JEM034 Corporate Finance Winter Semester 2017/2018

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1 JEM034 Corporate Finance Winter Semester 2017/2018 Lecture #3 Olga Bychkova

2 Topics Covered Today Making investment decisions with NPV rule (more practical guidance) and capital budgeting (chapter 6 in BMA) Project analysis (chapter 10 in BMA)

3 Making Investment Decisions with NPV Rule: Topics Covered Applying the Net Present Value Rule Investment Timing Equivalent Annual Cash Flows

4 What To Discount Rule 1: Only Cash Flow is Relevant Rule 2: Estimate Cash Flows on an Incremental Basis Do not confuse average with incremental payoffs Include all incidental effects Forecast sales today and recognize after sales cash flows to come later Do not forget working capital requirements Include opportunity costs Forget sunk costs Beware of allocated overhead costs Remember salvage value Rule 3: Treat Inflation Consistently 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.

5 Investment Timing Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. A common example involves a tree farm. You may defer the harvesting of trees. By doing so, you defer the receipt of the cash flow, yet increase the cash flow.

Investment Timing Example #1: You own a large tract of inaccessible timber. To harvest it, you have to invest a substantial amount in access roads and other facilities.

6 Investment Timing Example #1: You own a large tract of inaccessible timber. To harvest it, you have to invest a substantial amount in access roads and other facilities. The longer you wait, the higher the investment required. However, lumber prices will rise as you wait, and the trees will keep growing, although at a gradually decreasing rate. Given the following data and a 10% discount rate, when should you harvest?

7 Investment Timing Net present value of investment if undertaken at date t = = Net future value at date t (1 + r) t

8 Investment Timing Example #2: You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer? Year Cost PV(Savings)

9 Investment Timing Net present value = PV (Savings) Costs (1 + r) t Year Cost PV(Savings) NPV

10 Comparing Projects with Different Time Horizons Projects with different time horizons are not directly comparable. Projects should always be compared over the same discounting period.

11 Methods of Evaluating Projects with Different Time Horizons Rolling over the shorter project; The equivalent annual net benefit method.

12 Equivalent Annual Cash Flows Equivalent annual cash flow the cash flow per period with the same present value as the actual cash flow of the the project. Equivalent annual annuity = present value of cash flows, annuity factor where annuity factor has the same life as the project. The annuity factor gives the present value of receiving $1 per year for t years: 1 (1 + r) t Annuity factor =. r

13 Equivalent Annual Cash Flows Example: Select one of the two following projects, based on highest equivalent annual cash flow (r = 9%). Project C 0 C 1 C 2 C 3 C 4 NPV EAA C D

14 Example of Comparing Projects with Different Time Horizons A town s recreation department is trying to decide how to use a piece of land. Basketball Courts (BC) Swimming Pool (SP) Expected Life 8 years 24 years Construction Costs $180,000 $2.25 million Yearly Net Benefits $40,000 $170,000 Each project is supposed to have zero salvage value at the end of its life. Assuming a real discount rate is 5 %, which project would you advise to implement?

15 Rolling over the Shorter Project Suppose that a town s recreation department decides to put up basketball courts. Further, suppose that in 8 years it puts up new basketball courts and in 16 years it puts up another new basketball courts. If so, the expected life of these three sequential basketball courts will be the same as the expected life of a swimming pool. This makes the projects comparable. 3BC = SP.

16 Rolling over the Shorter Project The NPV of putting up basketball courts (BC) is the difference between the present value of annual net benefits from using basketball courts and the costs of putting them up: ( ) $40, NPV (BC) = $180, ( ) 8 = $78, 529. The NPV of three back to back installing basketball courts is: NPV (3BC) = $78, $78, 529 $78, = $167, 655. ( ) 8 ( ) 16

17 Rolling over the Shorter Project The NPV of installing a swimming pool (SP) is the difference between the present value of annual net benefits from using a swimming pool and costs of installing it: ( ) $170, NPV (SP) = $2.25 million ( ) 24 = $95, 769. As the NPV of three back to back installing basketball courts is larger than the NPV of installing a swimming pool, a town s recreation department should put up basketball courts.

18 Equivalent Annual Net Benefit Method The annuity factor for 8 years is: 1 ( ) = The annuity factor for 24 years is: 1 ( ) 24 =

19 Equivalent Annual Net Benefit Method The EANB of putting up basketball courts is: EANB(BC) = NPV (BC) annuity factor for 8 years = $78, = $12, 150. The EANB of installing a swimming pool is: EANB(SP) = NPV (SP) annuity factor for 24 years = $95, = $6, 940. As the EANB of putting up basketball courts is larger than the EANB of installing a swimming pool, a town s recreation department should put up basketball courts.

20 Making Investment Decisions with NPV Rule: Problem 30, Chapter 6 of BMA Textbook The president s executive jet is not fully utilized. You judge that its use by other officers would increase direct operating costs by only $20,000 a year and would save $100,000 a year in airline bills. However, you believe that with the increased use the company will need to replace the jet at the end of three years rather than four. A new jet costs $1.1 million and (at its current low rate of use) has a life of six years. Assume that the company does not pay taxes. All cash flows are forecasted in real terms. The real opportunity cost of capital is 8%. Should you try to persuade the president to allow other officers to use the plane? With a 6-year life, the equivalent annual cost (at 8%) of a new jet is: $1, 100, 000 = $237,

21 The president should allow wider use of the present jet because the present value of the savings is greater than the present value of the cost. Making Investment Decisions with NPV Rule: Problem 30, Chapter 6 of BMA Textbook If the jet is replaced at the end of year 3 rather than year 4, the company will incur an incremental cost of $237,941 in year 4. The present value of this cost is: $237, = $174, 894. The present value of the savings is: 3 t=1 $80, t = $206, 168.

22 Project Analysis: Topics Covered The Capital Investment Process Sensitivity Analysis Monte Carlo Simulation Real Options and Decision Trees

23 Capital Investments Items for consideration: Capital budget a list of investment projects under consideration by a firm. Post audits a review of the project to see how closely it met forecasts. Do not add fudge factors to the cost of capital.

24 Three Horizons of Corporate Planning

25 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.

26 Break-Even Analysis Point at which the NPV = 0 is the break-even point. Otobai Motors has a break-even point of 85,000 units sold (Chapter 6, BMA).

27 Break-Even Analysis Accounting break-even is different, yet wrong. It does not consider the time value of money. Otobai Motors has an accounting break-even point of 60,000 units sold (Chapter 6, BMA).

28 Operating Leverage Operating leverage the degree to which costs are fixed. Degree of operating leverage (DOL) percentage change in profits given a 1 percent change in sales. DOL = % change in profits % change in sales The following formula shows how DOL is related to the business s fixed costs (including depreciation) as a proportion of pretax profits: fixed costs DOL = 1 + profits

29 Monte Carlo Simulation Modeling process Step 1: Modeling the project Step 2: Specifying probabilities Step 3: Simulate the cash flows Step 4: Calculate present value

30 Monte Carlo Simulation

31 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.

32 Decision Trees Example: FedEx expansion option

33 Pharmaceutical R&D Before launch, any new drug must pass Phases I-III of trials and prelaunch phase. A new drug has passed Phase I clinical trials. Now it requires an investment of $18 million for Phase II trials. These trials take 2 years and the probability of success is 44%. If the trials are successful, the manager learns the commercial potential of the drug, which depends on how widely it can be used. Assume that the forecasted PV at launch depends on the scope of use allowed by the FDA (Food and Drug Administration): an upside outcome (NPV of $700 million for wide use), a most likely case (NPV of $300 million), and downside case for very restricted use (NPV of $100 million) these NPVs are payoffs at launch after investment in marketing. Launch comes 3 years after the start of phase III if the drug is approved by the FDA. The probabilities of the upside, most likely, and downside case are 25, 50, and 25 percent, respectively. Further R&D investment of $130 million is needed for Phase III trials and for the prelaunch period and the probability of final FDA approval and launch is 80%. Assume cost of capital equal to 9.6%. Should we invest into this drug? Why?

34 Decision Trees: Pharmaceutical R&D

35 Decision Trees: Pharmaceutical R&D

36 Real Options 1. Option to expand 2. Option to abandon 3. Timing option 4. Flexible production facilities

37 Project Analysis: Problem 18, Chapter 10 of BMA Textbook Describe the real option in each of the following cases: (a) Deutsche Metall postpones a major plant expansion. The expansion has positive NPV on a discounted-cash-flow basis but top management wants to get a better fix on product demand before proceeding. Timing option (b) Western Telecom commits to production of digital switching equipment specially designed for the European market. The project has a negative NPV, but it is justified on strategic grounds by the need for a strong market position in the rapidly growing, and potentially very profitable, market. Expansion option

38 Project Analysis: Problem 18, Chapter 10 of BMA Textbook (c) Western Telecom vetoes a fully integrated, automated production line for the new digital switches. It relies on standard, less-expensive equipment. The automated production line is more efficient overall, according to a discounted-cash-flow calculation. Abandonment option (d) Mount Fuji Airways buys a jumbo jet with special equipment that allows the plane to be switched quickly from freight to passenger use or vice versa. Production option

JEM034 Corporate Finance Winter Semester 2018/2019

JEM034 Corporate Finance Winter Semester 2018/2019 Lecture #4 Olga Bychkova Topics Covered Today Finalize more practical guidance on making investment decisions with NPV rule and capital budgeting (chapter