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Chapter 6 Investment Decision Rules Investment Decisions • NEW YORK, May 1, 2007 (PRIME NEWSWIRE) - Dow Jones & Company (NYSE:DJ - News) today confirmed that its Board of Directors has received an unsolicited proposal from News Corporation to acquire all of the outstanding shares of Dow Jones common stock and Class B common stock for $60.00 per share in cash, or in a combination of cash and News Corporation securities. 6-2 Shareholders to vote on TXU buyout FERC signs off on TXU deal; shareholders are expected to approve it Friday, September 7, 2007, The Dallas Morning News The Federal Energy Regulatory Commission has approved the $45 billion private buyout of TXU. FERC says the buyout is 'consistent with the public interest.' The idea of selling TXU to Kohlberg Kravis Roberts & Co. and TPG for $45 billion, in the biggest leveraged buyout ever, has gained popularity among shareholders lately, as the stock market drop made the $69.25-a-share offer look pretty good. TXU shares closed up 1 percent at $67.32 Thursday. The rise toward the $69.25-per-share offer shows that investors are feeling more optimistic that the deal will be completed. 6-3 Graham and Harvey, 2002 “It is a major tenet of modern finance theory that the value of an asset (or an entire company) equals the discounted present value of its expected future cash flows. Hence, companies contemplating investments in capital projects should use the net present value rule: that is, take the project if the NPV is positive (or zero); reject if NPV is negative.” 6-4 Graham and Harvey, 2002 6-5 NPV and Stand-Alone Projects • Researchers at FFF face an investment decision. The project requires $250 million to build a new plant. The benefits will be $35 million per year, starting at the end of the first year and lasting forever. Should the firm take the project? 6-6 NPV of FFF’s New Project The graph shows the NPV as a function of the discount rate. The NPV is positive only for discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of capital of 10%, the project has a positive NPV of $100 million. 6-7 Alternative Decision Rules • • • • The Payback Rule The Internal Rate of Return Rule Economic Profit or EVA Why Do Rules Other Than the NPV Rule Persist? 6-8 Using the Payback Rule 6-9 Merits of the Payback Rule • Cons – – – – Ignores timing and risk of cash flows (time-value-of-money) Imposes an arbitrary payback threshold Completely ignores the cash flows after the payback point If the project generates both positive and negative cash flows (other than the initial outlay) we can have multiple payback periods and no clear interpretation • Pros? – Simplicity – Accounts for the liquidity of the project – Accounts for the uncertainty of the cash flows 6-10 IRR • Take a project if its IRR exceeds the opportunity cost of capital • The IRR is the rate at which the NPV is zero. 6-11 Deviations between NPV and IRR • John Star is offered $1 million to write a book. He will forgo $500,000 a year for three years in opportunity costs. Should he take the book deal? 6-12 NPV of Star’s $1 million Book Deal When the benefits of an investment occur before the costs, the NPV is an increasing function of the discount rate. 6-13 Non-existent IRR • John Star is offered $1 million per year in each of the next three years if he gave four lectures per month. He will forgo $500,000 a year for three years in opportunity costs. Should he take the lecture deal? 6-14 NPV of Lecture Contract No IRR exists because the NPV is positive for all values of the discount rate. Thus the IRR rule cannot be used. 6-15 Multiple IRRs • John Star is offered $1 million to write a book. He will forgo $500,000 a year for three years in opportunity costs. After the book is written (in year 3), he will receive $20,000 per year in royalties, forever. Should he take the book deal? 6-16 NPV of Star’s Book Deal with Royalties In this case, there is more than one IRR, invalidating the IRR rule. If the opportunity cost of capital is either below 4.723% or above 19.619%, Star should make the investment. 6-17 Mutually Exclusive Investment Opportunities • Don is evaluating two investment opportunities: 1) Invest $1,000, get $1,100 in year 1, declining at 10% thereafter, forever. 2) Invest $1,000, get $400, declining at 20% thereafter, forever. 6-18 NPV of Don’s Investment Opportunities with the Single-Machine Laundromat The NPV of his girlfriend’s business is always larger than the NPV of the single-machine laundromat. The same is true for the IRR; the IRR of his girlfriend’s business is 100%, while the IRR for the laundromat is 20%. 6-19 Project of Different Scale • Suppose Don can install 20 laundromats instead of 1? 6-20 NPV of Don’s Investment Opportunities with the 20-Machine Laundromat As in Figure 6.5, the IRR of his girlfriend’s business is 100%, while the IRR for the laundromat is 20%. But in this case, the NPV of his girlfriend’s business is larger than the NPV of the 20-machine laundromat only for discount rates in excess of 13.9%. 6-21 Economic Value Added: EVA® • EVA is a measure of performance developed by the consulting company Stern Stewart. It measures the value that your company (or division within a company) creates through its investment and financing decisions. • EVA= Economic Profit = “Profit” – Capital Charge 6-22 EVA in Period n (When Capital Lasts Forever) 6-23 Calculating EVA When Invested Capital is Constant 6-24 Calculating EVA When Invested Capital is Constant 6-25 EVA in Period n (When Capital Depreciates) 6-26 Calculating EVA When Invested Capital Changes 6-27 Calculating EVA When Invested Capital Changes 6-28 • In general, EVA = (Net Operating Profit After Tax ) - [(Cost of Capital %) * (Total Capital)] • where NOPAT = EBIT x (1 - T) 6-29 Comparison between NPV and EVA NPV = PV ( Future CF ) - Initial Outlay EVA = NOPAT - Capital Charge = NOPAT - Cost of Capital x Level of Capital NPV EVA Application Projects or Investment Decision Performance Evaluation of the Firm or Division Time Project's Life Any defined period Base Cash Flows NOPAT Capital Expenditure Reduces CF Increased Level of Capital Depreciation Added to NOPAT Reduces Level of Capital Working Capital Affects CF Affects Level of Capital 6-30