Valuation of Capital Investments Corporate Finance: March 28 (LA) and March 27 (OCC)
Capital Investments • Like common stock cash flows, payments from investments in capital are not determined • Investments are the foremost decision of the management of the firm • The firm’s investment decisions should maximize shareholders’ wealth
Investment Decision Rules • Discussion based on Chapter 6 (not assigned) • Corporate practice is not always good practice and some common rules are wrong • Payback period = time to recover investment, e.g $100 tool saving $50/year has two-year payback period • Average (accounting) return = Average Income/Average investment, e.g $50/year income and $100 tool with two year life implies $50/(($100+0)/2 = 100% return
Payback Period andAverage Accounting Return • Payback period ignores future cash flows with possibly large present value. We can see the effect of this in the “Simple Present Value Factors” • Timing of cash flows critical in present value analysis • Accounting rate of return does not consider timing of cash flows at all
Investment Valuations in Finance • Estimate future cash flows and current costs • Choose a discount rate or calculate internal rate of return • Accept project if net present value > 0 or internal rate > hurdle rate • Other criteria (payback period, average accounting return) are wrong • Use of net present value recommended
Internal Rate of Return • Internal rate of return (IRR) is that discount rate which make NPV = 0 • Tricky in application, users must be wary of problems in computation and interpretation • Assumptions make IRR dangerous • Mathematical properties make interpretation of IRR hard or impossible • Net present value is the best method to evaluate investments
Capital Budgeting impliesLimitated Funds for Investment • Why are funds limited? • What is suggested if NPV > 0 projects are rejected? • What is real corporate world like and what does that suggest about project screening? • Profitability index can be useful:
Objective is to Maximize Value • PI > 1 means NPV > 0 • Initial Investment*(PI-1) = NPV since NPV=PVCF – C dividing each side by C • Rank PIs and take maximum combination of NPVs withing budget constraint • Easily programmed for large-firm administration
Maximizing NPV using PIs withCapital Budgeting • Assume capital budget of $10 million • Have six projects as follows: • Project Cost PI • A $2 Million 1.5 • B 4 “ 1.4 • C 5 “ 1.3 • D 3 “ 1.05 • E 2 “ .90 • F Flexible 1.00 • How to maximize NPV with budget contraints?
Topics in Investment Analysis • Estimating incremental cash flows, i.e. cash flows due to the investment decision • Importance of including net working capital • Inflation effects on cash flows and the choice of real or nominal discount rates • Analyzing components the present value of cash flows • Comparing projects with unequal lives
Cash Flow Estimation • Cash flows from operations • Increase or decrease in sales • Increase or decrease in costs • Change in depreciation and taxes • Other cash flows from the decision • Changes in investment in working capital • Changes in fixed assets or required maintenance cycles • Initial cash flows from the investment
Estimate the Cash Flows • Baldwin Example (pp. 200-206) • Inputs into cash flows • Question 7.1 • The Best Company example (question 7.2) • Scott Investors (question 7.21) • What are sources of value?
Inflation Effects • Inflation means future revenues are inflated in terms of current purchasing power • Two ways of dealing with inflation • Discount rate includes an inflation allowance (most common since market rates are nominal rates) • Deflate projected revenues and costs to convert to current dollars and discount using real risk-adjusted discount rate • Steady or predictable versus varying inflation
Components of Present Values • Components of cash flows from investment may have different risks • Tax-shield from depreciating original cost is risk free if the firm will certainly be paying taxes but tax savings are in inflated dollars • Investment costs are usually current and are not discounted, but not always true • Operating cash flow risk depends on project
Replacement and Unequal Lives • If different acceptable machines must be replaced at different intervals or have different periodic lumpy costs like major maintenance over longer time periods, they must be made comparable to choose best • Two methods are used to compare • Replacement chain - compare a cost cycle • Equivalent annual cost - treat as annuities
For Next Class • Read Chapter 3 • Review the “Financial Statement Analysis and Assumptions for Valuation” and compare to Chapters 2 and 3 • Review old midterms and bring questions to optional review session