sloan corporate finance tutorial i308[2]

8/6/2019 Sloan Corporate Finance Tutorial i308[2]

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Todays Topic

NPVA Simple Case Study

Eagle Industry


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NPV (Net Present Value)


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NPV

NPV = Discounted Cash Flow (Inflow outflow)

In other words, it is the fundamental value of

an asset at current period. Note: NPV is not necessarily equal to marketvalue! (Market value is determined by supplyand demand in the market. If the market is

efficient, NPV is equal to market value.)


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Investment Decision and NPV

What is the goal of a firm? Maximizingshareholders value

NPV = shareholders value

Therefore, Investment decisions should bebased on the NPV of the project.


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NPV

NPV of cash on hand = amount of cash Ex) NPV of 100 on hand = 100

Suppose annual interest rate is rf= 10% Ex 1) NPV of 100 of next year?

Ans) 100/(1+rf) = 100/1.1 = 90.91 Ex 2) NPV of the following cash flow: 100(year 1), 100(year 2), 200(year 3) Ans) 100/1.1 + 100/1.12 + 200/1.13 = 323.82

In general, you have NPV formula such that

NPV = where Ct is cash flow at time t= +

N

t

t

t

r

C

0 )1(


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NPV of Uncertain Cash Flow

Calculating NPV is that simple! But, what ifyou have uncertain cash flow?

Can we just use expected cash flow like the

following? NPV = where E(C) is expectation of C

The answer is no. Lets look at an example!

= +

N

t

t

t

r

CE

0 )1(

)(


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Example: A Coin Tossing

Consider a gamble where you pay a certain amountnow, and receive money next year. Next year youwill toss a coin, and you will get 100 if it is head,0 if it is tail.

Expected cash flow (C) in the next year is E(C) =

0.5*100+0.5*0 = 50Suppose annual interest rate is rf= 7%

Are you willing to pay 50/(1+rf) = 50/1.07 = 47 forthis betting? Probably not!

Probably, you want to pay somewhat lower than 47.Suppose you want to pay P = 35 for the gamble.


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Return on Coin Tossing

The expected return on this betting is E(r) = E(C)/P 1 = 50/35 1 = 43%

You want to ask for higher return than the interestrate because this is a risky choice. We call it riskpremium! E(r) = rf+ risk premium = 7% + 36%

In general, this is decided by the risk of an asset. ex) CAPM: E(r) = rf+ (rM rf)

Therefore, we can calculate NPV of uncertain cash

flow by using an appropriate discount factorconsidering the risk of investment. (We will coverthis later in the cost of capital part.)


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A Simple Case Study

Ginos Trattoria Case

(Adapted from Brealey and Myers)


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Sample Problem

Ginos Trattoria is considering a new project, which requires

an investment of 2 million. The project is expected togenerate sales revenue of 1 million in the first year, 2million in the second year and 3 million each for year 3, 4and 5. The cost of goods sold is expected to be 75 percentof sales revenue. Other costs are expected to be 7 percentof sales in the first year and 5 percent of sales thereafter.

The project will need working capital investment of 200,000 in the first year and an additional 100,000 in thesecond year. The investment in plant ( 2 million) will bedepreciated using 25% declining balance over 5 years. Ifthe companys opportunity cost of capital is 10 percent,calculate the NPV for the project. Assume that the plant willoperate for 5 years, and at the end of 5 years, the plant canbe sold for a salvage value of 600,000. The tax rate forthe company is 36 percent.


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Approach for the Case

We need to calculate NPV to evaluate theproject

Remember NPV is discounted cash flows

Thus, all the information you will need is cashflowThe paragraph looks a bit too messy, and

very boring. Instead of trying to read it, we

can just pick up necessary information fromthe paragraph


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Cash Flow ?

Cash Flow = Cash Flow from Operation + Cash Flow from Investment + Cash Flow from Financing

= Net Income + Changes in WC + Capital Expenditure

+ Raising and Paying Debt orEquity


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CF fromInvestmentCF fromOperation

CF fromFinancing

Investment

Salvage

Value

Tax on differencebetweensalvage value andending book value=

-

+Cost

Tax SavingsFrom

Depreciation

=

Sales-

Tax EffectofSales &Cost+-

Change inWorking Capital

+

We wont havethis part in our

simple example

Ginos TrattoriaCase


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Necessary Information

All the information you will need will be thefollowing blocks from the case:

Investment SalvageValue

Tax on differencebetweensalvage value andending book value

Cost

Tax SavingsFrom

Depreciation

Sales

Tax EffectofSales &Cost

lso, you will need to know tax rate, discount rate,nd depreciation rule.

Change inWorkingCapital


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Step 1. Find Necessary Information

1.1 Find Investment and salvage value Ginos Trattoria is considering a new project, which requires an investment of 2

million. Assume that the plant will operate for 5 years, and at the end of 6 years, the plant can

be sold for a salvage value of 600,000.

1.2 Find Revenue (or Sales)

The project is expected to generate sales revenue of 1 million in the first year, 2million in the second year and 3 million each for year 3, 4 and 5.

1.3 Find Cost The cost of goods sold is expected to be 75 percent of sales revenue. Other costs

are expected to be 7 percent of sales in the first year and 5 percent of sales thereafter.

YearsInvestmentYearsSales

Years 0 1 2 3 4 5 6COGS 750 1500 2250 2250 2250

Other Costs 70 100 150 150 150


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Step 1. Find Necessary Information (2)

1.4 Find Working Capital

The project will need working capital investment of 200,000 in the first year and an additional$100,000 in the second year.

1.5 Find Depreciation Rule The investment in plant ( 2 million) will be depreciated using 25% declining balance over

schedule for the 5-year class.

1.6 Find Tax Rate The tax rate for the company is 36 percent.

1.7 Find Cost of Capital If the companys opportunity cost of capital is 10 percent, calculate the NPV for the project.

1.8 Duration of the project Assume that the plant will operate for 5 years, and at the end of 5 years, the plant can be sold

for a salvage value of 600,000.

YearsChange in Work

Capital


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Step 2. Calculate Profit, Tax effect of Sales&Costs,Depreciation, and Tax Savings

2.1 Profit = Sale

Years

Sales2.2 Tax = tax rYears


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Step 2. Calculate Profit, Tax effect of Sales&Costs,Depreciation, and Tax Savings (2)

2.4 Tax Saving

YearsDepreciation

Depreciation (25% Declining Rule) UK Tax Depreciationreciation in the first year = 25% of Value = .25 * 2000 = 500reciation after the second year = 75% of previous years depreciation = .75*500

2.5 Thus, we caYears


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Step 3. Calculate Cash Flow

Total Cash Flo

Years


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Step 4. Calculate NPV, IRR, Payback,and so on..

Using 10% cost of capital, we derive NPV = -220,962.07 IRR = 6.84%

Payback Period = 5 yearsThen, we can evaluate the project by given

criteria.


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Graham & Harvey (2007)s Survey


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NPV Criteria

Investment Decision using NPV: accept the project if NPV > 0

Strength

Consistent with the goal of shareholder valuemaximization

Weakness

Relies on cash flow forecasts, which tend to beinaccurate and biased upwards.


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IRR Criteria

Investment Decision using IRR: accept the project if IRR > opportunity costs of capital

Strength

IRR gives the same answer as NPV if used properly More intuitive (summarized to one number)

Weakness

Multiple solutions Easily misleading: timing, scale, etc


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Payback Period Criteria

Investment Decision using Payback: accept the project if it pays back its initial investment within the

cutoff period

Strength

Does not use distant cash flows which could be inaccurate ingeneral Make sure the initial investment is recovered within short term

Weakness

The payback rule ignores all cash flows after the cutoff date. The payback rule gives equal weight to all cash flows before thecutoff date. (It ignores the timing of cash flows within thepayback period)


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Quiz!

The Campbell-Graham survey shows thatover half of their CFOs use payback period(in conjunction with NPV) to assess projects.

Why do they use payback period?Payback period has its own strengths which

NPV does not have although it is a bitoversimplified.

Thus, payback period could provide a bettercriteria together with NPV.


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Best Criteria?

In an ideal world (where forecasting isunbiased and accurate), NPV is the bestrule as we have seen.

In reality, there is always the possibility of

having optimistic bias, and other biases inforecasting. Given that, using other criteria(payback) together with NPV will give youmore effective way of investment decision

making.


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A Review on Eagle Industry

C Mi t k i E l I d t


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Common Mistakes in Eagle IndustryCase

Tax savingsSunk Cost

Opportunity Cost

Minor mistakes

Tax Savings


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Tax Savings(Straight-line Depreciation)

Building (25 years straight line depreciation) Initial value: 1000, salvage value: 0

After 5 years, the book value is still 800 although thesalvage value is 0. Therefore, the difference between theending book value and the salvage value could be usedfor tax savings.

Tax Savings in year 6: 30%*(800)=240

0 1 2 3 4 5 6

Book Value 1000 960 920 880 840 800

Depreciation 40 40 40 40 40 800

Tax Savings 12 12 12 12 12 240

Tax Savings


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Tax Savings(25% declining balance)

Plant and machinery (25% declining balance) Initial value: 1200, salvage value: 100

After 5 years, the book value is still 285 although the salvagevalue is 100. Therefore, the difference between the endingbook value and the salvage value could be used for taxsavings.

Tax Savings in year 6: 30%*(285-100)=55

Book Value 1200 900 675 506 380 285

Depreciation 300 225 169 127 95 185

Tax Savings 90 68 51 38 28 55


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Opportunity Cost

Opportunity Cost of Land should be included in theanalysisThe criteria whether its a positive NPV project will be

NPV > 0

In case you dont include the opportunity cost Option 1: Run the project (Opportunity cost is not included)

Option 2: Sell the land at 100,000

The criteria whether its a positive NPV project will be NPV > 100,000


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Sunk Cost

Sunk cost shouldnt be included R&D cost (500,000) over the past two years is

a sunk cost, thus its not included in theanalysis

How to decide whether to include or notIf something can be affected by the decision to

accept or reject the project, it should beincluded.

Otherwise, it should be ignored.


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Working Capital

Working Capital = Current Asset Current Liability = Inventory + Account Receivable Account Payable

Use change in working capital, not working capital

itself to calculate cash flowThere is no tax effect on change in working capitalWith reasonable assumptions, working capital should

be recovered after the projects duration


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Minor Mistakes

Tax-free Grant In a development area, there is a tax free grant of 15%

on the value ofinvestment in buildings, plant, andmachinery. (only in the first year!)

15%*(1000+1200) = 330

There are launching costs of 200 and 100 in eachof the first two years respectively:

year 0 1 2 3 4 5

launching costs 200 100


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Next Time (Tentative)

Valuation with InflationSensitivity Analysis

Capital Structure

Fixed Income

You can download materials from

http://phd.london.edu/jhan.phd2005
http://phd.london.edu/jhan.phd2005http://phd.london.edu/jhan.phd2005

sloan corporate finance tutorial i308[2]

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