Fin351: lecture 5 Other Investment Criteria and Free Cash Flows in Finance Capital Budgeting Decisions

Today’s agenda Net Present Value (revisit) Other two investment rules Free cash flows calculation A specific example

Net Present Value rule (NPV) NPV is the present value of a project minus its cost If NPV is greater than zero, the firm should go ahead to invest; otherwise forget about this project A hidden assumption: there is no budget constraint or money constraint.

NPV (continue) In other words: Managers can increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value if there is no budget constraint.

Net Present Value NPV = PV - required investment

Net Present Value Example You have the opportunity to purchase an office building. You have a tenant lined up that will generate $16,000 per year in cash flows for three years. At the end of three years you anticipate selling the building for $450,000. How much would you be willing to pay for the building?

Net Present Value $16,000 $450,000 $466,000 Example - continued

Net Present Value $16,000 $450,000 $466,000 Present Value 14, ,395 $409,323 Example - continued

Net Present Value Example - continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?

Net Present Value Example - continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?

Another example about NPV An oil well, if explored, can now produce 100,000 barrels per year. The well will produce forever, but production will decline by 4% per year. Oil prices, however, will increase by 2% per year. The discount rate is 8%. Suppose that the price of oil now is $14 for barrel. If the cost of oil exploration is $12.8 million, do you want to take this project?

Solution Visualize the cash flow patterns C0=1.4, C1=1.37, C2=1.34, C3=1.31 What is the pattern of the cash flow? g=C1/C0 -1 = =-2.1% PV( the project) =C0+C1/(r-g)=15 NPV=PV( the project ) -12.8>0 What’s your decision?

Two other investment rules IRR rule Payback period rule

IRR rule Internal Rate of Return (IRR) – Single discount rate at which NPV = 0. IRR rule - Invest in any project offering a IRR that is higher than the opportunity cost of capital or the discount rate.

IRR rule Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment?

Internal Rate of Return Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment?

Internal Rate of Return Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment? IRR = 12.96%

Internal Rate of Return IRR=12.96%

What’s wrong with IRR? Pitfall 1 - Mutually Exclusive Projects IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem. Example You have two proposals to choose between. The initial proposal (H) has a cash flow that is different from the revised proposal (I). Using IRR, which do you prefer?

Internal Rate of Return (1) Example You have two proposals to choose between. The initial proposal (H) has a cash flow that is different from the revised proposal (I). Using IRR, which do you prefer?

Internal Rate of Return

What’s wrong with IRR (2)? Pitfall 2 - Lending or Borrowing? Example projectC0C1IRR (%)NPV at 10% J K $ $36.4

What’s wrong with IRR (3)? Pitfall 3 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=0 at both (- 50%) and 15.2%. Example A project costs $1000 and produces a cash flow of $800 in year 1, a cash flow of $150 every year from year 2 to year 5, and a cash flow of -150 in year 6.

Payback period rule Payback period is the number of periods such that cash flows recover the initial investment of the project. The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period. The following example will demonstrate the absurdity of this rule.

Payback period rule The following example shows that all the three projects have a payback period of 2. If the payback period used by the firm is 2, the firm can take project C and lose money. Cash Flows Prj. C 0 C 1 C 2 C 3 Payback A ,429 B C

Some points to remember in calculating free cash flows Depreciation and accounting profit Incremental cash flows Change in working capital requirements Sunk costs Opportunity costs Forget about financing

Cash flows, accounting profit and depreciation Discount actual cash flows Using accounting income, rather than cash flows, could lead to wrong investment decisions Don’t treat depreciation as real cash flows

Example A project costs $2,000 and is expected to last 2 years, producing cash income of $1,500 and $500 respectively. The cost of the project can be depreciated at $1,000 per year. Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income.

Solution (using accounting profit)

Solution (using cash flows)

Forget about financing When valuing a project, ignore how the project is financed. You can assume that the firm is financed by issuing only stocks; or the firm has no debt but just equity

Incremental cash flows Incremental cash flows are the increased cash flows due to investment Do not get confused about the average cost or total cost? Do you have examples about incremental costs? Incremental Cash Flow cash flow with project cash flow without project = -

Working capital Working capital is the difference between a firm’s short-term assets and liabilities. The principal short-term assets are cash, accounts receivable, and inventories of raw materials and finished goods. The principal short-term liabilities are accounts payable. The change in working capital represents real cash flows and must be considered in the cash flow calculation

Example We know that inventory is working capital. Suppose that inventory at year 1 is $10 m, and inventory at year 2 is $15. What is the change in working capital? Why does this change represent real cash flows?

Sunk costs The sunk cost is past cost and has nothing to do with your investment decision Is your education cost so far at SFSU is sunk cost?

Opportunity cost The cost of a resource may be relevant to the investment decision even when no cash changes hands. Give me an example about the opportunity cost of studying at SFSU?

Be consistent in how you handle inflation!! Use nominal interest rates to discount nominal cash flows. Use real interest rates to discount real cash flows. You will get the same results, whether you use nominal or real figures Inflation rule

Example You own a lease that will cost you $8,000 next year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?

Inflation Example - nominal figures

Inflation Example - real figures

How to calculate free cash flows? Free cash flows = cash flows from operations + cash flows from the change in working capital + cash flows from capital investment and disposal We can have three methods to calculate cash flows from operations, but they are the exactly same, although they have different forms.

How to calculate cash flows from operations? Method 1 Cash flows from operations =revenue –cost (cash expenses) – tax payment Method 2 Cash flows from operations = accounting profit + depreciation Method 3 Cash flows from operations =(revenue – cost)*(1-tax rate) + depreciation *tax rate

Example revenue 1,000 - Cost Depreciation Profit before tax Tax at 35% 70 - Net income 130 Given information above, please use three methods to calculate Cash flows

Solution: Method 1 Cash flows= =330 Method 2 Cash flows = =330 Method 3 Cash flows =( )*(1-0.35)+200*0.35 =330

A summary example ( Blooper) Now we can apply what we have learned about how to calculate cash flows to the Blooper example, whose information is given in the following slide.

Blooper Industries (,000s)

Cash flows from operations for the first year or $3,950,000

Blooper Industries Net Cash Flow (entire project) (,000s) 12% = $3,564,000