Capital Budgeting and Risk: Chapter 10

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1 Lecture Notes: Part II Finance 302 Fall 2009 Capital Budgeting and Risk: Chapter 10 Topics: WACC Asset Betas When you can (can t) use the WACC as a discount rate. A firm s value can be stated as the sum of the value of the assets; PV of cash flows that accrue (sooner or later) to bondholders and stockholders. I.e.,: Firm value = PV of cash flows assets produce for security holders (debt, PS, CS) Example of projects of differing risk: Category Speculative Ventures New products Expansion of existing business Cost improvement, known technology Discount Rate 30% 20% 15% (Company COC) 10% What would happen if we used the WACC to evaluate ALL projects (both high and low risk)? Company Cost of Capital (COC) is based on the average beta of the assets. The average Beta of the assets is based on the % of funds in each asset Example 1/3 New Ventures $ =2.0 1/3 Expand existing business $ =1.3 1/3 Plant efficiency $ =0.6 AVG $ of assets = 1.3 1

2 A company s cost of capital can be compared to the CAPM required return Company Cost of Capital (using the SML) Required return SML Company Cost of Capital R 2 =.27 β = 1.61 Price data: Dec 97 - Apr Project Beta 2

3 Issue: How stable is beta? (What we really want is the beta in the future period for which we are trying to predict returns.) Can we estimate the future expected beta using past data? Evidence of Beta Stability: Chart in text: percentage of stocks in same risk category 5-years later. Notes: The Weighted Average Cost of Capital: WACC: for a firm with only bonds (D) & common stock (E): (1-T c )D/(D+E) r D + E/(D+E) r E r is the rate of return on new issues of debt (equity) Query: The WACC measures required rate for projects of: a) All risks b) Average risk c) Some risk (not riskless) Why does the WACC use the after-tax cost of debt? Notes: EXG: $1000, 10% bond. T c = 40% How much after-tax cash flows could have been used to pay bond s interest? EBT 100 (could be used to pay I of $100) Less Tax -40 = NI 60 (10% before tax payout equivalent to a 6% After-tax payout. ) COC = r portfolio = r assets r assets $ assets r equity 3

4 IMPORTANT: E, D, and V are all market values (not book values). debt $ < asset $ < equity $ Capital Structure & the Cost of Capital (COC) Expected Returns and Betas prior to refinancing 20 R equity =15 R assets =12.2 R debt =8 Expected return (%) β debt β assets β equity Concept: Balance sheets balance in: Book value (accounting) Market value (V = D + E) Risk (& $): Beta of assets is weighted average beta of debt & equity Expected rates of return Expected return on assets = weighted average of expected rate on debt + equity. Projects that are not of average risk: Easier to assess risk when it is measured RELATIVE to that of the firm s typical project Make an ad-hoc adjustment to your WACC, and use as a discount rate 4

5 Characteristics that affect market risk (beta) of a project: 1) Cyclicality of cash flows 2) Fixed operating costs Notes: Discussion: Are the following risks mostly diversifiable or undiversifiable risk? Risk that an oil well will come up dry Risk that a new drug to cure baldness will not be approved by the FDA Risk to Sheraton that their hotel in Lebanon will be bombed by terrorists Risk that people, worried about job security, delay purchase of a new car Risk that people, worried about the price of oil, delay the purchase of a new car. Risk that the Fed will raise interest rates, thereby reducing sales of fall clothing financed using variable rate credit cards. International Project Risk Issue: Which risks should be incorporated into the discount for international projects rate? Does it matter that US investors are not to optimally diversified internationally? Which is riskier for an investor in the US the S&P composite or the stock market in Egypt? Egyptian stocks have more total risk (Var), but a lower beta than US stocks, because they have a lower return correlation to US stocks International Risk: σ Ratio - Ratio of standard deviations, country index vs. S&P composite index Ratio of Standard Deviations Correlation Coefficient Beta Brazil Egypt India Indonesia Mexioco Poland Thailand South Africa

6 EXG: Carrefour, a French retailing giant is considering opening stores in the US. The beta for such a project is 1.1 for such stores in France. Similarly, for US firms, the beta for opening a new store in the US is also 1.1. The market risk premium for French stocks in 7%. Carrefour therefore determines that the correct discount rate for their new US store is: Euro i-rate + 1.1(7%) = 7.7% + Euro i-rate. Is this correct? Are there other considerations? 6

7 Chapter 6: Introduction to NPV analyses If we assume efficient markets, should positive NPV investments in real assets exist? Source of positive NPV: 1) Special skills of employees 2) Duopoly or monopoly investment powers 3) Technological innovation 4) New untapped markets 5) Brand loyalty 6) Cost Advantage Beware: Math error on part of analyst or persons providing cash flow estimates. Note: Sometimes NPV is NOT the best method to value an asset. I.e., when there is an active secondary market for the asset, it is often better to consider market prices to best represent asset value. i.e., Rental properties Commercial Aircraft Land for development Part I: Identifying Incremental Cash Flows Incremental Cash Flows Cash flows that occur as a result of accepting the project, and which would not occur were the project to be rejected (or discontinued). Where does the financial manager obtain the numbers to use in capital budgeting? Cash flow review Total Revenues -Total expenses - Depreciation =EBT - taxes =Net Income + Deprecation CASH FLOW 7

8 Why do we subtract depreciation, only to add it back in later on? What is the impact on a project s cash flows if $10,000 in depreciation were mistakenly excluded from the analysis? Assume T c = 30% Depreciation tax shield: The tax savings resulting from depreciation = T c x $deprec Side Effects: Impact of your project on firm s other cash flows May be positive or negative cannibalization Examples: 1) Impact on book sales of having a coffee shop in the store 2) Impact on tire sales for doing muffler work 3) Impact on Toyota Sienna (minivan) sales for producing Toyota Sequoia (large SUV Should side-effects be included in our analysis? Sunk Costs: Money which has already been spent; can t be recovered if the project is halted, rejected or discontinued at the time of the analysis. Should sunk-costs be included in our analysis? 8

9 Opportunity Costs: Cost of using an asset that your firm already owns measured by its value when put to its next best use. Examples: Use of warehouse your firm already owns Use of machine your firm already owns Use of some stored furniture that your firm already owns Should opportunity costs be included in our analysis? How do you value an opportunity cost? Use asset s highest value when put to an alternative use. Opportunity costs are cash outflows, i.e., they represent a cash flow that the firm will not receive when the asset is used in an alternative way. Other cash flows and special valuation techniques: 1) Change in NWC (Net Working Capital) )NWC = )current assets - )current liabilities Current Assets (CA): Cash, Accts Rec., Inventory Current Liabilities (CL): Accts Payable 1) Suppose the change in NWC is positive. Is this a net inflow or outflow? 2) In general, will the change in NWC be positive or negative at the start of the project? at the end of the project? 3) What if the asset is to be replaced with a like asset at the end of the project? Should we consider any change in NWC to occur at the end of the life of the project? 2) Treatment of Inflation: Should we consider the impact of inflation (or other expected changes in price) when estimating future cash flows? (Note: Some products may be expected to decline in price over the life of a project: I.e., high tech products like Plasma TVs. This will affect future revenue estimates.) Other than revenues, which cash flows would also likely be affected by changes associated with inflation? 9

10 3) Treatment of cash flows of varying risk: The objective of NPV analyses is to discount cash flows by a rate which reflects the riskiness of the cash flows. Are SOME cash flows in a project riskier (less certain) than others? What types of cash flows MIGHT be known with certainty? 4) Valuing projects with cash flows of unequal risk: Discount riskless cash flows by risk free rate, and risky cash flows by risky rate (or WACC if appropriate). Example: Initial outlay: $100,000, no salvage value Dep = $20,000 for 5 yrs, riskless cash flow Revenues (risky) $60,000 for 5 yrs Expenses (risky) $20,000 for 5 yrs Expenses (riskless contracted labor) $10,000 for 5 yrs Riskless rate = 5% Risky rate = 10% Tax rate = 30% PV Aftertax PV init outlay Revs PV of rev Exp (risky) PV of exp Exp (riskless) PV of exp Dep Tax shield PV of DTS NPV

11 Practice Problems 1: SPROCKETS Compute the NPV of the following project: A project to manufacture SPROCKETS is being considered. a) Initial outlay is $100,000 to be depreciated straight line down to $0 in 10 years. The machine will be sold in year 5 for 70,000 and the project will end at that time. b) Revenues are expected to be $50,000, and decrease at a rate of 5% per year. c) Actual expenses associated with the project are expected to be 20% of the expected revenues for each year. d) Working capital will increase by $5,000 at time 0, increase by another $2000 in year 1, and decrease by $7,000 at the end of 5 years. e) This project will decrease the sales revenue of the WIDGET division by $1000 (before tax) per year but will increase sales of the GADGET division by $2000 per year (before tax). All expenses associated with these divisions will remain unchanged. f) The Sprocket project will be funded using a 100,000 10% bond issue. g) The firm discounts risky cash flows by the risky rate, and riskless cash flows by the riskfree rate of 5%. The depreciation tax shield is the only riskless cash flow. h) The corporate tax rate is 30% i) If the project is accepted, the firm will hire consultants to decide how to market the SPROCKETS, at a cost of $4000 in year 1 (before tax) j) The firm s WACC is 12%. The above project is of average risk to the firm. 11

12 Practice problem 2: Compute the NPV of the following project to make widgets. The project will involve the following outlays: A) A $25,000 study conducted last month determined that the Widgets project will produce annual revenues of $600,000, and require annual expenses of $200,000 at the end of year 1. Revenues will increase at the rate of inflation of 5% per year, starting in year 2. Costs will increase at 8% per year, starting in year 2. The project will continue through year 5. B) Cost of the Widget machine: $1,000,000, to be incurred at the start of the project (time = 0) & depreciated as a 7-year class asset using MACRS. The Widget machine will be sold for $100,000 at the end of year 5. MACRS depreciation schedule: % 25% 17% 13% 9% 9% 9% 4% C) At the start of the project, cash will increase by $50,000, Accounts Receivable will increase by $40,000, and inventory will increase by $50,000. Accounts Payable will increase by $20,000. At the end of year 5, there is a 95% probability that the widget machine will be replaced by a new widget machine, which will require similar levels of cash, accounts receivable and inventory and have similar amounts of accounts payable as that associated with the old machine. However, if the widget project were not to be continued, the working capital would be recaptured at the end of year 5. D) The widget project will be housed in a warehouse that the company already owns, and has fully depreciated. If the warehouse were not used to house this project, it could be leased for (before tax) revenues of $50,000 per year, to be paid at the end of years 1-5. E) [Note: Cogs in this question refers to a piece of machinery, not cost of goods sold ] Since Widgets and Cogs are interchangeable parts, the widget project will decrease the sales revenues of Cogs by $50,000 per year, but decrease costs of manufacturing Cogs by $20,000 per year. Since Cogs are produced by contracted laborers, the costs will be unaffected by inflation however, Cog revenues increase at the inflation rate, starting in year 2. F) The project will be funded through a 1,000,000 10% 5-year bond issue, with interest paid annually, at the end of each year. G) The project will take up 10% of the area in the warehouse, and associated costs will be allocated by the firm s accountants to the firm s widget division, based on 10% of the total warehouse overhead. Overhead to keep the warehouse heated, and electricity to keep the warehouse operational is $100,000 per year, total. However, the actual cost of the utilities to run the widget machine = $20,000 per year. H) The firm s cost of debt (before tax) is 10%. The firm s cost of equity is 16%, and the riskless rate is 6%. The firm s debt/asset ratio is 40%. The firm discounts riskless cash flows by the riskless rate. The project is of average risk for the firm however the firm s discounts riskless cash flows by the riskless rate. Riskless cash flows are any contracted cash flows and the depreciation tax shield. Assume a corporate tax rate of 30%. 12

13 Practice Problem III: Compute the NPV of the following project to make Gadgets. 1) ABC Corp is considering a 5-year project to manufacture GADGETS. They anticipate the following cash flows. The corporate tax rate is 25%. The firm discounts all cash flows by a rate of 15%, except for riskless cash flows, which they discount at a rate of 6%. Only the depreciation tax shield and other cash flows listed as known with certainty are discounted at the riskless rate. 2) The GADGET machine will cost $1.5 million to be paid in two installments; $1 million at the time of purchase and $500,000 at the end of the first year. 3) The GADGET project is somewhat unusual, in that it will DECREASE net working capital by $50,000 at time=0 and INCREASE net working capital by $50,000 at time = 5, when NWC is recaptured. However, the firm expects to buy another GADGET machine at the end of year 5, causing NWC to decrease by $50,000 at that time. 4) The GADGET machine will be depreciated, straight line, over 10 years, down to 0. However, the GADGET machine will be sold at the end of year 5 for $600,000. At this time, the project will be discontinued. 5) Revenues associated with this project are expected to be $900,000 in year 1, and will increase at a rate of 8% per year. The gadgets are contracted to be sold to the military, so the revenues are known with certainty. 6) Expenses associated with the project (excluding utilities) are expected to be 40% of revenues in year 1 (only), and increase at a rate of 5% per year, thereafter. Unlike revenues, expenses are not known with certainty. 7) The GADGET project will be housed in a warehouse that the company already owns. If the GADGET project were not housed there, the warehouse could be leased to NBC Co on a five-year lease, for $200,000 per year, before taxes. 8) The GADGET project will occupy 10% of the floor space in the warehouse. 10% of the warehouse s total utilities (of $10,000 per year including the GADGET machine) will be allocated to the division producing the GADGETS. However, actual warehouse utility bills will increase by $50,000 as a direct result of the GADGET project. 9) The firm s net revenues of thingamajigs will decrease by $100,000 in year 1, as a direct result of the gadget project. If the firm decides not to produce Gadgets, net revenues of thingamajigs would increase at a rate of 5% per year. 10) If the project is accepted, the firm will contract with quality control consultants for $100,000 at time=1, to ensure sufficient quality control, as per government contract specifications. 11) The project will be funded with an equity issue, requiring $20,000 in additional dividends per year. 13

14 5) Valuing projects with unequal lives: Valuation method: Compute the NPV of the projects, assuming that the projects are extended for a given number of lives, so that both projects end at the same time. (# of lives will be lowest common denominator of the two projects lives.) Example 1 Projects A and B are mutually exclusive. Project A requires an initial outlay of $100, and will produce a cash inflow of 30 for 5 years Project B requires an initial outlay of $132, and will produce a cash inflow of $25 for 10 years. Both projects will be replaced, ad-infinitum. Which project should you accept? The cost of capital is 12% YEAR A initial outlay net cash flows PV B initial outlay -132 net cash flow PV NPV (A) = NPV (B) = 9.26 On your own: Practice Problem 1 Projects A and B are mutually exclusive. Project A requires an initial outlay of $10, and will produce a cash inflow of $4 for 6 years Project B requires an initial outlay of $12, and will produce a cash inflow of $7 for 4 years. Both projects will be replaced, ad-infinitum. Which project should you accept? The cost of capital is 10% Practice Problem 2 Projects X and Y are mutually exclusive. Project X requires an initial outlay of $60, and will produce a cash inflow of $35 for 6 years Project Y requires an initial outlay of $80, and will produce a cash inflow of $25 for 10 years. Both projects will be replaced, ad-infinitum. Which project should you accept? The cost of capital is 8% Practice Problem 3 Projects K and L are mutually exclusive. Project K requires an initial outlay of $4000, and will produce a cash inflow of $800 for 10 years Project L requires an initial outlay of $700, and will produce a cash inflow of $600 for 2 years. Both projects will be replaced, ad-infinitum. Which project should you accept? The cost of capital is 12% 14

15 Some reference formulas (review from introductory finance course) A) Cost of (new) Debt: r D : cost at which debt of similar maturity (to the project) could be issued. B) Cost of new Preferred Stock: r PE D ps / P 0 C) Cost of Common Equity: r S 2) From the CAPM: r S = R f + [R m R f ] [R m R f ] = Market Risk Premium R m = Expected rate of return on the Market 3) Solving the formula: P 0 = D 1 /(r S -g) for r S : r S = D 1 /P 0 + g What is the difference (if any) between the cost of debt, equity and preferred stock for the firm, and the required rate of return on debt, equity and preferred stock (for the investors)? Although not explicitly noted in the above formulas, all costs measured by the above formulas are net of floatation costs. Note that floatation costs make the cost of debt (equity) to the firm exceed their required rates of return to investors. 15

16 Chapter 11: Sensitivity Analysis / Monte-Carlo Simulation What is a black box? A black box is something we accept, but do not understand. Why is it important that a project NOT be a black box? We need to understand what could go wrong with the project.what is the source of its positive NPV. Even if a project s risk is all business risk (a.k.a. fully diversifiable ) you need to understand why the venture could fail and once you understand this, you need to determine whether it s worth taking steps ($$$) to ensure that this doesn t happen. Sensitivity Analysis 1) Identify what could go wrong - patents - product malfunctions - market reactions 2) Limits to Sensitivity Analysis - optimistic / pessimistic are subjective - Difficult to obtain a forecaster s notion of true probabilities of possible outcomes. (Exg: Ask a person who repairs your TV about the probability that it will work for at least a year Try to construct a probability distribution for the # of phone calls you will receive next week.) Scooter project: Cost = 15 billion yen; expected after tax cash flow = 3 billion yen; WACC = 10%; life = 10 years; no salvage value. (NPV in billions of yen) 10 NPV = /(1.10) n = 3.43 n=1 16

17 Examples: Sensitivity analysis (from text): Electric Scooter Project NPV Range: Variable Market Size Market Share Unit price Unit Var Cost FixedCost Pessimistic.9 mil , ,000 4 bil Range Expected 1.0 mil.1 375, ,000 3 bil Optimistic 1.1mil , ,000 2 bil Variable Market Size Market Share Unit price Unit Var Cost Fixed Cost Pessimisti c Range Expected Optimistic What are the greatest risks associated with this project? - Suppose that the pessimistic unit variable cost reflects, in part, uncertainty about the design of the scooter, and that additional work may be required to obtain a functional scooter. The extra work will cost 20,000 per unit. However, you believe that the chance this will happen is only 10%. Note: Expected unit sales are 100,000 and the tax rate is 50%. Expected additional after tax cost per year = unit sales x cost x (1-T c )= 100,000 x 20,000 x (1-.5) = 1 billion per year 10 1/(1.10) n = 6.4 billion reduction in NPV; n=1 Since the expected NPV of the project is 3.43 billion, this problem would result in a negative NPV: billion yen. Also suppose that additional pre-testing (at a cost of 10 million yen would avoid the 10% probability of scooter failure.) Compare cost of pre-testing to expected reduction in NPV. Probability of reduction in NPV x reduction in NPV =.10 x 6.4 billion yen = 640 million Cost of pre-testing = 10 million yen. Since cost of pre-testing < expected reduction in NPV, spend the 10 million yen and perform the pre-testing. 17

18 Monte-Carlo Simulations: 1) Assume probability distribution regarding revenues and or costs (usually normal; sometime uniform distribution). 2) Use random number function in Excel to extract a value from the assumed distribution. 3) Plug extracted random number into excel spreadsheet to compute project s NPV Model building is like spinach, you may not like the taste, but it s good for you. More complex variations: Compute demand using a distribution and random number function. Might price be set, based on demand? Can revenues go up if price is reduced? Compute price as a function of demand using if statement in excel. Revenues = price x # sold. Variable costs = variable cost per unit x # produced (sold). Total costs = variable costs + fixed costs. 18

19 Monte Carlo Simulation example: Q1 & Q2 are random numbers created using the function: =rand() Once you have created a column of random numbers, you must copy and paste them into a new column, or they will keep changing when you make changes to the spreadsheet. Use the command copy/paste special / values only. The posted spreadsheet does not show the =rand() function, because the column of number has already been copied and pasted, values only. Z creates a Z-score from the normal distribution function: =normsinv(a7) X1 (revenue) = mean revenue + (z-score x Std Dev): = $B$4 + (B7 * $c$4) Y1 (expenses) = [(max min) x rand#] + min: = (5000*d7) Sprocket Example - Addendum A B C D E F Revenue: Mean Std. Dev. Expenses: uniform on [$8000, $13000) $50,000 $12,000 Q1 Z X1 (revenue) Q2 Y1 (expenses) NPV $47, $10,601 $32, $66, $8,486 $80, $47, $8,384 $37, $33, $9,840 $1, $60, $12,528 $57, $51, $12,534 $36, $54, $8,951 $52, $69, $12,623 $77, $40, $12,774 $11, $53, $8,608 $49, $41, $8,501 $23, $36, $11,557 $4, $70, $12,660 $80, $59, $9,999 $59, $83, $8,173 $119, $44, $9,867 $27, $53, $11,905 $42, $74, $9,981 $94, $52, $9,000 $46, $55, $8,682 $54, $41, $12,447 $14, $57, $10,729 $54, $20, $12,420 -$33, $55, $10,983 $48, $42, $10,811 $20,386 The Monte-Carlo simulation can be found on sheet 2 of the Excel workbook. 19

20 Chapters 11 & 23: Real Options: Note: Real options generally add value (NPV); they never decrease value. Investment Timing Options: Option to delay a project Exg: Delay development of a DVD burning system until demand is more apparent Is there a tradeoff in delaying? Consider patents that prevent entry of competitors and/or brand loyalty Growth Options: Build a factory (embark in a business) that is currently negative NPV because of future growth options (entry into new geographic markets etc.) Banks did this when it was uncertain regarding how regulators might view non-bank lines of business re: risk. Abandonment Options (or option to sell to higher bidder): Variation: Option to reduce capacity Flexibility Options: Option to convert plant from production of one product to production of another. Often used in automotive plants. Also Utility plants are sometimes built which can generate electricity using coal, oil or natural gas, depending on global markets for these products. Value of embedded option increases as: A) Variability in the value of the underlying asset (or asset associated with the option) increases. Example: You are valuing an acre of vacant city land. If the land were developed today, it would be worth 1 million. However, you could choose to keep the land vacant and develop it two year from now, when you know what will happen with the downtown economy. The value of the option increases, as the variability in the potential value of the land increases. B) The closer the market value to the strike price (price at which you would exercise your option.) C) Time to maturity of the option increases. 20

21 Suggested exercises for chapter 11: Chapter 11: #3 (all except e ), 4, 13, 14, 18 Additional Exercise: Using the sprocket example for the Monte-Carlo Simulation, compute the NPV for 10 simulations assuming that revenues are uniformly distributed, with a minimum of $40,000 and a maximum of $60,000. Assume expenses are normally distributed, with mean = $10,000, and a standard deviation of $3,000. All other assumptions in the original problem apply. What is the expected NPV? What was the minimum NPV? Maximum NPV? (Note: answers will vary). Chapter 23: Valuation of Real Options Option to Wait to Invest Wait, if NPV of wait decision > NPV of invest now decision What are the benefits of investing now? What are the benefits of delaying investment? Basic valuation technique: Assume that, if you wait, the NPV will be known with greater certainty, and you have the option NOT to invest if the project will be negative NPV. Thus, the NPV under certain scenarios, if you wait, will be 0, as you will not invest. However, if you wait, the cash flows will be deferred, revenues may be lower (as competition may have increased) and the cost to invest may be greater. Step-by-step valuation example: Step 1: Compute the NPV under option to invest today. You may either use expected cash flows, or compute the NPV under each state of nature, and then compute the E[NPV] answer will be the same. : (from text) Demand Probability Ann cash flow (millions) HIGH 0.25 $33 AVG 0.50 $25 LOW 0.25 $ 5 Expected Cash flow =.25 ($33) +.5 ($25) +.25 ($5) = $22 Initial outlay = 50 million (0 salvage) 21

22 Project life = 3 years Discount rate = 0.14 NPV = /(1.14) + 22/(1.14) /(1.14) 3 = 1.08 million WHAT IF YOU HAD THE OPTION TO WAIT A YEAR UNTIL CASH FLOWS BECAME KNOWN with certainty? Step II: Compute the NPV in year 1 of each state of nature. WAIT OPTION: Demand Probability Ann cash flow NPV IN year 1 (millions) HIGH 0.25 $ AVG 0.50 $ LOW 0.25 $ But, if you were to wait, would you invest knowing that the low demand had occurred? Answer: NO! Step III: Redo above table replacing each decision NOT to invest (due to negative NPV) with an NPV of 0. Compute NPV as of year 0. Demand Probability Ann cash NPV In year 1 NPV In year 0 flow (millions) HIGH 0.25 $ AVG 0.50 $ LOW 0.25 $ Expected NPV =.25 x (.5 x 7.05) +.25 (0) = 9.36 Step IV: Compare NPV of invest NOW option, to NPV of wait option. Option to abandon / sell Basic valuation technique: For each scenario, value assuming you sell, value assuming you don t see. Use highest value under each scenario. 22

23 Complex options: Option to sell and option to delay Examples Basic valuation technique: Compute NPV under keep and sell scenarios. Retain highest NPV. Then, if the highest NPV is negative under wait scenario, set equal to 0. 1) You are considering a project to build a supermarket today with the option to sell it at the end of year 5 for $1 million. The NPV of the supermarket project will depend on whether or not condos are built on the adjacent lot. You estimate that there is a 60% chance that the condos will be built. You will know whether the condos are built by the end of the first year. You estimate that the following NPVs: NPV (t=0) Condos built, supermarket sold -$100,000 Condos built, supermarket kept $300,000 No Condos, supermarket sold -$150,000 No Condos, supermarket kept -$500,000 You are conducting a capital budging analysis today. What is the NPV of this project? 2) Oklahoma Instruments (OI) is considering a project that has an up-front cost of $250,000. The project s subsequent cash flows critically depend on whether its products become the industry standard. There is a 50% chance that the expected cash flows will be $100,000 at the end of each of the next five years. There is a 50% chance that the project s cash flows will be $25,000 at the end of each of the next five years. Assume that the project s cost of capital is 12%. Some calculations have been done in excel (next page). A) Based on the above information, what is the project s NPV if you invest today? B) One year from now, OI will KNOW if its products will have become the industry standard, or not. After receiving the cash flows at t=1, the company has the option to sell the project for $150,000 at t=1. If they sell the project, they will no longer receive cash flows (at t=2, t=3, etc). Note: Because OI will be making their investment decision today (t=0) but will not know their cash flows until t=1, they do not have the option to choose not to do the project if a negative NPV results. Their only option is to sell or not to sell it at the end of year 1. Using a 12% cost of capital, what is the NPV of the project with the abandonment option? Note: The cash flows below do not include the initial outlay of $250 at t=0 for the project, only the cash inflows. 23

24 C) Should you wait to invest, or invest today? Partial EXCEL ANALYSIS TIME (end of year) sum of PV of inflows at t= % chance of CF PV of above(@ t=0) $360 50% chance of CF PV of above (@ t=0) $90 3) Beta Corp has a project to manufacture new DVD recording disks. They estimate that the project has an NPV equal to $50,000 if they invest and start production today, at a time when both the demand for and legality of a competing product, Red-Ray DVD recording disks, is uncertain. However, if Beta waits a year to invest, they will know for certain whether the competing Red- Ray DVD recording media has been legalized and what the price of Red-Ray DVDs will be. At that time, they can decide to go forward with the project, or not. They estimate the following cash flows (discounted to reflect today s dollars) are as follows: Probability NPV of Beta s Project (t=0 dollars) Red-Ray DVDs legal & under $ $190,000 Red-Ray DVDs legal and over $ $9,000 Red-Ray DVDs illegal.30 $200,000 Regardless of the DVD pricing and legality, Beta can sell their project in year 5 for $200,000. Under the assumption that they sell the project in year 5, Beta has recomputed the NPV of the project with the assumption that the sell the project in year 5. Probability NPV of Beta project (t=0 dollars) Red-Ray legal & under $ $65,000 Red-Ray DVDs legal and over $20.40 $10,000 Red-Ray DVDs illegal.30 $130,000 What is the NPV of the decision for Beta Corp assuming they wait a year to invest? 24

25 Chapter 13: Agency Costs, Management Compensation and Assessment of Managerial Performance Overview and Definitions Why don t managers always maximize shareholder wealth? Defininitions: Entrenchment: Agency Costs: are agents of the (fill in managers or shareholders for each blank line) Assume that managers have incentives to maximize their own wealth. Sometimes maximizing their own wealth conflicts with objective to maximize shareholder wealth. Mechanisms to reduce AGENCY COSTS: 1) Boards of directors: Duties of directors: a) Duty of Loyalty b) Duty of Care Strict Outside directors: examples: Affiliated (a.k.a. Greys): (Some incentive to side with managers) examples: Inside directors: examples: 25

26 2) Influential Outside Shareholders: a) Blockholders: Blockholders have monitoring incentives: Gains from monitoring more likely to outweigh monitoring cost. Because they hold a large amount of stock, they can influence votes. Blockholder types: Affiliated (or potentially affiliated): Unaffiliated: b) Institutional outside stockholders Some studies suggest that institutional shareholders can be better monitors of management than individuals. The empirical evidence, however, is mixed on this issue. Recent studies suggest that these inst shareholders Vote with their feet on bad proposals. What does this mean? c) Activist Stockholders May wage a proxy fights to vote-out bad managers; propose amendments to articles of incorporation. 3) Inside firm ownership (Beneficial inside ownership includes top manager holdings in firm & board ownership). A) Two offsetting incentives: managers who hold stock in their own firm have greater incentives to maximize S/H wealth, but also greater ability to maximize their own utility (perks, shirking, wealth expropriation)? EXG: Assume a manager owns 50% of the stock in his firm. He can either use $100,000 of corporate profits to buy himself a perk (a $100,000 limo) or allow it to accrue to the shareholders. If we assume no corporate taxes, how much is it worth (to his stock) if he forgoes the limo and allows the money to accrue to the shareholders? 26

27 B) If management holds stock in their own firm, will this affect their risk-taking incentives? 4) Legal means to reduce agency costs associated with fraud / violation of director responsibilities. a) Credible prosecution of managers for fraud/theft b) Florida bankruptcy loophole c) Prosecution of directors 5) Performance-contingent Compensation: Reward managers for good performance. Options do not penalize for poor performance increase manager s risk-taking incentives. Recent studies suggest that option compensation can be subject to fraud / deception to manipulate profits. 6) Tournaments: Large pay disparity between lower-level and top-level employees. Tournaments compel lower-level employees to work hard to earn the big bucks. Other than US corporations, what other industries have tournament style incentives to achieve? Performance Assessment: How can we assess (and reward) good managers? How can we identify bad ones? Accounting vs. Financial Measures of Performance: * Accounting measures of profitability can reflect downturn within industry; must judge relative to similar firms * Accounting measures of performance (especially ROE) can reflect differences in firm leverage. The higher the leverage the (higher / lower) the ROE, ceteris paribus? * Accounting measures are too low when a project or business is young, and too high as it matures. Why? 27

28 * EVA: What are the returns, after deducing a charge for the cost of capital: Income earned income required * Long vs. short-run returns - Consider a pharmaceutical project, where the profits are unlikely to occur until 12+ years hence. Will managers wish to accept such projects? Measures of Performance Operating ROA: EBIT/Assets Market Equity / Book Equity Market Assets / Book Assets (a.k.a. Tobin s Q) Other indirect sources of agency costs: 1) Debt policy (Threat of bankruptcy) need to earn sufficient EBIT to pay interest obligation (or else what?) 2) Dividend Policy a) Proof of cash flows b) Less opportunity for managers to waste cash c) Firm more likely to go to capital markets (and use underwriters) to raise capital for new investment 3) Underwriters: Due Diligence Investigation of firm 4) Threat of being fired (reputation loss): Managers may propose takeover deterrents or require golden parachutes to minimize this risk. Some argue that these measures can make managers more willing to accept long-term projects where the gains will not be apparent in the short-run. Discussion Questions: a) Why might firm value and managerial ownership be positively related? Why might they be negatively related? 28

29 b) How would you classify former managers who serve on a firm s board (affiliated, insiders or strict outsiders?) Explain your reasoning. c) What types of shareholders have the potential to reduce agency costs? Explain why. d) Which has the potential to reduce agency costs more: interest obligations or dividend obligations? Why? e) Outline the benefits and costs of structuring managerial compensation so that it is closely tied to firm performance. f) True or false (& why): Investors should buy stock or well-managed firms, and avoid purchasing equity of poorly managed firms. Explain. 29