Thorie Financire 6.

Analyse de projets dinvestissement

P f Professeur A Andr d F Farber b

NPV - Review
N V: measure NPV: easu e change c a ge in market a et value va ue of o company co pa y if project p oject accepted As market value of company V = PV(Future Free Cash Flows)
NPV = V = FCFt
t t (1 + r )

V = Vwith project - Vwithout project Cash flows flo s to consider: cash flows (not accounting numbers) do not forget g depreciation p and changes g in WCR incremental (with project - without project) forget sunk costs include opportunity costs include all incidental effects beware of allocated overhead costs
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Investment rules
Net Present ese t Value Va ue (NPV) (N V) NPV Discounted incremental free cash flows Rule: invest if NPV>0 Internal Rate of Return (IRR) IRR: discount rate such that NPV=0 Rule: R le: invest in est if IRR > Cost of capital Payback period Numbers of y year to recoup p initial investment No precise rule Profitability Index (PI) PI = NPV / Investment Useful to rank projects if capital spending is limited

IRR

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What do CFOs Use?

Internal Rate of Return Net Present Value Pa back period Payback Discounted payback period Accounting g rate of return Profitability index Based on a survey of 392 CFOs

% Always or Almost Always 75.6% 74.9% 56 7% 56.7% 29.5% 30.3% 11.9%

Source: Graham, , John R. and Harvey y R. Campbell, p , The Theory y and Practice of Corporate p Finance: Evidence from the Field, , Journal of Financial Economics 2001 September 15, 2009 Tfin 06 Capital budgeting |4

Internal Rate of Return IRR

Can be viewed Ca v ewed as the t e yield y e d to maturity atu ty of o the t e project p oject Remember: the yield to maturity on a bond is the rate that set the present value of the expected cash flows equal to its price Consider the net investment as the price of the project The IRR is the rate that sets the present value of the expected cash flows equal q to the net investment The IRR is the rate that sets the net present value equal to zero

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IRR Pitfall 1: Lending g or borrowing? g

Consider following gp projects: j
IRR: borrowing or lending?

N e t P re se e n t V a lu e

0 1 IRR NPV(10%) A -100 100 +120 20% 9 9.09 09 B +100 -120 20% -9.09 A: lending Rule IRR>r B: borrowing Rule IRR<r

30.00 20.00 10.00 0 00 0.00

0%

3%

6%

9%

12

15

18

21

24

27

-20.00 -30.00 Discount rate Project A Project B

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30

-10.00

IRR Pitfall 2 Multiple p Rates of Return

Consider the following gp project j Year 0 1 2 CF -1,600 10,000 -10,000
1500.00 N et P resen t V alu e

Multiple Rates of Return

2 IRRs : +25% &

+400%

1000.00 500.00 0 00 0.00 0% 45% 90% 135% 180% 225% 270% 315% 360% 405%
|7

-500.00 -1000.00 -1500.00 -2000.00

To overcome problem, use modified IRR method

Reinvest all intermediate cash flows at the cost of capital till end of project Calculate IRR using the initial investment and the future value of intermediate cash flows

Discount Rate

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450% 495%

This happens if more than one change in sign of cash flows

IRR Pitfall 3 - Mutually y Exclusive Projects j

Scale Problem (r = 10%) ) Timing g Problem (r = 10%) ) C0 C1 C2 NPV IRR A -100 +20 +120 17.4 20.0% B -100 100 +80 +52 15.7 15 7 22.5% 22 5% A-B 0 -60 +68 1.7 13.3%

Small Large

C0 -10 -50

C1 +20 +80

NPV IRR 8.2 100% 22.7 60%

To choose, look at incremental cash flows C0 C1 NPV IRR L-S -40 +60 14.5 50%

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Mutually y Exclusive Project j - Illustration

50.0

40.0

A
30.0

20 0 20.0

B
10.0

0.0 0.0%

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

17.5%

20.0%

22.5%

25.0%

27.5%

30.0%

32.5%

-10.0

-20.0 20.0

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Inflation
Be e consistent co s ste t in how ow you handle a d e inflation at o Discount nominal cash flows at nominal rate Discount real cash flows at real rate Both approaches lead to the same result.
Example: Real cash flow in year 3 = 100 (based on price level at time 0) Inflation rate = 5% Real discount rate = 10% Discount real cash flow using real rate PV = 100 / (1.10)3 = 75.13 Discount nominal cash flow using nominal rate Nominal cash flow = 100 (1.05)3 = 115.76 Nominal discount rate = (1.10)(1.05)-1 (1 10)(1 05)-1 = 15 15.5% 5% 3 PV = 115.76 / (1.155) = 75.13

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Investment Project j Analysis: y BOF

Big Oversea Firm is considering the project
Year Initial Investment Resale value Sales Cost of sales 100 50 100 50 0 60 20 1 2 3

Corporate tax rate = 40% Working Capital Requirement = 25% Sales Discount rate = 10%

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BOF: Free Cash Flow Calculation

Year Sales Cost of sales EBITDA Depreciation EBIT T Taxes Net income 0 1 100 50 50 30 20 8 12 2 100 50 50 30 20 8 12 8 -8 3

Net income Depreciation DWCR CFInvestment F Free Cash C h Fl Flow

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12 30 25 -60 -60 60
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12 30 0

-8 0 -25 20

17

42
|12

37

BOF: g go ahead?
NPV N V ca calculation: cu at o :

NPV = 60 +

17 42 37 + + = 17.96 2 3 1.10 (1.10) (1.10)

Internal Rate of Return = 24% Pa back period = 2 years Payback ears

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BOF: checking g the numbers

Sensitivity Se s t v ty analysis a a ys s What if expected sales below expected value? Sales 60 70 80 90

100 17.96

NPV

-22.11

-12.09

-2.07

7.95

Break-even point p What is the level of sales required to break even? Break even sales = 82

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BOF Project j with inflation rate = 100%

Nominal free cash flows
Year Sales C Cost of f sales l EBITDA Depreciation EBIT Taxes Net income Net income Depreciation WCR CFInvestment Free Cash Flow 0 1 200 100 100 30 70 28 42 42 30 50 -60 -60 22 2 400 200 200 30 170 68 102 102 30 50 82 3

64 -64 -64 0 -100 160 196

Nominal discount rate = (1+10%)(1+100%)-1 = 120% NPV = -14.65

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IRR = 94%
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Ap project j is not a black box

Se s t v ty analysis: Sensitivity a a ys s: analysis of the effects of changes in sales, costs,.. on a project. Scenario analysis: project analysis given a particular combination of assumptions. Simulation analysis: estimations of the probabilities of different outcomes. o tcomes Break even analysis analysis y of the level of sales at which the company p y breaks even.

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Sensitivity y analysis y
Year ea 0 1,500 Year ea 1-5 5 6,000 (3,000) (1,791) (300) 909 (309) ( ) 600 900

Initial investment Revenues Variables costs Fixed costs Depreciation Pretax Profit Tax ( (TC = 34%) ) Net Profit Cash flow

NPV calculation (for r = 15%): NPV = - 1,500 1 500 + 900 3.3522 3 3522 = + 1 1,517 517
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Sensitivity y analysis y using g Excel Use Data|Table (Donnes|Table) =C12 10 20 30

Excel E l recalculates using these values Result to calculate

Values to use (in cell B3 for instance)

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Sensitivity y analysis y
1. . Identify dentify key variables va iables Revenues = Nb engines sold 6,000 3,000 Nb engines sold = Market share 3 000 3,000 0 30 0.30 V.Cost =V.cost per unit 3,000 , 1 Total cost = Variable cost + 4,791 3,000 Price per engine 2 Size of market 10 000 10,000 Number of engines 3,000 , Fixed costs 1,791

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Sensitivity y analysis y
2. . Prepare epa e pessimistic, best, optimistic forecasts fo ecasts (bop) Variable Market size Market share Price V.cost / unit Fixed cost Investment Pessimistic 5,000 20% 19 1.9 1.2 1,891 , 1,900 Best 10,000 30% 2 1 1,791 , 1,500 Optimistic 20,000 50% 22 2.2 0.8 1,741 , 1,000

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Sensitivity y analysis y
3. Recalculate ecalculate N NPV V changing one variable va iable at a time Variable Market size Market share Price V.cost / unit Fixed cost Investment Pessimistic -1,802 -696 853 189 1,295 , 1,208 Best 1,517 1,517 1 517 1,517 1,517 1,517 , 1,517 Optimist 8,154 5,942 2 844 2,844 2,844 1,628 , 1,903

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Scenario analysis y
Co s de p Consider plausible aus b e combinations o of variables va ab es Ex: If recession - market share low - variable cost high - price low

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Monte Carlo simulation

Tool oo for o co considering s de g a all co combinations b at o s model the project specify probabilities for forecast errors select numbers for forecast errors and calculate cash flows O tcome: sim Outcome: simulated lated distribution distrib tion of cash flows flo s

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Monte Carlo Simulation - Example p

Model Qt = Qt-1 + ut mt = m + vt CFt = (Qtmt - FC - Dep)(1-TC)+Dep Procedure 1. Generate large number of evolutions 2. Calculate average annual cash flows 3. Discount using risk-adjusted rate Notations Qt quantity mt unit margin FC fi d costs fixed t Dep depreciation TC corporate tax rate ut,,vt random variables Random number generation Random number Ri : uniform distribution on [0,1] U RAND() i Use in E Excel l To simulate ~ N(0,1): NORMSINV(Rand())

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Standard normal random variable g generation

1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20

RAND() ALEA()

LOI.NORMALE.STANDARD.INVERSE(ALEA())
0.10 0.00 0.00 0.20 0.40 0.60 0.80 1.00 -3.00 -2.80 -2.60 -2.40 -2.20 -2.00 -1.80 -1.60 -1.40 -1.20 -1.00 -0.80 -0.60 -0.40 -0.20

NORMSINV(RAND())
1.20 1.40 1.60 1.80 2.00 2.20 2.40 2.60 2.80 3.00

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Simulated cash flows

Cash flow simulation
120,000

100,000

80,000

60,000

40,000

20,000

0 1 2 3 4 5 6 7 8 9 10

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Break even analysis y

Sales Sa es level eve to b break-even? ea eve ? 2 v views ews Account Profit Break-Even Point: Accounting profit = 0 Present Value Break-Even Point: NPV = 0

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Break even analysis y with Excel

Use Goal Goa See Seek (Va (Valeur eu cible) c b e) Tell Excel to change the value of one variable until NPV = 0

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Timing g
Even ve p projects ojects with w t positive pos t ve N NPV V may ay be more o e va valuable uab e if deferred. de e ed. Example You may sell a barrel of wine at anytime over the next 5 years. Given the future cash flows, when should you sell the wine?

0 C h fl Cash flow % change

1 130 30%

2 156 20%

3 180 15%

4 202 12%

5 218 8%

100

Suppose discount rate r = 10% NPV if sold ld now = 100 NPV if sold in year 1 = 130 / 1.10 = 118

Wait

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Optimal p timing g for wine sale?

Calculate Ca cu ate N NPV( V(t): NPV N V at time t e 0 if wine w e sold so d in year yea t: NPV(t) = Ct / (1+r)t

0 Cash flow NPV(t) 100 100

1 130 118.2

2 156 129

3 180 135

4 202 138

5 218 135

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When to invest
Traditional ad t o a NPV N V rule: u e: invest vest if NPV>0. N V 0. Is s it t always a ways valid? va d? Suppose that you have the following project: Cost I = 100 Present value of future cash flows V = 150 Possibility to mothball the project Should you start the project? If you choose to invest, the value of the project is: Traditional NPV = 150 - 100 = 50 >0 What if you wait?

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To mothball or not to mothball?

Suppose t that at the t e project p oject might g t be delayed de ayed for o one o e year. yea . One year later: Cost is unchanged (I = 100) Present value of future cash flow = 160 NPV1 = 160 - 100 = 60 in year 1 To decide: compare present values at t time ti 0. 0 Invest now : NPV = 50 year later: NPV0 = PV(NPV ( Invest one y 1) = 60/1.10 = 54.5 Conclusion: you should delay the investment + Benefit from increase in present value of future cash flows (+10) + Save cost of financing of investment (=10% * 100 = 10) - Lose return on real asset (=10% * 150 = 15)
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Equivalent q Annual Cost

The e cost per pe period pe od with w t the t e same sa e present p ese t value va ue as the t e cost of o buying buy g and a d operating a machine. Equivalent Annual Cost = PV of costs / Annuity factor Example: cheap & dirty vs good but expensive Given a 10% cost of capital, which of the following machines you buy? y would y C0 C1 C2 C3 PV EAC
A B 15 10 4 6 4 6 4 24.95 20.41 10.03 11.76

EAC calculation: A: EAC = PV(Costs) / 3-year annuity factor = 24.95 / 2.487 = 10.03 B: EAC = PV(Costs) / 2-year 2 year annuity factor = 20.41 / 1.735 = 11.76
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The Decision to Replace p

W When e to replace ep ace an a existing e st g machine ac e with w t a new ew one? o e? Calculate the equivalent annual cost of the new equipment Calculate the yearly cost of the old equipment (likely to rise over time as equipment becomes older) Replace just before the cost of the old equipment exceeds the EAC q p on new equipment Example Annual operating cost of old machine = 8 Cost of new machine : C0 C1 C2 C3 15 5 5 5 PV of cost (r = 10%) = 27.4 27 4 EAC = 27.4 / 3-year annuity factor = 11 p until operating p g cost of old machine exceeds 11 Do not replace
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