Week 1 - Capital budgeting & NPV rule

Question 1

Opportunity cost of capital

aka a project’s hurdle rate

Answer 1

The rate of return shareholders (investors) of a firm can expect to earn on financial investment of equivalent risk, in fin. markets

Question 2

NPV rule

2 advantages

Answer 2

Accept project if NPV>0
= accept if the expected return on investment is higher than the opportunity cost of capital

1. Precise - Accounts for time value of money + RISK.
   - More risky project, higher discount rate, discounted more heavily.
2. Convenient - present values are additive, ie. NPV(A+B) = NPV(A) + NPV(B)
   - assuming 2 projects A & B are independent & not mutually exclusive

Question 3

Fisher separation

Answer 3

under PERFECT CAPITAL MARKETS, investment decision can be separated from consumption decision.
- Don’t have to worry about whether investors are patient or impatient. Just want more +ve NPV.
- NPV becomes the optimal decision-making tool

However, when capital markets are NOT perfect, maximising NPV is not necessarily = maximising shareholder wealth.

Question 4

Book/Accounting rate of return

4 problems

Answer 4

= Book income / Book assets
Accept if book rate of return is ‘high enough’

1. Acct. income is not = cash flow due to accrual components. Mismatch between revenue (more maniputable by firm’s managers, more prone to managerial discretion) and actual cash flow.
2. Book assets (recorded at cost of purchase) don’t tend to = market value of assets
3. Time value of money is ignored.
4. Only considers averages & risk is ignored.

Question 5

Payback period

3 flaws

Answer 5

= how much time (no. of years) it takes for project to pay back initial investment
Accept project that pays back within a desired timeframe, eg. 1-2 years

1. Ignores all cash flows generated AFTER the PAYBACK PERIOD; biased against long term projects
2. Ignores time value of money & risk
   - Can discount cash flows first then calculating payback period (’discounted payback’)
3. Decision rule is ARBITRARY, eg. rejecting 2.01 years vs 2 years. Is there a good enough reason to reject a good project?

Question 6

Internal rate of return (IRR)

*use quadratic formula or Excel function

Answer 6

= Constant discount rate that makes NPV = 0
Accept if IRR > opp. cost of capital (discount rate)
b/c means +ve NPV

When cost of capital = expected return on investment ⇒ NPV = 0
» Therefore, IRR is interpreted as the EXPECTED RETURN ON INVESTMENT

Question 7

4 pitfalls of IRR

Answer 7

1. Lending vs borrowing
   - For borrowing/financing projects, need to reverse IRR rule & flip NPV profile. Only accept if IRR < cost of capital (discount rate).
2. Multiple IRRs
   - If “non-normal cash flows” where signs change more than once
3. No IRR {then fall back to NPV rule}
4. Mutually exclusive projects (important CROSSOVER part)
   - Pick the project w/ highest IRR
   - Implicit assumption that 2 projects have the SAME level of RISK (ie. same cost of capital)

Question 8

2 projects even if same level of risk might have difference in __ and/or __, so IRR rule might still give incorrect decision.

What should then be done to compare the projects?

Answer 8

May differ in SCALE (size of CF, usually size of initial outlay) and/or TIMING.

Calculate the IRR of the INCREMENTAL CASH FLOWS to see if investment in A instead of B is worthwhile
- make the CFs look like an investment project, -ve CF first then +ve CF
- If yes, choose A.

Question 9

Incremental IRR

+ additional use of IRR rule

Answer 9

= discount rate at which the NPV of 2 projects are the same.
ie, corresponds to the crossover point

IRR rule gives us the MARGIN OF ERROR for the opp. cost of capital before the NPV turns negative.

Question 10

Free cash flows (definition) + assumption + 3 main rules

Answer 10

= CFs a project leaves behind after all expenses paid that can be distributed for investors of firm/project.
> ASSUMPTION that the project is all-equity financed.
> Find expected after-tax free cash flows.

1. Only CASH FLOWS are relevant
2. Estimate CFs on an INCREMENTAL basis - Incremental CFs are only those that will be impacted as a result of taking the project.
   - include opportunity costs, eg. using a land that is already owned, could’ve sold the land if not doing project → foregone sales revenue
   - ignore sunk costs = costs already incurred.
   - include all externalities, eg. lost sales of existing normal Coke from release of new flavour
3. Treat inflation consistently

Question 11

Free cash flows (formula)

Answer 11

FCF = EBIT(1-tax rate) + Depreciation - ΔNWC - CAPEX + Salvage

1. Start w/ (unlevered) incremental ACCOUNTING INCOME then remove accrual components.
2. Ignore interest expense! b/c assume project is 100% equity-financed & keep investment and financing decisions separate
3. Depreciation is a NON-CASH EXPENSE, hence add back.
   > EBIT = EBITDA - depreciation. More dep, higher FCF (reduces amt of tax to be paid, good for investors)
   > DEPRECIATION TAX SHIELD = tax benefit provided by dep.
4. ΔNWC = CA - CL = net inv in short term assets
5. CAPEX - investment in long term assets, eg. PPE
6. Salvage value (after-tax proceeds of sale of asset)

Question 12

EBIT(1-tax rate) & EBIT are also known as…

Answer 12

1. EBIT(1-tax rate) = Profit after tax
2. EBIT = Net operating income