acquisitions and projects - new york university stern...
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AcquisitionsandProjects
AswathDamodaran
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¨ Anacquisitionisaninvestment/projectlikeanyotherandalloftherulesthatapplytotraditionalinvestmentsshouldapplytoacquisitionsaswell.Inotherwords,foranacquisitiontomakesense:¤ ItshouldhavepositiveNPV.Thepresentvalueoftheexpectedcash
flowsfromtheacquisitionshouldexceedthepricepaidontheacquisition.
¤ TheIRRofthecashflowstothefirm(equity)fromtheacquisition>Costofcapital(equity)ontheacquisition
¨ Inestimatingthecashflowsontheacquisition,weshouldcountinanypossiblecashflowsfromsynergy.
¨ Thediscountratetoassessthepresentvalueshouldbebasedupontheriskoftheinvestment(targetcompany)andnottheentityconsideringtheinvestment(acquiringcompany).
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TataMotorsandHarmanInternational
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¨ HarmanInternationalisapubliclytradedUSfirmthatmanufactureshighendaudioequipment.TataMotorsisanautomobilecompany,basedinIndia.
¨ TataMotorsisconsideringanacquisitionofHarman,withaneyeonusingitsaudioequipmentinitsIndianautomobiles,asoptionalupgradesonnewcars.
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EstimatingtheCostofCapitalfortheAcquisition(nosynergy)
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1. Currency:EstimatedinUS$,sincecashflowswillbeestimatedinUS$.2. Beta:HarmanInternationalisanelectroniccompanyandweusetheunleveredbeta
(1.17)ofelectronicscompaniesintheUS.3. EquityRiskPremium:ComputedbasedonHarman’soperatingexposure:
4. Debtratio&costofdebt:TataMotorsplanstoassumetheexistingdebtofHarmanInternationalandtopreserveHarman’sexistingdebtratio.Harmancurrentlyhasadebt(includingleasecommitments)tocapitalratioof7.39%(translatingintoadebttoequityratioof7.98%)andfacesapre-taxcostofdebtof4.75%(basedonitsBBB- rating).
LeveredBeta=1.17(1+(1-.40)(.0798))=1.226CostofEquity=2.75%+1.226(6.13%)=10.26%
CostofCapital=10.26%(1-.0739)+4.75%(1-.40)(.0739)=9.67%
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EstimatingCashflows- FirstSteps
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¨ OperatingIncome:Thefirmreportedoperatingincomeof$201.25milliononrevenuesof$4.30billionfortheyear.Addingbacknon-recurringexpenses(restructuringchargeof$83.2millionin2013)andadjustingincomefortheconversionofoperatingleasecommitmentstodebt,weestimatedanadjustedoperatingincomeof$313.2million.Thefirmpaid18.21%ofitsincomeastaxesin2013andwewillusethisastheeffectivetaxrateforthecashflows.
¨ Reinvestment:Depreciationin2013amountedto$128.2million,whereascapitalexpendituresandacquisitionsfortheyearwere$206.4million.Non-cashworkingcapitalincreasedby$272.6millionduring2013butwas13.54%ofrevenuesin2013.
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Bringingingrowth
¨ WewillassumethatHarmanInternationalisamaturefirm,growing2.75%inperpetuity.
¨ Weassumethatrevenues,operatingincome,capitalexpendituresanddepreciationwillallgrow2.75%fortheyearandthatthenon-cashworkingcapitalremain13.54%ofrevenuesinfutureperiods.
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ValueofHarmanInternational:BeforeSynergy
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¨ Earlier,weestimatedthecostofcapitalof9.67%astherightdiscountratetoapplyinvaluingHarmanInternationalandthecashflowtothefirmof$166.85millionfor2014(nextyear),assuminga2.75%growthrateinrevenues,operatingincome,depreciation,capitalexpendituresandtotalnon-cashworkingcapital.Wealsoassumedthatthesecashflowswouldcontinuetogrow2.75%ayearinperpetuity.
¨ Addingthecashbalanceofthefirm($515million)andsubtractingouttheexistingdebt($313million,includingthedebtvalueofleases)yieldsthevalueofequityinthefirm:
¨ ValueofEquity =ValueofOperatingAssets+Cash– Debt
=$2,476+$515- $313million=$2,678million
¨ ThemarketvalueofequityinHarmaninNovember2013was$5,428million.
¨ TotheextentthatTataMotorspaysthemarketprice,itwillhavetogeneratebenefitsfromsynergythatexceed$2750million.
MeasuringInvestmentReturnsII.InvestmentInteractions,OptionsandRemorse…
Lifeistooshortforregrets,right?
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Independentinvestmentsaretheexception…
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¨ Inalloftheexampleswehaveusedsofar,theinvestmentsthatwehaveanalyzedhavestoodalone.Thus,ourjobwasasimpleone.Assesstheexpectedcashflowsontheinvestmentanddiscountthemattherightdiscountrate.
¨ Intherealworld,mostinvestmentsarenotindependent.Takinganinvestmentcanoftenmeanrejectinganotherinvestmentatoneextreme(mutuallyexclusive)tobeinglockedintotakeaninvestmentinthefuture(pre-requisite).
¨ Moregenerally,acceptinganinvestmentcancreatesidecostsforafirm’sexistinginvestmentsinsomecasesandbenefitsforothers.
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I.MutuallyExclusiveInvestments
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¨ Wehavelookedathowbesttoassessastand-aloneinvestmentandconcludedthatagoodinvestmentwillhavepositiveNPVandgenerateaccountingreturns(ROCandROE)andIRRthatexceedyourcosts(capitalandequity).
¨ Insomecases,though,firmsmayhavetochoosebetweeninvestmentsbecause¤ Theyaremutuallyexclusive:Takingoneinvestmentmakestheother
oneredundantbecausetheybothservethesamepurpose¤ Thefirmhaslimitedcapitalandcannottakeeverygoodinvestment
(i.e.,investmentswithpositiveNPVorhighIRR).¨ Usingthetwostandarddiscountedcashflowmeasures,NPV
andIRR,canyielddifferentchoiceswhenchoosingbetweeninvestments.
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ComparingProjectswiththesame(orsimilar)lives..
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¨ Whencomparingandchoosingbetweeninvestmentswiththesamelives,wecan¤ Computetheaccountingreturns(ROC,ROE)oftheinvestmentsandpicktheonewiththehigherreturns
¤ ComputetheNPVoftheinvestmentsandpicktheonewiththehigherNPV
¤ ComputetheIRRoftheinvestmentsandpicktheonewiththehigherIRR
¨ Whileitiseasytoseewhyaccountingreturnmeasurescangivedifferentrankings(andchoices)thanthediscountedcashflowapproaches,youwouldexpectNPVandIRRtoyieldconsistentresultssincetheyarebothtime-weighted,incrementalcashflowreturnmeasures.
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Case1:IRRversusNPV
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¨ Considertwoprojectswiththefollowingcashflows:Year Project1CF Project2CF0 -1000 -10001 800 2002 1000 3003 1300 4004 -2200 500
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Whatdowedonow?
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¨ Project1hastwointernalratesofreturn.Thefirstis6.60%,whereasthesecondis36.55%.Project2hasoneinternalrateofreturn,about12.8%.
¨ Whyaretheretwointernalratesofreturnonproject1?
¨ Ifyourcostofcapitalis12%,whichinvestmentwouldyouaccept?a. Project1b. Project2
¨ Explain.
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Case2:NPVversusIRR
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Cash Flow
Investment
$ 350,000
$ 1,000,000
Project A
Cash Flow
Investment
Project B
NPV = $467,937IRR= 33.66%
$ 450,000 $ 600,000 $ 750,000
NPV = $1,358,664IRR=20.88%
$ 10,000,000
$ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000
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Whichonewouldyoupick?
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¨ Assumethatyoucanpickonlyoneofthesetwoprojects.YourchoicewillclearlyvarydependinguponwhetheryoulookatNPVorIRR.Youhaveenoughmoneycurrentlyonhandtotakeeither.Whichonewouldyoupick?a. ProjectA.Itgivesmethebiggerbangforthebuckandmore
marginforerror.b. ProjectB.Itcreatesmoredollarvalueinmybusiness.
¨ IfyoupickA,whatwouldyourbiggestconcernbe?
¨ IfyoupickB,whatwouldyourbiggestconcernbe?
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CapitalRationing,UncertaintyandChoosingaRule
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¨ Ifabusinesshaslimitedaccesstocapital,hasastreamofsurplusvalueprojectsandfacesmoreuncertaintyinitsprojectcashflows,itismuchmorelikelytouseIRRasitsdecisionrule.¤ Small,high-growthcompaniesandprivatebusinessesaremuchmorelikelytouseIRR.
¨ Ifabusinesshassubstantialfundsonhand,accesstocapital,limitedsurplusvalueprojects,andmorecertaintyonitsprojectcashflows,itismuchmorelikelytouseNPVasitsdecisionrule.
¨ Asfirmsgopublicandgrow,theyaremuchmorelikelytogainfromusingNPV.
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Thesourcesofcapitalrationing…
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Cause Number of firms Percent of total Debt limit imposed by outside agreement 10 10.7 Debt limit placed by management external to firm
3 3.2
Limit placed on borrowing by internal management
65 69.1
Restrictive policy imposed on retained earnings
2 2.1
Maintenance of target EPS or PE ratio 14 14.9
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AnAlternativetoIRRwithCapitalRationing
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¨ TheproblemwiththeNPVrule,whenthereiscapitalrationing,isthatitisadollarvalue.Itmeasuressuccessinabsoluteterms.
¨ TheNPVcanbeconvertedintoarelativemeasurebydividingbytheinitialinvestment.Thisiscalledtheprofitabilityindex.¤ ProfitabilityIndex(PI)=NPV/InitialInvestment
¨ Intheexampledescribed,thePIofthetwoprojectswouldhavebeen:¤ PIofProjectA=$467,937/1,000,000=46.79%¤ PIofProjectB=$1,358,664/10,000,000=13.59%¤ ProjectAwouldhavescoredhigher.
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Case3:NPVversusIRR
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Cash Flow
Investment
$ 5,000,000
$ 10,000,000
Project A
Cash Flow
Investment
Project B
NPV = $1,191,712IRR=21.41%
$ 4,000,000 $ 3,200,000 $ 3,000,000
NPV = $1,358,664IRR=20.88%
$ 10,000,000
$ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000
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Whythedifference?
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¨ Theseprojectsareofthesamescale.BoththeNPVandIRRusetime-weightedcashflows.Yet,therankingsaredifferent.Why?
¨ Whichonewouldyoupick?a. ProjectA.Itgivesmethebiggerbangforthebuckand
moremarginforerror.b. ProjectB.Itcreatesmoredollarvalueinmybusiness.
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NPV,IRRandtheReinvestmentRateAssumption
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¨ TheNPVruleassumesthatintermediatecashflowsontheprojectgetreinvestedatthehurdlerate(whichisbaseduponwhatprojectsofcomparableriskshouldearn).
¨ TheIRRruleassumesthatintermediatecashflowsontheprojectgetreinvestedattheIRR.ImplicitistheassumptionthatthefirmhasaninfinitestreamofprojectsyieldingsimilarIRRs.
¨ Conclusion:WhentheIRRishigh(theprojectiscreatingsignificantsurplusvalue)andtheprojectlifeislong,theIRRwilloverstatethetruereturnontheproject.
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WhyNPVandIRRmaydiffer..Evenifprojectshavethesamelives
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¨ AprojectcanhaveonlyoneNPV,whereasitcanhavemorethanoneIRR.
¨ TheNPVisadollarsurplusvalue,whereastheIRRisapercentagemeasureofreturn.TheNPVisthereforelikelytobelargerfor“largescale” projects,whiletheIRRishigherfor“small-scale” projects.
¨ TheNPVassumesthatintermediatecashflowsgetreinvestedatthe“hurdlerate”,whichisbaseduponwhatyoucanmakeoninvestmentsofcomparablerisk,whiletheIRRassumesthatintermediatecashflowsgetreinvestedatthe“IRR”.
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Comparingprojectswithdifferentlives..
AswathDamodaran
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-$1500
$350 $350 $350 $350$350
-$1000
$400 $400 $400 $400$400
$350 $350 $350 $350$350
Project B
NPV of Project A = $ 442IRR of Project A = 28.7%
NPV of Project B = $ 478IRR for Project B = 19.4%
Hurdle Rate for Both Projects = 12%
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WhyNPVscannotbecompared..Whenprojectshavedifferentlives.
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¨ Thenetpresentvaluesofmutuallyexclusiveprojectswithdifferentlivescannotbecompared,sincethereisabiastowardslonger-lifeprojects.TocomparetheNPV,wehaveto¤ replicatetheprojectstilltheyhavethesamelife(or)¤ convertthenetpresentvaluesintoannuities
¨ TheIRRisunaffectedbyprojectlife.WecanchoosetheprojectwiththehigherIRR.
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Solution1:ProjectReplication
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Project A: Replicated
-$1500
$350 $350 $350 $350$350 $350 $350 $350 $350$350
Project B
-$1000
$400 $400 $400 $400$400 $400 $400 $400 $400$400
-$1000 (Replication)
NPV of Project A replicated = $ 693
NPV of Project B= $ 478
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Solution2:EquivalentAnnuities
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¨ EquivalentAnnuityfor5-yearproject¤ =$442*PV(A,12%,5years)¤ =$122.62
¨ EquivalentAnnuityfor10-yearproject¤ =$478*PV(A,12%,10years)¤ =$84.60
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Whatwouldyouchooseasyourinvestmenttool?
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¨ Giventheadvantages/disadvantagesoutlinedforeachofthedifferentdecisionrules,whichonewouldyouchoosetoadopt?a. ReturnonInvestment(ROE,ROC)b. PaybackorDiscountedPaybackc. NetPresentValued. InternalRateofReturne. ProfitabilityIndex
¨ Doyouthinkyourchoicehasbeenaffectedbytheeventsofthelastquarterof2008?Ifso,why?Ifnot,whynot?
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Whatfirmsactuallyuse..
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DecisionRule %ofFirmsusingasprimarydecisionrulein1976 1986 1998
IRR 53.6% 49.0% 42.0%AccountingReturn 25.0% 8.0% 7.0%NPV 9.8% 21.0% 34.0%PaybackPeriod 8.9% 19.0% 14.0%ProfitabilityIndex 2.7% 3.0% 3.0%
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II.SideCostsandBenefits
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¨ Mostprojectsconsideredbyanybusinesscreatesidecostsandbenefitsforthatbusiness.¤ Thesidecostsincludethecostscreatedbytheuseofresourcesthatthebusinessalreadyowns(opportunitycosts)andlostrevenuesforotherprojectsthatthefirmmayhave.
¤ Thebenefitsthatmaynotbecapturedinthetraditionalcapitalbudgetinganalysisincludeprojectsynergies(wherecashflowbenefitsmayaccruetootherprojects)andoptionsembeddedinprojects(includingtheoptionstodelay,expandorabandonaproject).
¨ Thereturnsonaprojectshouldincorporatethesecostsandbenefits.
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A.OpportunityCost
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¨ Anopportunitycostariseswhenaprojectusesaresourcethatmayalreadyhavebeenpaidforbythefirm.
¨ Whenaresourcethatisalreadyownedbyafirmisbeingconsideredforuseinaproject,thisresourcehastobepricedonitsnextbestalternativeuse,whichmaybe¤ asaleoftheasset,inwhichcasetheopportunitycostistheexpectedproceedsfromthesale,netofanycapitalgainstaxes
¤ rentingorleasingtheassetout,inwhichcasetheopportunitycostistheexpectedpresentvalueoftheafter-taxrentalorleaserevenues.
¤ useelsewhereinthebusiness,inwhichcasetheopportunitycostisthecostofreplacingit.
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Case1:ForegoneSale?
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¨ AssumethatDisneyownslandinRioalready.Thislandisundevelopedandwasacquiredseveralyearsagofor$5millionforahotelthatwasneverbuilt.Itisanticipated,ifthisthemeparkisbuilt,thatthislandwillbeusedtobuildtheofficesforDisneyRio.Thelandcurrentlycanbesoldfor$40million,thoughthatwouldcreateacapitalgain(whichwillbetaxedat20%).Inassessingthethemepark,whichofthefollowingwouldyoudo:¤ Ignorethecostoftheland,sinceDisneyownsitsalready¤ Usethebookvalueoftheland,whichis$5million¤ Usethemarketvalueoftheland,whichis$40million¤ Other:
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Case2:IncrementalCost?AnOnlineRetailingVentureforBookscape
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¨ Theinitialinvestmentneededtostarttheservice,includingtheinstallationofadditionalphonelinesandcomputerequipment,willbe$1million.Theseinvestmentsareexpectedtohavealifeoffouryears,atwhichpointtheywillhavenosalvagevalue.Theinvestmentswillbedepreciatedstraightlineoverthefour-yearlife.
¨ Therevenuesinthefirstyearareexpectedtobe$1.5million,growing20%inyeartwo,and10%inthetwoyearsfollowing.Thecostofthebookswillbe60%oftherevenuesineachofthefouryears.
¨ Thesalariesandotherbenefitsfortheemployeesareestimatedtobe$150,000inyearone,andgrow10%ayearforthefollowingthreeyears.
¨ Theworkingcapital,whichincludestheinventoryofbooksneededfortheserviceandtheaccountsreceivablewillbe10%oftherevenues;theinvestmentsinworkingcapitalhavetobemadeatthebeginningofeachyear.Attheendofyear4,theentireworkingcapitalisassumedtobesalvaged.
¨ Thetaxrateonincomeisexpectedtobe40%.
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Costofcapitalforinvestment
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¨ Wewillre-estimatethebetaforthisonlineprojectbylookingatpubliclytradedonlineretailers.Theunleveredtotalbetaofonlineretailersis3.02,andweassumethatthisprojectwillbefundedwiththesamemixofdebtandequity(D/E=21.41%,Debt/Capital=17.63%)thatBookscapeusesintherestofthebusiness.WewillassumethatBookscape’staxrate(40%)andpretaxcostofdebt(4.05%)applytothisproject.LeveredBetaOnlineService =3.02[1+(1– 0.4)(0.2141)]=3.41CostofEquityOnlineService =2.75%+3.41(5.5%)=21.48%CostofCapitalOnlineService=21.48%(0.8237)+4.05%(1– 0.4)(0.1763)=18.12%
¨ Thisismuchhigherthanthecostofcapital(10.30%)wecomputedforBookscapeearlier,butitreflectsthehigherriskoftheonlineretailventure.
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IncrementalCashflowsonInvestment
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NPV of investment = $76,375
0 1 2 3 4Revenues $1,500,000 $1,800,000 $1,980,000 $2,178,000
Operating ExpensesLabor $150,000 $165,000 $181,500 $199,650Materials $900,000 $1,080,000 $1,188,000 $1,306,800Depreciation $250,000 $250,000 $250,000 $250,000
Operating Income $200,000 $305,000 $360,500 $421,550Taxes $80,000 $122,000 $144,200 $168,620After-tax Operating Income $120,000 $183,000 $216,300 $252,930+ Depreciation $250,000 $250,000 $250,000 $250,000- Change in Working
Capital $150,000 $30,000 $18,000 $19,800 -$217,800+ Salvage Value of
Investment $0Cash flow after taxes -$1,150,000 $340,000 $415,000 $446,500 $720,730Present Value -$1,150,000 $287,836 $297,428 $270,908 $370,203
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Thesidecosts…
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¨ Itisestimatedthattheadditionalbusinessassociatedwithonlineorderingandtheadministrationoftheserviceitselfwilladdtotheworkloadforthecurrentgeneralmanagerofthebookstore.Asaconsequence,thesalaryofthegeneralmanagerwillbeincreasedfrom$100,000to$120,000nextyear;itisexpectedtogrow5percentayearafterthatfortheremainingthreeyearsoftheonlineventure.Aftertheonlineventureisendedinthefourthyear,themanager’ssalarywillrevertbacktoitsoldlevels.
¨ ItisalsoestimatedthatBookscapeOnlinewillutilizeanofficethatiscurrentlyusedtostorefinancialrecords.Therecordswillbemovedtoabankvault,whichwillcost$1000ayeartorent.
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NPVwithsidecosts…
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¨ Additionalsalarycosts=PVof$34,352
¨ OfficeCosts¤ After-TaxAdditionalStorageExpenditureperYear=$1,000(1– 0.40)=$600¤ PVofexpenditures=$600(PVofannuity,18.12%,4yrs)=$1,610
¨ NPVwithOpportunityCosts=$76,375– $34,352– $1,610=$40,413¨ Opportunitycostsaggregatedintocashflows
Year Cashflows Opportunity costs Cashflow with opportunity costs Present Value0 ($1,150,000) ($1,150,000) ($1,150,000)1 $340,000 $12,600 $327,400 $277,170 2 $415,000 $13,200 $401,800 $287,968 3 $446,500 $13,830 $432,670 $262,517 4 $720,730 $14,492 $706,238 $362,759 Adjusted NPV $40,413
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Case3:ExcessCapacity
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¨ IntheValeexample,assumethatthefirmwilluseitsexistingdistributionsystemtoservicetheproductionoutofthenewironoremine.Theminemanagerarguesthatthereisnocostassociatedwithusingthissystem,sinceithasbeenpaidforalreadyandcannotbesoldorleasedtoacompetitor(andthushasnocompetingcurrentuse).Doyouagree?a. Yesb. No
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AFrameworkforAssessingTheCostofUsingExcessCapacity
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¨ IfIdonotaddthenewproduct,whenwillIrunoutofcapacity?
¨ IfIaddthenewproduct,whenwillIrunoutofcapacity?
¨ WhenIrunoutofcapacity,whatwillIdo?¤ Cutbackonproduction:costisPVofafter-taxcashflowsfromlostsales
¤ Buynewcapacity:costisdifferenceinPVbetweenearlier&laterinvestment
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ProductandProjectCannibalization:ARealCost?
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¨ AssumethatintheDisneythemeparkexample,20%oftherevenuesattheRioDisneyparkareexpectedtocomefrompeoplewhowouldhavegonetoDisneythemeparksintheUS.Indoingtheanalysisofthepark,youwoulda. Lookatonlyincrementalrevenues(i.e.80%ofthetotalrevenue)b. Lookattotalrevenuesattheparkc. Chooseanintermediatenumber
¨ WouldyouranswerbedifferentifyouwereanalyzingwhethertointroduceanewshowontheDisneycablechannelonSaturdaymorningsthatisexpectedtoattract20%ofitsviewersfromABC(whichisalsoownedbyDisney)?a. Yesb. No