Chapter 10 - Project Analysis

Learning objectives:

1. appreciate the practical problems of capital budgeting in large corporations
2. Use sensitivity, scenario and break-even analysis to see how project profitability would be affected by an error in your forecasts
3. Understand why an overestimate of sales is more serious for projects with high operating leverage.
4. Recognize the importance of managerial flexibility in capital budgeting

Two stages of investment evaluation
1) The capital budget: list of planned investment projects. earch year the list is generated and then assessed by senior management. senior management needs to ensure that the budgets matches teh firm's strategic plans. that the firm is concentrating efforts in areas of competitive advantage and identifying declining business that should be sold or allowed to run down.

2) project authorization: If you're on teh capital budget that doesn't mean your project is authorized. at a later stage you will need to draw up details on engineering analyses, cash-flow forecasts, PV calculations.

Chapter 9 - Usind Discounted Cash-Flow Analysis to Make Investment Decisions

Learning Objectives

1. Identify the cash flows properly attributable toa proposed new project
2. Calculate the cash flows of a porject from standard financial statements
3. Understand how the company's tax bill is affected by depreciation and how this affects project value
4. Understand how changes ni working capitral affect project cash flows.

Review:  Estimating NPV

1. Forecase the project cash flows
2. Estimate the opportunity cost of capital, that is, the rate of return that you shareholders could expect to earn if they invested their money in the capital market.
3. Use the opportunity cost of capital to discount the future cash flows. The projects's present value (PV) is equal tot he sum of the discounted future cash flows.
4. NPV measures whether the project is worth more than it costs. To calculate NPV,  you need to subtract the required investment from the present value of the future payoffs:

NPV = PV - required investement

When you discount NPV, discount CASH FLOWS, not accounting profits.

Recognize expenses when they occur, not when they show up as depreciation. 

Incremental Cash Flows

A projects present value depends on teh extra cash flows that it produces. So you need to forecast first the firms cash flows if you go ahead with thte project, then forecas the cash flows if you don't accept the project. Take the diff and you have the increamental cash flows

Incremental cash flow = cash flow with project - cash flow without project.

Example: Windows Vista

Inclue all indirect effects when forecasting cash flows.

Sometimes a new project will help the firms existing business indirectly. don't just look at the NPV in isolation.

example: adding new flight to airline service.

Dont include sunk costs. Example, lockheeds Tristar airplane. They sunk nearly $1 billion on the project and were tryign to decide on whether to .. But how do you know when somethign is fully sunk?

Include opportunity costs

Def opportunity cost - benefit of cash flow forgone as a result of an action .

 

Recognize the investment in working capital 

Def net working capital - current assets minus current liabilities.

Remember shut down cash flows

example: nuclear power plants, coal mines are very expensive. However, certain shutdown costs can be cash inflows, from selling of equipment, plants, inventories.

Ignore financing decisions when forecasting cash flows for NPV. Regardless of whether you finance with debt or with equity. Keep the invesmtnet decision seperate from the financing decision. first ask whether the project has positive NPV, then if it does, figure out the best financing strategy.

9.2 Calculating Cash flow

Total cash flow = Cash flows from capital invesmtents

+ cash flows from chagnes in working capital

+ operating cash flows.

Capital investments

In general, an increase in working capital is an investment adn therefore implies a negative cash flow. a decrease in working cap implies a positive cash flow. The cash flow is measured byt the change in working capital, not the lievel of working capital.

Operating Cash Flow = revenues - costs - taxes.

Dealing with depreciation when working out project's cash flows (pg 267) See three methods for operating cash flow.

Depreciation example - straight line depreciation: constat depreciateion each eyar of the asset's accounting life. for JBEI question. 

Deprecitation Tax Shield - pg 271

 

Straight line depreciation is one method, but Modified accelerated cost recovery system (MACRS) is another

Depreciation method that allows higher tax deductions in early years and lower deductions later

All large corporations use two sets of books, one for stockholders with straight line depreciation and one for the IRS with MACRS.  Only the tax books are relevant in capital budgeting.

9.3 - Great Example (pg  269)

Chapter 8 - NPV and Other Investment Criteria

Learning objectives:
1) calculate NPV of an investment
2) calculate IRR of a project adn know what to look out for when using the Internal rate or return rule.
3) explain why the payback rule doesn't always make shareholders better off.
4) use the net present value rule to analyze three common problems that involve competing projects
a) when to postpone an investment expenditure
b) how to choose between projects with unequal lives
c) when to replace equipment
5) Calculate the profitability index and use it to choose between projects when funds are limited.

The investment decision aka "Capital budgeting" is

Any expenditure made in the hope of generating more cash later is called a capital investment project, regardless of whether the cash outlay goes to tangible or intangible assets.

Every shareholder wants to make money, therefore they want the firm to invest in every project that is worth more than it costs.

The difference between a project's value and its cost is termed the Net Present Value.(NPV)

Companies should invest in projects with positive NPV.

When companies have to make choices, they should pick the projects that have the highest NPV per dollar invested (the Profitability index)

8.1 Net Present Value

Def - Opportunity cost of capital - expected rate of return given up by investing ina  project.

Def - Net Present Value: Present Value (PV) of cash flows minus investment.
The net present value rule states that managers increase shareholder's wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive NPV.

Basic Financial Principle: a risky dollar is worth less than a safe one.

NPV = C0 + C1/(1+r) + C2/(1+r)^2 + ... CH/(1+r)^H

Calculation NPV 
1) forecast future cash flows- this is hard to do. NPV analysis is only as good as it's forecasts.

2) estimate opportunity cost of capital


Def - mutually exclusive projects: two or more projects that cannot be pursued simultaneously. When you need to choose amont mutually exclusive projects, the decision rule is simpe: Calculate the NPV of each alternative, and choose the highest positive NPV project

8.2 Payback and IRR
Def - payback period: time until cash flows recover the initial investment in teh project.

Payback is a simple mechanism for assessing profitability. Often looks at short term and small capital investments. Manager asks "What is the payback period?" "When will this be profitable?".

Def IRR - Internal Rate of Return. Discount rate at which project NPV = 0. See Figure 8-2.

Instead of doing NPV calc, companies often prefer to ask whether the project's return is higher or lower than the opportunity cost of capital (return on other investments at same risk level in the market).

TWO RULES FOR DECIDING WHETHER TO INVEST
1) The NPV Rule: Invest in any project that has a positive NPV when its cash flows are discounted at the opportunity cost of capital
2) Rate of Return Rule: Invest in any project offering a rate of return that is higher than the opportunity cost of capital.

More decision making criteria
Investment timing - should you buy a computer now or wait and think again next year?
The decision rule for investment timing is to choose the investment date that results in the highest net present value today. (see pg 241)

Long vs Short lived equipment - should the company save money today by installing cheaper machinery that will not last as long? Select the machine with the lowest equivalent annual annuity.

Def - equivalent annual annuity: the cash flow per period with the same present value as the cost of buying and operating a machine.

Equivalent Annual Annuity = Present value of costs/Annuity Factor

Replacing an old machine - When should existing machinery be replaced?

8.4 Capital Rationing

Def Capital Rationing - limit set on the amount of funds available for investment

Soft Rationing - limits set by management, not investors

Hard Rationing - the firm can't raise the money it needs.

Def profitability index - ratio of net present value to initial index.

If you have 5 investments all with positive NPV but limited funds, you need to select the projects that give the highest nPV per dollar of investment.

Table 8-3 has a good overview of investment decision rules

Chapter 7: Valuing Stocks

 Goals:

1. learn how to read stock trading reports
2. calculate the PV of a stock given forecasts of future dividends and future stock price
3. use stock valuation formulas to infer the expected rate of return on a common stock
4. Interpret 'priece-earnings ratios'
5. Understand 'no free lunches' means on Wall street

 Def : Common stock - ownership shares in a publicly held corporation

LArge firms sell or issue shares of stock tot he public when they need to raise money.

Def: Primary market. Market for the sale of new securities by corporations.Fed ex and other frims sell new shares to the public only infrequentyly. These take place in the 'primary market'

Def IPO: First offering of stock to the general public.  The first time a company sells shares to the public.  Companies raise funds by selling these new shares, but the previous owners (investors, founders, employees) have to share ownership (and profits) with the new shareholders.  Current record ipo VA Linux Systems. In 1999 they shold shares at $30, but by the end of the day they had reached $239 (700% gain).

Def: secondary market. Market in which previously issued securities are traded among investors.  Exchanges are really markets for secondhand stocks. (NYSE and NASDAQ are the two main ones in US)  Every day the NYSE trades 3 billion shares with market value over $100billion.

Def P/E Ratio: Ratio of stock price to earnings per share.

What determines the value of a stock?

Def: Book value: Net worth of the firm according to the balance sheet.  = Total Equity/number of shares
Example. Fed Ex Equity on 5/31/07 was $12,656 mill.  Outstanding shares were 296 mill. book value = 12,656/296 = $42.76/share

Def: Liquidation value:  Net proceeds that could be realized by selling the firm's assets and paying off its creditors.

Market price is not the same as book or liquidation value. Investors buy shares on teh basis of present and future earning power. Two key features determine the profits the firm will be able to producer
1) the earnings that can be generated by the firm's current tangible AND intangible assets
2) the opportunities that the firm has to invest in lucrative projects that will increase future earnings.

7.3 Valuing Common Stocks

a. Valuation by Comparables - common first approach. divid stock price by measures of assets or earningsa nd see how these ratios stack up against other firsms.  See table 7-5 for examples in different industries.  Look at the industry average "price to book values" or "Price to earnings ratio" and then assume then multiply your company's book value times average ratio.

"Price to book" works best for companies with lots of fixed assets.  Not so good with companies with lots of intangibles and R&D

Price and Intrinsic Value
Just as bond values are the present value of all future coupon payments + PV of final payment,
Stock value is the present value of all future dividend payments up to the time of sale + the PV of the final selling point at the time of sale.

Intrinsic Value of Stocks is the present value of future cash flows except there's no final payment.

Say for example, you want to buy stock in Blue Skies Inc and sell it in a year, what price should you pay for it?  If the predicted stock price after 1 year is P1 and the expected dividend payout is DIV1, and the discount rate for the stock's expected cash flows is r, then...
The PV of the cash flows the investor will receive is
Vo = (DIV1+P1)/(1+r)

So if you're looking to buy a stock, you need to try to guess the intrinsic value and see what the going price is Po. If Po
If Po>Vo, then don't buy.

But how do we estimate the Future price P1?

Def - Dividend Discount Model : Discounted cash flow model which states that today's stock price equals the present value of all expected future dividends


Po = PV(DIV1, DIV2, DIV3,...DIVt, ...)
= DIV1/(1+r) + DIV2/(1+r)^2 + ... + DIVt/(1+r)^t + ...

Suppose our horizon date is H

Then the stock valuation formula using the DDM is

Po = DIV1/(1+r) + DIV2 (1+r)^2 + ... + DIVH/(1+r)^H

Which is always the same regardless of time horizon.

7.4 Simplifying the Dividend Discount model (DDM)


DDM with no growth, all earnings paid out as DIVs.  This is a special case. For example, there might be a producer in an industry that is heavily regulated and has fixed limits on annual production.

Value (or price of a share) of a No-growth stock  = Po = EPS1/r

EPS = earnings per share

In other words, the stock prices is the present value of future earnings per share.

Constant Growth Dividend Discount Model, - dividend grows at constant rate.

Version of the dividend discount model in which dividends grow at a constant rate

Po = DIV1/(r-g)

r = discount rate

g = constant growth rate

Estimating Expected Rates of Return (ERR)

In competitive markets, common stocks with the same risk are expected to have the same ERR. But how do you figure ERR? It ain't easy.

Rules of thumb

1) rewrite the constant growth DDM as

r = DIV1/Po + g

r = dividend yield + growth rate

ex. Blueskies

r = $3/$75 + .08 = 12%

Rate of Return for a particular company is determined by the rate of return offered by other equally risky stocks., not by DIV or g. DIV or g affect stock price, not rate of return.

So rate of return r for a company is based on the risk, if growth changes, stock price changes with it, not necessarily the rate of return.

NonConstant Growth (variable growth?)

Many companies grow at different rates for several years before settling down. we can't use the constant growh model to estimate value. Alternative approach see page 200

7.5 Growth Stocks and Income Stocks

"Growth stocks are ones that are expected to have capital gains. Income Stocks are ones that give cash dividends." Aha!

Def payout ratio - Fraction of earnings paid out as dividents

Def Plowback ratio - fraction of earnings retained by the firm

Def Sustainable Growth Rate : steady rate at which firm can grow; 

g = return on equity X plowback ratio

The total value of stock is equal to the value of it's assets in place (tangible/intangible) plus the present value of its growth opportunities (PVGO)

Def Present value of Growth opportunities (PVGO). Net present value of a firm's future investments.

Price to Earnings (P/E) ratio is an indicator of prospects. High P/E means that investors think that the company has good growth potential. however, if earnings are trending down, P/E will increase. Not necessarily a good sign.

7.6 No such thing as free lunches
Difference between technical analysts, and fundamental analysts. one look at numbers, the other look at trends in market/govt/society.

Chapter 6 - Valuing Bonds

Def - Bond: a security that obligates the issuer to make specified payments to the bondholder

Def - Face Value: payment at the maturity of the bond. Also called the 'principal' or 'par value'

Def - coupn: The interest payments paid to the bondholder.

Terminology "The 5s of 2011" is the 5% coupon bonds maturing in 2011.

Calculating the present value of a bond.

PV = PV(Coupons issued over time) + PV(Face value of the bond)
= (coupon X annuity factor) + (FV X Discount factor)
=  Coupon [1/r - 1/r(1+r)^t] + FV x (1/r^t)

6.3 yield to maturity

Def current yield = annual coupon payments divided by bond price - thiis not really good for anythign besides telling you how much you'll get this year.

Def yield to maturity = interest rate for which the PV of teh bond's payments equals the price

Def Rate of return = Total income per period per dollar invested

Def Default (or credit) risk: The risk that a bond issuer may default on its bonds. This is relevant to corporate bond issuers, not so much national governments

Def default premium: the additional yield on a bond that investors require for bearing credit risk.

Def Investment grade: Bonds are rated by Moody's or S&P's. from Triple A: Aaa, Aa, A.Baa...
Bonds rated Baa and above are Investment grade (according to Moody's). BBB and above are investmetn grade for S&P (as opposed to Junk  Bonds) see table 6.2 for ratings



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