1. CORPORATE FINANCE I ESCP-EAP European Executive MBA
21 Sept p.m. Paris
Investment Decisions-Net Present Value
Ertürk
Senior Fellow in Banking

2. CORPORATE FINANCE (2) (1) Firm's Financial Financial (4a) operations
manager
markets
(3)
(4b)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors

4. RESPONSIBILITIES OF THE FINANCIAL MANAGER
DECISIONS IN ANY BUSINESS
WHAT LONG-TERM INVESTMENTS SHOULD YOU ACCEPT?
CAPITAL BUDGETING DECISION
WHERE WILL YOU GET THE MONEY TO PAY FOR YOUR INVESTMENTS?
FINANCING DECISION

5. VALUE OF THE FIRM
Returns generated by investments (assets) -return on assets- should be greater than the cost of liabilities (weighted average cost of capital)
ROA > WACC
Assets Liabilities
Current
Fixed
Debt
Equity

6. IS GREATER THAN THE COST OF THE ASSET
CAPITAL BUDGETING
FINANCIAL MANAGER ATTEMPTS TO ENSURE THAT
THE PRESENT VALUE
(OR THE VALUE TODAY )
OF THE CASH FLOWS
GENERATED BY THE ASSET
IS GREATER THAN THE COST OF THE ASSET

7. Laurentian Bakeries
Should the company invest in the expansion?

8. TWO RULES FOR ACCEPTING OR REJECTING PROJECTS
1. INVEST IN PROJECTS WITH POSITIVE NPV –Net Present Value
2. INVEST IN PROJECTS OFFERING RETURN
GREATER THAN OPPORTUNITY COST OF CAPITAL

9. DISCOUNTED CASH FLOWS -DCF
OFTEN CALLED DISCOUNT FACTOR
r DISCOUNT RATE
HURDLE RATE
OPPORTUNITY COST OF CAPITAL
Also appears as “k”

10. Present Value

11. Discount Factor = DF = PV of €1
Present Value
Discount Factor = DF = PV of €1
Discount Factors can be used to compute the present value of any cash flow.

12. Present Values
Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time.

14. RETURN = PROFIT = 400 - 350 = 14.3% RATE OF RETURN RULE INVESTMENT 350
ACCEPT PROJECT BECAUSE RATE OF RETURN IS GREATER THAN THE OPPORTUNITY COST OF CAPITAL, 7%

15. NPV RULE STEP 1: FORECAST CASH FLOWS Cost of building, C0 = 350
Sale price in Year 1, C1 = 400
STEP 2: ESTIMATE OPPORTUNITY COST OF CAPITAL
If equally risky investments in the capital market
offer a return of 7%, then cost of capital, r = 7%
STEP 3: Discount future cash flows C
PV = = = 374
1 + r
STEP 4: Accept project if PV of payoff exceeds investment
NPV = = +24

16. ONE-PERIOD PROJECT: RETURN UNCERTAIN
INVEST $1,000 NOW.
RECEIVE EXPECTED UNCERTAIN CASH FLOW AFTER 1 YEAR, WHOSE EXPECTED VALUE IS $1,300
INVESTORS CAN BUY EQUALLY RISKY SECURITIES WITH 35% EXPECTED RETURN.
DECISION:
1. DON'T INVEST BECAUSE 30% PROJECT RETURN IS LESS THAN 35% OPPORTUNITY COST.
2. DON'T INVEST BECAUSE NET PRESENT VALUE IS NEGATIVE.
1,300
NET PRESENT VALUE = ,000 = ,000 = -37
VALUE OF FIRM
WILL FALL BY €37
IF WE ACCEPT THE PROJECT

17. DISCOUNTED CASH FLOW (DCF) EQUATION
PV0 =
DISCOUNTED CASH FLOW (DCF) EQUATION

18.  NPV = NET PRESENT VALUE OF A PROJECT
WHERE THE SUMMATION IS OVER ALL THE CASH FLOWS
GENERATED BY THE PROJECT,
INCLUDING INITIAL NEGATIVE CASH FLOWS
AT THE START OF THE PROJECT, C0 ETC.

19. Present Values Example
Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value.

20. Present Values Example - continued
Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value.

21. EXAMPLE C0 = -500, C1 = +400, C2 = +400 r1 = r2 = .12 NPV = -500 + +
= (.893) (.794)
= =
(1.12)2

22. INTERNAL RATE OF RETURN, IRR
NPV =
IRR IS THE DISCOUNT RATE FOR WHICH NPV=0

23. NET PRESENT VALUE PROFILE
C0 = - 4
C1 = +2
C3 = +4
NPV +2
IRR = 28%
DISCOUNT 50
RATE (%) -1

24. IRR vs. NPV IRR IS AN INTENSIVE MEASURE OF PROFITABILITY
NPV IS AN EXTENSIVE MEASURE OF PROFITABILITY
AT THE END OF THE DAY, WE ARE INTERESTED IN A MONETARY (EXTENSIVE) MEASURE OF PROFITABILITY
NOT IN THE PROFITABILITY PER EURO OF INVESTMENT
BOTH GIVE SAME RESULT IF WE’RE NOT DEALING WITH MUTUALLY EXCLUSIVE PROJECTS OR PROJECTS WITH NONCONVENTIONAL CASH FLOWS

25. Identifying Relevant Cash flows
Use cash flows only not accounting figures
Depreciation is not a cash flow but capital expenditure is
Construct “Project Appraisal Table”
Use incremental cash flows only
Separate investment and financing decisions
Include all incidental effects.
Do not forget working capital requirements.
Forget sunk costs.
Include opportunity costs.
Beware of allocated overhead costs
Use after-tax cash flows only

26. After-tax cash flows
Incremental costs and depreciation/capital allowances reduce tax and hence increase investment cash flows by:
(cost/depreciation) X (tax rate)
Incremental income/savings increase tax and hence increase investment cash flows by:
(income/savings) X (1-tax rate)

27. Laurentian Bakeries Relevant Cash flows
Land value of the Winnipeg plant $250,000?
Administrative staff salaries $223,000?
Staff expenses and salaries
to secure the US contract $40,000?
Working capital needs
Cost reductions
Capital cost allowance

28. Laurentian Bakeries Investment costs (C$millions)
Extension to the building $1.3
Spiral freezer
High speed processing line
Additional warehouse space
Contingency
TOTAL $5.2

30. Laurentian Bakeries Need to consider hurdle rate Is 18% right?
Sensitivity and scenario analyses
Need to consider qualitative factors
Expansion into US
Human resources
Environment

31. Project Appraisal –example 2
INNOVATION LTD
Project Appraisal –example 2

33. ALTERNATIVES TO THE NPV RULE
SIMPLE AND DISCOUNTED PAYBACK
AVERAGE RETURN ON BOOK VALUE
INTERNAL RATE OF RETURN
PROFITABILITY INDEX

34. PAYBACK RULE NPV Year: 0 1 2 3 Payback At 10% A -2 +2 1 -0.2
PROJECT A HAS SHORTER PAYBACK BUT LOWER NPV

35. PAYBACK RULE NPV Year: 0 1 2 3 Payback At 10% A -2 +2 1 -0.2
PROJECT A HAS SHORTER PAYBACK BUT LOWER NPV

36. PAYBACK RULE IF FIRM USES 1 YEAR CUTOFF PERIOD , ACCEPT PROJECT A
IF FIRM USES 2 YEAR CUTOFF PERIOD, ACCEPT PROJECTS A & B
REGARDLESS OF CUTOFF PERIOD, PAYBACK RULE MAY GIVE DIFFERENT ANSWER THAN NPV
PAYBACK GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE PAYBACK DATE AND NO WEIGHT TO LATER CASH FLOWS
NO DISCOUNTING - IGNORES TIME VALUE OF MONEY
NO GOOD RATIONALE FOR CUTOFF

37. PAYBACK RULE CASH FLOWS (€000) NPV Year: 0 1 2 3 Payback At 10%D

38. DISCOUNTED PAYBACK RULE
CALCULATE LENGTH OF TIME UNTIL THE SUM OF THE DISCOUNTED CASH FLOWS IS EQUAL TO THE INITIAL INVESTMENT
ACCEPT PROJECT IF IT IS LESS THAN SOME CUTOFF VALUE
DISCOUNTED-PAYBACK RULE ASKS HOW LONG WILL IT BE UNTIL THE PROJECT HAS A POSITIVE NPV
NO LONGER GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE PAYBACK DATE BUT STILL IGNORES CASH FLOWS AFTER CUTOFF DATE
CANNOT BE USED FOR RANKING PROJECTS

39. AVERAGE RETURN ON BOOK VALUE
FORECASTED NET INCOME
AVERAGE BOOK VALUE
OF THE INVESTMENT
ACCEPT OR REJECT AN INVESTMENT BASED ON ITS BOOK RATE OF RETURN
COMPARE WITH BOOK RATE OF RETURN FOR THE FIRM OR THE INDUSTRY
FITS INTO FORMAT OF ACCOUNTING STATEMENTS
INFORMATION READILY AVAILABLE
SOUNDS ATTRACTIVE BUT WRONG

40. ACCEPT PROJECT IF FIRM’S TARGET BOOK RATE OF RETURN IS LESS THAN 44%
AVERAGE RETURN ON BOOK
Year:
Book
Gross profit
Depreciation
Net income
Average return on book = = 44% 2
4.5
ACCEPT PROJECT IF FIRM’S
TARGET BOOK RATE OF RETURN IS LESS THAN 44%

41. CAPITAL RATIONING
SOMETIMES THE FIRM CAN’T FINANCE ALL PROJECTS WHICH HAVE A POSITIVE NPV TODAY
AND ANTICIPATES CAPITAL RATIONING IN VARIOUS FUTURE YEARS
IDENTIFY PACKAGE OF PROJECTS WHICH SATISFY CAPITAL CONSTRAINTS AND MAXIMIZE NPV
IRR RULE WILL NOT WORK
USE PROFITABILITY INDEX IN SIMPLE CASES
LINEAR PROGRAMMING IN GENERAL CASE

42. CAPITAL RATIONING
% A B C
LIMITED €10 MILLION CAPITAL
FIRM CAN INVEST IN PROJECT A OR PROJECTS B AND C
INDIVIDUALLY, B AND C HAVE LOWER NPV
TAKEN TOGETHER, B AND C HAVE HIGHEST NPV
CHOOSE PROJECTS THAT OFFER HIGHEST NPV PER EURO INVESTED

43. PROFITABILITY INDEX = NET PRESENT VALUE
CAPITAL RATIONING
PROFITABILITY INDEX = NET PRESENT VALUE
INITIAL INVESTMENT
PROJECT INVESTMENT NPV PROFITABILITY INDEX A B C
RANK PROJECTS IN TERMS OF DECLINING PI
CONTINUE MAKING INVESTMENTS UNTIL
CAPITAL EXHAUSTED
ACCEPT PROJECTS B AND C