Lecture Week 2 Corporate Finance Fundamentals PDF

BSP050 Corporate Finance Fundamentals Week 2 Net Present Value and Other Investment Rules Dr Kai Hong Tee School of Business and Economics...

BSP050 Corporate Finance Fundamentals Week 2 Net Present Value and Other Investment Rules Dr Kai Hong Tee School of Business and Economics 1  Amended Office Hour Tuesday: 11 am to 1 pm Email: [email protected] and arrange a time if you want to come and see me Alternatively, if you cannot come at the hour, email to fix another time  Last week lecture Introduction to Corporate Finance functions: Investment, financing and short-term financing decisions Accounting profit and cash flows opportunity costs and cash flows Value of cash flows: Present and future values 3  Overview of today Lecture Why Use NPV? The Internal Rate of Return The Payback Period Method Problems with the IRR Approach The Discounted Payback Period The Profitability Index The Average Accounting Method 4 Example 6.1: Net Present Value Alpha Corporation is considering investing in a riskless project costing £100. The project receives £107 in one year and has no other cash flows. The discount rate is 6 percent. What is the NPV of the project? £107 £.94  £100  (6.1) 1.06 5  interpretation The accounting profit: £107-£100 = £7 The profit consider opportunity cost = £0.97 (also implies positive NPV) 6 Present Value and the NPV Decision Rule The net present value (NPV) of a project or investment is the difference between the present value of its benefits and the present value of its costs. – Net Present Value NPV  PV (Benefits)  PV (Costs) 7  NPV Investment Rule Acce NPV is pt Greater than Zero Rejec NPV is Less t than Zero 8  Strengths of NPV Uses Cash Uses all Discounts Flows Cash Flows Cash Flows Cash Other Fully Flows are approache incorporat better s ignore es the than cash flows Time Earnings beyond a Value of certain Money date 9  Alternative Decision Rule Payback period (PP) PP = time until cash flows recover the initial Investment of the project. Accept all and only those projects that have a payback period less than or equal to a “cut-off” time (an acceptable payback value) Payback Period is less Accept than benchmark Payback Period is Reject greater than benchmark 10  Payback Period Example What is the payback period of the following cash flow stream? 11  Payback – Another Example (2) Initial cash outlay is -£5000 Accumulated cash flow from year 1 to 3 is 5550; Accumulated cash flow from year 1 to 2 is 2550 Amount needed in year 2 to complete payment is 5000 – 2550 = 2450 The payback period is between year 2 and year 3: £3000 = 1 year (from year 2 to year 3, i.e., taking 5550 - 2550) £2450 = 2450/3000 = 0.82 Therefore, both projects need 2.82 years to payback. Both are less than12 the cut off 3 years, so both should be accepted. However, project B will Problems with the Payback Period Year A B C 0 £100 £100 £100 1 20 50 50 2 30 30 30 3 50 20 20 4 60 60 60,000 Payback period 3 3 3 (years) 13 Problems with the Payback Period Weaknesses Payments Arbitrary after the Standard Timing of Payback for the Cash Flows Period not Payback accounted Period for 14 Advantages of Payback Period Strengths Exception Very small Firms with ally scale severe Simple to investmen capital Understan ts rationing d 15 Discounted Payback Period Acce Discounted Payback Period pt is Less than Benchmark Rejec Discounted Payback Period t is Greater than Benchmark 16  Discounted payback – Example (1) Payback period = 4 years Discounted (based on 10% interest rate) payback = ? years 17  Discounted payback – Example (2) Initial cash outlay is -£10 Accumulated discounted cash flow from year 1 to 6 is 10.9; Accumulated discounted cash flow from year 1 to 5 is 9.77 Discounted cash-flow needed in year 5 to match initial outlay of £10 is 10 – 9.77 = 0.23 The discounted payback period is between year 5 and year 6: £1.13 = 1 year (from year 5 to year 6, i.e., taking 10.9 – 9.77) £0.23 = 0.23/1.13 = 0.20 Therefore, discounted payback = 5.20 years 18  Alternative Decision Rule Accounting Rate of Return (ARR) ARR= (average) accounting profit Investment Conventional accounting models of calculating income and required investment The effect of an investment on project’s financial statement All profits – arsing during the life of an investment project The rule accepts project with an ARR greater than a cut-off rate 19 The Average Accounting Return method Acce Average Accounting Return pt is Greater than Target Return Rejec Average Accounting Return t is Less than Target Return 20  Accounting Rate of Return (ARR) Example: A company’s expected ARR is 10%. It now considers to buy a machine costs $12,000. This machine increases cash inflows by £4,000 annually for four years. The machine has zero salvage value after that. Depreciation = $12,000 ÷ 4 = $3,000 per year. Incremental income from the machine = $4,000 – $3,000 = $1,000 per year. (assume no other expenses) Therefore, the average income over the life of the asset is also $1,000 annually. 21 Accounting Rate of Return 22 Example 6.2: Average Accounting Return Averag e Target Accou Accou nting nting Return Return is is 10% 16.7% Accept 23 Accounting rate of return (ARR) as investment rule Invest £30,000 in machinery: life of three years – Timewarp plc 24 Strengths and Weaknesses of the Average Accounting Return Strengths Weaknesses Simple return Does not use based measure cash flows Does not use time value of money Arbitrary target rate 25 Internal Rate of Return (IRR) investment rule (1) 26 Internal Rate of Return (IRR) investment rule (2) The basic rationale behind the IRR method is that it provides a single number summarizing the merits of a project. That number does not depend on the interest rate prevailing in the capital market. That is why it is called the internal rate of return. The number is internal or intrinsic to the project and does not depend on anything except the cash flows of the project. 27  Net Present Value (NPV) as investment rule Alpha Corporation is considering investing in a riskless project costing £100. The project receives £107 in one year and has no other cash flows. The discount rate is 6 percent. What is the NPV of the project? £107 £.94  £100  (6.1) 1.06 28 Internal Rate of Return (IRR) investment rule (3) The implication of this is very simple. For Alpha corporation, the firm should be equally willing to accept or reject the project if the discount rate is 7 per cent (7% being the IRR) – The firm should accept the project if the discount rate is below 7 per cent. – The firm should reject the project if the discount rate is above 7 per cent. 29 Internal Rate of Return (IRR) investment rule (4) 30 Internal Rate of Return (IRR) investment rule (5) The figure plots the NPV as a function of the discount rate. The curve crosses the horizontal axis at the IRR of 7 per cent because this is where the NPV equals zero. It should also be clear that the NPV is positive for discount rates below the IRR and negative for discount rates above the IRR. This means that if we accept projects like this one when the discount rate is less than the IRR, we shall be accepting positive NPV projects. Thus the IRR rule coincides exactly with the NPV rule. 31  Internal Rate of returns (2) - CF Example 1 CF0 + =0 1+r 12 –11+ =0 1+r Let us try 5 per cent: 12 –11+ = £0.42857m or £428,571 1 + 0.05 Try 10 per cent: 12 –11+ = –0.0909 or –£90,909 1 + 0.1 Try 9 per cent: 12 –11+ = +0.009174 or +£9,174 1 + 0.09 32  Internal Rate of returns (3) - Example A®B = 9,174 – 0 = 0.0917 A®C 9,174 + 90,909 IRR: 9,174 = 9+ × (10 – 9) = 9.0917 per cent 100,083 33 Interpolating IRR – Practice exercise –4 –10 1 –11 + + + (1 + r) (1 + r)2 (1 + r)3 2 4 40 + + + =0 (1 + r)4 (1 + r)5 (1 + r)6 Try 14 per cent: NPV (approx.) = –£0.043 or –£43,000 At 13 per cent: NPV = £932,000 How to find the discount rate (between 13% and 14%) when NPV is zero 34 Interpolating IRR – Practice exercise Answer (1) 35  Problems with IRR associated with cash flows (1) But, it is NOT ALWAYS that projects are accepted on condition the discount rate is less than IRR. This depends on the nature (i.e., whether this is a cash inflow or outflow) of the pattern of the cash flows throughout the life span of the project. 36 Some Problems with IRR: Investment Project A Dates: 0 1 2 Cash flows £100 £130 IRR 30% NPV @10% £18.2 Accept if market 30% rate Financing or Investing investing 37 Some Problems with IRR: Investing type project (2) 38  Some Problems with IRR: Financing Project B Dates: 0 1 2 Cash flows £100 £130 IRR 30% NPV @10% £18.2 Accept if 30% market rate Financing or Financing investing 39 Some Problems with IRR: Financing (2) 40  Some Problems with IRR: Mixed Cash Flows Project C Dates: 0 1 2 Cash flows £100 £230 £132 IRR 10% and 20% NPV @10% 0 Accept if 10% but 20% market rate Financing or Mixture investing 41 General Investment Rules: IRR and NPV 1st Cash Flow Number of IRRs: 1 Negative; Accept if IRR > R; Reject if IRR < R Remaining Cash Accept if NPV > 0; Reject if NPV < 0 Flows Positive 1st Cash Flow Number of IRRs: 1 Positive; Accept if IRR < R; Reject if IRR > R Remaining Cash Accept if NPV > 0; Reject if NPV < 0 Flows Negative Mixture of Number of IRRs: Usually More than 1 Positive and No Valid IRR Negative Cash Accept if NPV > 0; Reject if NPV < 0 Flows 42  Some Important Definitions Mutually Exclusive Projects With mutually exclusive projects, you can accept A or you can accept B or you can reject both of them, but you cannot accept both of them, due to capital constraint, for example. 43 Problems of IRR associated with Mutually Exclusive Projects - The Scale problem 44 Problems of IRR associated with the type of project (3) Independent and Mutually Exclusive Projects - The Scale problem The problem with IRR is that it ignores issues of scale. Although small budget has a greater IRR, the investment is much smaller. This is one of the reasons NPV method is preferred over IRR method. We can somehow remedy this problem by using incremental IRR 45 Incremental analysis – NPV & IRR (1) 46 Incremental analysis – NPV & IRR (2) 47 Problems of IRR associated with the type of project (6) Independent & Mutually Exclusive Projects - incremental NPV and IRR Our calculations show the NPV on the incremental investment to be positive. We also show the incremental IRR of 66.67% is higher than the discount rate of 25% For both reasons, the incremental investment can be justified, so the large-budget movie should be made. 48  The Profitability Index Profitability index (PI)  PV of cash flows subsequent to initial investment Initial investment 49 PI for project 1 50 PI for project 2 51 Profitability Index: Mutually Exclusive Projects Use Incremental Cash Flows Acce Profitability pt Index is Greater than 1 Rejec Profitability t Index is Less than 1 52 Profitability Index: Mutually Exclusive Projects If both projects are found to have Profitability indexes of more than one, then must carry out incremental analysis. We should cover incremental analysis for profitability indexes in next week lecture. 53