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1 Capital Investment Decision

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2 Revision Purpose Methods

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3 The Investment Decision The objective of the corporation is to Maximise Shareholders Wealth To do this we need to invest in those projects that will give the correct rate of return for the risk involved To do this we need to be able to

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4 The Investment Decision 1.Identify suitable investment opportunities 2.Decide on the best selection method 3.Identify the cash flows that will be generated by those investments 4.Discount them at the correct cost of capital 5.Choose the best one or ones from those available

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5 Capital Investment Decision The ideal selection method will Select the project that maximises shareholders wealth Consider all cash flows Discount the cash flows at the appropriate market determined opportunity cost of capital Will allow managers to consider each project independently from all others

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6 Capital Investment Decision Methods for evaluating projects Payback ARR, Accounting Rate of Return IRR. Internal rate of return is the discount rate that will give a Net Present Value of 0. NPV is the Net Present Value of a stream of cash flows discounted at the correct cost of capital for the degree of risk inherent in realising those cash flows NPV is best but what do companies use and why?

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7 The graph shows the NPV as a function of the discount rate. The NPV is positive only for discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of capital of 10%, the project has a positive NPV of $100 million. Capital Investment Decision Figure 6.1 NPV of FFFs New Project

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8 Capital Investment Decision We know that the NPV is the best method because; The reinvestment rate assumption Value additivity Differences in scale Multiple IRRs

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9ACFL19 Capital Investment Decision Why not IRR and does it have a use? 1.Delayed Investments The Bonzo Dog DoDah Band are offered USD2,000,000 today from a rich investor to make a new vinyl LP. They calculate that they will need three years to make the recording and that they will have to give up earnings in each of those years of USD 1,000,000. Should they do it?

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10ACFL110 Capital Investment Decision 1 st question. What is the opportunity cost of capital? Say 6% 2 nd question. What is the IRR? With a wild stabbing guess say 23.38% +2,000,000 – 1,000,000 – 1,000,000 – 1,000,000 1.2338 (1.2338) 2 (1.2338) 3 - 1,999,855 = -810,504 - 656,917 - 532,434 Thats close enough

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11ACFL111 Capital Investment Decision But using 6% as the cost of capital + 2,000,000 – 1,000,000 – 1,000,000 -1,000,000 (1.06) (1.06) 2 (1.06) 3 -2,673,022 = -943,396 - 889,996 - 839,630 So what should they do? Can we explain what is going on here?

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12 Capital Investment Decision Value Additivity Try working out the NPV for the following - 1,000,000 + 350,000 +650,000 +650,000 +650,000 -1,000,000 + 650,000 +650,000 +650,000 + 350,000 At 10% and now combine them. What is the combined NPV? Answer = 787,686 and 855,509 = 1,643,195 As combined flows = 1,643,193

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13 Capital Investment Decision -1,000,000 + 350,000 +650,000 +650,000 +650,000 -IRR = 39% -1,000,000 + 650,000 +650,000 +650,000 + 350,000 -IRR = 49% - 2,000,000 + 1,000,000 +1,300,000 + 1,300,000 +1,000,000 - IRR = 43.5%

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14 Capital Investment Decision Issues of scale What would you prefer A return of 50 % or one of 20% ? an NPV of 50 or an NPV of 500? Depends for the IRR but you would prefer the higher NPV

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15ACFL115 Advanced Corporate Finance Project A with IRR of 12% -1201 + 500 + 500 + 500 PVF 1.1200 1.2544 1.4049 PV +1201 446 399 356 Double the scale IRR still 12% -2402 +1000 +1000 +1000 PV +2402 893 797 712

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16 Capital Investment Decision Figure 6.4 B&DeM In this case, there is more than one IRR, invalidating the IRR rule. If the opportunity cost of capital is either below 4.723% or above 19.619%, Star should make the investment.

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17 Capital Investment Decision So, its NPV But………. Some Reasons for usage of wrong techniques. Managers prefer % figures => IRR, ARR Managers dont understand NPV/ Complicated Calculations. Payback simple to calculate. Short-term compensation schemes => Payback (Levy 200 –203, Pike 1985 pg 49). Behavioural Factors (see later section on Behavioural Finance!!) Increase in Usage of correct DCF techniques: Computers. Management Education.

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18ACFL118 Capital Investment Decision How do we decide when resources are constrained? We need to maximise NPV which may mean not going for the project with the highest NPV, rather the combination of projects that gives the highest total NPV. Why would resources be constrained? This could be due to Capital Rationing

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19ACFL119 Capital Investment Decision 150million to invest Three projects Project NPV Investment PI * A 100 125.80 B 80 75 1.07 C 70 75.93 *PI = Profitability Index = Value Created Resource Consumed

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20 Capital investment Decision What about other scarce resources? E.g. bright Bath Students There are never enough

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21 Capital Investment Decision Profitability Index = Value created = NPV Resource consumed RC ProjectNPV Bath Students Headcount PI A30100.3 B35150.23 C2070.28 D1580.18 E1228.43

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22 Capital Investment Decision ProjectNPV HeadcountHeadcount PI Cumulative requirement E1228.4228 A30100.30128 C2070.28198 B35150.23 Broken the budget D1580.18 A mere 200 students are available

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23 Capital Investment Decision Try this one 380 tonnes of scarce material ProjectNPV Mats Usage Mats PI A50180 B2070 C45120 D1575 E35100

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24 Capital Investment Decision What do you notice? So? Now Moving on

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25 Capital Investment Decision Remember We have to look at all the relevant, incremental cash flows - Taxes/tax losses - Opportunity costs - Depreciation - Working capital - Cannibalisation

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26 Capital Investment Decision Illustrations using examples from B&DeM New project, units 100,000 pa at 260 per unit = 26 million Cost of production is 110 per unit = 11M Gross profit 15 million pa Operating expenses = 2.8 million pa 5 million to be spent on design and engineering 10 million on software 7.5 million equipment depreciated over 5 years on straight line basis

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27 Capital Investment Decision Table 7.1 HomeNets Incremental Earnings Forecast (Spreadsheet)

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28 Capital Investment Decision Points to make so far 1 Tax losses 2 Depreciation 3 Interest cost Now Opportunity cost

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29 Capital Investment Decision New lab will be housed in existing space. What should the cost be? Well what are the alternative uses? Suppose could rent for 200,000 pa for years 1 to 4 then this is a foregone income of 200,000 x (1-.4)

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30 Capital Investment Decision Cannibalisation 25 % of the sales of the new product will come from existing sales of a similar product. How do we account for this? Lost revenue at price of 100 per unit 100,000 x.25 x 100 = 2,500,000 But there will be lower cost of sales 100,000 x.25 x 60 (cost per unit) = 1.5 m

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31 Capital Investment Decision Table 7.2 HomeNets Incremental Earnings Forecast Including Cannibalization and Lost Rent

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32 Capital Investment Decision Need to work out the Free Cash Flow i.e. the effect of the project on the companys cash. So far looked at sales and costs just need to add a couple of things in. 1. Depreciation (which you are already familiar with 2. Net working capital

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33 Capital investment Decision Table 7.3 Calculation of HomeNets Free Cash Flow (Including Cannibalization and Lost Rent)

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34 Capital Investment Decision Table 7.5 Computing HomeNets NPV (Spreadsheet)

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35 Capital Investment Decision Anything else? Timing of cash flows Liquidation/salvage value Terminal Value - multiple - constant growth

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36 Capital Investment Decision Terminal value Constant Growth 1) Year 5 free cash flow is 3,000,000. If cost of capital is 10% then PV at end year 5 of future cash flows is 3,000,000 = 30,000,000.10 2) Suppose expect to grow at 3% pa thereafter Then PV at end year five of future cash flows is 3,000,000 = 42,857,143.10 -.03

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37 Capital Investment Decision Break even analysis Using the IRR to give a feel for the margin of safety ref the cost of capital Sensitivity analysis Scenario analysis

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38 Capital Investment Decision Sensitivity Analysis Table 7.9 Best- and Worst-Case Parameter Assumptions for HomeNet

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39 Capital Investment Decision Figure 7.1 HomeNets NPV Under Best- and Worst-Case Parameter Assumptions Green bars show the change in NPV under the best-case assumption for each parameter; red bars show the change under the worst-case assumption. Also shown are the break- even levels for each parameter. Under the initial assumptions, HomeNets NPV is $5.0 million.

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40 Capital Investment Decision Scenario Analysis Table 7.10 Scenario Analysis of Alternative Pricing Strategies

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41 Figure 7.2 Price and Volume Combinations for HomeNet with Equivalent NPV Capital Investment Decision The graph shows alternative price per unit and annual volume combinations that lead to an NPV of $5.0 million. Pricing strategies with combinations above this line will lead to a higher NPV and are superior.

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42 Capital Investment Decision Summary Investments should add to shareholder wealth NPV is the correct method Incremental free cash flows Forecasting cash flows

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43ACFL143 Advanced Corporate Finance Before moving on to other aspects of using the NPV approach we should consider EVA or Economic Value Added. The cash flows of a project less a capital charge that reflects the opportunity cost of the capital invested as well as any capital consumed How does it differ from NPV?

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44ACFL144 Advanced Corporate Finance Basically NPV gives the return of a project over a period of time while EVA focuses more on the individual time segments within the overall period but will give the same result

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45 Capital Investment Decision ProjectNPVMats PI (NPV per T) Tonnes Used Cumulative tonnes used C45.375120 E35.35100220 B20.28670290 A50.277180470 D15.20075-

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