Week-1

Dr. Ahmed
FINC 5880

Name__________

Investment Decisions
The purpose of capital budgeting analysis is to determine whether the project
is profitable based on todays dollar value. This approach is appropriate
because the projects costs and future cash flows price are spread over the
life of the project. To make a decision on whether to accept or reject a
project today, both costs and future cash flows must be in todays dollar
value.
Factors involved in Investment Decisions
Future Sales
Expected Cash Flows
Capital Expenditure
Timing
Cash Flows
Cash Outflows
Cash Inflows
Terminal Year Cash flows
Project Classifications
1. Replacement
2. Expansion
3. Safety /environment
4. Other
Investment Decision Rules
Payback Period
Payback period is the amount of time required to recover its initial
investment in a project. It ignores the time value of the money.
Net Present Value (NPV)
Net Present Value is the difference between the present value of the
cash inflows and the present value of the cash outflows.

Internal Rate of Return (IRR)

Internal rate of return is the rate of return at which the net present
value of the project is equal to zero.
Modified Internal Rate of Return (MIRR)
Profitability Index (PI)
Profitability Index is the ratio between the present value of the cash
inflows and the present value of the cash outflows.
Project Acceptance-Rejection Criterion:
NPV
NPV
IRR
IRR
PI
PI

>
<
>
<
>
<

0.00
0.00
RRR
RRR
1.00
1.00

(Accept the Project)

(Reject the Project)
(Accept the Project)
(Reject the Project)
(Accept the Project)
(Reject the Project)

Net Present Value

PV of Cash Inflows - Present Value of Cash Outflows + PV of Terminal
Year Cash Flows

Capital Budgeting Analysis

Facts:
Cost
Shipping
Installation
Depreciable cost
Inventories will rise by
Payables will rise by
Change in NWC
Economic life
Salvage value
Depreciation Method
Incremental gross sales
Incremental cash operating costs
Tax rate
Overall cost of capital

Calculations
$200,000
$10,000
$30,000
$25,000
$5,000
4 years
$25,000
MACRS 3-year class
$250,000
$125,000
40%
10%

Three Cash Flows

Initial Cash Outlays
Net Operating Cash Flows
Terminal Year Cash Flows
Initial Cash Flows
Equipment
($200,000)
Freight & Installation
(40,000)
Change in NWC
(20,000)
Net Cash Flows t=0 ($260,000)

Net Operating Cash Flows

Year -1
Incremental gross sales
$250,000
Incremental operating costs ($125,000)
Net Revenue
$125,000
Depreciation
EBT (Earnings Before Taxes)
Taxes (40%)
Net income (EAT)
Add: Depreciation
Net Operating Cash Flows

Year - 2
$250,000
($125,00)
$125,00

Year - 3
$250,000
($125,000)
$125,000

Terminal Year Cash Flows

Salvage value
$25,000
Tax on salvage value (10,000)
Recovery on NWC
20,000
Net terminal CF
$35,000

Time Line:

Payback Period:
Year Beginning balance Annual cash inflows Balance
0
($260,000)
0
($260,000)
1

Year - 4
$250,000
($125,000)
$125,000

2
3
4
Payback Period =

) =

Net Present Value =

Internal Rate of Return =

Modified Internal Rate of Return

years

Optimal Capital Budget

Capital Rationing
Real Option Analysis

Risk in Capital Budgeting

Standalone Risk
Corporate Risk
Market Risk
Stand-Alone Risk
The projects risk if it were the firms only asset and there were no
shareholders
Ignores both firm and shareholder diversification.
Measured by the or CV of NPV, IRR, or MIRR
Corporate Risk
Reflects the projects effect on corporate earnings stability
Considers firms other assets (diversification within firm)
Depends on projects , and its correlation, r, with returns on
firms other assets
Measured by the projects corporate beta.
Market Risk
Reflects the projects effect on a well-diversified stock portfolio
Takes account of stockholders other assets
Depends on projects and correlation with the stock market
Measured by the projects market beta
Other Issue in Capital Budgeting

What is a real option?

Real options exist when managers can influence the size and risk of a
projects cash flows by taking different actions during the projects life in
response to changing market conditions.
Alert managers always look for real options in projects.
Smarter managers try to create real options
What is the single most important characteristic of an option?
It does not obligate its owner to take any action. It merely gives the owner
the right to buy or sell an asset.
How are real options different from financial options?
Financial options have an underlying asset that is traded--usually a security
like a stock.
A real option has an underlying asset that is not a security--for example a
project or a growth opportunity, and it isnt traded.
How are real options different from financial options?
The payoffs for financial options are specified in the contract.
Real options are found or created inside of projects. Their payoffs can be
varied.
What are some types of real options?
Investment timing options
Growth options
Expansion of existing product line
New products
New geographic markets
Abandonment options
Contraction
Temporary suspension

Flexibility options
Five Procedures for Valuing Real Options
1.DCF analysis of expected cash flows, ignoring the option.
2.Qualitative assessment of the real options value.
3.Decision tree analysis.
4.Standard model for a corresponding financial option.
5.Financial engineering techniques.
Nebraska Pharmaceuticals Company (NPC) is considering a project that has an up-front
cost at t = 0 of $1,500. (All dollars in this problem are in thousands.) The projects
subsequent cash flows are critically dependent on whether a competitors product is
approved by the Food and Drug Administration. If the FDA rejects the competitive
product, NPCs product will have high sales and cash flows, but if the competitive
product is approved, that will negatively impact NPC. There is a 75% chance that the
competitive product will be rejected, in which case NPCs expected cash flows will be
$500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that
the competitors product will be approved, in which case the expected cash flows will be
only $25 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure
one year from today whether the competitors product has been approved.
NPC is considering whether to make the investment today or to wait a year to find out
about the FDAs decision. If it waits a year, the projects up-front cost at t = 1 will
remain at $1,500, the subsequent cash flows will remain at $500 per year if the
competitors product is rejected and $25 per year if the alternative product is approved.
However, if NPC decides to wait, the subsequent cash flows will be received only for six
years (t = 2 ... 7).
Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before
proceeding, how much will this increase or decrease the projects expected NPV in
todays dollars (i.e., at t = 0), relative to the NPV if it proceeds today?

The CV = SD / Expected NPV.

Invest immediately:
Prob.
0.75
0.25
1.00

NPV
$934.21
-$1,378.29
$356.08

Squared dev.
NPVi E(NPV) Squared deviation
times probability
$578
$334,228
$250,671
-$1,734
$3,008,054
$752,013
Variance $1,002,685
Standard deviation
$1,001.34
CV
2.81

Delay, then invest in period 1 if the outlook is good:

Prob.
0.75
0.25
1.00

NPV
$616.03
$0.00
$462.02

Squared dev.
NPVi E(NPV) Squared deviation
times probability
$154
$23,718
$17,789
-$462
$213,463
$53,366
Variance
$71,154
Standard deviation
$266.75
CV
0.58
Reduction in the CV due to waiting

2.23