Finance Lecture5

MBAM 614 Finance Capital Investment Decisions • MBAM614 Class 5 - 1 Summary of Last Class 1. Payback Period is the time it takes to recover the original investment 2. AAR = (average net income) (average book value) 3. The IRR is the discount rate for which the NPV of all project cash flows is equal to 0 4. When projects are mutually exclusive or have cash flows of alternating sign, use NPV 5. PI = PV(all future cash flows) (initial investment) 6. ALWAYS USE NPV: ACCEPT WHEN NPV>0 • MBAM614 Class 5 - 2 1 Agenda 1. 2. 3. 4. 5. Project Cash Flows Incremental Cash Flows Project Evaluation “Special” Project Evaluation Types Scenario & Sensitivity Analysis • MBAM614 Class 5 - 3 Project Cash Flows Relevant Cash Flows are strictly incremental (they are created or eliminated because the project was adopted) Can view project as “mini-firm” with its own – assets – revenues – costs Allows us to evaluate project separate from rest of firm This is the Stand-Alone Principle • MBAM614 Class 5 - 4 2 What Are Incremental Cash Flows? Sunk Costs - cash flows already paid or promised. These are NOT project cash flows Eg. Firm pays tuition of managers who take an MBA while working. If a manager is taking an MBA and is transferred to a project, should the manager’s tuition be charged to the project? Opportunity Costs - cash flows lost or foregone because a project was accepted rather than some other course. Clearly applies if an asset can be sold if not used. Eg. Would unused land, already owned by a firm, be “free” when considering the investment required to build a plant on it? • MBAM614 Class 5 - 5 What Are Incremental Cash Flows? Side Effects - when a firm has multiple lines/projects, new projects often effect existing ones. – Erosion or Cannibalization: revenues gained at the expense of existing projects Eg. Every time Kellogg’s brings out a new oat cereal, sales of some existing lines decline as people switch – Halo Effect: revenues generated in OTHER projects Eg. When Seagram introduced cognac as a product, their entire line became more attractive to retailers since it now offered everything • MBAM614 Class 5 - 6 3 What Are Incremental Cash Flows? Net Working Capital - new projects usually require additional cash, inventories, and receivables. Some may be offset by payables As projects end, this investment is often recovered Financing Costs - are not included! – discount rate accounts for them – they are a division of cash flows from assets between the providers of funds Always use After-Tax Cash Flow - never accounting earnings • MBAM614 Class 5 - 7 Finding Project Cash Flows Project capital needs, sales, fixed & variable costs Create pro formas and compute Cash Flow From Assets = Operating Cash Flow - Spending - Working Capital Capital Increases in Net Operating Cash Flow = EBIT + Depreciation - Taxes Remember, compute taxes assuming there is NO INTEREST To make investment decision, apply NPV and any other investment decision rule • MBAM614 Class 5 - 8 4 Example: Point Dume Driving Range You are considering opening a golf driving range. Expected sales are 20,000 buckets at $3 per bucket in the first year growing by 750 buckets per year thereafter. Equipment, which will be straight line depreciated over 6 years, includes: Ball dispensing machine Ball pick-up vehicle Tractor and accessories $2000 7000 9000 A small “pro-shop” and banking arrangements make working capital needs in the first year $3000. This is expected to grow by 5% per year thereafter. Total fixed costs per year (including things like land lease, insurance, labor, etc.) will be $53,000. Balls, baskets, tees, etc. are expected to cost $4000 in the first year and grow by 5% per year after that. If your required return is 15%, should you start this business? • MBAM614 Class 5 - 9 PDDR Pro Forma Income Statements Year Buckets @ $3 Revenue Fixed Costs Buckets & Balls Depreciation EBIT Taxes (17%) Net Income 1 2 3 4 5 6 20,000 20,750 21,500 22,250 23,000 23,750 60,000 62,250 64,500 66,750 69,000 71,250 53,000 53,000 53,000 53,000 53,000 53,000 4,000 4,200 4,410 4,631 4,862 5,105 3,000 3,000 3,000 3,000 3,000 3,000 0 2,050 4,090 6,119 8,138 10,145 0 349 695 1,040 1,383 1,725 0 1,701 3,395 5,079 6,755 8,420 + 750/yr 53,000/yr + 5%/yr 3,000/yr 17% of = Operating Cash Flow 3,000 • MBAM614 + 4,701 6,395 8,079 9,755 11,420 Class 5 - 10 5 PDDR Net Working Capital + 5%/yr Year NWC ∆ NWC 0 3,000 3,000 1 3,150 150 2 3,308 158 3 3,473 165 4 3,647 174 5 3,829 182 6 4,020 191 -4,020 3473 - 3308 NWC Recapture NWCt - NWCt-1 • MBAM614 Class 5 - 11 PDDR Cash Flow From Assets Year Operating Cash Flow Less: Capital Spending Less: ∆ NWC Cash Flow from Assets 0 0 18,000 3,000 -21,000 1 3,000 0 150 2,850 2 4,701 0 158 4,543 3 6,395 0 165 6,230 4 8,079 0 174 7,905 5 6 9,755 11,420 0 182 0 -3,829 9,573 15,249 NPV = $4,881 and IRR = 21.3% • MBAM614 Class 5 - 12 6 Terminal or Salvage Value When project ends, assets are often sold at some “Terminal Value” or “Salvage Value” If the terminal value is less than the Net Asset Value – Have not claimed enough depreciation – Have a Terminal Loss = NAV - Terminal Value – Loss provides a tax deduction (tax shield) If the terminal value is greater than the Net Asset Value – Have claimed too much depreciation – Have a Terminal Gain = Terminal Value - NAV – Gain is taxable • MBAM614 Class 5 - 13 Example: Cost Cutting Projects Your firm is considering a new $10,000 machine that will reduce (pre-tax) operating costs by $3,000 per year over a 5 year period. Assuming straight line depreciation over 5 years, a salvage value of $500, no change in net working capital, a 40% tax rate and a discount rate of 10%, should you proceed? Year 0 1 2 3 4 5 Asset Value 10,000 10,000 10,000 10,000 10,000 10,000 Depreciation 2,000 2,000 2,000 2,000 2,000 Acc. Dep. 2,000 4,000 6,000 8,000 10,000 Net Asset Value 8,000 6,000 4,000 2,000 0 Gain (Loss) on Sale 500 • MBAM614 Class 5 - 14 7 Example: Cash Flows From Cutting Costs Year 0 Op. Income Depreciation EBIT Gain (Loss) on Sale Taxes (40%) Net Income Cash Flow Ops Net Cap Inv. -10,000 ∆ NWC Cash Flow -10,000 1 3,000 2,000 1,000 400 600 2,600 2 3,000 2,000 1,000 400 600 2,600 3 3,000 2,000 1,000 400 600 2,600 4 3,000 2,000 1,000 400 600 2,600 5 3,000 2,000 1,000 500 600 400 2,400 500 2,900 2,600 2,600 2,600 2,600 NPV = $42.32 • MBAM614 and IRR = 10.2% Class 5 - 15 Operating Cash Flows: A Quicker Way OCF = EBIT + Depreciation - Taxes EBIT = Revenues - Costs - Depreciation Taxes = EBIT * TC OCF = EBIT + Depreciation - (EBIT * TC) OCF = EBIT * (1 - TC) + Depreciation • MBAM614 Class 5 - 16 8 Example: Projects With Different Lives Pebble Beach Golf Club is trying to decide between two types of batteries for their electric golf carts. Burnout batteries (BOBs) cost $36 each, last for 3 years, cost $100 per year to keep charged, and have a salvage value of $5. Longlasting batteries (LLBs) cost $60 each, last for 5 years, cost $88 per year to keep charged and also have a salvage value of $5. Presuming PBGC will continue to replace batteries and assuming straight line depreciation, a 40% tax rate and a 15% required rate of return, which batteries should PBGC choose? For BOBs: OCF = (R - C - D) * (1 - TC) + D = (0 - 100 - 12) * (1 - 0.40) + 12 = -$55.20 per year • MBAM614 Class 5 - 17 Example: NPV of BOBs SL depreciation over 3 years so $5 salvage value is a terminal gain and taxable. After tax terminal value = $5 * (1 - 0.40) = $3 t=0 BOBs OCF Cap. Inv. Total CF 0 -36 -36 -55.20 0 -55.20 -55.20 0 -55.20 -55.20 3 -52.20 0 0 0 0 0 0 1 2 3 4 5 NPV = -$160.06 • MBAM614 Class 5 - 18 9 Example: NPV of LLBs For LLBs: OCF = (R - C - D) * (1 - TC) + D = (0 - 88 - 12) * (1 - 0.40) + 12 = -$48.00 per year t=0 LLBs OCF Cap. Inv. Total CF 0 -60 -60 -48 0 -48 -48 0 -48 -48 0 -48 -48 0 -48 -48 3 -45 1 2 3 4 5 NPV = -$219.41 • MBAM614 Class 5 - 19 Example: Choosing BOBs or LLBs BOBs cost less (-$160.06 vs -$219.41) but only last 3 years (not 5) Need to find the Equivalent Annual Cost for each or the annual cost of an annuity with the same present value as the project NPV Since we need APV = C * PVIFA(r,t) -NPVproject = EACproject * PVIFA(r,t) $160.06 = EACBOBs * PVIFA(15%,3) = EACBOBs * 2.283 EACBOBs = $70.10 $219.41 = EACLLBs * PVIFA(15%,5) = EACLLBs * 3.352 EACLLBs = $65.45 • MBAM614 Class 5 - 20 10 Testing Your Analysis NPV based on estimates – if NPV > 0: 1) good project or 2) poor estimate of NPV – if NPV < 0: 1) poor project or 2) poor estimate of NPV – NPV based on projected (estimates of) cash flows What if you’re wrong? (How bad can it be?) Scenario Analysis involves possible range of values – base case; use expected values for variables – worst case; use least favorable plausible values – best case; use most favorable plausible values • MBAM614 Class 5 - 21 Example: PDDR Scenarios Consider a simplified PDDR proposal: rentals are expected to be 20,000 buckets at $3 each, equipment costs $20,000 which will be depreciated SL over 5 years and will have no salvage value. Variable costs are 10% of rentals and fixed costs are $45,000 per year. Assume no working capital or additional capital outlays, a tax rate of 17% and a required return of 15%. What is the NPV? Variable Rentals Rental Revenue Variable Costs (%) Fixed Costs Depreciation Taxes Expected 20,000 $60,000 10% $45,000 $4,000 17% Low 15,000 $45,000 8% $45,000 $4,000 17% High 25,000 $75,000 12% $45,000 $4,000 17% • MBAM614 Class 5 - 22 11 Example: PDDR Scenarios No additional capital expenditures or NWC so Total CF = OCF t=0 1 2 3 4 5 -20,000 OCF OCF OCF OCF OCF OCF = (R - C - D) * (1 - TC) + D Base Case: OCF = (60,000 - 6,000 - 45,000 - 4,000) * (1 - 0.17) + 4,000 = $8,150/yr NPV = $7,320 and IRR = 29.6% • MBAM614 Class 5 - 23 Example: PDDR Scenarios Worst Case (low rentals = $45,000, high variable cost = 12%): OCF = (45,000 - 5,400 - 45,000 - 4,000) * (1 - 0.0) + 4,000 = -$5,400/yr NPV = -$38,101 and IRR = n.a. Best Case (high rentals = $75,000, low variable cost = 8%): OCF = (75,000 - 6,000 - 45,000 - 4,000) * (1 - 0.17) + 4,000 = $20,600/yr NPV = $49,054 and IRR = 99.8% Use calls for judgement • MBAM614 Class 5 - 24 12 Key Points 1. When valuing projects, find NPV of all incremental cash flows 2. Always use After-Tax Cash Flow - never accounting earnings 3. Don’t forget NWC Recapture and Salvage Value when project ends 4. The Equivalent Annual Cost is the annual cost of an annuity with the same present value as the project NPV 5. EAC is only valid for projects that repeat (use NPV otherwise) 6. Use Scenario and Sensitivity Analysis to get a “feel” for riskiness of NPV estimate • MBAM614 Class 5 - 25 MBAM 614 Finance Capital Markets I • MBAM614 Class 5 - 26 13 Agenda 1. 2. 3. 4. 5. 6. Returns Inflation The Fisher Effect Capital Market History Average Returns Risk and Reward • MBAM614 Class 5 - 27 What Do You Mean “Return?” Return on investment is the gain because you owned it Return has two components – Income component (eg. coupons, dividends) Total $’s received due to ownership – Price change (often called capital gain or loss) ∆Price = Pt+1 - Pt Total Dollar Return = Income + Capital Gain For capital gains, it doesn’t matter whether we actually sell the security or not. Point is, we could have. • MBAM614 Class 5 - 28 14 Example: DUK Energy On Sep 14,1998, Duke Energy’s common stock (DUK) was trading for $64.0625 per share. On Sep 13, 1999, it closed at $57.875 and DUK had paid a total dividend over the intervening year of $2.20 per share. If you had purchased a share of DUK, what would your total dollar return have been? Income = Total dividends = $2.20 Capital Gains = ∆Price = P1999 - P1998 = $57.875 - $64.0625 = -$6.1875 Total Dollar Return = $2.20 + (-$6.18750) = -$3.9875 • MBAM614 Class 5 - 29 Percentage Returns Generally, more interested in return per $ invested. This is an investment’s Percentage Return (or Return) Percentage Return = Total Dollar Return Original Investment Dt+1 + (Pt+1 - Pt) Pt Percentage Return = Percentage Return = Dividend Yield + Capital Gains Yield Dividend Yield = Dt+1 Pt Capital Gains Yield = (Pt+1 - Pt) Pt Class 5 - 30 • MBAM614 15 Example: DUK Returns On Sep 14,1998, Duke Energy’s common stock (DUK) was trading for $64.0625 per share. On Sep 13, 1999, it closed at $57.875 and DUK had paid a total dividend over the intervening year of $2.20 per share. What was the dividend yield on DUK shares? The capital gains yield? What return would you have earned on these shares? Dt+1 Pt Dividend Yield = = $2.20/$64.0625 = 3.4% = ($57.875 - $64.0625)/$64.0625 = -9.7% Capital Gains Yield = (Pt+1 - Pt) Pt Return = Dividend Yield + Capital Gains Yield = 3.4% + (-9.7)% = -6.3% • MBAM614 Class 5 - 31 Inflation Over time, prices of consumable goods change The percentage increase in prices is called inflation Inflation causes erosion of purchasing power may be measured Actual Inflation: ht-1 = ht = Pricet - Pricet-1 Pricet-1 Expected Inflation: can only be estimated • MBAM614 Expected(Pricet+1) - Pricet Pricet Class 5 - 32 16 U.S. CPI Jan 1946 to Jul 1999 180 160 140 120 100 80 60 40 20 0 J an-46 J an-48 J an-50 J an-52 J an-54 J an-56 J an-58 J an-60 J an-62 J an-64 J an-66 J an-68 J an-70 J an-72 J an-74 J an-76 Consumer Price Index (a basket of consumer goods) Inflation from 121.1 - 101.9 = 18.8% = 1984 to 1989 101.9 CPI1989 = 121.1 CPI1984 = 101.9 CPI Price of basket over time J an-78 J an-80 J an-82 J an-84 J an-86 J an-88 J an-90 J an-92 J an-94 J an-96 J an-98 Year • MBAM614 Class 5 - 33 Example: Buying Goodie Baskets If we had $1019 in 1984, we could have purchased 10 baskets. If we had invested our money at 10% compounded annually, how many baskets could we have purchased in 1989? In 1989 (5 years) we have $1019 * (1.10)5 = $1641 Since baskets cost $121.10 in 1989, we could purchase 13.55 baskets. Total Nominal Return Nominal Return In terms of $’s, our total return was 61.1% (10% per year) but in terms of baskets, our total return was only 35.5% (6.3% per year) Total Real Return Real Return Inflation eroded the purchasing power of our $’s • MBAM614 Class 5 - 34 17 Real Returns Nominal Returns are NOT adjusted for inflation – nominal returns measure increases in wealth Inflation adjusted returns are called Real Returns – real returns measure increases in purchasing power In general, interest rates and returns are quoted as nominal rates • MBAM614 Class 5 - 35 Example: Increasing Purchasing Power You have saved $3700, most of the $4000 cost of a trip to Disney World this winter, but you’ve decided not to go now because Finance is far too fun and you might miss some. Instead, you plan to invest the money to earn the extra $500 and go next February when you’ll only miss some HRM. If you expect inflation over the next year to be h = 4%, what nominal rate must you earn on your $3700 in order to have enough to pay for your trip? Expected cost of trip = $4000 * (1 + h) = $4000 * (1.04) = $4160 Nominal Return = ($4160 - $3700)/$3700 = 12.4% Return has two parts: inflation + real return • MBAM614 Class 5 - 36 18 Nominal Returns Nominal Return or Rate Real Return or Rate Inflation Rate (1 + R) = (1 + r) * (1 + h) R = r + h + (r * h) R≈r+h Fisher Effect When r, h are small, term is very very small Can be used in two ways: – Theoretical relationship between nominal returns, real returns, and expected inflation – As a definition of realized real returns given past inflation and nominal rates • MBAM614 Class 5 - 37 Growth of $1 in U.S. Capital Markets 5520 1000 S&P Small Cap Corp Bonds Long Bond T Bill 1828 55.38 39.07 10 14.25 1 0.1 1925 Which did best? Why buy anything else? 1933 1941 1949 1957 1965 1973 1981 1989 1997 Source: Ibbotson Associates Year End Class 5 - 38 • MBAM614 19 Average Returns To find the Average Return, simply add returns for T years and divide by T 26-97 3.8% 5.6% 6.1% 13.0% 17.7% T-Bills Long US Corporate Bonds S&P 500 Stocks Small Cap Stocks Why do average returns differ? • MBAM614 Class 5 - 39 U.S. Capital Market Annual Returns 60 40 Percentage Return Lowest average return Greatest variability in returns 20 0 -20 -40 Greatest average return Lowest variability in returns Common Stocks Long T-Bonds T-Bills -60 26 30 35 40 45 50 55 60 65 70 75 80 85 90 95 Year Source: Ibbotson Associates • MBAM614 Class 5 - 40 20 Risk Notice the volatility or uncertainty about returns That is, Expected Returns are RISKY The greater the volatility, the greater the risk The difference in average returns is because of differing return risk THERE IS A REWARD FOR BEARING RISK • MBAM614 Class 5 - 41 Risk Premiums T-Bills are often considered risk-free since they’re guaranteed by the Government. The T-Bill rate is often called the Risk-Free Rate The difference between the risk-free rate and a risky investment’s rate of return is the Risk Premium paid for bearing risk • MBAM614 Class 5 - 42 21 Example: Capital Market Risk Premiums Average Return 3.8% 5.6% 13.0% Risk Premium 1.8% 9.2% Historic Excess Return T-Bills Long US All Stocks If we invested in all stocks, we would be taking on Average Risk The risk premium on all stocks, or the reward for taking average risk, is also called the Market’s Excess Return (over the risk-free rate) • MBAM614 Class 5 - 43 Key Points 1. Percentage Return = Dt+1 + (Pt+1 - Pt) Pt 2. 3. 4. 5. Percentage Return = Dividend Yield + Capital Gains Yield (1 + R) = (1 + r) * (1 + h) THERE IS A REWARD FOR BEARING RISK The historic average risk premium for bearing average risk, the average Excess Return, is 9.2% • MBAM614 Class 5 - 44 22