Sloan Corporate Finance Tutorial I

Project Valuation
Jungsuk Han

Todays Topic
NPV A Simple Case Study Eagle Industry

NPV (Net Present Value)

NPV
NPV = Discounted Cash Flow (Inflow outflow) In other words, it is the fundamental value of an asset at current period.
Note: NPV is not necessarily equal to market value! (Market value is determined by supply and demand in the market. If the market is efficient, NPV is equal to market value.)

Investment Decision and NPV

What is the goal of a firm? Maximizing shareholders value NPV = shareholders value Therefore, Investment decisions should be based on the NPV of the project.

NPV
NPV of cash on hand = amount of cash

Suppose annual interest rate is rf = 10%

Ex) NPV of 100 on hand = 100

In general, you have NPV formula such that N Ct

Ex 1) NPV of 100 of next year? Ans) 100/(1+rf) = 100/1.1 = 90.91 Ex 2) NPV of the following cash flow: 100(year 1), 100(year 2), 200(year 3) Ans) 100/1.1 + 100/1.12 + 200/1.13 = 323.82

NPV =
t =0

(1 + r ) t

where Ct is cash flow at time t

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NPV of Uncertain Cash Flow

Calculating NPV is that simple! But, what if you have uncertain cash flow? Can we just use expected cash flow like the following?

NPV =

E (C t ) (1 + r ) t t =0
N

where E(C) is expectation of C

The answer is no. Lets look at an example!

Example: A Coin Tossing

Consider a gamble where you pay a certain amount now, and receive money next year. Next year you will toss a coin, and you will get 100 if it is head, 0 if it is tail. Expected cash flow (C) in the next year is E(C) = 0.5*100+0.5*0 = 50 Suppose annual interest rate is rf = 7% Are you willing to pay 50/(1+rf) = 50/1.07 = 47 for this betting? Probably not! Probably, you want to pay somewhat lower than 47. Suppose you want to pay P = 35 for the gamble.
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Return on Coin Tossing

The expected return on this betting is

You want to ask for higher return than the interest rate because this is a risky choice. We call it risk premium!

E(r) = E(C)/P 1 = 50/35 1 = 43%

In general, this is decided by the risk of an asset.

E(r) = rf + risk premium = 7% + 36% ex) CAPM: E(r) = rf + (rM rf )

Therefore, we can calculate NPV of uncertain cash flow by using an appropriate discount factor considering the risk of investment. (We will cover this later in the cost of capital part.)
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A Simple Case Study

Ginos Trattoria Case (Adapted from Brealey and Myers)

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Sample Problem
Ginos Trattoria is considering a new project, which requires an investment of 2 million. The project is expected to generate sales revenue of 1 million in the first year, 2 million in the second year and 3 million each for year 3, 4 and 5. The cost of goods sold is expected to be 75 percent of sales revenue. Other costs are expected to be 7 percent of sales in the first year and 5 percent of sales thereafter. The project will need working capital investment of 200,000 in the first year and an additional 100,000 in the second year. The investment in plant ( 2 million) will be depreciated using 25% declining balance over 5 years. If the companys opportunity cost of capital is 10 percent, calculate the NPV for the project. Assume that the plant will operate for 5 years, and at the end of 5 years, the plant can be sold for a salvage value of 600,000. The tax rate for the company is 36 percent.
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Approach for the Case

We need to calculate NPV to evaluate the project Remember NPV is discounted cash flows Thus, all the information you will need is cash flow The paragraph looks a bit too messy, and very boring. Instead of trying to read it, we can just pick up necessary information from the paragraph
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Cash Flow ?

Cash Flow + + = + + Equity

Cash Flow from Operation Cash Flow from Investment Cash Flow from Financing

Net Income + Changes in WC Capital Expenditure Raising and Paying Debt or

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Investment

Sales

- -

Salvage Value Tax on difference between salvage value and ending book value

CF from Investment

Ginos Trattoria Case

+ =

Cost

Tax Effect of Sales & Cost Tax Savings From Depreciation Change in Working Capital

We wont have this part in our simple example

CF from Operation

Cash Flow

+ +

CF from Financing

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Necessary Information
All the information you will need will be the following blocks from the case:
Investment Tax Effect of Sales & Cost Salvage Value Tax Savings From Depreciation Sales Cost Change in Working Capital

Tax on difference between salvage value and ending book value

Also, you will need to know tax rate, discount rate, and depreciation rule.
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Step 1. Find Necessary Information

1.1 Find Investment and salvage value Ginos Trattoria is considering a new project, which requires an investment of 2 million. Assume that the plant will operate for 5 years, and at the end of 6 years, the plant can be sold for a salvage value of 600,000.

1.2 Find Revenue (or Sales) The project is expected to generate sales revenue of 1 million in the first year, 2 million in the second year and 3 million each for year 3, 4 and 5.

1.3 Find Cost The cost of goods sold is expected to be 75 percent of sales revenue. Other costs are expected to be 7 percent of sales in the first year and 5 percent of sales thereafter.
Years COGS Other Costs 0 1 750 70 2 1500 100 3 2250 150 4 2250 150 5 2250 150 6

Years Investment Years Sales

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Step 1. Find Necessary Information (2)

1.4 Find Working Capital The project will need working capital investment of 200,000 in the first year and an additional $100,000 in the second year.

1.5 Find Depreciation Rule The investment in plant ( 2 million) will be depreciated using 25% declining balance over schedule for the 5-year class. 1.6 Find Tax Rate The tax rate for the company is 36 percent. 1.7 Find Cost of Capital If the companys opportunity cost of capital is 10 percent, calculate the NPV for the project. 1.8 Duration of the project Assume that the plant will operate for 5 years, and at the end of 5 years, the plant can be sold for a salvage value of 600,000.

Years Change in Workin Capital

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Step 2. Calculate Profit, Tax effect of Sales&Costs, Depreciation, and Tax Savings

2.1 Profit = Sales

Years 2.2 Tax = tax ra Sales Years COGS

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Step 2. Calculate Profit, Tax effect of Sales&Costs, Depreciation, and Tax Savings (2)

3 Depreciation (25% Declining Rule) UK Tax Depreciation preciation in the first year = 25% of Value = .25 * 2000 = 500 preciation after the second year = 75% of previous years depreciation = .75*500

2.4 Tax Savings Years 2.5 Thus, we can

Depreciation Years
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Step 3. Calculate Cash Flow

Total Cash Flow

Years
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Step 4. Calculate NPV, IRR, Payback, and so on..

Using 10% cost of capital, we derive NPV = -220,962.07 IRR = 6.84% Payback Period = 5 years Then, we can evaluate the project by given criteria.
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Graham & Harvey (2007)s Survey

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NPV Criteria
Investment Decision using NPV:
accept the project if NPV > 0

Strength
Consistent with the goal of shareholder value maximization

Weakness
Relies on cash flow forecasts, which tend to be inaccurate and biased upwards.
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IRR Criteria
Investment Decision using IRR: Strength
accept the project if IRR > opportunity costs of capital

IRR gives the same answer as NPV if used properly More intuitive (summarized to one number)

Weakness

Multiple solutions Easily misleading: timing, scale, etc

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Payback Period Criteria

Investment Decision using Payback: Strength
accept the project if it pays back its initial investment within the cutoff period

Does not use distant cash flows which could be inaccurate in general Make sure the initial investment is recovered within short term

Weakness

The payback rule ignores all cash flows after the cutoff date. The payback rule gives equal weight to all cash flows before the cutoff date. (It ignores the timing of cash flows within the payback period)
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Quiz!
The Campbell-Graham survey shows that over half of their CFOs use payback period (in conjunction with NPV) to assess projects. Why do they use payback period?
Payback period has its own strengths which NPV does not have although it is a bit oversimplified. Thus, payback period could provide a better criteria together with NPV.

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Best Criteria?
In an ideal world (where forecasting is unbiased and accurate), NPV is the best rule as we have seen. In reality, there is always the possibility of having optimistic bias, and other biases in forecasting. Given that, using other criteria (payback) together with NPV will give you more effective way of investment decision making.
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A Review on Eagle Industry

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Common Mistakes in Eagle Industry Case

Tax savings Sunk Cost Opportunity Cost Minor mistakes

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Tax Savings (Straight-line Depreciation)

Building (25 years straight line depreciation)
Initial value: 1000, salvage value: 0
0 1 2 3 4 5 6 Book Value 1000 960 920 880 840 800 Depreciation 40 40 40 40 40 800 Tax 12 12 12 12 12 240 Savings After 5 years, the book value is still 800 although the salvage value is 0. Therefore, the difference between the ending book value and the salvage value could be used for tax savings. Tax Savings in year 6: 30%*(800)=240
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Tax Savings (25% declining balance)

Plant and machinery (25% declining balance)
Initial value: 1200, salvage value: 100

Book Value 1200 900 675 506 380 285 Depreciation 300 225 169 127 95 185 Tax Savings 90 68 51 38 28 55 After 5 years, the book value is still 285 although the salvage value is 100. Therefore, the difference between the ending book value and the salvage value could be used for tax savings. Tax Savings in year 6: 30%*(285-100)=55
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Opportunity Cost
Opportunity Cost of Land should be included in the analysis

The criteria whether its a positive NPV project will be NPV > 0
Option 1: Run the project (Opportunity cost is not included) Option 2: Sell the land at 100,000

In case you dont include the opportunity cost

The criteria whether its a positive NPV project will be NPV > 100,000
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Sunk Cost
Sunk cost shouldnt be included
R&D cost (500,000) over the past two years is a sunk cost, thus its not included in the analysis

How to decide whether to include or not

If something can be affected by the decision to accept or reject the project, it should be included. Otherwise, it should be ignored.
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Working Capital
Working Capital

= Current Asset Current Liability = Inventory + Account Receivable Account Payable

Use change in working capital, not working capital itself to calculate cash flow There is no tax effect on change in working capital With reasonable assumptions, working capital should be recovered after the projects duration

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Minor Mistakes
Tax-free Grant
In a development area, there is a tax free grant of 15% on the value of investment in buildings, plant, and machinery. (only in the first year!) 15%*(1000+1200) = 330

There are launching costs of 200 and 100 in each of the first two years respectively:

year launching costs

1 200

2 100

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Next Time (Tentative)

Valuation with Inflation Sensitivity Analysis Capital Structure Fixed Income You can download materials from http://phd.london.edu/jhan.phd2005
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