Title: Sloan Corporate Finance Tutorial I Project Valuation
1Sloan Corporate Finance Tutorial I Project
Valuation
2Todays Topic
- NPV
- A Simple Case Study
- Eagle Industry
3NPV (Net Present Value)
4NPV
- NPV Discounted Cash Flow (Inflow outflow)
- In other words, it is the fundamental value of an
asset at current period. - Note NPV is not necessarily equal to market
value! (Market value is determined by supply and
demand in the market. If the market is efficient,
NPV is equal to market value.)
5Investment Decision and NPV
- What is the goal of a firm? Maximizing
shareholders value - NPV shareholders value
- Therefore, Investment decisions should be based
on the NPV of the project.
6NPV
- NPV of cash on hand amount of cash
- Ex) NPV of 100 on hand 100
- Suppose annual interest rate is rf 10
- Ex 1) NPV of 100 of next year?
- Ans) 100/(1rf) 100/1.1 90.91
- Ex 2) NPV of the following cash flow
- 100(year 1), 100(year 2), 200(year 3)
- Ans) 100/1.1 100/1.12 200/1.13 323.82
- In general, you have NPV formula such that
- NPV where Ct is cash
flow at time t
7NPV of Uncertain Cash Flow
- Calculating NPV is that simple! But, what if you
have uncertain cash flow? - Can we just use expected cash flow like the
following? - NPV where E(C) is
expectation of C - The answer is no. Lets look at an example!
8Example A Coin Tossing
- Consider a gamble where you pay a certain amount
now, and receive money next year. Next year you
will toss a coin, and you will get 100 if it is
head, 0 if it is tail. - Expected cash flow (C) in the next year is E(C)
0.51000.50 50 - Suppose annual interest rate is rf 7
- Are you willing to pay 50/(1rf) 50/1.07 47
for this betting? Probably not! - Probably, you want to pay somewhat lower than
47. Suppose you want to pay P 35 for the
gamble.
9Return on Coin Tossing
- The expected return on this betting is
- E(r) E(C)/P 1 50/35 1 43
- You want to ask for higher return than the
interest rate because this is a risky choice. We
call it risk premium! - E(r) rf risk premium 7 36
- In general, this is decided by the risk of an
asset. - ex) CAPM E(r) rf ß(rM rf )
- Therefore, we can calculate NPV of uncertain cash
flow by using an appropriate discount factor
considering the risk of investment. (We will
cover this later in the cost of capital part.)
10 A Simple Case Study
- Ginos Trattoria Case
- (Adapted from Brealey and Myers)
11Sample Problem
- Ginos Trattoria is considering a new project,
which requires an investment of 2 million. The
project is expected to generate sales revenue of
1 million in the first year, 2 million in the
second year and 3 million each for year 3, 4
and 5. The cost of goods sold is expected to be
75 percent of sales revenue. Other costs are
expected to be 7 percent of sales in the first
year and 5 percent of sales thereafter. The
project will need working capital investment of
200,000 in the first year and an additional
100,000 in the second year. The investment in
plant ( 2 million) will be depreciated using 25
declining balance over 5 years. If the companys
opportunity cost of capital is 10 percent,
calculate the NPV for the project. Assume that
the plant will operate for 5 years, and at the
end of 5 years, the plant can be sold for a
salvage value of 600,000. The tax rate for the
company is 36 percent.
12Approach for the Case
- We need to calculate NPV to evaluate the project
- Remember NPV is discounted cash flows
- Thus, all the information you will need is cash
flow - The paragraph looks a bit too messy, and very
boring. Instead of trying to read it, we can just
pick up necessary information from the paragraph
13Cash Flow ?
- Cash Flow Cash Flow from Operation
- Cash Flow from Investment
- Cash Flow from Financing
-
- Net Income Changes in WC
- Capital Expenditure
- Raising and Paying Debt or Equity
14Sales
Investment
We wont have this part in our simple example
-
Cost
Salvage Value
-
Tax Effect of Sales Cost
-
Tax on difference between salvage value and
ending book value
Tax Savings From Depreciation
Change in Working Capital
CF from Investment
CF from Financing
CF from Operation
Cash Flow
Ginos Trattoria Case
15Necessary Information
- All the information you will need will be the
following blocks from the case
Investment
Salvage Value
Sales
Cost
Tax on difference between salvage value and
ending book value
Change in Working Capital
Tax Savings From Depreciation
Tax Effect of Sales Cost
Also, you will need to know tax rate, discount
rate, and depreciation rule.
16Step 1. Find Necessary Information
- 1.1 Find Investment and salvage value
- Ginos Trattoria is considering a new project,
which requires an investment of 2 million. - Assume that the plant will operate for 5 years,
and at the end of 6 years, the plant can be sold
for a salvage value of 600,000. - 1.2 Find Revenue (or Sales)
- The project is expected to generate sales
revenue of 1 million in the first year, 2
million in the second year and 3 million each
for year 3, 4 and 5. - 1.3 Find Cost
- The cost of goods sold is expected to be 75
percent of sales revenue. Other costs are
expected to be 7 percent of sales in the first
year and 5 percent of sales thereafter.
17Step 1. Find Necessary Information (2)
- 1.4 Find Working Capital
- The project will need working capital investment
of 200,000 in the first year and an additional
100,000 in the second year. - 1.5 Find Depreciation Rule
- The investment in plant ( 2 million) will be
depreciated using 25 declining balance over
schedule for the 5-year class. - 1.6 Find Tax Rate
- The tax rate for the company is 36 percent.
- 1.7 Find Cost of Capital
- If the companys opportunity cost of capital is
10 percent, calculate the NPV for the project. - 1.8 Duration of the project
- Assume that the plant will operate for 5 years,
and at the end of 5 years, the plant can be sold
for a salvage value of 600,000.
18Step 2. Calculate Profit, Tax effect of
SalesCosts, Depreciation, and Tax Savings
19Step 2. Calculate Profit, Tax effect of
SalesCosts, Depreciation, and Tax Savings (2)
2.3 Depreciation (25 Declining Rule) UK Tax
Depreciation Depreciation in the first year 25
of Value .25 2000 500 Depreciation after
the second year 75 of previous years
depreciation .75500 .
20Step 3. Calculate Cash Flow
21Step 4. Calculate NPV, IRR, Payback, and so on..
- Using 10 cost of capital, we derive
- NPV -220,962.07
- IRR 6.84
- Payback Period 5 years
- Then, we can evaluate the project by given
criteria.
22Graham Harvey (2007)s Survey
23NPV Criteria
- Investment Decision using NPV
- accept the project if NPV gt 0
- Strength
- Consistent with the goal of shareholder value
maximization - Weakness
- Relies on cash flow forecasts, which tend to be
inaccurate and biased upwards.
24IRR Criteria
- Investment Decision using IRR
- accept the project if IRR gt opportunity costs of
capital - Strength
- IRR gives the same answer as NPV if used properly
- More intuitive (summarized to one number)
- Weakness
- Multiple solutions
- Easily misleading timing, scale, etc
25Payback Period Criteria
- Investment Decision using Payback
- accept the project if it pays back its initial
investment within the cutoff period - Strength
- Does not use distant cash flows which could be
inaccurate in general - Make sure the initial investment is recovered
within short term - Weakness
- The payback rule ignores all cash flows after the
cutoff date. - The payback rule gives equal weight to all cash
flows before the cutoff date. (It ignores the
timing of cash flows within the payback period)
26Quiz!
- The Campbell-Graham survey shows that over half
of their CFOs use payback period (in conjunction
with NPV) to assess projects. - Why do they use payback period?
- Payback period has its own strengths which NPV
does not have although it is a bit
oversimplified. - Thus, payback period could provide a better
criteria together with NPV.
27Best Criteria?
- In an ideal world (where forecasting is unbiased
and accurate), NPV is the best rule as we have
seen. - In reality, there is always the possibility of
having optimistic bias, and other biases in
forecasting. Given that, using other criteria
(payback) together with NPV will give you more
effective way of investment decision making.
28A Review on Eagle Industry
29Common Mistakes in Eagle Industry Case
- Tax savings
- Sunk Cost
- Opportunity Cost
- Minor mistakes
30Tax Savings (Straight-line Depreciation)
- Building (25 years straight line depreciation)
- Initial value 1000, salvage value 0
- After 5 years, the book value is still 800
although the salvage value is 0. Therefore, the
difference between the ending book value and the
salvage value could be used for tax savings. - Tax Savings in year 6 30(800)240
31Tax Savings(25 declining balance)
- Plant and machinery (25 declining balance)
- Initial value 1200, salvage value 100
- After 5 years, the book value is still 285
although the salvage value is 100. Therefore,
the difference between the ending book value and
the salvage value could be used for tax savings. - Tax Savings in year 6 30(285-100)55
32Opportunity Cost
- Opportunity Cost of Land should be included in
the analysis - The criteria whether its a positive NPV project
will be - NPV gt 0
- In case you dont include the opportunity cost
- Option 1 Run the project (Opportunity cost is
not included) - Option 2 Sell the land at 100,000
- The criteria whether its a positive NPV project
will be - NPV gt 100,000
33Sunk Cost
- Sunk cost shouldnt be included
- RD cost (500,000) over the past two years is a
sunk cost, thus its not included in the analysis - How to decide whether to include or not
- If something can be affected by the decision to
accept or reject the project, it should be
included. - Otherwise, it should be ignored.
34Working Capital
- Working Capital
- Current Asset Current Liability
- Inventory Account Receivable Account
Payable - Use change in working capital, not working
capital itself to calculate cash flow - There is no tax effect on change in working
capital - With reasonable assumptions, working capital
should be recovered after the projects duration
35Minor Mistakes
- Tax-free Grant
- In a development area, there is a tax free grant
of 15 on the value of investment in buildings,
plant, and machinery. (only in the first year!) - 15(10001200) 330
- There are launching costs of 200 and 100 in
each of the first two years respectively
36Next Time (Tentative)
- Valuation with Inflation
- Sensitivity Analysis
- Capital Structure
- Fixed Income
- You can download materials from
- http//phd.london.edu/jhan.phd2005