INVESTMENT DECISION RULES

CFO

Investment decision: What to invest in?

Financing decision: Where to get the money?

Goal of financial mananagement: maximize shareholders's weath

Choose Project(s)

Profitability

Time: Payback Period (PP)

Limited funds: Profitability Index (PI) = NPV/Initial Investment
(Used when the budget is limited or there is budget constraint.)


Net Present Value (NPV) in $: directly measure of how much the project contributes to the firm

Internal Rate of Return (IRR) in %

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Investing project: negative CF followed by positive CFs

Financing project: positive CF followed by negative CFs

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Conventional CFs: -++++ or --+++ (CFs change sign only once)

Non-conventional CFs: -+++- or -+-++ (CFs change sign more than once)

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Mutually exclusive project: can only choose 1 project & reject the rest

Independent project: can choose more than 1 project

Capital Budgeting (valuing projects)

Technique: NPV(Primary); IRR, PP, PI(Supplementing)

Payback Period (PP)

Profitability Index: PI = NPV/Initial Investment >0 (accept) or PI = Discount Cash Inflow/Initial Investment >1 (accept) (Used when the budget is limited or there is budget constraint.)

IRR: Project's rate of return. (Calculation: Set the NPV=0, then find IRR). If IRR<Cost of capital(K), then rejects. Otherwise, accept

Disadvantage of IRR: IRR rule is not working when:

Non-conventional CFs (cash flow changes direction more than 1 time)

Mutually exclusive projects => Calculate NPV simultaneously

Financing Project

Project with even CFs: PP=Initial CF/Annual CF

Project with uneven CFs: PP=Number of years before cost recovery + Remaining to recover/CF during the year

Procedure (estimating CFs):

6 steps (standard projects)

Equivalent Annual Cost (EAC) (special cases)

  1. Side effects: increased/lost sales due to the new project => Relevant
  1. Net Working Capital (NWC) = Current Assets - Current Liabilities
  1. Oppotunities cost: benefit given up if the project is accepted => Relevant
  1. Overheads: only included if they occur because of the project being accepted
  1. Sunk cost: past expense, occured regardless of the project being accepted => Not relevant
  1. Financing costs: not include in expense (because it has been already counted in the cost of capital, so counting it again leads to double-counting.

At the beginning of the project: NWC increase, CF decrease

During the project, NWC changes

At the end of the project, NWC is recovered => NWC decrease, CF increase. Then CF (delta NWC) = -(NWCt-NWCt-1)

  1. Taxes: the project CFs are after-tax CFs

Disadvantage of NPV: Can't be used in Capital Rationing

There will be one IRR with conventional CF and more than one IRR with non-conventional CF.

Disadvantages of PP:

Do not apply NPV

Forgone the potential following profits after the paypack period

CASH FLOWS IN A TYPICAL PROJECT

Beginning: Investing in:

End:

During

Fixed assets

NWC

Revenue, Costs, Taxes (OCF = Revenues - Costs - Taxes)

Delta NWC

Salvage value (Sell the fixed assets on 2'nd hand maket)

Shut-down costs (if any)

Revenue of NWC

OCF(Operating Cash Flow)

Top down: Cash revenue - Cash expense(not include Depreciation) - Taxes

Tax shield: (Cash revenues - Cash expenses) x (1 - Tax rate) + Depreciation x Tax

Bottom up: Net Income + Depreciation

Initial Cost ( cost of acquiring the Fixed Assets and making it available for use)

Purchase price

Installation cost

Shipping cost

Book value = Initial Cost - Accumulated Depreciation

ATSV(After Tax Salvage alue) = Salvage - Tax x (Salvage - Book value)

6 steps of estimating projects CFs(traditional projects)

Step 2: OCF (3 approaches:)

Step 3: NWC (NWC = Current Assets - Current Liabilities)

Step 1:

Ignore sunk costs

Include opportunity cost ( if there are several opportunities costs, choose the next best alternative_

Investment in Fixed Assets

Bottom up

Tax shield

Top down

CF(Delta NWC) = (NWCt - NWCt-1)

Step 4: ATSV

Step 5: Project CFs

Apply NPV or IRR to decide to Accept or

Portfolio => Expected Weight Of Return E(Rp) = Cost of Financing/Capital

Weight (use market value)

Expected Return ( cost of the Capital Structure Component)

Requity = DDM or CAPM

Rprefered stock = D/P0

Rdebt = YTM