Corporate finance chapter 06 analyzing investment projects

Chapter 6: Analyzing
Investment Projects

Objective
Explain Capital Budgeting
Develop Criteria
1


Chapter 6 Contents
• 1 The Nature of Project
Analysis

• 7 Analyzing Cost-Reducing
Projects

• 2 Where do Investments
Ideas come from?

• 8 Projects with Different
Lives

• 3 The NPV Investment Rule

• 9 Ranking Mutually
Exclusive Projects

• 4 Estimating a Project.s Cash
Flows
• 5 Cost of Capital

• 10 Inflation & Capital
Budgeting

• 6 Sensitivity Analysis
2


Objectives
• To show how to use discounted cash
flow analysis to make decisions such as:
– Whether to enter a new line of business
– Whether to invest in equipment to reduce
costs

3


NPV of a Project
Discout

10%

Year
0
1
2
3
4
5

DCF Payback

Flow
PV
Cum_PV
-1000
-1000
-1000
450
409
-591
350
289
-302
250
188
-114
150
102
-11
50
31
20
NPV

20
4

Do Project

NPV of a Project
Discout

15%

Year
0
1
2
3
4
5

Flow
PV
Cum_PV
-1000
-1000
-1000
450
391
-609
350
265
-344
250
164
-180
150

86
-94
50
25
-69
NPV

-69
5

Don’t Do Project


Internal Rate of Return
NPV of a Project
Discout

11.04%

Year
0
1
2
3
4
5

Flow
PV
Cum_PV

-1000
-1000
-1000
450
405
-595
350
284
-311
250
183
-128
150
99
-30
50
30
0
NPV

0
6

Indifferent


NPV as a Function of Discount Rate
250
200
150

NPV

100
50
0
-50

0%

5%

10%

15%

-100
-150
-200
7

Discount Rate

20%


Average Cost of Capital:
Example with 3-Securities
• Let
• ke be the return on equity

• kd be the return on debt
• kp be the return on preferred
• Ve be the market value of issued equity
• Vd be the Market value of issued bonds
• Vp be the market value of issued preferred
• t be the tax rate
8


Average Cost of Capital:
Example with 3-Securities
• k = ke * Ve + kp * Vp + kd * Vd* (1 - t)
• The average cost of capital is also the
cost of capital for each of the firms
business divisions weighted according to
their market value

9


Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt

Investment schedule
Capital movements sch
Dividend
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)

40.00%
$4,000
0.00%
$5,000
0.00%
3,100,000
0.00%
75.00%
400,000

2,200,000
2,800,000
0
1,000,000
2,200,000
0

2200
2,800
5,000
-5,000
-5000

NPV =

1236

1

2

3

4

5

6

7

20,000

20,000

20,000

20,000

20,000

20,000

20,000

3,100
15,000
400
1,500
600
900
1,300

3,100
15,000
400
1,500
600
900
1,300

3,100
15,000
400
1,500
600
900
1,300

3,100
15,000
400
1,500
600
900
1,300

3,100
15,000
400
1,500
600
900
1,300

3,100
15,000
400
1,500
600

900
1,300

0
1,300
1130

0
0
1,300
983

0
0
1,300
855

0
0
1,300
743

0
0
1,300
646

0
0
1,300

562

3,100
15,000
400
1,500
600
900
1,300
-2,200
0
-2,200
3,500
1316

10


Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt

Investment schedule
Capital movements sch
Dividend
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)

(Table in $'000)
15.00%
40.00%
$4,000
2.00%
$5,000
-3.00%
3,100,000
8.00%

75.00%
400,000
2,200,000
2,800,000
0
1,000,000
2,200,000
0

2200
2,800
5,000
-5,000
-5000

NPV =

-797

1

2

3

4

5

6

7

20,000

19,788

19,578

19,371

19,165

18,962

18,761

3,100
15,000
400
1,500
600
900
1,300

3,348
14,841
400
1,199
480

719
1,119

3,616
14,684
400
879
351
527
927

3,905
14,528
400
538
215
323
723

4,218
14,374
400
174
70
104
504

4,555
14,222
400

-214
-86
-129
271

0
1,300
1130

0
0
1,119
846

0
0
927
610

0
0
723
413

0
0
504
251

0

0
271
117

4,919
14,071
400
-629
-252
-377
23
-2,200
0
-2,200
2,223
836

11


Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent

Depreciation schedule
Start working capt
Investment schedule
Capital movements sch
Dividend
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)

(Table in $'000)
25.00%
40.00%
$4,000
0.00%
$5,000
0.00%

3,100,000
0.00%
75.00%
400,000
2,200,000
2,800,000
0
1,000,000
2,200,000
0

2200
2,800
5,000
-5,000
-5000

Was 15%
NPV =

-429

1

2

3

4

5

6

7

20,000

20,000

20,000

20,000

20,000

20,000

20,000

3,100
15,000
400
1,500
600
900
1,300

3,100
15,000

400
1,500
600
900
1,300

3,100
15,000
400
1,500
600
900
1,300

3,100
15,000
400
1,500
600
900
1,300

3,100
15,000
400
1,500
600
900
1,300

3,100
15,000
400
1,500
600
900
1,300

0
1,300
1040

0
0
1,300
832

0
0
1,300
532

0
0
1,300
426

0
0
1,300

341

3,100
15,000
400
1,500
600
900
1,300
-2,200
0
-2,200
3,500
734

0
0
1,300
66612


Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth

Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Capital movements sch
Dividend
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)

(Table in $'000)
15.00%
30.00%
$4,000
0.00%
$5,000

0.00%
3,100,000
0.00%
75.00%
400,000
2,200,000
2,800,000
0
1,000,000
2,200,000
0

2200
2,800
5,000
-5,000
-5000

Was 40%
NPV =

1860

1

2

3

4

5

6

7

20,000

20,000

20,000

20,000

20,000

20,000

20,000

3,100
15,000
400
1,500
450
1,050
1,450

3,100

15,000
400
1,500
450
1,050
1,450

3,100
15,000
400
1,500
450
1,050
1,450

3,100
15,000
400
1,500
450
1,050
1,450

3,100
15,000
400
1,500
450
1,050
1,450

3,100
15,000
400
1,500
450
1,050
1,450

0
1,450
1261

0
0
1,450
1096

0
0
1,450
953

0
0
1,450
829

0
0

1,450
721

0
0
1,450
627

3,100
15,000
400
1,500
450
1,050
1,450
-2,200
0
-2,200
3,650
1372

13


Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price

Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Capital movements sch
Dividend
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)

(Table in $'000)
15.00%
40.00%

$4,000
5.00%
$5,000
0.00%
3,100,000
0.00%
75.00%
400,000
2,200,000
2,800,000
0
1,000,000
2,200,000
0

2200
2,800
5,000
-5,000
-5000

Was 0%
NPV =

2885

1

2

3

4

5

6

7

20,000

21,000

22,050

23,153

24,310

25,526

26,802

3,100
15,000
400
1,500
600
900

1,300

3,100
15,750
400
1,750
700
1,050
1,450

3,100
16,538
400
2,013
805
1,208
1,608

3,100
17,364
400
2,288
915
1,373
1,773

3,100
18,233
400
2,578

1,031
1,547
1,947

3,100
19,144
400
2,881
1,153
1,729
2,129

0
1,300
1130

0
0
1,450
1096

0
0
1,608
1057

0
0
1,773
1014

0
0
1,947
968

0
0
2,129
920

3,100
20,101
400
3,200
1,280
1,920
2,320
-2,200
0
-2,200
4,520
1699

14


Assumptions
Cost of capital
Tax rate

Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Capital movements sch
Dividend
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)

(Table in $'000)
15.00%
40.00%
$4,000
0.00%
$5,000
0.00%
3,100,000
0.00%
85.00%
400,000
2,200,000
2,800,000
0
1,000,000
2,200,000
0

2200
2,800
5,000
-5,000
-5000

Was 75%
NPV =

-3757

1

2

3

4

5

6

7

20,000

20,000

20,000

20,000

20,000

20,000

20,000

3,100
17,000
400

-500
-200
-300
100

3,100
17,000
400
-500
-200
-300
100

3,100
17,000
400
-500
-200
-300
100

3,100
17,000
400
-500
-200
-300
100

3,100

17,000
400
-500
-200
-300
100

3,100
17,000
400
-500
-200
-300
100

0
100
87

0
0
100
76

0
0
100
66

0

0
100
57

0
0
100
50

0
0
100
43

3,100
17,000
400
-500
-200
-300
100
-2,200
0
-2,200
2,300
865

15

Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Capital movements sch
Dividend
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF

Net CF
PV(NCF)

(Table in $'000)
15.00%
40.00%
$4,000
0.00%
$5,000
0.00%
3,500,000
0.00%
75.00%
400,000
2,200,000
2,800,000
0
1,000,000
2,200,000
0

2200
2,800
5,000
-5,000
-5000

Was $3,100,000
NPV =

237

1

2

3

4

5

6

7

20,000

20,000

20,000

20,000

20,000

20,000

20,000

3,500
15,000
400
1,100
440
660
1,060

3,500
15,000
400
1,100
440
660
1,060

3,500
15,000
400
1,100
440
660
1,060

3,500
15,000
400
1,100
440
660

1,060

3,500
15,000
400
1,100
440
660
1,060

3,500
15,000
400
1,100
440
660
1,060

0
1,060
922

0
0
1,060
802

0
0
1,060

697

0
0
1,060
606

0
0
1,060
527

0
0
1,060
458

3,500
15,000
400
1,100
440
660
1,060
-2,200
0
-2,200
3,260
1226

16


Table 6.4 Project Sensitivity to Sales Volume

Sales Units
2000
3000
3604
4000
5000
6000

Net CF Operations
200000
550000
1003009
1300000
2050000
2800000

17

NPV Project
5005022
1884708
0
1235607
4355922
7476237

NPV v. Discount Rate
$7,000
$6,000
$5,000

NPV $000

$4,000
$3,000
$2,000
$1,000
$0
0%

5%

10%

15%

20%

25%

30%

$1,000
$2,000

$3,000

Rate
18

35%

40%

45%

50%


Sensitivity of Project to Sale Volume
$3,000,000

Net CF from Operations

$2,500,000

$2,000,000

$1,500,000

$1,000,000

$500,000

$0

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$500,000

Sales (Units)
19

$5,000

$5,500

$6,000


NPV Project
$10,000,000

$8,000,000

$6,000,000

NPV

$4,000,000

$2,000,000

$0
2000

2500

3000

3500

4000

4500

$2,000,000

$4,000,000

$6,000,000

Sales (Units)
20

5000

5500

6000


Schedule of Bdella Price & Maint
Age
0
1
2
3
4
5
6
7
8
9
10
Discount

Price
Maint
Intang
20,000
0
16,000
0
1,000
12,800

1,000
800
10,240
1,100
0
8,192
1,210
-500
4,096
1,331
-600
2,048
1,464
-840
1,024
1,611
-1,176
512
1,772
-1,646
256
1,949
-2,305
128
2,144
-3,227
5.00%
21

Schedule of Bdella Price & Maint
Age
0
1
2
3
4
5
6
7
8
9
10
Discount

Price
Maint
Intang
PV_Price PV_Maint PV_Intang PV_Proj
20,000
0
20,000
16,000
0
1,000
15,238
0
952
-3,810
12,800

1,000
800
11,610
907
726
-7,619
10,240
1,100
0
8,846
950
0
-11,334
8,192
1,210
-500
6,740
995
-411
-14,846
4,096
1,331
-600
3,209
1,043
-470
-19,890
2,048
1,464
-840

1,528
1,093
-627
-23,290
1,024
1,611
-1,176
728
1,145
-836
-26,071
512
1,772
-1,646
347
1,199
-1,114
-28,766
256
1,949
-2,305
165
1,256
-1,486
-31,689
128
2,144
-3,227
79
1,316

-1,981
-35,073
5.00%
22


Schedule of Bdella Price & Maint
Age
0
1
2
3
4
5
6
7
8
9
10
Discount

Price
Maint
Intang
PV_Price PV_Maint PV_Intang PV_Proj Rate
PV_Infinity Ann_Equ
20,000
0
20,000
16,000

0
1,000
15,238
0
952
-3,810
5.00%
-80,000
-3,810
12,800
1,000
800
11,610
907
726
-7,619
10.25%
-81,951
-3,902
10,240
1,100
0
8,846
950
0
-11,334
15.76%
-83,236
-3,964
8,192

1,210
-500
6,740
995
-411
-14,846
21.55%
-83,738
-3,988
4,096
1,331
-600
3,209
1,043
-470
-19,890
27.63%
-91,881
-4,375
2,048
1,464
-840
1,528
1,093
-627
-23,290
34.01%
-91,771
-4,370
1,024

1,611
-1,176
728
1,145
-836
-26,071
40.71%
-90,112
-4,291
512
1,772
-1,646
347
1,199
-1,114
-28,766
47.75%
-89,013
-4,239
256
1,949
-2,305
165
1,256
-1,486
-31,689
55.13%
-89,167
-4,246
128

2,144
-3,227
79
1,316
-1,981
-35,073
62.89%
-90,841
-4,326
5.00%

23