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FINANCIAL MANAGEMENT
Valuing Projects and Firms
Final Exam (03/04/15)
Preparation – Key elements
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COURSE PRESENTATION - AIMS
• To get an overview on investment decisions in
a company
• To understand the company’s investment
decision (NPV, IRR, Payback Investment Rules)
• To understand the fundamentals of capital
budgeting
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COURSE PRESENTATION - AIMS
• To understand the fundamentals of stock
valuation
• To link financial management decisions with
the company’s global strategy
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Chapter 3
Financial Decision
Making and the Lawof One Price
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Using Market Prices to Determine Cash
Values – General Principle
“Whenever a good trades in a competitive
market – by which we mean a market in which it
can be bought and sold at the same price – that
price determines the cash value of the good. As
long as a competitive market exists, the value of
the good will not depend on the views orpreferences of the decision maker”
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The Interest Rate: An Exchange Rate
Across Time
Present Versus Future Value
When we express the value in terms of dollars
today, we call it the present value (PV) of theinvestment.
If we express it in terms of dollars in the future,
we call it the future value of the investment.
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Present Value
and the NPV Decision Rule
The net present value (NPV) of a project or
investment is the difference between the
present value of its benefits and the present
value of its costs.
Net Present Value
(Benefits) (Costs) NPV PV PV
(All project cash flows) NPV PV
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The NPV Decision Rule
When making an investment decision, take the
alternative with the highest NPV.
Choosing this alternative is equivalent to
receiving its NPV in cash today.
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The NPV Decision Rule
Accepting or Rejecting a Project
• Accept those projects with positive NPV
because accepting them is equivalent toreceiving their NPV in cash today.
• Reject those projects with negative NPV
because accepting them would reduce thewealth of investors.
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Choosing Among Alternatives
We can also use the NPV decision rule to choose
among projects. To do so, we must compute the
NPV of each alternative, and then select the one
with the highest NPV. This alternative is the onewhich will lead to the largest increase in the
value of the firm.
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NPV and Cash Needs
Regardless of our preferences for cash today
versus cash in the future, we should always
maximize NPV first. We can then borrow or lend
to shift cash flows through time and find our
most preferred pattern of cash flows.
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Arbitrage and the Law of
One Price
Law of One Price
If equivalent investment opportunities trade
simultaneously in different competitive markets,
then they must trade for the same price in both
markets.=> Any competitive price can be used to determine a cashvalue, without checking the price in all possible markets
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The NPV of Trading Securities and Firm Decision Making
Separation Principle
We can evaluate the NPV of an investment decision
separately from the decision the firm makes
regarding how to finance the investment or any
other security transactions the firm is considering.
=> We can separate the firm’s investment decision
from its financing choice
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Chapter 4
The Time Value
of Money
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The Timeline
• A timeline is a linear representation of the
timing of potential cash flows.
•It can be used to represent a series of cashflows lasting several periods (= stream of cash
flows).
• Drawing a timeline of the cash flows will helpyou visualize the financial problem.
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The Timeline
Differentiate between two types of cash flows
– Inflows are positive cash flows.
– Outflows are negative cash flows, which areindicated with a – (minus) sign.
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The Timeline
• Assume that you are lending $10,000 today and that the loan will berepaid in two annual $6,000 payments.
• The first cash flow at date 0 (today) is represented as a negative sumbecause it is an outflow (vs the 2 inflows of + $6000)
• Timelines can represent cash flows that take place at the end of any timeperiod – a month, a week, a day, etc.
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Three Rules of Time Travel
• Financial decisions often require combining
cash flows or comparing values. Three rules
govern these processes.The Three Rules of Time Travel
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• Most investment opportunities have multiple
cash flows that occur at different point in time
• Based on the first rule of time travel we can
derive a general formula for valuing a stream
of cash flows:
If we want to find the present value of a stream
of cash flows, we simply add up the present
values of each.
Valuing a Stream of Cash Flows
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The Internal Rate of Return
In some situations, you know the present value
and cash flows of an investment opportunity but
you do not know the internal rate of return
(IRR), the interest rate that sets the net present
value of the cash flows equal to zero.
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Chapter 7
InvestmentDecision Rules
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The NPV Decision Rule (reminder)
When making an investment decision, take the
alternative with the highest NPV.Choosing this alternative is equivalent to receiving
its NPV in cash today.
=> Compare the project’s NPV to zero and acceptthe project if its NPV is positive
NPV and Stand-Alone Projects
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Alternative Rules Versus the NPV Rule
• Sometimes alternative investment rules may
give the same answer as the NPV rule, but at
other times they may disagree.
• When the rules conflict, the NPV decision rule
should be followed => in these cases, the
alternative rules lead to bad decisions that
reduce wealth
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The Internal Rate of Return Rule
• Internal Rate of Return (IRR) Investment Rule
Take any investment where the IRR exceeds the cost
of capital. Turn down any investment whose IRR is
less than the cost of capital.
• Project cost of capital : return on other
alternatives in the market with equivalent riskand maturity
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The Internal Rate of Return Rule
• The IRR Investment Rule will give the same answer as the NPV rulein many, but not all, situations.
• In general, the IRR rule works for a stand-alone project if all of theproject’s negative cash flows precede its positive cash flows.
• In other cases, the IRR rule may disagree with the NPV rule andthus be incorrect.
•
Situations where the IRR rule and NPV rule may be in conflict:• Delayed Investments
• Nonexistent IRR
• Multiple IRRs
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The Payback Rule
• The payback period is amount of time it takes to recover or payback the initial investment. If the payback period is less than a pre-specified length of time, you accept the project. Otherwise, youreject the project.
• The payback rule is used by many companies because of itssimplicity.
• Pitfalls:
– Ignores the project’s cost of capital and time value of money.
– Ignores cash flows after the payback period.
– Relies on an ad hoc decision criterion.
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Mutually Exclusive Projects :
• When you must choose only one project
among several possible projects, the choice ismutually exclusive.
• NPV Rule
• Select the project with the highest NPV.• It leads to the greatest increase in wealth
Choosing Between Projects
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• Mutually Exclusive Projects :
– IRR Rule :
• Selecting the project with the highest IRR
• But, it may lead to mistakes :
– When projects differ in scales of investment
– When projects differ in the timing of their cash flows
– When projects differ in their riskiness
=> Then their IRRs cannot be meaningfhully compared
Choosing Between Projects
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The Incremental IRR Rule
Incremental IRR Investment Rule
• Apply the IRR rule to the difference between thecash flows of the two mutually exclusive
alternatives (the increment to the cash flows ofone investment over the other)
• The incremental IRR tells the discount rate atwhich it becomes profitable to switch from one
project to the other => we don’t compare theprojects directly, we evaluate the decision toswitch from one to the other using the IRR rule
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The Incremental IRR Rule
• Shortcomings of the Incremental IRR Rule (sameas for IRR Rule) :
– The incremental IRR may not exist.
– Multiple incremental IRRs could exist.
– The fact that the IRR exceeds the cost of capital forboth projects does not imply that either project has apositive NPV.
– When individual projects have different costs ofcapital, it is not obvious which cost of capital theincremental IRR should be compared to.
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Project Selection
with Resource Constraints
• Evaluation of Projects with Different Resource
Constraints
• The profitability index can be used to identify theoptimal combination of projects to undertake.
Value Created NPVProfitability IndexResource Consumed Resource Consumed
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Shortcomings of the Profitability Index
• In some situations the profitability Index doesnot give an accurate answer.
• Two Conditions of the Profitability Index :
– The set of projects taken following the
profitability index ranking completely exhausts the
available ressource
–
There is only a single relevant ressource constraint => With multiple resource constraints, the
profitability index can break down completely.
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Chapter 8
Fundamentals of
Capital Budgeting
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Forecasting Earnings
• Capital Budget
Lists the investments that a company plans
to undertake
• Capital Budgeting
Process used to analyze alternate investments and
decide which ones to accept
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Forecasting Earnings
• Incremental Earnings
The amount by which the firm’s earnings are
expected to change as a result of the investment
decision
• Earnings are not actual cash flow. However, as
a practical matter, to derive the forecasted
cash flow of a project, financial managersoften begin by forecasting earnings.
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Interest Expense
• In capital budgeting decisions, interest
expense is typically not included . The rationale
is that the project should be judged on its
own, not on how it will be financed.
• For this reason, we refer to the net income we
compute as the unlevered net income
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Taxes
• Marginal Corporate Tax Rate
The tax rate on the marginal or incremental dollar of
pre-tax income. Note: A negative tax is equal to a
tax credit.Income Tax EBIT
c
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Unlevered Net Income
Unlevered Net Income Calculation
Unlevered Net Income EBIT (1 ) (Revenues Costs Depreciation) (1 )
c
c
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Incremental Earnings Forecast
Spreadsheet Incremental Earnings Forecast
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Sunk Costs and Incremental Earnings
• Sunk costs are costs that have been or will be paid regardless of thedecision whether or not the investment is undertaken.
• Sunk costs should not be included in the incremental earningsanalysis.
•
Typically overhead costs are fixed and not incremental to theproject and should not be included in the calculation of incrementalearnings (except the additional overhead expenses that arisebecause of the decision to take the project).
•
Past Research and Development Expenditures :Money that hasalready been spent on R&D is a sunk cost and therefore irrelevant.The decision to continue or abandon a project should be based onlyon the incremental costs and benefits of the product going forward.
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Determining Free Cash Flow and NPV
• Earnings are an accounting measure of the
firm’s performance.
• To evaluate a capital budgeting decision, we
must determine its consequences for the
firm’s available cash.
• The incremental effect of a project on a firm’s
available cash is its free cash flow.
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Calculating the Free Cash Flow
from Earnings
• Net Working Capital (NWC)
– Most projects will require an investment in net
working capital.
• Trade credit is the difference between receivables
and payables.
– The increase in net working capital is defined as:
Net Working Capital Current Assets Current Liabilities
Cash Inventory Receivables Payables
1 t t t NWC NWC NWC
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Calculating the Free Cash Flow
from Earnings
Spreadsheet Calculation of Free Cash
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Calculating Free Cash Flow Directly
• Free Cash Flow
– The term c × Depreciation is called the depreciation taxshield (tax savings resulting from the ability to deductdepreciation => depreciation expenses have a positiveimpact on the free cash flow)
Unlevered Net Income
Free Cash Flow (Revenues Costs Depreciation) (1 )
Depreciation CapEx
c
NWC
Free Cash Flow (Revenues Costs) (1 ) CapEx
Depreciation
c
c
NWC
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Calculating the NPV
year discount factor
1( )
(1 ) (1 )
t
t t t t
t
FCF PV FCF FCF
r r
Spreadsheet Computing NPV
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Analyzing the Project
Break-Even Analysis
• The break-even level of an input is the level
that causes the NPV of the investment to
equal zero.
• In a break-even analysis, for each parameter,
we calculate the value at which the NPV is
zero.
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Sensitivity Analysis
• Sensitivity Analysis shows how the NPV varies
with a change in one of the assumptions,
holding the other assumptions constant.
• Which aspects of the project are more critical
when managing the project
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Chapter 9
Valuing Stocks