Principles of Corporate Finance

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1 Principles of Corporate Finance Professor James J. Barkocy Business, that s easily defined it s other people s money. Peter Drucker McGraw-Hill/Irwin Copyright 2015 by The McGraw-Hill Companies, Inc. All rights reserved.

2 Capital Budgeting Process Capital Budget - The list of planned investment projects. The Decision Process 1 - Develop and rank all investment projects 2 - Authorize projects based on: Outlays required by law or company policy Maintenance or cost reduction Capacity expansion in existing business Investment for new products NPV 2

3 Capital Budgeting Process Capital Budgeting Problems Inconsistent forecasts Conflict of interest Forecast bias Selection criteria (NPV and others) 3

4 How To Handle Uncertainty Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project analysis given a particular combination of assumptions. Simulation Analysis - Estimation of the probabilities of different possible outcomes. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even. 4

5 Example Sensitivity Analysis Given the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital. Assume that all variables remain constant, except the one you are changing. Note: Cash Flows the Same Each Year and No Change in Working Capital or Salvage 5

6 Example continued (,000s) Sensitivity Analysis Year 0 Years1-12 Investment -5,400 Sales 16,000 Variable Costs 13,000 Fixed Costs 2,000 Depreciation 450 Pretax profit 40% 220 Profit after tax 330 Depreciation 450 Net Cash Flow -5, NPV@ 8%= $478 CF0= CF1= 780 CF2= CF12= 780 i= 8 6

7 Sensitivity Analysis Possible Outcomes Range Variable Pessimistic Expected Optimistic Investment(000s) 6,200 5,400 5,000 Sales(000s) 14,000 16,000 18,000 Var Cost (% of sales) 83% 81.25% 80% Fixed Costs(000s) 2,100 2,000 1,900 7

8 Sensitivity Analysis NPV Calculations for Optimistic Investment Scenario Year 0 Years 1-12 Investment - 5,000 Sales Variable Costs Fixed Costs Depreciation Pretax profit. Profit after taxes Depreciation Net Cash Flow - 5,000 16,000 13,000 2, NPV= $780 Depreciation is less Pretax profits higher Taxes higher AT profit higher CF0= CF1to CF12= 767 i=8 8

9 Sensitivity Analysis NPV Calculations for Pessimistic Investment Scenario Investment - 5,400 Sales Variable 83% Fixed Costs Depreciation Pretax profit. Profit after taxes Depreciation Net Cash Flow - 5,400 Year 0 Years ,000 13,280 2, NPV= -$788 Var. Cost higher Pretax profits lower Taxes lower AT profit lower CF0= CF1to CF12= 612 i=8 9

10 NPV Possibilities Sensitivity Analysis NPV (000s) Variable Pessimistic Expected Optimistic Investment(000s) Sales(000s) -1, ,174 Var Cost (% of sales) ,382 Fixed Costs(000s)

11 Scenario Analysis Cash Flows (years 1-12) 1.Sales 2. Variable costs 3.Fixed costs 4. Depreciation 5. Pretax profit ( ) 6.Taxes 7. Profit after tax 8.Cash flow from operations(4 7) 9. Present value of 10. NPV cash flows Base Case. 16,000,000 13,000,000 2,000, , , , , ,000 5,878, ,000 Competing Store Scenario. 13,600,000 11,152,000 2,000, ,000-2, , ,000 3,382,000-2,018,000 Assumptions: Sales Down 15% Variable Costs up to 82% of sales from 81.25% CF0= CF1to CF12 = 448 i=8 11

12 Revenue/Cost ($ millions) Accounting Break Even Revenue exceeds costs Total Revenue Breakeven Point Total Costs Variable Costs Costs exceed revenue C Prentice Hall, 1999 Loss Area Profit Area Sales revenue ($ millions) Fixed Cost s 12

13 Accounting Break Even Break even Sales Fixed Costs Depreciation Add. PROFIT per $ of Sales Break even Sales Fixed Costs Depreciation 1 ( VariableCosts / Sales) 13

14 Economic (NPV) Break Even Analysis Investment 1. Sales Year 0 Years 1-12 $5.4 mil 2. Var.Cost 81.25% of sales 3. Fixed Costs $2 mil 4. Depreciation $0.45mil 5. Pretax Profit (.1875 x sales - $2.45 mil) 6. Taxes (40%).40 x (.1875 x sales - $2.45 mil) 7. Profit After Taxes.60 x (.1875 x sales - $2.45 mil) 8. Cash Flow (3 + 6) x (.1875 x sales - $2.45 mil) =.1125 sales mil 14

15 Economic (NPV) Break Even Analysis For NPV Breakeven: PV (Cash Flows) = Investment Annuity Factor* x Cash Flows = Investment (.1125sales -1.02) = sales = sales = $15.4 mil The break even point, sales generate a NPV=$0. *The present value annuity factor of a 12 year cash flow at 8% is (n=12, i=8, FV=0, PMT = -1, PV=?? 7.536) 15

16 Operating Leverage High Fixed Costs VC = 81.25% High Variable Costs VC = 84% Slump Normal Boom Slump Normal Boom Sales -Variable costs - Fixed costs - Depreciation 13,000 10,563 2, ,000 13,000 2, ,000 15,438 2, ,000 10,920 1, ,000 13,440 1, ,000 15,960 1, = Profit* , ,030 + Depreciation = Cash Flow 437 1,000 1, ,000 1,480 *Assumes no taxes 16

3 8.01 Failure p=.3.24-33.2-7.97 ($500) Don t expand p=.

17 Decision Trees Expand (Invest $10,000) p=.8 Success p=.7 15,000 15,000 Joint NPV Prob x NPV Failure p= ($500) Don t expand p=.2 PV=0 (10,000) (20,000) Expected NPV =

18 Flexibility & Real Options Decision Trees - Diagram of sequential decisions and possible outcomes. Decision trees help companies determine their Options by showing the various choices and outcomes. The Option to avoid a loss or produce extra profit has value. The ability to create an Option thus has value that can be bought or sold. 18

19 Real Options Option to expand Option to abandon Timing option Flexible production facilities 19

Decision Trees Expand (Invest $10,000) p=.8 Success p=.7 15,000 15,000 Joint NPV Prob x Prob. @9.5% NPV.56 14.3 8.01 ($500) Failure p=.3 (10,000) (20,000).

20 Decision Trees Expand (Invest $10,000) p=.8 Success p=.7 15,000 15,000 Joint NPV Prob x NPV ($500) Failure p=.3 (10,000) (20,000) Don t expand p=.2 PV= Expected NPV = -.06 If you abandon after then loss on branch becomes 4.31 and Expected NPV =

Corporate Financial Management

Corporate Financial Management Professor James J. Barkocy There are three kinds of people: the ones that can count and the ones that can t. McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies,