l 3 - investment management incl. solutions 2012

7/29/2019 L 3 - Investment Management Incl. Solutions 2012

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1Markus Neuhaus I Corporate Finance I [email protected]

Corporate Finance

Investment Management

Dr. Markus R. Neuhaus

Patrick Schwendener, CFA, CAIA

Autumn Term 2012


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2Markus Neuhaus I Corporate Finance I [email protected] Term 2012

21.09. No lecture No lecture28.09. Fundamentals (4 hours) M. Neuhaus & M. Schmidli

05.10. Investment Management M. Neuhaus & P. Schwendener12.10. No lecture No lecture

19.10. Mergers & Acquisitions I & II (4 hours) M. Neuhaus & S. Beer

26.10. Taxes (4 hours) M. Neuhaus & M. Marbach

02.11. Business Valuation (4 hours) M. Neuhaus & M. Bucher

09.11. Value Management M. Neuhaus, R. Schmid & G. Baldinger

16.11. No lecture No lecture

23.11. No lecture No lecture30.11. Legal Aspects I. Pschel

07.12. Turnaround Management M. Neuhaus & R. Brunner

14.12. Financial Reporting M. Neuhaus, M. Jeger & T. Busch

21.12. Summary, repetition M. Neuhaus

Corporate Finance: Course overview


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Markus R. Neuhaus

PricewaterhouseCoopers AG, Zrich

Phone: +41 58 792 40 00Email: [email protected]

Grade Chairman Qualification Doctor of Law (University of Zurich), Certified Tax Expert

Career Development Joined PwC in 1985, became Partner in 1992 and CEO from 2003

2012, became Chairman in 2012

Subject-related Exp. Corporate Tax

Mergers & Acquisitions

Lecturing SFIT: Executive in Residence, lecture: Corporate Finance

Multiple speeches on leadership, business, governance, commercialand tax law

Published Literature Author of commentary on the Swiss accounting rules

Publisher of book on transfer pricing

Author of multiple articles on tax and commercial law, M&A, IPO, etc.

Other professional roles: Member of the board of conomiesuisse, member of the board

and chairman of the tax chapter of the Swiss Institute of

Certified Accountants and Tax Consultants


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Grade Advisory Senior Manager Qualification lic.oec.HSG, CFA, CAIA

Career Development Joined PwC Corporate Finance in October 2004

Subject-related Exp. Numerous projects in the field of valuation

Lecturing Treuhandkammer - Business valuations using DCF technique

KV Zurich Business School - Capital budgeting

ZHAW Zurich University of Applied Sciences - Corporate Finance

Seminar

Published Literature Several articles on valuation topics

Patrick Schwendener

PricewaterhouseCoopers AG, Zrich

Phone: +41 58 792 15 08Email: [email protected]


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Contents

Learning targets

Pre-course reading

Lecture Investment management

Case study

Solution to case study

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Learning targets

Know the discipline of investment management and its relevant stakeholders and

understand their contributions and responsibilities

Understand the strategic importance of investing and the various types of investments

Distinguish between static and dynamic methods and know the characteristics of the

various analysis methods in each category

Know when to apply which methods and be able to make a qualified judgment whether

an investment opportunity should be undertaken or not

Know potential limitations and shortcomings of quantitative capital budgeting methods

Autumn Term 2012


7/687Markus Neuhaus I Corporate Finance I [email protected]

Contents

Learning targets

Pre-course reading


Case study


Autumn Term 2012



Pre-course reading

Books

Mandatory reading

Brealey, Myers, Allen (2011): chapter 2 (pp. 48 - 55)

Brealey, Myers, Allen (2011): chapter 5 (pp. 129 - 154) Optional reading



Volkart (2011): chapter 4 (pp. 277 - 298)

Presentation slides

Structure of lecture (pp. 1 - 11)

Case study (pp. 46 - 58)

Autumn Term 2012



Contents

Learning targets

Pre-course reading


Case study


Autumn Term 2012



Agenda (1/2)

1. Introduction

Investment process

Nature of investment opportunities

Need for investment management Overview of capital budgeting methods

2. Static methods

Static methods

Cost and profit comparison method

Simple payback period method

Average rate of return method (Return on investment method)

Conclusion on static methods

Autumn Term 2012



Agenda (2/2)

3. Dynamic methods

Compounding and discounting

Opportunity cost of capital

Dynamic methods Net present value method (NPV)

Internal rate of return method (IRR)

Dynamic payback period method

Annuity method

Conclusion on dynamic methods

4. Case study

Circuit AG

5. Solution to case study

6. Q&A and discussion

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Agenda: Introduction

Investment process

Nature of investment opportunities

Need for investment management

Overview of capital budgeting methods

Autumn Term 2012



Investment process (1/2)

Shareholders prefer to be rich rather than poor. Therefore, they want the firm to invest

available cash in every project that is worth more than it costs (circle of cash)

If the firm is perceived to fall short of that goal, shareholders prefer to invest their capital

themselves more profitably outside the company on their own

Investment

(project X) Firm Shareholders

Investment

(financial assets)

Cash

Option 2:

The firm pays dividend

to its shareholders

Option 1:

The firm makes

investment decision

Source: Brealy, Myers, Allen (2011), p. 131.

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Shareholders

invest for

themselves



Investment process (2/2)

Most organisations have developed special procedures and methods for dealing with

investment management, involving

the formulation of long-term goals as part of the overall strategy process

the search for and identification of new investment opportunities

the estimation and forecasting of relevant parameters

the development of decision rules

the controlling and monitoring of investment projects

Consequently, investment management has many different stakeholder groups. For

instance, engineering manpower is indispensable as it

helps translate technical talk into financial talk

provides relevant data for financial models

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Nature of investment opportunities (1/2)

A capital investment can generally be characterized as follows

Lapse of a significant period of time (more than one year) between investment

outlay and receipt of benefits

Benefits are unevenly distributed over the expected useful life

Investment outlay is mostly long-term in nature and hardly reversible

Therefore, making capital investments is obviously a vital activity in business. Important

goals include

Achievement of strategic goals

Abolition of capacity constraints

Maintenance of the asset base

Compliance with legal conditions

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Nature of investment opportunities (2/2)

In practice, capital investments can be grouped using various characteristics

By categories of investment projects (not exhaustive):

New investments

Expansion investments Replacement investments

Productivity investments

Infrastructure investments

By degree of dependence:

Mutually exclusive investments

Complementary investments

Substitute investments

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Need for investment management

Capital investments can be huge and have a significant impact on the future financial

performance and the value of the firm

When analyzing capital investment opportunities, companies are usually confronted with

a series of challenges

Limited capital resources

Limited predictability of relevant data

Relevant data partly insufficiently quantifiable

The tools and methods of investment management help overcome the complexity of

investing by providing a sound basis for decision making

Investment

Financing

Profitability /excess return

Future valueof the firm

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Overview of capital budgeting methods

The term capital budgeting refers to a firms entire process of analyzing investment

opportunities and determining opportunities that are worth being pursued and realized

Several methods of analyzing investment opportunities have evolved which can be

divided into static and dynamic methods

Historically, static methods were developed first. Today, professionals typically make

use of the dynamic methods and apply static methods as 'rules of thumb' at best

Static methods Dynamic methods

Cost comparison method

Profit comparison method


Average rate of return method

(Return on investment method)

Net present value method (NPV)



Annuity method

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Agenda: Static methods

Static methods



Average rate of return method (Return on investment method) Conclusion on static methods

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Most easily understood methods

Analysis of average per year or average per produced unit if capacities are different

Cost comparison method: Choice of investment opportunity with lowest costs:

Cost comparison method = min (average annual costs) or min (average costs per unit) Profit comparison method: Choice of investment opportunity with highest profits:

Profit comparison method = max (average annual profit) or max (average profit per unit)

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Simple payback period method (1/2)

The simple payback period method (SPP) considers the initial investment and the

resulting annual cash flows and tells the investor the time it takes to recover the initial

investment

Decision rule: Accept an investment opportunity when its payback period is shorterthan the expected useful life, i.e. when total cumulative cash flows exceed the required

investment

In case of uneven cash flows, cumulate actual annual cash flows

If investment opportunities with different useful lives are compared, determine how

many times the investment's cash flows will pay back the initial investment outlay

(expected useful life / payback period = total cash flows / initial investment outlay)

Simple payback period = Required investmentAverage annual cash flow

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Simple payback period method (2/2)

Example 1: Even cash flow pattern

Investment sum: 100

Annual cash flow: 20

Expected useful life: 10 years

Accept project as payback < 10 years

Example 2: Uneven cash flow pattern (useful life: 5 years)

Accept project as payback < 5 years

YearNominal

cash flow

Cumulated

cash flow

0 (today) -100 -1001 30 -70

2 35 -35

3 35 0

4 40 40

5 40 80

SPP =Required investment

annual cash flow= 5 years

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Average rate of return method (Return on investment

method) (1/2) The average rate of return (ARR) or Return on investment (ROI) can be calculated by

dividing the benefit of an investment, i.e. earnings before interest payments, by the

average capital tie-up

Decision rule: ARR is usually compared to some firm-specific threshold called hurdlerate, opportunity cost of capital, cost of capital or minimum rate of return. Projects with

an ARR above the threshold should be realized

ARR is a popular metric due to its versatility (can be defined differently) and simplicity.The downside of this is that it is prone to manipulation

Practitioners often use ARR as a means of relative performance measurement

ARR is also known as return on investment, accounting rate of return or book rate of

return

ARR =

Net profit +

Interest Capital tie-up (= Inv. capital)

= Earnings before interest Capital tie-up (= Inv. capital)

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Average rate of return method (Return on investment

method) (2/2) Example

Initial investment outlay: 300 Net profit: 30

Depreciation period (years): 10 Imputed interest rate: 10%

Liquidation value: 60 Hurdle rate: 15%

Accept project as ARR > 15%

ARR = Net profit + Interest

Capital tie-up=

30 + 18

180= 26.7%

Interest = Capital tie-up * Imputed interest rate = 180 * 10.0% = 18.0

Capital tie-up =Initial outlay + Liquidation value

2=

300 + 60

2= 180

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Conclusion on static methods

Pros

Static methods are easy to understand

Time and effort for data collection is manageable

Cons

Static methods only consider "average periods"

Time value of money not considered

Potential risk of oversimplification

Use static methods as rules of thumb at best

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Agenda: Dynamic methods

Compounding and discounting

Opportunity cost of capital

Dynamic methods

Net present value method (NPV)



Annuity method


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Compounding and discounting (1/3)

Time value of moneyInvestors prefer to receive a payment of a fixed amount of money today rather than the

equal amount of money at a point of time in the future, all other circumstances being

equal. In other words, to forego the use of money today, investors must receive some

compensation in the future

Compounding interestDescribes the process of adding accumulated interest to the principal, so that interest is

earned on interest from that moment on. In other words, compounding determines the

future value of a principal

Discounting interest

Describes the inverse process, i.e. finding the present value (today) of an amount ofcash received at some future date. The future value of each cash flow is reduced by

applying an appropriate discount rate

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PV FV1 FV2 FV3

Compound

interest

t

Compounding:

FV3 = PV * (1+r)3

Discounting:

PV = FV3 *

General:

FVn = PV * (1+r)n

PV = FVn *

1

(1+r)n

1

(1+r)3

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Example applying an interest rate of 10%

Compounding and discounting are very sensitive to changes in the discount rate

YearNominal

cash flow

Compound

factor @ 10%

Compound

cash flow (FV)

Nominal

cash flow

Discount

factor @ 10%

Discounted

cash flow (PV)

1 100 1.611 161 100 0.909 91

2 100 1.464 146 100 0.826 83

3 100 1.331 133 100 0.751 75

4 100 1.210 121 100 0.683 68

5 100 1.100 110 100 0.621 62

Total 500.0 671.6 500.0 379.1

Compounding Discounting

YearNominal

cash flow

Compound

factor @ 15%

Compound

cash flow (FV)

Nominal

cash flow

Discount

factor @ 15%

Discounted

cash flow (PV)

Total 500.0 775.4 500.0 335.2

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Opportunity cost of capital (1/2)

The opportunity cost of capital for an investment project is the expected rate of return

demanded by investors in common stocks or other securities subject to the same risks

as the project

Therefore, determining the opportunity cost of capital for an investment project involves

Searching for securities with identical risk profiles (perfect match) and

Determining the expected return of these securities

Discounting the investment project's expected cash flow at its opportunity cost of capital

will result in the price that investors would be willing to pay for the project

In practice, it is usually difficult to find such securities. A companys "weighted averagecost of capital" (WACC) is often taken as a convenient approximation for the opportunity

cost of capital

A company WACC needs to be adjusted for projects whose risk profile is different from

the company risk profile

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Opportunity cost of capital (2/2)

The riskier a project, the higher the return required by investors. Factors that need to be

considered include:

Inflation

Entrepreneurial business risk

Industry / sector risk

Project-specific risks

Increasing the share of debt capital (cheaper than equity capital) will not lower the

opportunity cost of capital of an investment project (neglecting the impact of taxes, for

further details see Miller Modigliani in lecture (business valuation)

The terms opportunity cost of capital, weighted average cost of capital, discount factor,

hurdle rate are often used interchangeably

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Net present value method (1/3)

The net present value (NPV) is defined as the total present value of a time series of

future cash flows less an initially required investment

Decision rule: Accept investment opportunities offering a positive net present value

Required input parameters:

Required investment (C0)

Expected payoffs/cash flows (Ct)

Number of years (t)

Discount rate/hurdle rate/opportunity cost of capital (r)

t

1it

t0

r1

CCNPV

TT

2

2

1

1

0

r1

C

r1

C

r1

CCNPV

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C0


PV

C1C2 C3

C4 Cnt

0 1 n32 4

NPV

Example: Discount rate 10%

Year 0 1 2 3 4 5 Total

Income 0 30 35 35 40 40 180

Capital investment -100 0 -100

Cash flow -100 30 35 35 40 40 80Discount factor 1.000 0.909 0.826 0.751 0.683 0.621

Discounted cash flow -100 27 29 26 27 25

Cum discounted cash flow -100 -73 -44 -18 10 35

NPV 35

C5

5

Some numbers are rounded.

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Cash flows pattern Flat Increasing Decreasing

Discount rate 10% 15% 10% 15% 10% 15%

NPV 36 21 35 18 38 23


Sound estimation of discount rate and cash flows is crucial as NPV is very sensitive to

these parameters

Distribution and timing of the cash flows impact the NPV as more distant cash flows are

discounted to a greater extent than earlier cash flows

Among mutually exclusive projects the one with the highest NPV should be chosen

1 The following table shows the detailed cash flows underlying the three scenarios defined above.

Year 1 2 3 4 5 Total

Flat cash flows 36 36 36 36 36 180

Increasing cash flows 30 35 35 40 40 180

Decreasing cash flows 40 40 35 35 30 180

1

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Internal rate of return method (1/4)

The internal rate of return (IRR) is defined as the rate of return that makes the net

present value equal to zero, i.e. the rate at which the present value of the expected

cash flows equals the required investment (or the NPV is zero after a defined number of

years)

Decision rule: Accept investment opportunities offering rates greater than theiropportunity cost of capital (hurdle rate)

Required input parameters: Required investment (C0)


Number of years (t)

0

IRR1

CCNPV

t

1it

t0

0

IRR1

C

IRR1

C

IRR1

CCNPV

TT

22

11

0

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Provides relative values compared to the absolute results of the NPV method

Results can be misleading when compared without considering required investment

IRR assumes that a project's cash flows can be reinvested at the same rate of return,

which can be a doubtful assumption

IRR is widely used in workday life and many alternative applications have been

developed

The later a project's cash flows will occur, the lower the IRR will be (provided total

nominal cash flow is equal), i.e. IRR (decreasing) > IRR (flat) > IRR (increasing)

Cash flows pattern Flat Increasing Decreasing

Discount rate 10% 15% 10% 15% 10% 15%

NPV 36 21 35 18 38 23

IRR 23.4% 22.1% 24.8%

1 See page 34 for detailed cash flow pattern assumptions.

1

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The IRR rule contains several pitfalls:

Conflicting results for mutually exclusive projects

Multiple rates of return (change in the sign of the cash flow stream, referred to as

"Descartes' rule of signs")

Lending vs. borrowing

Multiple opportunity costs

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NPV vs. IRR1

Investment opportunities with discount rates below IRR will yield positive NPV and

should be accepted and vice versa

IRR and NPV analyses result in the same answer when applied properly, but NPV iseasier to use and less prone to wrong decisions

Only IRR is based on the reinvestment assumption but not NPV

NPV is superior - in case of conflicting results, go with NPV!

Discount

rate

IRRNPV

NPV > 0

NPV < 0Discount rate < IRR

Discount rate > IRR

1 See Brealy, Myers, Allen (2011), p. 131ff for a detailed explanation.

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Dynamic payback period method (1/3)

The dynamic payback period method (DPP) determines the length of time required for

an investments cash flows, discounted at its opportunity cost of capital, to recover its

initial required investment

Decision rule: Accept an investment opportunity when its payback duration is shorter

than the expected useful life (same as for static payback method) Required input parameters:

Required investment (C0)


Expected useful life (t)

Discount rate/hurdle rate/opportunity cost of capital (r)

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t

CF1 CF5CF3CF2 CF4

Payback period = ?

PVC0

Example: DPP using a discount rate of 10%

DPP = 3.0

+ (18/28)= 3.6

SPP = 3.0

YearNominal

cash flow

Cumulated

cash flow

Discount

factor

Discounted

cash flow

Cumulated

cash flow

0 (today) -100 -100 1.000 -100 -100

1 30 -70 0.909 27 -73

2 35 -35 0.826 29 -44

3 35 0 0.751 26 -18

4 40 40 0.683 27 10

5 40 80 0.621 25 35

Static payback (SP) Dynamic payback (DP)

Some numbers are rounded.

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DPP provides useful results and is often applied as a complementary method to NPV

but should not be used as the sole investment decision criterion

NPV and DPP can lead to different results depending on

the distribution of cash flows over the investment's useful life

the designated time limit of the investment

DPP omits all cash flows after the investment sum is recovered, which may be

inadequate for long-running investments

In practice, both simple and dynamic payback durations are often used as simple

measures of risk since short payback durations are generally considered safer than

longer periods (liquidity aspect)

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Annuity method (1/2)

An annuity is a series of equal annual cash flows over a given period. The sum of these

cash flows is equal to a project's NPV

Decision rule: Accept investment opportunities with annuities greater than zero

The annuity method is similar to NPV but somewhat more difficult to calculate

Based on the initial investment outlay, the rate of return and the project's time horizon,

the required cash flow is calculated (equals IRR or NPV of zero). This required cash

flow is then subtracted from the project's actual cash flow. The difference represents the

annuity, which in sum must be equal to the project's NPV

The use of annuities is often unnecessary as NPV analyses will come to identical results

Only two arguments support the use of the annuity method:

Annuities help to calculate the NPV for perpetual cash flows (e.g. terminal value

calculation in business valuation)

As a one-period measure annuities can be interpreted more easily than NPV

Annuity (finite) = NPV *(1 + r)T * r

(1 + r)T - 1Annuity (infinite) = NPV * r

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Present value interestfactor for annuity

Annuity method (2/2)

Calculation of future and present values of ordinary annuity and annuity due:

Future value interestfactor for annuity

Ordinary =(1+r)n -1

r

1r

Due = (1+r)n -1

r* (1+r)

r*(1+r)n1

-Ordinary =

Due = 1r r*(1+r)n1 - * (1+r)

YearNominal

cash flow

Compound

factor @ 10%

Compound

cash flow (FV)

Nominal

cash flow

Discount

factor @ 10%

Discounted

cash flow (PV)

1 100 1.611 161 100 0.909 91

2 100 1.464 146 100 0.826 83

3 100 1.331 133 100 0.751 75

4 100 1.210 121 100 0.683 68

5 100 1.100 110 100 0.621 62

Total 500.0 6.716 671.6 500.0 3.791 379.1

Compounding Discounting

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Pros

Consideration of time value of money

Consideration of effective cash flows instead of average values

Enable detailed analysis of the investment project

Cons

Time and effort for data collection can be overwhelming

Sensitivity of results to changes of some parameters (e.g. WACC)

Risk of neglecting aspects of non-monetary nature

Calculations are more complex, prone to error and time-consuming

Uncertainty of future projections

Dynamic methods are preferred over static methods

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Agenda: Case study

Circuit AG

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Circuit AG

The Swiss Circuit AG (Circuit) was founded in 1975 and is a well

established producer of medium and high quality printed circuit boards

(PCB)

Circuit produces only in Switzerland at four plants

Since 2005, domestic and European demand has been significantlydeclining. However, Circuit faces only slightly weaker demand in the

area of high-quality circuit boards and only a moderate slowdown in the

medium quality sector

The latest industry outlook is very solid and Circuit is expected to

experience above-average growth

Given these circumstances, Circuit is now examining potential

investment opportunities in the field of high-quality multi-layer circuit

boards

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Circuit AG: High-speed milling (1/4)

The product manager of Circuit's high-frequency PCB department has proposed two

alternative investments in the field of high-speed milling. The following data have been

gathered

Alternative A Alternative B

Expected useful life (in years) 6.0 6.0

Sales volume (units per year) 14'000 18'000

Sales price (CHF per unit) 10.0 10.0

Initial investment outlay 200'000 250'000

Construction costs 18'000 28'000

Freigth costs 2'000 2'000

Liquidation value after 8 years 16'000 0

Fixed operating costs (per year) 6'000 22'000

Variable unit costs (CHF per unit) 4.6 3.9

Tax rate (% per year) 20.0% 20.0%

Imputed interest rate (% per year) 6.0% 6.0%

6

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Identify the preferred investment using

the profit comparison method

the average rate of return method

the static payback method

Discuss and justify your overall decision

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Revenue

./. Variable costs

./. Fixed costs

EBITDA

./. Depreciation

EBIT

./. Average interest

EBT

./. Tax

Average profit

Rank

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Static payback period method


Average profit

Average interest

Average capital tie-up

Average rate of return

Rank


Average profit

+ Average depreciation

Average cash flow

Total investment outlay

Static payback period in years

Rank

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Circuit AG: Etching technology (1/6)

In early 2012, Mr. Sell, Chief Strategy Officer in Circuit's high-frequency PCB

department, has proposed to venture into the field of plasma etching. However, based

on preliminary studies, Mr. Sell currently still favors two different etching technologies,

wet etching and plasma etching. While wet etching is expected to be an expiring

technology, the market is not sure whether plasma etching will advance to the state of

the art technology. Circuit can invest only in one technology

Mr. Sell has told you that he favors IRR, because the results of NPV can be misleading.

He has already assessed plasma etching and determined its IRR to be 23.3%. He asks

you to calculate the IRR for the potential investment in wet etching and hand in a

reasonable proposal in which technology to invest

Use the following pages to determine the IRR by interpolation

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IRR calculation for wet etching technology (low IRR bound)

Cash flow Discount rate Present value

Capital outlay year 0 -150

Cash flow year 1 80

Cash flow year 2 75

Cash flow year 3 55

Cash flow year 4 20

Cash flow year 5 10 0.3277

Net present value

Wet etching @ %

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IRR calculation for wet etching technology (high IRR bound)


Capital outlay year 0 -150

Cash flow year 1 80

Cash flow year 2 75

Cash flow year 3 55

Cash flow year 4 20

Cash flow year 5 10 0.3149

Net present value

Wet etching @ %

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As part of the investment appraisal, Mr. Sell also asks for a net present value

calculation for both technologies. The appropriate discount rate has been determined to

amount to 15%

Compare the results obtained by the different methods and formulate a final investment

recommendation

Cash flow Discount factor Present value

Capital outlay year 0 -150 1.000 -150

Cash flow year 1 30 0.870 26


Cash flow year 3 60

Cash flow year 4 75

Cash flow year 5 90

Net present value

Rank

Plasma etching

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Cash flow year 3 55

Cash flow year 4 20

Cash flow year 5 10

Net present value

Rank

Wet etching

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Contents

Learning targets

Pre-course reading


Case study

Solution to cases

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Circuit AG: Solution high-speed milling (1/4)

Calculation of necessary inputs


Total investment outlay 220'000 280'000Average capital tie-up 118'000 140'000

Average interest 7'080 8'400

Average depreciation 34'000 46'667

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Average profit per unit 1.6 1.5

Rank 1 2


Revenue 140'000 180'000

./. Variable costs -64'400 -70'200

./. Fixed costs -6'000 -22'000

EBITDA 69'600 87'800

./. Depreciation -34'000 -46'667

EBIT 35'600 41'133

./. Average interest -7'080 -8'400

EBT 28'520 32'733

./. Tax -5'704 -6'547

Average profit 22'816 26'187

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Static payback period method



Average interest 7'080 8'400

Average capital tie-up 118'000 140'000Average rate of return 25.34% 24.70%

Rank 1 2



+ Average depreciation 34'000 46'667

Average cash flow 56'816 72'853

Total investment outlay 220'000 280'000

Static payback period in years 3.87 3.84

Rank 2 1

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Overall assessment

Investment outlay and total profit of Alternative A are smaller (220'000 vs.

280'000 and 22'816 vs. 26'187). However, profit per unit is larger for

Alternative A (1.6 vs. 1.5)

ARR is marginally higher for Alternative A (25.3% vs. 24.7%)

Payback period for both Alternative A and Alternative B are shorter than theexpected life and approximately equal (3.87 vs. 3.84)

Based on the three methods applied above, Alternative A outperforms Alternative

B. However, consider market size and demand in your investment

recommendation

Alternative A Alternative BProfit comparison method 1 2

Average rate of return method 1 2

Static payback period method 2 1

Autumn Term 2012


63/68


Circuit AG: Solution etching technology (1/6)

IRR calculation for wet etching technology (low IRR bound)


Capital outlay year 0 -150 1.0000 -150Cash flow year 1 80 0.8000 64





Net present value 1.629

Wet etching @ 25 %

Autumn Term 2012


64/68



IRR calculation for wet etching technology (high IRR bound)


Capital outlay year 0 -150 1.0000 -150Cash flow year 1 80 0.7937 63





Net present value -0.688

Wet etching @ 26 %

IRR wet etching = 25% + 1% * (1.629/[1.629+0.688]) = 25.7%

IRR wet etching (25.7%) > IRR plasma etching (23.3%)

Autumn Term 2012


65/68


66/68



Net present value calculation for plasma etching (discount rate: 15%)








Net present value 37

Rank 1

Plasma etching

Autumn Term 2012


67/68










Net present value 29

Rank 2

Wet etching

Net present value calculation for wet etching (discount rate: 15%)

Autumn Term 2012


68/68


Overall assessment

IRR of wet etching is higher than the IRR of plasma etching (25.7% vs.

23.3%)

NPV @ 15% is higher for plasma etching than for wet etching (37 vs. 29)

Conflicting NPV and IRR results are due to the different cash flow patterns of

each technology. While wet etching cash flows will decrease, those of plasma

etching will increase

Pay attention when dealing with mutually exclusive investment projects

Based on the two methods applied above, plasma etching outperforms wet

etching and should be recommended in your investment proposal

Wet etching Plasma etchingIRR 1 2

NPV 2 1

l 3 - investment management incl. solutions 2012

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