Corporate Finance MLI28C060 Lecture 7 Tuesday 20 October 2015

Capital budgeting: Introduction to project evaluation techniques Structure: - Introduction of various forms of foreign direct investment (FDI) - Introduction of net present value (NPV) techniques - Introduction of internal rate of return (IRR) techniques - Introduction of accounting payback techniques - Critical appraisal of all three techniques Reading: Stonehill & Eiteman: Chapters 18 and 19 Brealey & Myers: Chapter 5

- Introduction of various forms of foreign direct investment (FDI)

Market Imperfections: A Rationale for the MNE Firms become multinational for one or several of the following reasons: – Market seekers – produce in foreign markets either to satisfy local demand or export to markets other than their own – Raw material seekers – search for cheaper or more raw materials outside their own market – Production efficiency seekers – produce in countries where one or more of the factors of production are cheaper – Knowledge seekers – gain access to new technologies or managerial expertise – Political safety seekers – establish operations in countries considered unlikely to expropriate or interfere with private enterprise

Exhibit 1 Trident Corp: Initiation of the Globalization Process

The Globalization Process The globalization process is the structural and managerial changes and challenges experienced by a firm as it moves from domestic to global in operations We will examine the case of Trident, a young firm that manufactures and distributes an array of telecommunication devices – Trident’s initial strategy is to develop a sustainable competitive advantage in the U.S. market – Trident is currently constrained by its small size, other competitors, and lack of access to cheap capital

Exhibit 2 Trident’s Foreign Direct Investment Sequence

Capital budgeting…..

Recall the Flows of funds and decisions important to the financial manager Financial Manager Financial Markets Real Assets Financing Decision Investment Decision Returns from InvestmentReturns to Security Holders ReinvestmentRefinancing Capital Budgeting is used to make the Investment Decision

Capital Budgeting Capital Budgeting is making a long-run planning decisions for investing in projects Capital Budgeting is a decision-making and control tool that spans multiple years

Six Stages in Capital Budgeting 1.Identification Stage – determine which types of capital investments are necessary to accomplish organizational objectives and strategies 2.Search Stage – Explore alternative capital investments that will achieve organization objectives

Six Stages in Capital Budgeting: Continued 3.Information-Acquisition Stage – consider the expected costs and benefits of alternative capital investments 4.Selection Stage – choose projects for implementation 5.Financing Stage – obtain project financing 6.Implementation and Control Stage – get projects under way and monitor their performance

Introduction of net present value (NPV) techniques

Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. CF 1 CF 2 CF n (1+k) 1 (1+k) 2 (1+k) n ICO - ICO NPV =

9-15 Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. Net Present Value (NPV)

Brighton Ventures has determined that the appropriate discount rate (k) for this project is 13%. $10,000 $7,000 NPV Solution $10,000 $12,000 $15,000 (1.13) 1 (1.13) 2 (1.13) $40,000 - $40,000 (1.13) 4 (1.13) 5 NPV NPV = +

NPV Solution NPV NPV = $10,000(PVIF 13%,1 ) + $12,000(PVIF 13%,2 ) + $15,000(PVIF 13%,3 ) + $10,000(PVIF 13%,4 ) + $40,000 $ 7,000(PVIF 13%,5 ) - $40,000 NPV NPV = $10,000(.885) + $12,000(.783) + $15,000(.693) + $10,000(.613) + $40,000 $ 7,000(.543) - $40,000 NPV $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000 NPV$1,428 NPV =- $1,428

NPV Acceptance Criterion Reject NPV0 No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ] The management of Brighton Ventures has determined that the required rate is 13% for projects of this type. Should this project be accepted?

Copyright © 2009 Pearson Prentice Hall. All rights reserved Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent Net Present Value (NPV) Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.

NPV Strengths and Weaknesses Strengths: – Cash flows assumed to be reinvested at the hurdle rate. – Accounts for TVM. – Considers all cash flows. Strengths: – Cash flows assumed to be reinvested at the hurdle rate. – Accounts for TVM. – Considers all cash flows. Weaknesses: – May not include managerial options embedded in the project.

Comparing Methods

Introduction of internal rate of return (IRR) techniques

Recap: Proposed Project Data Alexia Simmonds is evaluating a new project for her firm, Brighton Ventures (BV). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.

9-24 Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return.

Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. CF 1 CF 2 CF n (1+IRR) 1 (1+IRR) 2 (1+IRR) n ICO =

$15,000 $10,000 $7,000 IRR Solution $10,000 $12,000 (1+IRR) 1 (1+IRR) 2 Find the interest rate (IRR) that causes the discounted cash flows to equal $40, $40,000 = (1+IRR) 3 (1+IRR) 4 (1+IRR) 5

IRR Solution (Try 10%) $40,000 $40,000 = $10,000(PVIF 10%,1 ) + $12,000(PVIF 10%,2 ) + $15,000(PVIF 10%,3 ) + $10,000(PVIF 10%,4 ) + $ 7,000(PVIF 10%,5 ) $40,000 $40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) + $ 7,000(.621) $40,000 $41,444[Rate is too low!!] $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 =$41,444[Rate is too low!!]

IRR Solution (Try 15%) $40,000 $40,000 = $10,000(PVIF 15%,1 ) + $12,000(PVIF 15%,2 ) + $15,000(PVIF 15%,3 ) + $10,000(PVIF 15%,4 ) + $ 7,000(PVIF 15%,5 ) $40,000 $40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) + $10,000(.572) + $ 7,000(.497) $40,000 $36,841[Rate is too high!!] $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 =$36,841[Rate is too high!!]

.10$41,444.05IRR$40,000 $4,603.15$36,841 X$1,444.05$4,603 IRR Solution (Interpolate) $1,444 X =

.10$41,444.05IRR$40,000 $4,603.15$36,841 ($1,444)(0.05) $4,603 IRR Solution (Interpolate) $1,444 X X =X =.0157 IRR = =.1157 or 11.57%

IRR Acceptance Criterion No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR < Hurdle Rate ] The management of Brighton Ventures has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted?

Copyright © 2009 Pearson Prentice Hall. All rights reserved Decision Criteria If IRR > k, accept the project If IRR < k, reject the project If IRR = k, technically indifferent Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return.

NPV Profile and the Solution for IRR -$100,000 -$50,000 $0 $50,000 $100,000 $150,000 $200,000 $250,000 $300,000 10%20%30%40%50%60%70%80%90%100% Discount Rate NPV

Multiple IRR Problem Two!! Two!! There are as many potential IRRs as there are sign changes. Let us assume the following cash flow pattern for a project for Years 0 to 4: -$100 +$100 +$900 -$1,000 How many potential IRRs could this project have?

NPV Profile -- Multiple IRRs Discount Rate (%) Net Present Value ($000s) Multiple IRRs at k 12.95%191.15% k = 12.95% and %

IRR Strengths and Weaknesses Strengths: Strengths: – Accounts for Time Value of Money – Considers all cash flows – Less subjectivity Strengths: Strengths: – Accounts for Time Value of Money – Considers all cash flows – Less subjectivity Weaknesses: – Assumes all cash flows reinvested at the IRR – Difficulties with project rankings and Multiple IRRs

Introduction of accounting payback techniques

Proposed Project Data Alexia Simmonds is evaluating a new project for her firm, Brighton Ventures (BV). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.

Independent Project Independent Independent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. u For this project, assume that it is independent of any other potential projects that Brighton Ventures may undertake.

Payback Period (PBP) PBP PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow K 10 K 12 K 15 K 10 K 7 K

(c) 10 K 22 K 37 K 47 K 54 K Payback Solution (#1) PBP 3.3 Years PBP = a + ( b - c ) / d = 3 + ( ) / 10 = 3 + (3) / 10 = 3.3 Years K 10 K 12 K 15 K 10 K 7 K Cumulative Inflows (a) (-b) (d)

Payback Solution (#2) PBP 3.3 Years PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. PBP 3.3 Years PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. Cumulative Cash Flows -40 K 10 K 12 K 15 K 10 K 7 K K -30 K -18 K -3 K 7 K 14 K

PBP Acceptance Criterion Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.] The management of Brighton Ventures has set a maximum PBP of 3.5 years for projects of this type. Should this project be accepted?

44 Cash Flows 1.Income Generated by the project 2.Depreciation “Expense” 3.Savings due to Increased Productivity

45 Net Cash Flows for Project S and Project L 1,500 1, ,300 1,500 ^ Net CashFlows, CF t r edpAExctefte-Tax Year(T)ProjectSPro tL 0 a $(3,000)$(3,000) Second Example of Payback Period Method

46 What is the Payback Period? The length of time before the original cost of an investment is recovered from the expected cash flows or... How long it takes to get our money back.

47 Payback Period for Project S = Payback S /800 = years Net Cash Flow Cumulative Net CF 1,500 -1, , , PB S 01234

48 = Payback L /1,500 = 3.3 years Net Cash Flow Cumulative Net CF ,600 1, , ,000 1,500 1,100 PB L Payback Period for Project L

PBP Strengths and Weaknesses Strengths: – Easy to use and understand – Can be used as a measure of liquidity – Easier to forecast ST than LT flows Strengths: – Easy to use and understand – Can be used as a measure of liquidity – Easier to forecast ST than LT flows Weaknesses: – Does not account for TVM – Does not consider cash flows beyond the PBP – Cutoff period is subjective