annual Annuity approach as discussed in your text book r =11.5%

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CE 350 Project Decison Making 20 Comparison of Projects with Unequal Lives (continued) Year0123456 Project ACFs-$60.00$18.00 Project BCFs-$45.00$30.00 Example: A firm is considering two mutually exclusive projects that have the annual cash flows shown below. Based on NPV analysis, which project should be accepted? The required rate of return is 7.0000%

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21 Risk-Adjusted Discount Rate (not in your text book) Definition: The discount rate (required rate of return) that applies to a particular risky project Used to determine a project’s NPV Applies the concept of risk aversion to project decisions Very subjective; there is no reliable technique for determining appropriate risk premiums for projects “Benchmark”; use what other firms (in same industry) use Should be consistently applied throughout the firm Process Determine the overall required rate of return for the average project(i.e. opportunity cost of capital) Classify all projects into three categories: low risk, moderate risk and high risk Determine appropriate risk adjustments modify required rate of return appropriately Results: riskier projects will have their NPVs artificially lowered because (according to the concept of risk aversion) riskier assets should have lower value compared to less risky assets Example: A firm is considering two mutually exclusive projects. Project A is a low risk project, Project B is moderately risky while Project C is considered to have a high degree of risk. The firm’s r required is 7.30%. The firm uses the risk-adjusted discount rate method to account for project risk. Projects posing minimal risk are evaluated using r required for the discount rate. 1.25% is added for moderately risky projects and 2.50% is added for significantly risky projects. What discount rates should be used for NPV calculations of Projects A, B and C? r Project A = r required = 7.30% r Project B = r required + 1.25% = 7.30% + 1.25% = 8.55% r Project C = r required + 2.50% = 7.30% + 2.50% = 9.80% MGT 326 Ch 8:Investment Decision Rules (bdh2e)

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