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INVESTMENT DECISION RULES, 6 steps of estimating projects CFs(traditional…
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
Net Present Value (NPV) in $: directly measure of how much the project contributes to the firm
Internal Rate of Return (IRR) in %
Time: Payback Period (PP)
Limited funds: Profitability Index (PI) = NPV/Initial Investment
(Used when the budget is limited or there is budget constraint.)
Investing project: negative CF followed by positive CFs
Financing project: positive CF followed by negative CFs
Conventional CFs: -++++ or --+++ (CFs change sign only once)
Non-conventional CFs: -+++- or -+-++ (CFs change sign more than once)
Mutually exclusive project: can only choose 1 project & reject the rest
Independent project: can choose more than 1 project
6 steps of estimating projects CFs(traditional projects)
Step 2: OCF (3 approaches:)
Bottom up
Tax shield
Top down
Step 3: NWC (NWC = Current Assets - Current Liabilities)
CF(Delta NWC) = (NWCt - NWCt-1)
Step 1:
Ignore sunk costs
Include opportunity cost ( if there are several opportunities costs, choose the next best alternative_
Investment in Fixed Assets
Step 4: ATSV
Step 5: Project CFs
Apply NPV or IRR to decide to Accept or
CASH FLOWS IN A TYPICAL PROJECT
Beginning: Investing in:
Fixed assets
NWC
End:
Salvage value (Sell the fixed assets on 2'nd hand maket)
Shut-down costs (if any)
Revenue of NWC
During
Revenue, Costs, Taxes (OCF = Revenues - Costs - Taxes)
Delta 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
Capital Budgeting (valuing projects)
Technique: NPV(Primary); IRR, PP, PI(Supplementing)
Payback Period (PP
)
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
Disadvantages of PP:
Do not apply NPV
Forgone the potential following profits after the paypack period
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
There will be
one
IRR with conventional CF and
more than one
IRR with non-conventional CF.
Disadvantage of NPV:
Can't be used in Capital Rationing
Procedure (estimating CFs):
6 steps (standard projects)
Side effects: increased/lost sales due to the new project => Relevant
Net Working Capital (NWC) = Current Assets - Current Liabilities
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)
Oppotunities cost: benefit given up if the project is accepted => Relevant
Overheads: only included if they occur because of the project being accepted
Sunk cost: past expense, occured regardless of the project being accepted => Not relevant
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.
Taxes: the project CFs are after-tax CFs
Equivalent Annual Cost (EAC) (special cases)
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
Book value = Initial Cost - Accumulated Depreciation
ATSV(After Tax Salvage alue) = Salvage - Tax x (Salvage - Book value)