* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Download Chapter 1: An Introduction to Corporate Finance
Survey
Document related concepts
International investment agreement wikipedia , lookup
Financialization wikipedia , lookup
Rate of return wikipedia , lookup
Investment management wikipedia , lookup
Land banking wikipedia , lookup
Stock selection criterion wikipedia , lookup
Corporate venture capital wikipedia , lookup
Financial economics wikipedia , lookup
Private equity in the 1980s wikipedia , lookup
Business valuation wikipedia , lookup
Modified Dietz method wikipedia , lookup
Investment fund wikipedia , lookup
Present value wikipedia , lookup
Early history of private equity wikipedia , lookup
Global saving glut wikipedia , lookup
Transcript
INTRODUCTION TO CORPORATE FINANCE SECOND EDITION Lawrence Booth & W. Sean Cleary Prepared by Ken Hartviksen & Jared Laneus Chapter 13 Capital Budgeting, Risk Considerations and Other Special Issues 13.1 Capital Expenditures 13.2 Evaluating Investment Alternatives 13.3 Independent and Interdependent Projects 13.4 Capital Rationing 13.5 International Considerations Booth/Cleary Introduction to Corporate Finance, Second Edition 2 Learning Objectives 13.1 Describe the capital budgeting process and explain its importance to corporate strategy. 13.2 Identify and apply the main tools used to evaluate investments. 13.3 Analyze independent projects and explain how they differ from interdependent projects. 13.4 Explain what capital rationing is and how it affects firms’ investment criteria. 13.5 Explain the importance of international foreign direct investment both inside and outside Canada. Booth/Cleary Introduction to Corporate Finance, Second Edition 3 Capital Expenditures • Capital expenditures are a firm’s investments in long-lived or fixed assets, which may be: • Tangible, such as property, plant and equipment • Intangible, such as research and development knowledge, patents, copyrights, trademarks, brand names and franchise agreements • Capital expenditures decisions determine the future direction of the company and are among the most important that a firm can make because they often: • • • • Involve a very significant outlay of money and managerial time Take many years to demonstrate their return Are irrevocable Significantly alter the risk of the entire firm because of their size and long-term nature • Capital budgeting is the process through which a firm makes capital expenditure decisions, and involves identifying and evaluating investment alternatives, implementing the chosen proposals, and monitoring implemented decisions Booth/Cleary Introduction to Corporate Finance, Second Edition 4 Porter’s Five Forces Model • Michael Porter’s Five Forces Model identifies five critical factors that determine the attractiveness of an industry: 1. 2. 3. 4. 5. Entry barriers Threat of substitute products Bargaining power of buyers Bargaining power of suppliers Rivalry among existing competitors • Companies do exert control over how they strive to create a competitive advantage within their industry. They can strive for: 1. 2. Cost leadership (i.e., be the lowest-cost producer) Product differentiation (i.e., have products considered unique) • Once attained, a competitive advantage is difficult to sustain and requires ongoing planning and investment • Capital expenditure decisions must be made with a strategic focus and be subject to rigorous financial analysis Booth/Cleary Introduction to Corporate Finance, Second Edition 5 Types of Analysis and DCF Methods • Bottom-up analysis is an investment strategy in which capital expenditure decisions are considered in isolation without regard for whether the firm should continue in its particular business or for general industry and economic trends • Top-down analysis is an investment strategy that focuses or strategic decisions, such as which industries or products the firm should be involved in, looking at the overall economic picture Booth/Cleary Introduction to Corporate Finance, Second Edition 6 Types of Analysis and DCF Methods • Capital expenditure decisions, like security valuation, must take into account the timing, magnitude, and riskiness of net incremental after-tax cash flow benefits that an initial investment is forecast to produce • Unlike security valuation, however, analysts can change the underlying cash flows by changing the structure of the project to impact its feasibility and profitability • All discounted cash flow (DCF) methods require an estimate of the initial investment, the net incremental after-tax cash flows, and the required rate of return on the project for the discount rate Booth/Cleary Introduction to Corporate Finance, Second Edition 7 Evaluating Investment Alternatives • Figure 13-1 shows the cash flow pattern for a traditional capital expenditure: Where : • CFt = the estimated after-tax future incremental cash flow at time t • CF0 = the initial after-tax incremental cash outlay • We will consider four DCF methods for evaluating investment alternatives: net present value (NPV), internal rate of return (IRR), payback period and discounted payback period, and profitability index (PI). Booth/Cleary Introduction to Corporate Finance, Second Edition 8 Cost of Capital • The firm’s cost of capital determines the minimum rate of return that would be acceptable for a capital project • The weighted average cost of capital (WACC) is the discount rate (k) used in NPV analysis, assuming the risk of the project being evaluated is similar to the risk of the overall firm, and the hurdle rate for IRR analysis • If the risk of the project differs from the risk of the overall firm, however, a risk-adjusted discount rate (RADR) should be used • RADRs can be estimated using two techniques: 1. Use the CAPM after determining the project’s beta. This approach involves forecast ROA that must be regressed against the ROA of the market index, and estimation errors can be significant. 2. Use a pure-play approach where you find the cost of capital of another firm operating in the industry associated with the project. The key to this approach is that the firm must not be diversified across industries but truly represent an investment solely in that industry. Booth/Cleary Introduction to Corporate Finance, Second Edition 9 Net Present Value (NPV) • Use Equation 13-1 to calculate NPV: n CF3 CFt CF1 CF2 NPV ... CF0 CF0 2 3 t 1 k (1 k ) (1 k ) t 1 (1 k ) • Essentially, the net present value (NPV) is the present value of all benefits (net cash inflows) minus the present value of costs (net cash outflows) • If PV(benefits) > PV(costs), then NPV > 0 and the project is acceptable because it will add value • If PV(benefits) < PV(costs), then NPV < 0 and the project should not be accepted because it will destroy value • NPV is an absolute measure, expressed in present dollars, of the net incremental benefit the project is forecast to bring shareholders • In a perfectly efficient market, the total value of the firm should rise by the value of the NPV if the project is undertaken Booth/Cleary Introduction to Corporate Finance, Second Edition 10 Net Present Value (NPV) • Example: Suppose a company has an investment that requires an aftertax incremental cash outlay of $12,000 today. It estimates that the expected future after-tax cash flows associated with this investment are $5,000 in years 1 and 2, and $8,000 in year 3. Using a 15% discount rate, determine the project’s NPV. • Solution by Formula: CF3 CF1 CF2 NPV CF0 2 3 1 k (1 k ) (1 k ) 5,000 5,000 8,000 12,000 $1,388.67 2 3 1.15 (1.15) (1.15) Booth/Cleary Introduction to Corporate Finance, Second Edition 11 Net Present Value (NPV) • Solution Using a Financial Calculator: • Solution Using Excel: • =NPV(rate, value 1, value 2, …, value n) • =NPV(0.15, 5000, 5000, 8000) = $13,388.67, the present value of future cash flows • Then, subtract the initial outlay of $12,000 to find NPV Booth/Cleary Introduction to Corporate Finance, Second Edition 12 Net Present Value (NPV) • An NPV profile is a set of NPVs for a project created by varying the discount rate used to find the present value of the cash flows • An NPV profile is also the slope of the line created when the results are graphed; the longer the life of a project, the steeper the slope of the NPV profile. NPV Profile for Example 13-1 $8,000 Project NPV $6,000 $4,000 $2,000 $0 0.05 $(2,000) Booth/Cleary Introduction to Corporate Finance, Second Edition 0.1 0.15 0.2 0.25 0.3 0.35 Discount Rate (k) 13 Internal Rate of Return (IRR) • The internal rate of return (IRR) is the discount rate that causes the NPV of the project to equal zero: n CFt NPV CF0 0 t t 1 (1 IRR ) • If the IRR > WACC, then the project is acceptable because it is forecast to yield a rate of return on invested capital that is greater than the cost of the fund invested in the project • If the IRR < WACC, the project should not be accepted because the investment will not earn its cost of capital Booth/Cleary Introduction to Corporate Finance, Second Edition 14 Internal Rate of Return (IRR) • Example: Suppose a company has an investment that requires an aftertax incremental cash outlay of $12,000 today. It estimates that the expected future after-tax cash flows associated with this investment are $5,000 in years 1 and 2, and $8,000 in year 3. The cost of capital is 15%. Determine the project’s IRR. • There is no closed-form formula solution for IRR. It can be solved iteratively, but technology expedites the process significantly. CF3 CF1 CF2 NPV CF0 0 2 3 1 k (1 k ) (1 k ) 5,000 5,000 8,000 12,000 0 2 3 1 IRR (1 IRR ) (1 IRR ) Booth/Cleary Introduction to Corporate Finance, Second Edition 15 Internal Rate of Return (IRR) • Solution Using a Financial Calculator: • Solution Using Excel: • =IRR(value 0, value 1, value 2, …, guess), guess can be blank • =IRR(-12000, 5000, 5000, 8000) = 21.31282726% Booth/Cleary Introduction to Corporate Finance, Second Edition 16 NPV versus IRR • Both methods use the same basic decision inputs • The difference is the assumed discount rate: the IRR assumes intermediate cash flows are reinvested at the IRR while the NPV assumes that they are reinvested at the WACC • This difference can produce conflicting decision results under specific conditions (see Table 13-1, next slide): 1. 2. 3. Evaluating two or more mutually exclusive investment proposals NPV profiles of the projects have different slopes and cross at a positive NPV The cost of capital (relevant discount rate) is lower than the crossover discount rate Booth/Cleary Introduction to Corporate Finance, Second Edition 17 NPV versus IRR Booth/Cleary Introduction to Corporate Finance, Second Edition 18 NPV versus IRR • In Figure 13-2 the IRR of B is 15% while the IRR of A is only 12%, so IRR would suggest that B is better than A • But, notice that the NPV of A is greater when the discount rate is lower than the 9% crossover rate. Booth/Cleary Introduction to Corporate Finance, Second Edition 19 NPV versus IRR • Both NPV and IRR use the same inputs • NPV measures in absolute terms the estimated increase in the value of the firm today that the project is forecast to produce, and assumes that cash flows are reinvested at WACC • IRR estimates the project’s rate of return and assumes that cash flows produced by the project are reinvested by the firm at the project’s IRR • The reason for the different accept/reject decisions is the different reinvestment rate assumptions used by the two techniques • Which method should be relied upon? • It depends which reinvestment assumption is more realistic • Most often, the NPV assumption of reinvestment at WACC is the most realistic because no rational manager would reinvest cash flows at rates lower than the firm’s cost of capital • If projects with high IRRs are rare, then reinvestment may not be possible Booth/Cleary Introduction to Corporate Finance, Second Edition 20 CFO Preferences • Despite the inherent superiority of the NPV approach, chief financial officers continue to use other approaches and do not necessarily favour NPV over IRR • Perhaps the reason for this is that it is difficult for people to understanding what a positive NPV really means Booth/Cleary Introduction to Corporate Finance, Second Edition 21 Payback Period • The payback period is a simple approach to capital budgeting that is designed to tell you how many years it will take to recover the initial investment • The payback period is often used by financial managers as one of a set of investment screens, because it gives the manager an intuitive sense of the project’s risk • The discounted payback period overcomes the lack of consideration of time value of money that is problematic with the simple payback period • Graphing the cumulative present value of cash flows can help identify the pattern of cash flows beyond the payback point • If carried to the end of the project’s useful life, it will tell us the project’s NPV if the WACC is used as the discount rate Booth/Cleary Introduction to Corporate Finance, Second Edition 22 Payback Period • Example: Determine the payback and discounted payback for a project that costs $100,000 to implement and gives $60,000 after-tax cash flows for six years • Solution: the payback period is 1.7 years and the discounted payback period is 1.9 years Year CF Discounted CF Cumulative CF Cumulative Discounted CF 0 -$100,000 -$100,000 -$100,000 -$100,000 1 $60,000 $54,545 -$40,000 -$45,455 2 $60,000 $49,587 $20,000 $4,132 3 $60,000 $45,079 4 $60,000 $40,981 5 $60,000 $37,255 6 $60,000 $33,868 Booth/Cleary Introduction to Corporate Finance, Second Edition 23 Discounted Payback Period Graphed NPV $ Discounted Payback Point Years Booth/Cleary Introduction to Corporate Finance, Second Edition 24 Profitability Index (PI) • The profitability index (PI) uses exactly the same decision inputs as the NPV • The PI simply expresses the relative profitability of the project’s incremental after-tax cash flow benefits as a ratio to the project’s initial cost: PV (Cash Inflows) PI PV (Cash Outflows) • If PI > 1, accept the project because the PV(Benefits) > PV(Costs) • If PI < 1, do not accept the project because the PV(Benefits) < PV (Costs) Booth/Cleary Introduction to Corporate Finance, Second Edition 25 Independent & Interdependent Projects • Independent projects have no relationship with one another; therefore, the decision to implement one project has no impact on the decision to implement another project. • Example: Building a store in Ottawa is independent of building a store in Edmonton. • Contingent projects, on the other hand, are projects where the acceptance of one requires the acceptance of another, either as a prerequisite or simultaneously • Example: Building a retail outlet in Edmonton requires warehouse space in Edmonton. • Mutually exclusive projects are substitutes where the decision to accept one project automatically means all other substitute proposals are rejected • Example: A commercial development on a parcel of land in Edmonton means an apartment building will not be built there Booth/Cleary Introduction to Corporate Finance, Second Edition 26 Evaluating Mutually Exclusive Projects with Unequal Lives There are two approaches to adjust for unequal lives among mutually exclusive projects: 1. The chain replication approach finds a time horizon into which all the project lives under consideration will divide equally (i.e., their lowest common multiple) and then assumes each project repeats until it reaches this horizon. This implicitly assumes the projects are repeatable on the same terms into the future. 2. The equivalent annual NPV (EANPV) approach compares projects by finding the NPV of the individual projects and then determining the amount of an annuity that is economically equivalent to the NPV generated by each project over its respective time horizon. Equation 13-4: Project NPV EANPV 1 1 1 k (1 k ) n Booth/Cleary Introduction to Corporate Finance, Second Edition 27 Capital Rationing • Capital rationing is the corporate practice of limiting the amount of funds dedicated to capital investments in any one year • It is academically illogical: why would a manager not invest in a project that will offer a greater return than the cost of capital used to finance it? • In the long-run, it could threaten a firm’s continuing existence through the erosion of its competitive position • But the firm may have owners who do not want to raise additional external equity because it will mean ownership dilution of their share • The firm may also have so many worthy investment projects that taking advantage of all of them exceeds the firm’s short-term managerial capacity • Under capital rationing the cost of capital is no longer the appropriate opportunity cost • IRR may have more validity because the firm may be able to reinvest its cash flows at rates that are higher than the cost of capital Booth/Cleary Introduction to Corporate Finance, Second Edition 28 Capital Rationing • The profitability index may also be a useful starting point because it ranks projects on PV per unit of investment • In the absence of capital rationing, NPV, IRR and PI will select valuemaximizing projects. • Figure 13-4 shows Tim Horton’s investment opportunity schedule: Booth/Cleary Introduction to Corporate Finance, Second Edition 29 Investment Opportunity Schedules • An investment opportunity schedule (IOS) is a prioritized list of capital projects, ranked from highest to lowest with the cumulative investment required also listed • Investments can be ranked according to any metric, but only NPV ensures maximization of shareholder wealth • Example: Suppose a firm has a 10% cost of capital and six projects from which it can choose to allocate $6 million in capital investment. Project Initial Cost ($) Annual ATCF ($) Useful Life NPV ($) IRR (%) PI A 1,500,000 290,000 7 -88,159 8.19 0.94 B 3,000,000 700,000 6 48,682 10.55 1.02 C 4,000,000 1,040,000 6 529,471 14.40 1.13 D 70,000 20,000 7 27,368 21.08 1.39 E 1,000,000 290,000 5 99,328 13.82 1.10 F 960,000 200,000 8 106,985 12.99 1.11 Booth/Cleary Introduction to Corporate Finance, Second Edition 30 Investment Opportunity Schedules • Example: Suppose a firm has a 10% cost of capital and six projects from which it can choose to allocate $6 million in capital investment • In the absence of capital rationing, all three methods choose value maximizing project and reject value destroying projects Rank NPV IRR PI 1st C D D 2nd F C C 3rd E E F 4th B F E 5th D B B Rejected A A A Booth/Cleary Introduction to Corporate Finance, Second Edition 31 Investment Opportunity Schedules • Example: Suppose a firm has a 10% cost of capital and six projects from which it can choose to allocate $6 million in capital investment • With only $6 million to allocate only NPV ensures maximization of shareholder wealth: Rank NPV IRR PI 1st C D D 2nd F C C 3rd E E n/a Capital Budget $5,960,000 $5,070,000 $4,070,000 Total NPV $735,785 $656,168 $556,840 Booth/Cleary Introduction to Corporate Finance, Second Edition 32 International Considerations • Capital investment decisions that involve foreign investment should taking into account additional factors: • Political risk • Potential legal and regulatory issues • Adjustments for foreign exchange risk • Adjustments for foreign taxation • Sources of financing if local capital markets are poorly developed or unsuitable • Export Development Canada (EDC) is a federal crown corporation that helps Canadian firms export and make foreign direct investment (FDI) • EDC provides insurance products to mitigate some risks of FDI • FDI outside of Canada is a growing phenomenon as Canadian companies are increasing seeking international investment opportunities • EDC encourages Canadian companies to look beyond the U.S. for FDI Booth/Cleary Introduction to Corporate Finance, Second Edition 33 Copyright Copyright © 2010 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein. Booth/Cleary Introduction to Corporate Finance, Second Edition 34