EFN406 Lecture 05 2010.ppt

1、Topic 5 Capital Budgeting Applications2010EFN406 Managerial Finance2On completing this topic students should be able to:Understand the principles used to project future cash flowsUnderstand relevant cash flowsDistinguish between Investment and financing cash flowsUnderstand the principle of consiste

2、ncyCompare mutually exclusive projects with unequal livesWork out when to replace,retire or abandon assetsAdjust cash flows for inflationDo NPV with capital rationing2010EFN406 Managerial Finance3 Review of Investment Evaluation Techniques Relevant Cash Flows Replacement Retirement Optimal Life Infl

3、ation and Project Evaluation Capital Rationing2010EFN406 Managerial Finance4 PBEHP Chapter 6 Read and study all parts of sections 6.1 to 6.4 Read section 6.5.1 on sensitivity analysis Read and study sections 6.7 and 6.8 Read lightly the rest of chapter six.2010EFN406 Managerial Finance5Common method

4、s NPVNet Present Value AEAnnual Equivalents IRRInternal Rate of Return Present Value Index2010EFN406 Managerial Finance6 Current and Future Cash Flows Exclude Financing Charges(Interest&Repayments)Incremental Cash Flows Exclude Sunk Costs Be Wary of Allocated Costs Look Out for Opportunity Costs and

5、 Benefits Terminal or Residual Values Taxation and Inflation Working Capital2010EFN406 Managerial Finance7 Uses cash flows or market values,not accounting values Considers timing of cash flows by using present values Indicate the increase in value of the company from undertaking the investment Easy

6、to adjust for Systematic Risk2010EFN406 Managerial Finance8 Concerned only with those factors that make a difference Costs:the initial outlays as well as all operating costs Benefits The timing of these costs and benefits Those that differ between alternatives That change because of the decision Rec

7、ognise genuine interdependencies Use cash flows and market values Opportunity costs and benefits2010EFN406 Managerial Finance9The relevant cash flows for evaluating a new investment project are the incremental cash flows contributed by the project.Project NewWithout FlowsCash sFirmProject NewWith Fl

8、owsCash sFirmFlowsCash lIncrementa2010EFN406 Managerial Finance10Projections must incorporate all costs and benefits that affect cash flows(including cost savings and efficiency gains as well as impact on other lines of business-e.g.,a more competitive MAppFin,reduces student numbers in MBA.2010EFN4

9、06 Managerial Finance11 The difference between accounting and finance-cash flows vs accounting entries.Golden Rule-Use only incremental cash flows when evaluating a project.Side Effects of project on other parts of firm Erosion is a most important side effect(-ve)Complimentary(+ve)2010EFN406 Manager

10、ial Finance12 Abandonment-Decision to abandon project and sell assets A project should be retired if the NPV of its future cash flows is less than zero.Replacement-When existing assets should be replaced in an ongoing business.The optimal life decision determines when to abandon or replace2010EFN406

11、 Managerial Finance13 The projects cash flows are converted into an annuity(equal annual cash flows)over the life of the project Decision rule:if AE=positive accept if negative reject Most useful for ranking projects-accept the project with the higher or highest AE AE=NPV/PVIAF(i,n)where n is the li

12、fe of this project Called Equivalent Annual Value in your text(page 152)See example below2010EFN406 Managerial Finance1401234(6000)2300315027003342010EFN406 Managerial Finance1501234(6000)23003150270033410.90910.82640.75130.683(6000)209126032029228PV of cash flows 1 to 46951951NPV2010EFN406 Manageri

13、al Finance16The spreadsheet below shows the annuity equivalent to the original cash flowsNPV 10%01234951-6000230031502700334951300300300300AE is commonly used in cost minimization problems2010EFN406 Managerial Finance17 Step One:Calculate the NPV of the project Step Two:Convert this NPV into an equi

14、valent annuity over the life of the project AEx=NPVx/PVIAF(i,n)where i is appropriate discount rate and n is the life of the project.eg for A in previous example AE=951/3.1699=$300 pa for four years2010EFN406 Managerial Finance18 Where we have with we need to use the following procedure If we have t

15、hen we must equate lives before comparing NPVs Equate lives by doing one of the following:cash flows over least common multiple(LCM)using annual equivalents(identical replacement)find the NPV of a perpetual chain of replacement2010EFN406 Managerial Finance19B012345678A01234(3000)1200120012001200(800

16、0)17001700170017001700170017001700012345678(3000)1200120012001200(3000)1200120012001200NPVB=$1069NPVA*=$1353AEBA*=$254AEBB=$2002xANPVA=$804AEBA =$254Example LCM2010EFN406 Managerial Finance20 If no replacement,then compare NPVs calculated in the normal manner over the life of each project(no equatin

17、g of lives)e g if we are considering the exploitation of an oil field,we might have two options small plant and extract oil over 10 years or large plant and extract oil over 5 years ME,unequal lives and no replacement Compare NPV small over ten years with NPV large over five years2010EFN406 Manageri

18、al Finance21 Two projects with differing lives.Alpha is two years and Beta is four years.The discount rate is 10%.Which is preferred.Simple AnalysisYear01234Alpha-200015001500Beta-48001800180018001800NPVAlpha$603.31Beta$905.762010EFN406 Managerial Finance22Least Common Multiple of LivesYear01234Alph

19、a-200015001500-200015001500Alpha Twice-20001500-50015001500Beta-48001800180018001800NPVAlpha Twice$1,101.91Beta$905.76Annual EquivalentsYear01234Alpha-200015001500Beta-48001800180018001800Alpha$603.31/PVIFA(2,.1)$347.62Beta$905.76/PVIFA(4,.1)$285.742010EFN406 Managerial Finance23Samantha owns a bloc

20、k of units which she is considering selling.Old units which require considerable upkeep.Sam wishes to sell within the next three years,but not sure exactly when.Solve her dilemma using the figures supplied,assuming a required rate of return of 20%.2010EFN406 Managerial Finance24*(year just completed

21、)The question is should we sell now(end 20X0)or hold for one year,or two years,or hold for three years.2010EFN406 Managerial Finance25Sell end 20X0 PV Disposal Value 300000 Sell end 20X1 PV Disposal Value PV Net Rents 20X1 Total Present Value 225000 79176 304176 Sell end 20X2 PV Disposal Value PV Ne

22、t Rents 20X1 PV Net Rents 20X2 Total Present Value 138889 79167 55556 273612 Sell end 20X3 PV Disposal Value PV Net Rents 20X1 PV Net Rents 20X2 PV Net Rents 20X3 Total Present Value 54870 79167 55556 40509 233102 2010EFN406 Managerial Finance2610(300000)95000210(300000)95000800000123(300000)9500080

23、000700002700002000001000004167(26389)(66893)2010EFN406 Managerial Finance27950002700003000001.2NPV295000800002000003000001.21.2NPV23950008000070000 1000003000001.21.21.2NPV2010EFN406 Managerial Finance28 Optimal replacement Replacement use AE Retirement use NPV Example Self-Test Problem 1,page 173 5

24、 ME projects with unequal lives2010EFN406 Managerial Finance29 Hard v Soft Capital Rationing To maximise shareholder value,calculate the NPV of each project and choose the combination that maximises NPV(or use profitability index).See Example 6.11 Problems mutually exclusive projects multi-period ca

25、pital constraints Soft CR is sub optimal Consistency in the treatment of inflationEstimate cash flows based on anticipated prices,and discount the cash flows using a nominal rate;orEstimate cash flows without adjusting them for anticipated price changes,and discount the cash flows using a real rate.

26、The key is consistency,if the cash flows are nominal(real),the discount rate must also be nominal(real).201030EFN406 Managerial Finance Assume that an investment of$1000 is expected to generate cash flows of$500,at constant prices,at the end of each of 3 years.Assume that the expected rate of inflat

27、ion is 10%p.a.,and that the nominal required rate of return is 15%p.a.(1+N)=(1+R)*(1+I)1.15=1+R)*1.1,solving for R gives 4.55%201031EFN406 Managerial FinanceNPV=$1000+$500(1.10)/(1.15)+$500(1.10)2/(1.15)2+$500(1.10)3/(1.15)3=$373201032EFN406 Managerial FinanceNPV=$1000+$500/(1.0455)+$500/(1.0455)2+$500/(1.0455)3=$373201033EFN406 Managerial Finance