Chapter 6. How to Analyze Investment Projects

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Chapter 6. How to Analyze Investment Projects
Objective Explain Capital Budgeting Develop
Criteria for Project Evaluation
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Chapter 6 Contents

• The Nature of Project Analysis
• Where Do Investment Ideas Come From?
• The NPV Rule
• Estimating a Projects Cash Flow
• Cost of Capital
• Sensitivity Analysis Using Spreadsheets

• Analyzing Cost-Reduction Projects
• Projects with Different Lives
• Ranking Mutually Exclusive Projects
• Inflation and Capital Budgeting

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Capital Budget and Capital Budgeting

• Once a company has decided what business it
  intends to be in, it must considers
• proposals for investment projects
• evaluating them
• deciding which ones to accept and which to reject
• It must prepare a plan (capital budget) for
  acquiring
• factories, machinery, warehouses
• research laboratories
• showrooms, and
• for training the personnel.

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The Nature of Project Analysis

• Starting point An idea for increasing
  shareholder wealth
• Procedures of project analysis
• Forecasting cash flows Decisions and events
• Flexibility of decisions in the projects life

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Where Do Investment Ideas Come from?

• Customers
• RD department
• Competition
• Production division
• Incentive systems

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Objectives

• To show how to use discounted cash flow analysis
  to make decisions such as
• Whether to enter a new line of business
• Whether to invest in equipment to reduce costs

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NPV Rule Revisited

• Invest if the proposed projects NPV is positive.
• Discount rate
• Opportunity cost The rate of return on
  comparable investment opportunities.
• Cost of capital
• NPV The fair market value in competitive and
  efficient market.

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Measurement of Value
Market?
Accounting?

• Two approaches of measuring value
• Accounting Book valueHistorical cost
• Financial Market valueDiscounting

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The Balance Sheet
Asset Liability Equity
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Continued
Corporate Finance Assets
Liabilities and Equity Asset 1
Asset 2
Liabilities Asset 3

Equity
Asset n Total Assets
Liabilities Equity
Accounting Yes! Finance No!
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Corporate Finance Assets
Liabilities and Equity
Asset 1 Asset
2 Liabilities
Asset 3
Equity
Asset n Total Assets
Liabilities Equity
NPV
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Example PC1000 of Compusell Corp.
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PC1000 Cash Flows

• A seven-year coupon bond with an annual coupon
  payment of 1.3 million, a face value of 2.2
  million, and a price of 5 million.

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Was 0
Was 0
Was 0
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Was 15
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Was 40
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Was 0
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Was 75
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Was 3,100,000
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Table 6.4 Project Sensitivity to Sales Volume

• 3640 is the NPV break-even point.

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Cost of Capital

• Risk-adjusted discount rate (k)
• The risk of a particular project may be different
  from the risk of the firms existing assets.
• The risk that is relevant in computing a
  projects cost of capital is the risk of the
  projects cash flows and not the risk of the
  financing instruments (e.g., stocks, bonds) the
  firm issues to finance the project.
• The cost of capital should reflect only the
  market-related risk of the project (its beta).

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Illustration 1

• 25-year U.S. Treasury bonds paying 100 per year
  are selling in the market at 1,000.
• A firm has the opportunity to buy 1 million
  worth of these bonds for 950 each.
• The firms overall (average) cost of capital is
  16.
• If discounted at 16, the NPV of the opportunity
  is -340,291.
• However, no one will forgo the opportunity.
• The correct cost of capital is nearly 10.

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Illustration 2

• Compusell Corporation is planning to finance the
  5 million outlay required to undertake the
  PC1000 project by issuing bonds.
• Compusell has a high credit rating because it has
  almost no debt outstanding and therefore can
  issue 5 million worth of bonds at an interest
  rate of 6 per year.
• It would be a mistake to use 6 as the cost of
  capital in computing the NPV of the PC1000
  project.

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Illustration 3

• An all-equity financed firm with tree divisions
• An electronics division, 30 of the firms market
  value, cost of capital 22
• A chemical division, 40 of the firms market
  value, cost of capital 17
• A natural gas transmission division, 30 of the
  firms market value, cost of capital 14.
• The cost of capital for the firm is 0.322
  0.417 0.314 17.6 .
• If 17.6 is adopted as discount rate for all
  projects, then it is likely
• to accept projects in the electronics division
  with negative NPV
• to pass up profitable natural gas transmission.

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Illustration 4

• An all-equity financed steel company considering
  the acquisition of an integrated oil company that
  is 60 crude oil reserves and 40 refining.
• The market capitalization rate on crude oil
  investments is 18.6 and on refining projects is
  17.6.
• The market capitalization rate on the oil company
  shares is 18.2.
• The market capitalization rate for steel projects
  is 15.3.
• The market price of the oil companys shares is
  fair (100, expected return 18.2) .
• An investment banker reports that all the shares
  could be acquired for a tender offer bid of 110
  per share.
• With 15.3, the NPV of the acquisition is
  11018.2/.1539.
• With 18.2, the NPV of the acquisition is
  11018.2/.182-10.

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Example Cost Reducing Project

• A firm is considering an investment proposal to
  automate its production process to save on labor
  costs.
• Invest 2 million now in equipment (an expected
  life of 5 years) and thereby save 700,000 per
  year in pretax labor costs.

• The incremental cash flows due to the investment
• At the 10 discount rate, the NPV is 274,472.

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Project with Different Lives

• Suppose that there are two different types of
  equipment with different economic lives in the
  previous example.
• The longer-lived requires twice the initial
  outlay but lasts twice as long.
• An easier approach is called annualized capital
  cost.

The Shorter-lived equipment
The Long-lived equipment
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Ranking Mutually Exclusive Projects

• Sometimes two or more projects are mutually
  exclusive.
• You own a parcel of land and have two
  alternatives
• Construct an office building
• Make a parking lot.

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Ranking Mutually Exclusive Projects

• Rule This firm should choose the project with
  the highest NPV at any cost of capital below 20.

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Inflation and Capital Budgeting

• Rule There are two correct ways of computing
  NPV
• Use the nominal cost of capital to discount
  nominal cash flows.
• Use the real cost of capital to discount real
  cash flows.
• Never compare the IRR computed using real cash
  flow estimates to a nominal cost of capital.