Topic 4: Project Evaluation Flashcards
Maximise NPV rule:
Corporation should invest in every project with a positive NPV.
* NPV measures the increase in wealth from an investment in real assets. Therefore choosing NPV positive projects enhances value for firm & shareholders
Project NPV (or MVA = ?
Project NPV (or MVA = EV (with project) - IC (for project) - EV (without project)
Good project selection should be based on: (4)
- timing & magitude of CFs, not just profit
- Discount CFs at appropriate opportunity cost of capital
- Select project that maximises value added on IC
- Be value additive
Incremental cashflows
- when valuing a project, you are concerned with the incremental CFs of the project
- incremental = only those flows that will change as a result of the decision
- Sunk costs are irrelevant, even if they relate to project under consideration. They have already been spent.
- Opportunity costs need to be included (eg opp cost of using land vs selling it)
- effects of a project on existing business (side effect - eg cannibalisation)
Alternative methods to calculate Terminal Value (3)
- Salvage value
- exit value
- continuing value
Continuing Value
- when used
- life
- growth rate
- when used: existing business
- life: impacts whether continuing or salvage value is used (if timeframe is short, use salvage. Note salvage value can have tax implications)
- growth rate: growth in CFs in terminal value period is more likely to be driven by market growth than the exercise of growth options
Exit value
- usually calculated as:
- notes to multiples
- usually calculated as: assumed sales multiple at end of investment period
- notes to multiples:
1. Even if sales price is partially or totally driven by estimate in continuing value; check the 2 terminal value estimates
2. Don’t use current multiples (these incorporate higher growth exectations) Use multiple expected to prevail at end of forecast period.
Salvage value (ie project is finished) - need to (3)
Salvage Value
- Assess disposal value of fixed and other assets - what price, or is there a cost
- Recover outstanding working capital
- Look for tax effects. Eg allow for tax on sale of assets.
Project Risks - assessment when considering a project
Primary objective is to test whether the NPV positive project is consistent
- Understand source of project’s NPV or economic rent
- Market based support for the financial projections used in the evaluation (multiples)
- Risk management plan (address risks & opportunities & ensure these are incorporated into the valuation)
Risk management process steps (6)
- identify potential risks
- assess and quantify potential risks
- determine impact on value
- develop a plan for monitoring and managing the identified critical risks
- tracking of risks through project implementation and after
- accountability & learning
Equivalent Annual COst - define
EAC is the annuity cash flow whose PV is equal to the PV of the after tax outlays, both operating and capital, for a project.
- it is helpful in breakeven analysis because it shows the annual (after tax revenues needed in order to generate zero NPV.
Applying NPV test to acquisitions
- EPS is not how you measure shareholder value; even if it is good for the shareholder.
- drivers of M&A are strategic and competitive
- pay up for a controlling share.
Synergy =
Incremental Cashflows =
Synergy = discounted sum of the incremental cashflows
Incremental Cashflows = change in revenue - chg costs - chg taxes + chg financing benefits - chg capital requirements + chg growth opps
Sources of incremental cashflows:
1. Increased revenues (eg)
- increased mkt power - concentration
2. gains from better marketing efforts
Sources of incremental cashflows:
2. decreased costs (eg)
- economies of scale
- economies of vertical integration
- complementary resources
- elimination of inefficiencies
Sources of incremental cashflows:
3. Financial benefits (eg)
- utilisation of tax losses
- unused / increased debt capacity
- improved access to funding
Sources of incremental cashflows:
4. reduced investment needs (eg)
1, integrating production facilities
2. integrating warehouse and distribution facilities
Sources of incremental cashflows:
5. enhance growth opportunities and strategic capability (eg)
- strategic benefits - beachhead to new markets
- acquire access to capabilities
- industry restructuring
Sources of incremental cashflows (list 5)
- increased revenues
- decreased costs
- financial benefits
- reduced investment needs
- enhance growth opportunities and strategic capability
Bid premium (in the case of acquisitions) =
Premium to target ($) =
Premium to target (%) =
Bid premium = difference between offer price and the previous market value of the company
Premium to target ($) = offer price - market price
Premium to target (%) = premium to target ($) / Market Price
Acquisitions
The size of the premium to the target depends on:
Generally bid premium is in the range of :
- potential for value creation
- support or opposition of target’s board
- emergence of counter-bids
- defensive strategies
Generally bid premium is in the range of : 40% to 60%
Managing the capital budget - capital rationing
- NPV suggests firm should invest in all positive NPV projects
- However, some value adding projects may not be undertaken and shareholder value not maximised due to capital rationing.
- too much capital can destroy value if it is left in cash deposits or thrown into NPV negative projects
Hard capital rationing vs soft capital rationing
hard capital rationing: constraints on investable funds are external (cap mkt or govt will not supply funds)
soft capital rationing is imposed internally, by the firm’s management due to internal limits.
Profitability Index
PI = PV / I(0)
Rank projects by profitability index rather than NPV
Techniques used to select between projects (4)
- DCF / NPV
- Internal rate of return (IRR)
- Payback period
- Average accounting return
Internal Rate of Return
- define
- interpret IRR result
- define: IRR is the discount rate that gives a zero NPV
- interpret IRR result: depends on cashflow profile
a) where outflow is followed by inflows, this is an INVESTING PROFILE; accept projects where IRR > hurdle
b) where a cash inflow is followed by a series of outflows, this is a FINANCING PROFILE, accept where IRR < hurdle
Reinvestment Rate: internal rate of return vs WACC
NPV calculated using WACC assumes reinvestment of intermediate cashflows at the opportunity cost rate.
IRR assumes intermediate cashflows are reinvested at the IRR rate. If the actual cashflows are not reinvested at this rate the IRR will be potentially misleading.
Internal Rate of Return: problems with mutually exclusive projects
- scale: where two projects have different outlays
- timing: when projects have different timing profiles; projects with front ended CFs will be more affected by the reinvestment rate. Could use Incremental IRR to help - the rate that equates the NPV of both projects
Payback:
- define
- problems
Payback:
- define: payback = time taken to recover capital outflow from the project OFCF. Sum the OFCF until they total the capital outlay.
- problems
a) timing of CFs, no discounting.
b) CFs after payback is reached are ignored
c) no standard exists for payback
Average Accounting Return (AAR)
- define
- problems
Average Accounting Return (AAR)
- define: Divide average income (NOPAT) by average IC
- problems
a) all periods are given same weighting
b) not based on CFs
c) subjective as to what period should be used for the calculations
d) not clear as to what the actual benchmark should be
