Download Chapter 1: An Introduction to Corporate Finance

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
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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.
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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
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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
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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
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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
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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).
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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.
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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
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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)
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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
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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)
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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
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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 )
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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%
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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
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NPV versus IRR
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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.
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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
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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
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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
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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
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Discounted Payback Period Graphed
NPV
$
Discounted Payback
Point
Years
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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)
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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
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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 
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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
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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:
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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
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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
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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
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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
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Copyright
Copyright © 2010 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
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use of the information contained herein.
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