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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.

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Presentation on theme: "MGT 326 Ch 8:Investment Decision Rules (bdh2e) 1 Project Decision Making Learning Objectives:  Explain the Cost-Benefit Analysis Concept  Compute the."— Presentation transcript:

1 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

2 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

3 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)

4 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 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)

5 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, ,200-3,000 1, Financial Calculator: I/Y=10, CF 0 =-3000, CF 1 =1500, CF 2 =1200, CF 3 =800, CF 4 =300; NPV = 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%? 10% 1 per. 10% 2per. 10% 3 per. 10% 4 per , NPV = [P/Y=1, N=4, I/Y=10, PMT=500; CPT, PV] = = 84.93

6 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%? $350$390$480$660$820$940-$2,000 x $1,000

7 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 = %? $ x $1, $500 0 $11,000.00

8 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, ,200-3, PB Example: Find the payback period for a project which has the following cash flows PB = /800 = 2.38 years Full-recovery year -3, ,500 -1, ,

9 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: Project A Project B PB = 4.5 yrs 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

10 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 r =10% PVCF t= Cum. NET Discounted Cash Flows Discounted Payback = /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

11 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 = % r per = 1.5%

12 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, ,200-3, Example: What is the IRR of a project with the following cash flows? 3000 = 1, , (1+IRR) (1+IRR) 2 (1+IRR) 3 (1+IRR) 4 NPV = 0 = , , (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 MGT 326 Ch 8:Investment Decision Rules (bdh2e) 13 Internal Rate of Return (continued) 3000 = 1, , (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 = % then: $3000 = $1, $ $ $  If the initial cost of the project is $3,000 and it produces a % 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, ,200-3,

14 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

15 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? $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 $50k $89k $130k $145k $170k $94k WACC = % 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 = % $45.66k $370k = $89K - $45.66k

16 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

17 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 , , 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 r = 9.55% IRR L = 18.9% IRR S = 25.7% NPV Discount Rate (r) PROJ L PROJ S

18 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

19 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 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 Proj F Replacement Chain NPV F = $9, ,00012,00013, ,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%

20 CE 350 Project Decison Making 20 Comparison of Projects with Unequal Lives (continued) Year 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 %

21 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 % = 7.30% % = 8.55%  r Project C = r required % = 7.30% % = 9.80% MGT 326 Ch 8:Investment Decision Rules (bdh2e)


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