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Sloan Corporate Finance Tutorial I Project Valuation

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Are you willing to pay 50/(1 rf) = 50/1.07 = 47 for this betting? Probably not! ... The expected return on this betting is. E(r) = E(C)/P 1 = 50/35 1 = 43 ... – PowerPoint PPT presentation

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Title: Sloan Corporate Finance Tutorial I Project Valuation


1
Sloan Corporate Finance Tutorial I Project
Valuation
  • Jungsuk Han

2
Todays Topic
  • NPV
  • A Simple Case Study
  • Eagle Industry

3
NPV (Net Present Value)
4
NPV
  • 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.)

5
Investment 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.

6
NPV
  • 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

7
NPV 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!

8
Example 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.

9
Return 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)

11
Sample 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.

12
Approach 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

13
Cash 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

14
Sales
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
15
Necessary 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.
16
Step 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.

17
Step 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.

18
Step 2. Calculate Profit, Tax effect of
SalesCosts, Depreciation, and Tax Savings
19
Step 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 .
20
Step 3. Calculate Cash Flow
21
Step 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.

22
Graham Harvey (2007)s Survey
23
NPV 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.

24
IRR 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

25
Payback 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)

26
Quiz!
  • 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.

27
Best 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.

28
A Review on Eagle Industry
29
Common Mistakes in Eagle Industry Case
  • Tax savings
  • Sunk Cost
  • Opportunity Cost
  • Minor mistakes

30
Tax 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

31
Tax 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

32
Opportunity 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

33
Sunk 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.

34
Working 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

35
Minor 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

36
Next Time (Tentative)
  • Valuation with Inflation
  • Sensitivity Analysis
  • Capital Structure
  • Fixed Income
  • You can download materials from
  • http//phd.london.edu/jhan.phd2005
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