Week 1 FINC $260,000 $106,680 $118,200 $89,400 $116,720. Capital Budgeting Analysis

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Dwight Lyons
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1 Dr. Ahmed FINC 5880 Week 1 Name Capital Budgeting Analysis Facts: Calculations Cost $200,000 Shipping $10,000 Installation $30,000 Depreciable cost $24,000 Inventories will rise by $25,000 Payables will rise by $5,000 Change in NWC Economic life 4 years Salvage value $25,000 Depreciation Method MACRS 3-year class 0.33 $79, $108, $36, $16,800 Incremental gross sales $250,000 Incremental cash operating costs $125,000 Tax rate 40% Overall cost of capital 10% Time Line: -$260,000 $106,680 $118,200 $89,400 $116,

2 Three Cash Flows: 1. Initial Cash Flows Equipment ($200,000) Freight & Installation (40,000) Change in NWC (20,000) Net Cash Flows t=0 ($260,000) 2. Net Operating Cash Flows Year -1 Year - 2 Year - 3 Year - 4 Incremental gross sales $250,000 $250,000 $250,000 $250,000 Incremental operating costs ($125,000) ($125,00) ($125,000) ($125,000) Net Revenue $125,000 $125,00 $125,000 $125,000 Depreciation $79,200 $108,000 $36,000 16,800 EBT (Earnings Before Taxes) 45,800 17,000 89, ,200 Taxes (40%) 18,320 6,800 35,600 43,280 Net income (EAT) 27,480 10,200 53,400 64,920 Add: Depreciation 79, ,000 36,000 16,800 Net Operating Cash Flows $106,680 $118,200 $89,400 ** $116, Terminal Year Cash Flows Salvage value * $25,000 Tax on salvage value (10,000) Recovery on NWC 20,000 Net terminal CF** $35,000 *

3 Project Profitability Analysis: Payback Period (PBP) Year Beginning balance Annual cash inflows Balance 0 ($260,000) 0 ($260,000) 1 ($260,000) $106,680 ($153,320) 2 ($153,320) $118,200 ($35,120) 3 ($35,120) $89,400 4 Payback Period = 2 + ( 35,000 / $89,000 ) = 2.39 years Net Present Value Data Entry Key Texas Instrument (TI) Hewlett Packard (HP).. CF Enter Key C Enter Key C Enter Key C Enter Key C Enter Key NPV I Enter Key NPV CPT I/Y IRR CPT Orange Key NPV Orange Key IRR Net Present Value = $81,556 Internal Rate of Return = 23.82%

4 Modified Internal Rate of Return I=10% -$260,000 $106,680 $118,200 $89,400 $116, $116,720 $ 98,340 $143,022 $141,991 Total FV =$500,073 MIRR PV i =? FV -$260,000 $500,

5 N= 4, PV = -260,000, PMT= 0, FV= $500,073, I=? % Optimal Capital Budget Capital Rationing Real Option Analysis Risk in Capital Budgeting Standalone Risk Corporate Risk Market Risk Stand-Alone Risk Corporate Risk Market Risk The project s risk if it were the firm s only asset and there were no shareholders Ignores both firm and shareholder diversification. Measured by the s or CV of NPV, IRR, or MIRR Reflects the project s effect on corporate earnings stability Considers firm s other assets (diversification within firm) Depends on project s s, and its correlation, r, with returns on firm s other assets Measured by the project s corporate beta. Reflects the project s effect on a well-diversified stock portfolio Takes account of stockholders other assets Depends on project s s and correlation with the stock market Measured by the project s market beta

6 Other Issue in Capital Budgeting What is a real option? Real options exist when managers can influence the size and risk of a project s cash flows by taking different actions during the project s life in response to changing market conditions. Alert managers always look for real options in projects. Smarter managers try to create real options What is the single most important characteristic of an option? It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell an asset. How are real options different from financial options? Financial options have an underlying asset that is traded--usually a security like a stock. A real option has an underlying asset that is not a security--for example a project or a growth opportunity, and it isn t traded. How are real options different from financial options? The payoffs for financial options are specified in the contract. Real options are found or created inside of projects. Their payoffs can be varied. What are some types of real options? Investment timing options Growth options Expansion of existing product line New products New geographic markets

7 Abandonment options Contraction Temporary suspension Flexibility options Five Procedures for Valuing Real Options 1.DCF analysis of expected cash flows, ignoring the option. 2.Qualitative assessment of the real option s value. 3.Decision tree analysis. 4.Standard model for a corresponding financial option. 5.Financial engineering techniques. Nebraska Pharmaceuticals Company (NPC) is considering a project that has an up-front cost at t = 0 of $1,500. (All dollars in this problem are in thousands.) The project s subsequent cash flows are critically dependent on whether a competitor s product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC s product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC s expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor s product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure one year from today whether the competitor s product has been approved. NPC is considering whether to make the investment today or to wait a year to find out about the FDA s decision. If it waits a year, the project s up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor s product is rejected and $25 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = ). Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before proceeding, how much will this increase or decrease the project s expected NPV in today s dollars (i.e., at t = 0), relative to the NPV if it proceeds today?

8 Cost of capital: 10% Invest immediately: Product: NPV* NPV Prob 75% Good $500 $500 $500 $500 $500 $500 $500 $ $ $1,500 25% Bad $25 $25 $25 $25 $25 $25 $25 -$1, $ Expected NPV if Go Now: $ Delay, then invest in period 1 if the outlook is good: Product: NPV* NPV Prob 75% Good $500 $500 $500 $500 $500 $500 $ $ $1,500 25% Bad $0 $0 $0 $0 $0 $0 $0.00 $ 0.00 Expected NPV if Wait: $ Increase in expected NPV from waiting: NPV Wait NPV Go Now = $ *The NPV under the delay option occurs one year later, so it must be discounted back to t = 0 at the cost of capital to make the NPVs comparable. The figure shown in the delay tree is after discounting. The CV = SD / Expected NPV. Invest immediately: Squared dev. Prob. NPV NPVi E(NPV) Squared deviation times probability 0.75 $ $578 $334,228 $250, $1, $1,734 $3,008,054 $752, $ Variance $1,002,685 Standard deviation $1, CV 2.81 Delay, then invest in period 1 if the outlook is good: Squared dev. Prob. NPV NPVi E(NPV) Squared deviation times probability 0.75 $ $154 $23,718 $17, $0.00 -$462 $213,463 $53, $ Variance $71,154 Standard deviation $ CV 0.58 Reduction in the CV due to waiting 2.23

CHAPTER 11. Topics. Cash Flow Estimation and Risk Analysis. Estimating cash flows: Relevant cash flows Working capital treatment

CHAPTER 11. Topics. Cash Flow Estimation and Risk Analysis. Estimating cash flows: Relevant cash flows Working capital treatment CHAPTER 11 Cash Flow Estimation and Risk Analysis 1 Topics Estimating cash flows: Relevant cash flows Working capital treatment Risk analysis: Sensitivity analysis Scenario analysis Simulation analysis