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Week-1

Dr. Ahmed Name__________

FINC 5880

Investment Decisions

The purpose of capital budgeting analysis is to determine whether the projectis profitable based on todays dollar value. This approach is appropriate

because the projects costs and future cash flows price are spread over thelife of the project. To make a decision on whether to accept or reject a

project today, both costs and future cash flows must be in todays dollarvalue.

Factors involved in Investment Decisions

Future SalesExpected Cash FlowsCapital ExpenditureTiming

Cash FlowsCash OutflowsCash InflowsTerminal Year Cash flows

Project Classifications

1. Replacement2. Expansion3. Safety /environment4. Other

Investment Decision RulesPayback Period

Payback period is the amount of time required to recover its initialinvestment in a project. It ignores the time value of the money.

Net Present Value (NPV)Net Present Value is the difference between the present value of thecash inflows and the present value of the cash outflows.

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Internal Rate of Return (IRR)

Internal rate of return is the rate of return at which the net presentvalue of the project is equal to zero.

Modified Internal Rate of Return (MIRR)

Profitability Index (PI)Profitability Index is the ratio between the present value of the cashinflows and the present value of the cash outflows.

Project Acceptance-Rejection Criterion:

NPV > 0.00 (Accept the Project)NPV < 0.00 (Reject the Project)IRR > RRR (Accept the Project)IRR < RRR (Reject the Project)PI > 1.00 (Accept the Project)

PI < 1.00 (Reject the Project)

Net Present Value

PV of Cash Inflows - Present Value of Cash Outflows + PV of TerminalYear Cash Flows

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Capital Budgeting Analysis

Facts: CalculationsCost $200,000

Shipping $10,000

Installation $30,000

Depreciable cost

Inventories will rise by $25,000

Payables will rise by $5,000

Change in NWC

Economic life 4 years

Salvage value $25,000

Depreciation Method MACRS 3-year class

Incremental gross sales $250,000

Incremental cash operating costs $125,000

Tax rate 40%

Overall cost of capital 10%

Three Cash Flows

Initial Cash OutlaysNet Operating Cash FlowsTerminal Year Cash Flows

Initial Cash Flows

Equipment ($200,000)

Freight & Installation (40,000)

Change in NWC (20,000)

Net Cash Flows t=0 ($260,000)

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Net Operating Cash Flows

Year -1 Year - 2 Year - 3 Year - 4

Incremental gross sales $250,000 $250,000 $250,000 $250,000Incremental operating costs ($125,000) ($125,00) ($125,000) ($125,000

Net Revenue $125,000 $125,00 $125,000 $125,000

Depreciation

EBT (Earnings Before Taxes)

Taxes (40%)

Net income (EAT)

Add: Depreciation

Net Operating Cash Flows

Terminal Year Cash Flows

Salvage value $25,000

Tax on salvage value (10,000)

Recovery on NWC 20,000

Net terminal CF $35,000

Time Line:

0 1 2 3 4

Payback Period:

Year Beginning balance Annual cash inflows Balance

0 ($260,000) 0 ($260,000)

1

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2

3

4

Payback Period = + ( / ) = years

Net Present Value =

Internal Rate of Return =

Modified Internal Rate of Return

0 1 2 3 4

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Optimal Capital Budget

Capital Rationing

Real Option Analysis

Risk in Capital BudgetingStandalone RiskCorporate RiskMarket Risk

Stand-Alone Risk

The projects risk if it were the firms only asset and there were noshareholders

Ignores both firm and shareholder diversification.Measured by the !or CV of NPV, IRR, or MIRR

Corporate Risk

Reflects the projects effect on corporate earnings stabilityConsiders firms other assets (diversification within firm)Depends on projects !, and its correlation, r, with returns on

firms other assetsMeasured by the projects corporate beta.

Market Risk

Reflects the projects effect on a well-diversified stock portfolioTakes account of stockholders other assetsDepends on projects !and correlation with the stock market

Measured by the projects market beta

Other Issue in Capital Budgeting

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What is a real option?

Real options exist when managers can influence the size and risk of aprojects cash flows by taking different actions during the projects life inresponse to changing market conditions.

Alert managers always look for real options in projects.

Smarter managers try to create real options

What is the single most important characteristic of an option?

It does not obligate its owner to take any action. It merely gives the ownerthe right to buy or sell an asset.

How are real options different from financial options?

Financial options have an underlying asset that is traded--usually a securitylike a stock.

A real option has an underlying asset that is not a security--for example aproject or a growth opportunity, and it isnt traded.

How are real options different from financial options?

The payoffs for financial options are specified in the contract.

Real options are found or created inside of projects. Their payoffs can bevaried.

What are some types of real options?

Investment timing options

Growth optionsExpansion of existing product line

New productsNew geographic marketsAbandonment options

ContractionTemporary suspension

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Flexibility options

Five Procedures for Valuing Real Options

1.DCF analysis of expected cash flows, ignoring the option.2.Qualitative assessment of the real options value.3.Decision tree analysis.

4.Standard model for a corresponding financial option.5.Financial engineering techniques.

Nebraska Pharmaceuticals Company (NPC) is considering a project that has an up-frontcost at t = 0 of $1,500. (All dollars in this problem are in thousands.) The projectssubsequent cash flows are critically dependent on whether a competitors product isapproved by the Food and Drug Administration. If the FDA rejects the competitiveproduct, NPCs product will have high sales and cash flows, but if the competitiveproduct is approved, that will negatively impact NPC. There is a 75% chance that thecompetitive product will be rejected, in which case NPCs expected cash flows will be$500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance thatthe competitors product will be approved, in which case the expected cash flows will beonly $25 at the end of each of the next seven years (t = 1 to 7). NPC will know for sureone year from today whether the competitors product has been approved.

NPC is considering whether to make the investment today or to wait a year to find outabout the FDAs decision. If it waits a year, the projects up-front cost at t = 1 willremain at $1,500, the subsequent cash flows will remain at $500 per year if thecompetitors product is rejected and $25 per year if the alternative product is approved.However, if NPC decides to wait, the subsequent cash flows will be received only for sixyears (t = 2 ... 7).

Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year beforeproceeding, how much will this increase or decrease the projects expected NPV intodays dollars (i.e., at t = 0), relative to the NPV if it proceeds today?

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The CV = SD / Expected NPV.

Invest immediately:Squared dev.

Prob. NPV NPVi E(NPV) Squared deviation times probability0.75 $934.21 $578 $334,228 $250,6710.25 -$1,378.29 -$1,734 $3,008,054 $752,013

1.00 $356.08 Variance $1,002,685Standard deviation $1,001.34CV 2.81

Delay, then invest in period 1 if the outlook is good:Squared dev.

Prob. NPV NPVi E(NPV) Squared deviation times probability0.75 $616.03 $154 $23,718 $17,7890.25 $0.00 -$462 $213,463 $53,3661.00 $462.02 Variance $71,154

Standard deviation $266.75

CV 0.58

Reduction in the CV due to waiting 2.23