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1、11 11Chapter FourAnalyzing Investment project 222ContentsThe concept of capital budgetingThe steps of investment analysisEstimation of cost of capitalMeasure cash flowsThe approaches of capital budgeting 3 3What is a investment or a project?Any decision that requires the use of resources(financial o
2、r otherwise)is a project.Broad strategic decisionsEntering new areas of businessEntering new marketInvesting in equipment to reduce costsAcquiring other companies4What is Corporate Finance talking aboutBalance Sheet CurrentAssetsFixedAssetsTotalAssetsCurrent LiabilitiesLong-term Liabilities Sharehol
3、dersEquityTotal Liabilities and Shareholders EquityInvestmentdecision(CapitalBudgetingFinancingdecision(CapitalStructure)CashManagement45 55Capital budgetingThe process of analyzing investment decisions for a firm is called capital budgeting.Well look at how to use discounted cash flow(DCF)analysis
4、and net present value(NPV)and other rules in capital budgeting decision making.66Steps in Investment Analysis1.Estimate a hurdle rate for the project,based upon the riskiness of the investment2.Estimate revenues and accounting earnings on the investment.3.Convert accounting earnings into cash flowsU
5、se the cash flows to evaluate whether the investment is a good investment.4.Time weight the cash flowsUse the time-weighted cash flows to evaluate whether the investment is a good investment.5.Evaluate investment and make decisions77Estimating the Hurdle Rate for an InvestmentIf a firm is in only on
6、e business,and all of its investments are homogeneous:Use the companys costs of capital to evaluate its investments.If the firm is in more than one business,but investments within each of business are similar:Use the divisional costs of capital to evaluate investments made by that division88 Example
7、：Suppose that a firm 100%equity funded,it has three divisions:(1)electronics which is occupied 30%of the firms market value,the cost of capital is 22%;(2)chemical department which has 40%of market value,its cost of capital is 17%;(3)nature gas transmission division has 30%of market value,the cost of
8、 capital is 14%.the weighted average cost of capital of the firm =0.322%+0.417%+0.314%=17.6%when we conduct capital budgeting for a project,assume its similar to electronic industry,if we use 17.6%as hurdle rate of the new investment,no doubt we would over value the investment,would make worry decis
9、ion in the consequence.How we estimate the appropriate discount rate then?9Estimating the Hurdle Rate for an InvestmentIf a firm is planning on entering a new business:Estimate a cost of equity for the investment,based upon the riskiness of the investmentEstimate a cost of debt and debt ratio for th
10、e investment based upon the costs of debt and debt ratios of other firms in the business.910Estimating the Hurdle Rate for an InvestmentThe hurdle rate of a particular project based upon the riskness of it.The risk that is relevant in computing a projects cost of capital is the risk of the projects
11、cash flows and not the risk of the financing instruments the firm issues to finance the project.101111Example:suppose that Compusell Corporation is planning to finance$5 million outlay required to undertake a new project by issuing bonds.Suppose Compusell can issue bonds at an interest rate of 6%per
12、 year.Can we adopts 6%as the cost of capital to evaluate the new project?Why?1212Estimating the Hurdle Rate for an InvestmentFinancingmixofaprojectorafirmOwnersfunds(equity)Borrowedmoney(debt)Costofdebt?rBCostofequity？rECAPMAftertaxofinterests/actualmoneyfundedTheWeightedAverageCostofCapital：13 13Es
13、timating the Hurdle Rate for an Investment Investor and InvesteeRequirearateofreturnCostofcapitalStep214Step 2:Estimate revenues and accounting earnings on the investment.Step 3:Convert accounting earnings into cash flows14MeasureCashFlows151515The features of cash flows in capital budgeting1.Cash f
14、lows from operating activities 2.After tax cash flows 3.Incremental cash flows operating+after tax+incremental161616Incremental cash flowsIn calculating the NPV of a project,incremental cash flows should be used.These cash flow are the changes in the firms cash flows that occur as a direct consequen
15、ce of accepting the project.The difference between the cash flows of the firm with the project and the cash flows of the firm without the project.1717From Cash Flows to Incremental Cash FlowsThe Key Questions to determine whether a cash flow is incremental:What will happen to this cash flow item if
16、I accept the investment?What will happen to this cash flow item if I do not accept the investment?If the cash flow will occur whether you take this investment or reject it,it is not an incremental cash flow.1818Sunk CostsAny expenditure that has already been incurred,and cannot be recovered(even if
17、a project is rejected)is called a sunk cost.When analyzing a project,sunk costs should not be considered since they are not incremental.By this definition,market testing expenses and R&D expenses are both likely to be sunk costs before the projects that are based upon them are analyzed.If sunk costs
18、 are not considered in project analysis,how can a firm ensure that these costs are covered?1919Side Effects-Costs and BenefitsMost projects considered by any business create side costs and benefits for that business.The side costs include the costs created by the use of resources that the business a
19、lready owns(opportunity costs)and lost revenues for other projects that the firm may have.The benefits that may not be captured in the traditional capital budgeting analysis include project synergies(where cash flow benefits may accrue to other projects)and options embedded in projects(including the
20、 options to delay,expand or abandon a project).2020Opportunity CostAn opportunity cost arises when a project uses a resource that may already have been paid for by the firm.When a resource that is already owned by a firm is being considered for use in a project,this resource has to be priced on its
21、next best alternative use,which may bea sale of the asset renting or leasing the asset outuse elsewhere in the business 2121Case 1:Opportunity CostsAssume that Boeing owns the land that will be used to build the plant for the Super Jumbo Jet.This land is undeveloped and was acquired several years ag
22、o for$40 million.The land currently can be sold for$100 million,though that would create a capital gain(which will be taxed at 20%).In assessing the Boeing Super Jumbo,which of the following would you do:Ignore the cost of the land,since Boeing owns its alreadyUse the book value of the land,which is
23、$40 millionUse the market value of the land,which is$100 millionOther:22Case 2:Excess CapacityIn the Boeing example,assume that the firm will use its existing storage facilities,which have excess capacity,to hold inventory associated with the Super Jumbo.The project analyst argues that there is no c
24、ost associated with using these facilities,since they have been paid for already and cannot be sold or leased to a competitor(and thus has no competing current use).Do you agree?YesNo222323Product and Project CannibalizationWhen a firm makes a new investment,some of the revenues may come from existi
25、ng investments of the firm.This is referred to as cannibalization(erosion).Examples would be:A New Starbucks that is opening four blocks away from an existing StarbucksA personal computer manufacturer like Apple or Dell introducing a new and more powerful PCA motor manufacturer determine to produce
26、a new convertible sports car.2424Product and Project Cannibalization:A Real Cost?Assume that in the Starbucks analysis,20%of the revenues at the store are expected to come from people who would have gone to a existing store nearby.In doing the analysis of the store,would youLook at only incremental
27、revenues(i.e.80%of the total revenue)Look at total revenues of the new storeChoose an intermediate number 2525Project SynergiesA project may provide benefits for other projects within the firm.If this is the case,these benefits have to be valued and shown in the initial project analysis.For instance
28、,the Home Depot,when it considers opening a new restaurant at one of its stores,will have to examine the additional revenues that may accrue to this store from people who come to the restaurant.26Depreciation and incremental cash flowIn accounting,the capital expense will be spread over assets life
29、time and treat the spreading as operating expense for each year.The point is depreciation can reduce taxable income therefore have taxes benefit.When a firm undertake a new project,the benefit would change arise cash flows changed.Depreciation effect should be considered in project analysis.262727De
30、preciation MethodsBroadly categorizing,depreciation methods can be classified as straight line and accelerated methods.In straight line depreciation,the capital expense is spread evenly over time,In accelerated depreciation,the capital expense is depreciated more in earlier years and less in later y
31、ears.Declining Balance Depreciation MethodSum of the Years Digits28Straight Line Method-exampleSL=Cost/LifeExample:A machine is purchased for$10000.The expected life is 5 years.Calculate the annual depreciation as follows:10000/5=2000Each year for 5 years$2000 would be expensed.2829Accelerated Metho
32、ds-examplesDeclining Balance Depreciation MethodExample:A copy machine is purchased for$3500.The expected life is 5 years.Using double declining balance the depreciation would be calculated as follows:factor=2*(1/5)=0.4029YearDepreciable BasisDepreciationCalculationDepreciation ExpenseAccumulatedDep
33、reciation11000010000*0.4040004000260006000*0.4024006400336003600*0.4014407840421602160*0.408648704512961296*0.40518.49222.430Accelerated Methods-examplesSum of the Years DigitsThe first step is to sum the digits or numbers starting with the life and going back to one.For example,an asset with a life
34、 of 5 would have a sum of digits as follows:5+4+3+2+1=15To find the percentage for each year divide the years digit by the sum.30Year 15/15=33.34%Year 24/15=26.67%Year 33/15=20%Year 42/15=13.33%Year 51/15=6.67%YearDepreciationCalculationDepreciationExpense110000*33.33%3333210000*26.67%2667310000*20%
35、2000410000*13.33%1333510000*6.67%6673131 DepreciationAssume that you made a large investment this year,and that you are choosing between straight line and accelerated depreciation methods.Which will result in higher net income this year?Straight Line DepreciationAccelerated DepreciationWhich will re
36、sult in higher cash flows this year?Straight Line DepreciationAccelerated Depreciation32Incremental cash flows in project analysisEstimate incremental cash flows when conduct project analysis consider:Sunk costSide effectOpportunity costCannibalization(erosion)Project synergyEmbedded optionsNon-cash
37、 working capitalDepreciation effect on taxes32*33Investments in Non-Cash Working CapitalThe difference between current assets and current liabilities is often titled working capital by accountants.We modify that definition to make it the difference between non-cash current assets and non-debt curren
38、t liabilities and call it non-cash working capital.We eliminate cash from current assets because large cash balances today earn a fair market return.Thus,they cannot be viewed as a wasting asset.We eliminate debt from current liabilities because we consider debt to be part of our financing and inclu
39、de it in our cost of capital calculations.333434Non-Cash Working Capital EffectIntuitively,money invested in inventory or in accounts receivable cannot be used elsewhere.It,thus,represents a drain on cash flows.To the degree that some of these investments can be financed using suppliers credit(accou
40、nts payable)the cash flow drain is reduced.3535Non-Cash Working Capital EffectInvestments in non-cash working capital are thus cash outflowsAny increase in non-cash working capital reduces cash flows in that yearAny decrease in non-cash working capital increases cash flows in that yearTo provide clo
41、sure,working capital investments need to be salvaged at the end of the project life.36ExerciseDetermine which of the following cash flows are incremental cash flows that should be incorporated into a NPV calculation.a.The sale of an old machine,when a company is replacing property,plant,and equipmen
42、t for a new product launch.b.The cost of research and development for a new product concept that was conducted over the past year that is now being put into production.c.Potential rental income that was forgone from a previously unused warehouse owned by the company,which is now being used as part o
43、f a new product launch.d.New equipment purchased for a project.e.The annual depreciation expense on new equipment purchased for a project.f.Net working capital expenditures of$10 million in year 0,$12 million in year 1 and$5million in year 2.g.A dividend payment that was funded in part by a given pr
44、ojects contribution to the net income for that year.363737From Accounting Earnings to Cash Flows Cash Flow from OperationsOCF=EBIT Taxes+DepreciationNet Capital SpendingDo not forget salvage value.Changes in Net Working Capitalwhen the project winds down,we enjoy a return of net working capital.Cash
45、 flow=OCF+net working capital Other Methods for Computing OCFBottom-Up ApproachWorks only when there is no interest expenseOCF=NI+depreciationTop-Down ApproachOCF=Sales Costs TaxesDo not subtract non-cash deductionsTax Shield ApproachOCF=(Sales Costs)(1 T)+Depreciation*T3939To Time-Weighted Cash Flo
46、wsIncremental cash flows in the earlier years are worth more than incremental cash flows in later years.In fact,cash flows across time cannot be added up.They have to be brought to the same point in time before aggregation.This process of moving cash flows through time isdiscounting,when future cash
47、 flows are brought to the presentcompounding,when present cash flows are taken to the futureThe discount rate is the mechanism that determines how cash flows across time will be weighted.40Example:The Baldwin CompanyqCosts of test marketing(already spent):$250,000qCurrent market value of proposed fa
48、ctory site(which we own):$150,000qCost of bowling ball machine:$100,000(depreciated according to MACRS 5-year)qIncrease in net working capital:$10,000qProduction(in units)by year during 5-year life of the machine:5,000,8,000,12,000,10,000,6,00041The Baldwin CompanyqPrice during first year is$20;pric
49、e increases 2%per year thereafter.qProduction costs during first year are$10 per unit and increase 10%per year thereafter.qAnnual inflation rate:5%qWorking Capital:initial$10,000 changes with sales42The Baldwin CompanyAttheendoftheproject,thewarehouseisunencumbered,sowecansellitifwewantto.Year 0Year
50、 1Year 2Year 3Year 4 Year 5 Investments:(1)Bowling ball machine100.00 21.77(2)Accumulated 20.0052.0071.2082.70 94.20 depreciation(3)Adjusted basis of 80.0048.0028.8017.30 5.80 machine after depreciation(end of year)(4)Opportunity cost 150.00 150.00(warehouse)(5)Net working capital 10.00 10.0016.3224