MODULE 1: PROJECT VALUATION, COSTS AND RISK
TOPIC 1: ESTIMATING CASH FLOWS AND NPVs
Estimate Cash Flows on an Incremental Basis
● The value of a project depends on all the incremental (additional) cash flows after-tax that follow from project acceptance
● Cash flows are different to accounting profits which include income and expenses not yet received / paid as well as depreciation charges which are not cash flows at all
● Important to include all incidental effects on the remainder of the firm’s business such as existing products sales
● Recognise after-sales cash flows to come later such as downstream activities on service and spare parts Working Capital requirements
● Firms generally use sales and COGS to estimate cash flows:
○ Cash inflow = sals
○ Cash outflow = COGS
○ Net cash flow = cash inflow - cash outflow = sales - COGS
● These are then amended to include changes in working capital i.e. this is any changes in current assets and current liabilities
● A positive amount of [accounts receivable + inventory - accounts payable] is an additional investment in net working capital (or simply as working capital) and is treated as an outflow
● All the investments in working capital over the life of the project are recovered (as cash inflow) at the end of the project’s life
Include Opportunity Costs
● Should include the opportunity cost of a resource used in a project even when no cash changes hands
● E.g. a new operation will use an already acquired land that could otherwise be sold
● The opportunity cost of the land is the cash it could generate for the company if the project were rejected and the land were sold or put to some other productive use
● Should judge projects on the basis of “with or without”
Sunk Costs, Allocated Overhead Costs, Inflation and Salvage Vale
● Ignore past and irreversible sunk costs
● Ignore the accountant’s allocation of existing overheads and include only the extra overhead expenses generated by a project
● Remember salvage value (net of any taxes) when the project comes to an end
● Treat inflation consistently by discounting nominal cash flows at a nominal rate of return and real cash flows at a real rate
Separate Investment and Financing Decisions
● Analyse the project as if it were all equity-financed
● If a project is partly financed by debt, we will neither subtract the debt proceeds from the required investment nor recognise interest and principal payments on the debt as cash outflows
● Financing costs are recognised in the discount rate instead Depreciation
● Is allowable tax deduction against profit
● It provides an annual tax shield: tax shield = (depreciation x tax rate)
● The tax shield is implicitly shown in the reduced amount of tax on operations recorded in the income statement
● As depreciation is a non-cash expense it has to be added back to profit after-tax to arrive at the net cash flow
● Straight-line depreciation will only be used Calculations
● Tax effect on sale of old machine today = tax rate x (book value - sale price)
○ Same formula for tax effect on sale of new machine in future years
● Increased depreciation = new depreciation - old depreciation
● Recovery of working capital in future years = extra initial recovery + (sum of increases in working capital) Using the NPV rule to choose among projects
● Mang real-world investment decisions entail either-or choices; mutually exclusive projects
● If the choice between the two projects does not affect any future decisions that you might wish to make, then choose the project with the higher NPV
● If the choice has an impact on future opportunities, choosing competing projects may require converting the PV or NPV into an equivalent annual cash flow (EAC)
● NPV = net future value at start date / 1.1
● Change in NPV = (NPV year 1 - NPV year 0) / NPV year 0 Investment Timing
● You maximise the NPV of your investment if you commence the project as soon as the rate of increase in value drops below the cost of capital
Long vs Short Lived Equipment
● PV = C0- (C1/ PV%) - (C2/ PV%2) - (C3/ PV%3) …
● The rule is compare the assets on their equivalent annual cash flow (EAC) i.e. the cash per year from buying and operating the asset
● PVAF = (1 - (1+i)-n) / i
● If the discount rate (risk) on each machine is different you need to find the PV of EAC in perpetuity e.g. what if the discount rates were different
● If discount rates the same we would choose lowest EAC of Y
● PV of perpetuity = PMT / i
● EAC = PV / annuity factor for number of years operating When to replace an old machine
● First calculate the EAC of the new machine:
○ NPV = -cost + (cash inflow x PVAF)
■ NPV = T0+ (inflow / rate of return)
○ EAC = NPV / PVAF
● The optimal timing of replacement can be decided by comparing the NPVs achieved over an infinite period of replacement with new machines
Cost of Excess Capacity
● Begin by converting the present value to an EAC: PV / [(1-r)-n/r]
○ When the new system wears out, replace it with another and pay expenses of EAC indefinitely
○ If undertaking a new project, the series of expenses begin the year before
■ Additional annual EAC cost
○ If not undertaking the new project, series of expenses begins in the current year Capital Budgeting Concepts
● Net Present Value = PV of all cash flows
○ NPV = PV of future cash flows - initial outlay
○ NPV = C0+ [CF1(1+r)-1+ CF2(1+r)-2+ … + CF0(1+r)-n]
● NPV rule:
○ Accept investment if NPV > 0 (positive)
■ PV of future cash flows > initial outlay
○ For several choices, accept project with the highest NPV PV Formulae from FBF
● Single cash flow due at the end of n periods:
○ PV = CFn(1+r)-n
● Multiple and irregular cash flows due during n period
○ PV = CF1(1+r)-1+ CF2(1+r)-2+ … +CFn(1+r)-n
● Annuity: regular and equal amount of cash flows due at the end of each period over n periods
○ PV = CF x [1 - (1+r)-n] / r
○ PV = CF [PVAF]
○ Rearrange: CF = PV / PVAF
○ Equivalent annual costs of initial capital outlay: EAC = PV = CF / [PVAF]
● Perpetuity: regular and equal amount of cash flows due at the end of each period over an infinite period
○ PV = [CF / r]
○ If the cash flow is deferred and commences t period later: PV = (1+r)-tx [CF/r]
● Tax = tax rate x (revenues - expenses)
TOPIC 2: COST OF CAPITAL OF A PROJECT
Why do we need a cost of capital
● The cost of capital is used to discount the expected cash flows of a project to their present values:
○ PV = ∑Ct/ (1 + r)t
● The cost of capital, r, is also referred to as the discount rate, hurdle rate, required rate of return or opportunity cost of capital
Project Cost of Capital
● The opportunity cost of capital is the expected return that is forgone by investing in a project rather than in financial securities with the same risk
● If the project is high risk, a firm should use a higher cost of capital than if the project is low risk
● The CAPM / SML is used to estimate the project cost of capital if a firm can figure out the project beta (asset beta) that reflects the project risk
○ rproject= rf+ βproject(rm- rf)
● Project betas are not available in most cases, so most companies start with the company cost of capital as a benchmark discount rate for new investments
Company Cost of Capital
● Is the opportunity cost of capital for investment in the firm as a whole
● Is defined as the expected return on a portfolio of the firm’s existing debt and equity securities
● Is usually calculated is a weighted average cost of capital:
○ Company cost of capital = rassets= (D/D+E * rdebt) + (E/D+E * requity)
● Is the correct discount rate for projects that have the same risk as the company’s existing business
● It is a useful starting point for setting discount rates for safer or riskier projects
● It is easier to add to, or subtract from, the company cost of capital than to estimate each projects cost of capital from scratch
● Many firms use the company cost of capital to discount the forecasted cash flows on all new projects and this results in good low risk projects with truly positive NPVs being rejected and poor high risk projects accepted Debt and the Company Cost of Capital
● If no debt is outstanding the company cost of capital is just the cost of equity requity
● With debt and company taxes existing the company cost of capital is typically called the weighted average cost of capital or WACC
○ WACC = rdebt(1-t)*D/(D+E) + requity* E/(D+E)
● rdebt(1-T) reflects interest being a tax deductible expense Measuring the Cost of Equity
● The hardest part of estimating the company cost of capital or the WACC is figuring out the expected rate of return to shareholders
● Many firms turn to the CAPM/ SML to estimate the cost of equity:
○ requity= rf+ βequity(rm- rf)
● To use the CAPM, you have to estimate equity beta βequity Estimating Beta
● Use past beta to find out how the stock price has responded to market changes in the past in order to predict the future beta
● The future beta is usually not far off from past beta as the beta of most stocks is quite stable over time
● By running a regression of 4-5 years of monthly rates of return on a stock against the corresponding market returns, the slope of the regression line is an estimate of beta
● Beta tells us how much on average the stock price changed when the market return was 1% higher or lower
● Only a small portion of each stock’s total risk comes from movements in the market (market risk); the rest is firm-specific, diversifiable unique risk which shows up in the scatter of points around the regression line
● R-squared (R2) measures the proportion of the total variance in the stock’s returns that can be explained by market movements (i.e. R2measures market risk)
● A confidence interval of the estimated beta plus or minus two standard errors shows that there is a 95% chance that the calculated confidence interval encompasses the true value of the beta
● The estimation errors of individual betas tend to cancel out when you estimate the beta of a portfolio, so it is more reliable to use industry betas which have lower standard errors
Setting the Discount Rate of a New Project
● If managers cannot rely on past records or other information, then
○ Think about the determinants of asset betas. Often the characteristics of high-beta and low-beta assets can be observed when the beta itself cannot be
○ Don’t be fooled by diversifiable risk
○ Adjust cash-flow forecasts first and avoid adding fudge factors to the discount rate to offset worries about bad outcomes
What Determines Asset Betas
● Cyclicality ⇒ Cyclical firms whose revenues and earrings are strongly dependant on the state of the business cycle tend to be high beta firms so high returns will be required
● Operating leverage ⇒ other things being equal, the alternative with the higher ratio of fixed costs to project value is said to have higher operating leverage and thus higher asset beta
● Other sources of risk ⇒ a long term project is more exposed to shifts in the discount rate caused by changes in the risk free rate or the market risk premium and therefore will have a high beta
Debt and Asset Beta
● A firm's asset beta is the beta of a portfolio of all the firm’s debt and equity securities:
○ βassets= βportfolio= (βdebt* debt / debt + equity) + (βequity* equity / debt + equity)
● When a firm issues more debt to replace part of its outstanding equity while holding the same assets, asset beta (reflecting asset risk) does not change
● A higher debt ratio increases the default risk to debtholders and debt beta; it also increases the financial risk to shareholders and equity beta
Allowing for Possible Bad Outcomes
● Project cash flows are supposed to be unbiased forecasts, which give due weight to all good and bad outcomes
● The unbiased forecast is the sum of the probability-weighted cash flows
● If managers have given bad outcomes their due weight in cash-flow forecasts, there is no need for a discount rate adjustment
When to use multiple Discount Rates
● For projects where risk and beta change as time passes, break the project into segments within which the same discount rate can be reasonably used
TOPIC 3: EVALUATING & MITIGATING THE RISKS OF A PROJECT - REAL OPTIONS
Sensitivity Analysis
● Revenue = unit sales * unit price = (market share * market size) * unit price
● Firms need to conduct sensitivity analysis with respect to key variables i.e. the NOV is recalculated as each underlying variable is set one at a time at its optimistic or pessimistic value and all other variables are as expected
● Benefits:
○ Forces the manager to identify the underlying variables and calculate the consequences of misestimating the variables
○ Indicates where additional information would be most useful and helps to expose in appropriate forecasts
● Drawbacks:
○ What exactly optimistic or pessimistic means
○ Underlying variables are likely to be interrelated not independent Scenario Analysis
● If the variables are interrelated we may use scenario analysis to look at different but consistent combinations of variables
● Variable costs = unit sales * unit variable cost Break-Even Analysis
● Analysis of the level of sales at which the project breaks even with a zero NOV
● NPV = {[Revenue - Variable cost - Fixed cost - Depreciation] x (1-tc) + Depreciation} x [Annuity factor] - Investment
● Managers frequently calculate break-even points in terms of accounting profits which does not consider the opportunity cost of capital on the investment (or the time value of money):
○ Profit before tax = [Revenue - Variable cost - Fixed cost - Depreciation]
● A lower break-even unit sales is derived based on accounting profits Operating Leverage and the Break-Even Point
● A business with high fixed costs is said to have high operating leverage and high business risk and will have a high break even sales
● Operating leverage is usually defined in terms of accounting profits rather than cash flows
● Degree of Operating Leverage (DOL) = % change in profits / % change in sales OR
● Degree of Operating Leverage (DOL) = 1 + (fixed costs incl. Dep’n / pretax profits) Flexibility & Real Options
● If cash flows are better than anticipated the project may be expanded; if they are worse it may be contracted or abandoned altogether
● Options to modify projects are known as real options
● Decision trees help companies determine their options by showing the timing of sequential decisions and possible cash outcomes
Real Options
● Option to expand
● Option to abandon (cut losses)
● Timing options (postpone investments)
● Production options (provide flexibility in production) Decision Trees
● Allow a graphical representations of the options we have in the investment decision
● We can incorporate what choices we haven likely payoff from these, probabilities of success/failure for each and a discount rate to incorporate project risk
MODULE 2: PRACTICES IN CORPORATE FINANCE
TOPIC 4: ETHICS & CSR IN FINANCE
Benefits and Costs of Acting Unethically Benefits of individuals behaving unethically:
● Reach targets and get bonuses - may include using other people
● Employ friends/family who will return the favour
Benefits of company behaving unethically:
● Paying suppliers slowly to reduce costs
● Use cheaper materials that break easily to force customers to pay for maintenance
Costs of individual behaving unethically:
● Job loss and reputational damage
● Friends/family employed are a reflection on you
Costs of company behaving unethically:
● Loss of suppliers
● Loss of future sales
Importance of Ethics
● Business must take ethics into account and integrates ethics into its organisational structure
● Scandals are brought about by ethical failures and unethical decisions
○ Royal Banking Commission EG compensation over $1b for customers charged for services not received during charging dead customers
Levels of Decision Making
● As individuals, each person interacts with businesses as customers, as employees, and as citizens of the countries in which they operate.
● Organisational culture and corporate leadership have important roles to play in decision making.
● Individual businesses' and industries' decisions are influenced by social, economic, and political environments.
Goals of Ethics
