Transcript Lecture 11.ppt

Principles of
Corporate
Finance
Seventh Edition
Richard A. Brealey
Stewart C. Myers
McGraw Hill/Irwin
Chapter 6
Making Investment Decisions
with the Net Present Value
Rule
Topics Covered
• What To Discount
• IM&C Project
• Project Analysis
What To Discount
Only Cash Flow is Relevant
Cash flows
• This information has to be checked for
completeness, consistency, and accuracy.
• The financial manager has to ferret out hidden
cash flows and take care to reject accounting
entries that look like cash flows but truly are
not.
• Second, how does the financial manager pull
everything together into a forecast of overall,
“bottom-line” cash flows?
Continue
• This requires careful tracking of taxes; changes
in working capital; inflation; and the end-ofproject “salvage values” of plant, property,
and equipment.
• Third, how should a financial manager apply
the net present value rule when choosing
between investments in plant or equipment
with different economic lives?
Cash Flows
1. Only cash flow is relevant:
• Net present value depends on future cash
flows.
• Cash flow is the simplest possible concept; it is
just the difference between dollars received
and dollars paid out.
– Always estimate cash flows on an after-tax basis.
– Make sure that cash flows are recorded only when
they occur and not when work is undertaken or a
liability is incurred.
Continue
• 2. Estimate CF’s on an Incremental Basis:
The value of a project depends on all the
additional cash flows that follow from project
acceptance.
– Do Not Confuse Average with Incremental
Payoffs;
• Does it always make sense to throw good money after
good?
• E.g., Railroad bridge repair project.
Continue
– Include All Incidental Effects;
• It is important to include all incidental effects on the
remainder of the business.
• For example, a branch line for a railroad may have a
negative NPV when considered in isolation, but still be
a worthwhile investment when one allows for the
additional traffic that it brings to the main line.
– Do Not Forget Working Capital Requirements;
• Most projects entail an additional investment in
working capital.
• This investment should, therefore, be recognized in
your cash-flow forecasts.
Continue
– Include Opportunity Costs;
• The cost of a resource may be relevant to the
investment decision even when no cash changes hands.
• For example, suppose a new manufacturing operation
uses land which could otherwise be sold for $100,000.
• This example prompts us to warn you against judging
projects on the basis of “before versus after.”
• The proper comparison is “with or without.”
• however, where the resource can be freely traded, its
opportunity cost is simply equal to the market price.
Continue
– Forget Sunk Costs;
• Sunk costs are like spilled milk.
• They are past and irreversible outflows.
• Sunk costs are bygones, they cannot be affected by the
decision to accept or reject the project, and so they should
be ignored.
– Beware of Allocated Overhead Costs;
• A project may generate extra overhead expenses; then
again, it may not.
• We should be cautious about assuming that the accountant’s
allocation of overheads represents the true extra expenses
that would be incurred.
Case: Simon North
• In 1898 Simon North announced plans to construct a
funeral home on land he owned and rented out as a
storage area for railway carts. (A local newspaper
commended Mr. North for not putting the cart
before the hearse.) Rental income from the site
barely covered real estate taxes, but the site was
valued at $45,000. However, Mr. North had refused
several offers for the land and planned to continue
renting it out if for some reason the funeral home
was not built. Therefore he did not include the value
of the land as an outlay in his NPV analysis of the
funeral home. Was this the correct procedure?
Explain.
Continue
• Solution: No, this is not the correct procedure.
The opportunity cost of the land is its value in
its best use, so Mr. North should consider the
$45,000 value of the land as an outlay in his
NPV analysis of the funeral home.
Inflation
INFLATION RULE
• 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
Inflation
Example
You own a lease that will cost you $8,000 next year,
increasing at 3% a year (the forecasted inflation rate)
for 3 additional years (4 years total). If discount rates
are 10% what is the present value cost of the lease?
1+ nominal interest rate
1  real interest rate =
1+inflation rate
Inflation
Example - nominal figures
Year
1
2
3
4
PV @ 10%
Cash Flow
8000
8000
1.10  7272.73
8240
 6809.92
8000x1.03 = 8240
1.102
8487 .20
 6376.56
8000x1.032 = 8240
1.103
.82
78
.
5970

8000x1.033 = 8487.20 8741
4
1.10
$26,429.99
Inflation
Example - real figures
Year
1
2
3
4
Cash Flow
8000
1.03 = 7766.99
8240
= 7766.99
1.032
8487.20
= 7766.99
1.033
8741.82
= 7766.99
1.034
[email protected]%
7766.99
1.068  7272.73
7766.99
 6809.92
1.0682
7766.99
 6376.56
1.0683
7766.99
 5970.78
1.0684
= $26,429.99
Inflation
Example
• You are given project cash flows estimated in real
terms, that is, current dollars and nominal interest
rate is 15%:
Real Cash Flows ($ 000)
• C0
C1
C2
C3
• -100
35
50
30
• It would be inconsistent to discount these real cash
flows at 15 percent.
Continue
• Two alternatives:
– Either restate the cash flows in nominal terms and
discount at 15 %,
– or restate the discount rate in real terms and use
it to discount the real cash flows.
• Assume that inflation is projected at 10 percent a year.
• Cash flow for year 1;
• 35,000 X 1.10 = $38,500
Continue
• Cash flow for year 2;
• 50,000 X (1.10)2 = $60,500
• Cash flow for year 3;
• 30,000 X (1.10)3 = $39,930
• NPV = 5.5, or $5,500.
IM&C’s Guano Project
• You are given the forecasts shown in Table 1.
– The project requires an investment of $10 million
in plant and machinery (line 1).
– This machinery can be dismantled and sold for net
proceeds estimated at $1.949 million in year 7
(line 1, column 7).
– This amount is your forecast of the plant’s salvage
value.
IM&C’s Guano Project
Revised projections ($1000s) reflecting inflation
IM&C’s Guano Project
• NPV using nominal cash flows
1,630 2,381 6,205 10,685 10,136
NPV  12,000 




2
3
4
1.20 1.20 1.20 1.20 1.205
6,110
3,444


 3,519 or $3,519,000
6
7
1.20 1.20
IM&C’s Guano Project
Cash flow analysis ($1000s)
A Further Note on Estimating Cash
Flow
• Working capital increases in the early and
middle years of the project.
• What is working capital?
• you may ask, and why does it increase?
• Its most important components are inventory,
accounts receivable, and accounts payable.
• i.e.,
– WC
– $1,289
= inventory + AR
- AP
=
635 + 1,030 - 376
Continue
• Why does working capital increase? There are
several possibilities:
– 1. Sales recorded on the income statement overstate
actual cash receipts from guano shipments because
sales are increasing and customers are slow to pay
their bills. Therefore, accounts receivable increase.
– 2. It takes several months for processed guano to age
properly. Thus, as projected sales increase, larger
inventories have to be held in the aging sheds.
– 3. An offsetting effect occurs if payments for materials
and services used in guano production are delayed. In
this case accounts payable will increase.
IM&C’s Guano Project
Details of cash flow forecast in year 3 ($1000s)
A Further Note on Depreciation
• It provides an annual tax shield equal to the
product of depreciation and the marginal tax
rate:
– Tax shield = depreciation x tax rate
–
= 1,583 x .35
–
=554, or $554,000
• The present value of the tax shields ($554,000
for six years) is $1,842,000 at a 20 % discount
rate.
IM&C’s Guano Project
Tax depreciation allowed under the modified accelerated cost
recovery system (MACRS)
IM&C’s Guano Project
Tax Payments ($1000s)
Continue
• Next slide Shows revised after-tax cash flows
and present value.
• This time we have incorporated realistic
assumptions about taxes as well as inflation.
• We of course arrive at a higher NPV than
previous calculations.
IM&C’s Guano Project
Revised cash flow analysis ($1000s)
Case: Firm’s Tax Position
• Discuss the following statement: “We don’t
want individual plant managers to get
involved in the firm’s tax position. So instead
of telling them to discount after-tax cash flows
at 10 percent, we just tell them to take the
pretax cash flows and discount at 15 percent.
With a 35 percent tax rate, 15 percent pretax
generates approximately 10 percent after tax.”
Continue
• Unfortunately, there is no simple adjustment
to the discount rate that will resolve the issue
of taxes. Mathematically:
C1 ≠
C 1 /(1 - 0.35)
1.10
1.15
C2 ≠
C2 /(1 - 0.35)
(1.10)2
(1.15)2
Case: Mrs. T. Potts
• Mrs. T. Potts, the treasurer of Ideal China, has a
problem. The company has just ordered a new kiln
for $400,000. Of this sum, $50,000 is described by
the supplier as an installation cost. Mrs. Potts does
not know whether the Internal Revenue Service (IRS)
will permit the company to treat this cost as a taxdeductible current expense or as a capital
investment. In the latter case, the company could
depreciate the $50,000 using the five-year MACRS
tax depreciation schedule. How will the IRS’s decision
affect the after-tax cost of the kiln? The tax rate is 35
% and the opportunity cost of capital is 5 %.
Continue
• If the $50,000 is expensed at the end of year
1, the value of the tax shield is:
– 0.35 x $50,000 = $16,667
1.05
• If the $50,000 expenditure is capitalized and
then depreciated using a five-year MACRS
depreciation schedule, the value of the tax
shield is:
Continue
• If the cost can be expensed, then the tax
shield is larger, so that the after-tax cost is
smaller.
Summary
• What To Discount
• IM&C Project