Beruflich Dokumente
Kultur Dokumente
2/15/2006
11/7/2014 8:27
Page 1
$12,000
$8,000
$6,000
20,000
0.0%
$3.00
$2.10
$8,000
2007
1.3%
$156
$156
$11,844
Years
2008
2.6%
$312
$468
$11,532
2009
2.6%
$312
$780
$11,220
2010
2.6%
$312
$1,092
$10,908
20.0%
$1,600
$1,600
$6,400
32.0%
$2,560
$4,160
$3,840
19.0%
$1,520
$5,680
$2,320
12.0%
$960
$6,640
$1,360
$7,500
$2,000
40%
12%
0.0%
0.0%
0.0%
The indicated percentages are multiplied by the depreciable basis ($12,000 for the building and $8,000 for
the equipment) to determine the depreciation expense for the year.
Building Equipment
$7,500
$2,000
10,908
1,360
-3,408
640
-1,363
256
$8,863
$1,744
Total
$10,607
Book value equals depreciable basis (initial cost in this case) minus accumulated MACRS depreciation.
For the building, accumulated depreciation is $1,092, so book value is $12,000 - $1,092 = $10,908. For the
equipment, accumulated depreciation is $6,640, so book value is $8,000 - $6,640 = $1,360.
Building: $7,500 market value - $10,908 book value = -$3,408, a loss. Thus there's a shortfall in depreciation
taken versus "true" depreciation, and it is treated as an operating expense for 2010. Equipment: $2,000
market value - $1,360 book value = $640 profit. Here the depreciation charge exceeds the "true"
depreciation, and the difference is called "depreciation recapture". It is taxed as ordinary income in 2010.
Net cash flow from salvage equals salvage (market) value minus taxes. For the building, the loss results
in a tax credit, so net salvage value = $7,500 - (-$1,363) = $8,863.
Page 2
1
2007
Years
2
2008
3
2009
-$12,000
-8,000
-6,000
20,000
$3.00
20,000
$3.00
20,000
$3.00
20,000
$3.00
$60,000
42,000
8,000
156
1,600
$8,244
3,298
$4,946
1,756
$6,702
$60,000
42,000
8,000
312
2,560
$7,128
2,851
$4,277
2,872
$7,149
$60,000
42,000
8,000
312
1,520
$8,168
3,267
$4,901
1,832
$6,733
$60,000
42,000
8,000
312
960
$8,728
3,491
$5,237
1,272
$6,509
4
2010
$6,000
10,607
$16,607
-$26,000
$6,702
$7,149
$6,733
$23,116
-$26,000
$6,702
$7,149
$6,733
$47,562
Net working capital (NWC) will be recovered at the end of the project's operating life, at year-end 2010, as
inventories are sold off and receivables are collected.
-26,000
-19,298
-12,149
-5,416
17,700
-26,000
-19,298
-12,149
-5,416
42,146
Payback: We first calculate the cumulative CFs. The payback period is the year before the cumulative
CF turns positive, which in this case is 3, plus a fraction equal to (unrecovered after Year 3) / (CF in
Year 4) = 0.23, so the payback is 3.23 years.
We also used an Excel Logical Function to automate payback calculation. This is useful if you plan
to do sensitivity analysis or want to analyze a lot of projects. See the Excel tutorial on the Web site for
an explanation of the payback function we developed.
Page 3
Based on the 12% WACC, the project's NPV is $5,166. Since the NPV is positive and both the IRR
and MIRR exceed the WACC, we tentatively conclude that the project should be accepted. Note,
though, that no risk analysis has been conducted. It is possible that BQC's managers, after appraising
the project's risk, might conclude that its projected return is insufficient to compensate for the risk
and thus reject it. Also, senior managers might conclude that the project is inconsistent with the
firm's long-run strategic plan. Finally, bringing in real options, which we discuss in the next tab, might
change the project's risk/return profile.
% Deviation
from
Base Case
-30%
-15%
0%
15%
30%
WACC
WACC
8.4%
10.2%
12.0%
13.8%
15.6%
NPV
from
5,166
Base Case
$8,294
-30%
$6,674
-15%
$5,166 Base Case
0%
$3,761
15%
$2,450
30%
VARIABLE COSTS
% Deviation
from
Variable
NPV
from
Base Case
Cost
$5,166
Base Case
-30%
$1.47
$28,129
-30%
-15%
$1.79
$16,647
-15%
0%
$2.10
$5,166 Base Case
0%
15%
$2.42
-$6,315
15%
30%
$2.73
-$17,796
30%
% Deviation
% Deviation
from
Base Case
-30%
-15%
0%
15%
30%
SALES PRICE
% Deviation
Sales
NPV
from
Price
$5,166
Base Case
$2.10
-$27,637
-30%
$2.55
-$11,236
-15%
$3.00
$5,166 Base Case
0%
$3.45
$21,568
15%
$3.90
$37,970
30%
FIXED COSTS
Fixed
NPV
Costs
$5,166
$5,600
$9,540
$6,800
$7,353
$8,000
$5,166
$9,200
$2,979
$10,400
$792
Page 4
We summarize the data tables, arranged by sensitivity, and graph the results in the following chart:
$45,925
$27,116
$19,682
$8,748
WACC
$8,294
6,674
5,166
3,761
2,450
$5,844
20,000
NPV
10,000
Unit sales
WACC
Fixed cost
-10,000
Variable cost
-20,000
-30,000
-30%
-15%
0%
15%
30%
Deviation
We see from the graph and the tables that NPV is quite sensitive to changes in the sales price and
variable costs, somewhat sensitive to changes in first-year sales and the sales growth rate, and not
very sensitive to changes in WACC and fixed costs. Thus, the key issue is our confidence in the
forecasts of the sales price and variable costs.
Note too that NPV can change dramatically if the key input variables change, but we do not know how
much the variables are likely to change. For example, if we were buying components under a fixed
price contract, then variable costs might be locked in and not likely to rise by more than say 5%, and
we might have a firm contract to sell the projected number of units at the indicated price per unit. In
that case, the "bad conditions" would not materialize, and a positive NPV would be pretty well
guaranteed. We bring probabilities of different conditions into the analysis in Part 7.
Page 5
Good
Base
26,000
$3.90
$1.47
20,000
$3.00
$2.10
Bad
14,000
$2.10
$2.73
Prob:
25%
50%
25%
0
-26,000
-26,000
-26,000
4
50,224
23,116
7,024
NPV @
12%
$87,503
$5,166
-$43,711
Expected NPV
Standard deviation
Coefficient of Variation
$13,531
$47,139
3.48
a. Probability Graph
Probability
50%
25%
-$43,711
$87,503
NPV ($)
$5,166
Most Likely NPV
$13,531
Expected NPV
b. Continuous Approximation
Probability Density
-$43,711
$0
$87,503
NPV ($)
$5,166
Page 6
The scenario analysis suggests that the project would be highly profitable, but it is quite risky. There
is a 25% probability that the project would result in a loss of $43.7 million. There is also a 25%
probability that it could produce an NPV of $87.5 million. The standard deviation is high, at $47.1
million, and the coefficient of variation is a high 3.48.
Note that the expected NPV in the scenario analysis is much higher than the base case value. This
occurs because under good conditions we have high numbers multiplied by other high numbers,
giving a very high result.
This analysis suggest that the project is relatively risky, thus the base case NPV should be
recalculated using a higher WACC. At a WACC of 15%, the base case NPV is shown below. That
number is not very high in relation to the project's cost.
NPV @ 15% =
$2,877
Changing the WACC would also change the scenario analysis. Here are new figures:
Best Case
Base Case
Worst Case
Prob.
25%
50%
25%
Expected NPV:
Standard Deviation:
Coefficient of Variation:
NPV @ 15%
$80,270
$2,877
($43,065)
$10,740
$44,309
4.13
Based on the analysis to this point, the project looks risky but acceptable. There is a good chance that
it will produce a positive NPV, but there is also a chance that the NPV could be dramatically higher or
lower.
If the bad conditions occur, this will hurt but not bankrupt the firm--this is just one project for a large
company.
We also noted that this project's returns would be highly correlated with the firm's other projects and
also with the general stock market. Thus, its stand-alone risk (which is what we have been analyzing)
also reflects its within-firm and market risk. If this were not true, then we would need to consider risk
further.
Finally, recall that we stated at the start that if the firm undertakes the project, it will be committed to
operate it for the full 4-year life. That is important, because if it were not so committed, then if the bad
conditions occurred during the first year of operations, the firm could simply close down operations.
This would cut its losses, and the worse case scenario would not be nearly as bad as we indicated.
Then, the expected NPV would be higher, and the standard deviation and coefficient of variation would
be lower. We extend the model to deal with abandonment and other real options in the next tab, "Real
Options".
Page 7
REAL OPTIONS
In this model we examine four types of real options: abandonment, timing, growth, and
flexibility.
Table 12-2. Decision Trees Without and With the Abandonment Option (Dollars in Thousands)
Situation 1. Cannot Abandon.
Best Case
Base
Worst Case
Prob:
25%
50%
25%
12%
Predicted Cash Flow for Each Year
0
1
2
3
4
-26,000
33,810
34,257
33,841
50,224
-26,000
6,702
7,149
6,733
23,116
-26,000
-9,390
-8,943
-9,359
7,024
Expected NPV
Standard Deviation (SD)
Coefficient of Variation (CV) = Std Dev/Expected NPV
Best Case
Base
Worst #1
Worst #2
Prob.
25%
50%
0%
25%
WACC =
0
-26,000
-26,000
-$26,000
-$26,000
NPV @
12%
$87,503
$5,166
-$43,711
$13,531
$47,139
3.48
WACC =
12%
End of Period Cash Flows:
1
2
3
33,810
34,257
33,841
6,702
7,149
6,733
-$9,390
-$9,390
-$8,943
$18,244
-$9,359
$0
4
50,224
23,116
$7,024
$0
Expected NPV
Standard Deviation (SD)
Coefficient of Variation (CV) = Std Dev/Expected NPV
Value of the Real Option to Abandon
Expected NPV with Abandonment
NPV @
12%
$87,503
$5,166
-$43,711 Disregard
-$19,840 Choose
$19,499
$40,567
2.08
$19,499
$13,531
$5,968
The possiblity of abandonment raises the expected NPV because some negative CFs will not
occur. The standard deviation also declines. Both of these changes cause the CV to decline.
The project's CV ends up close to 2.0, which is the average for BQC's projects, which in turn
suggests that it is appropriate to evaluate the project using the 12% WACC.
Finally, note that the difference between the expected NPV with and without abandonment
represents the value of the abandonment option.
It often turns out that without abandonment, the bad case outcome is so bad that it causes the
expected NPV to be negative, hence causes the project to look unacceptable. However, when
abandonment possibilities are factored in, the worse case outcome is not nearly as bad, and
the expected NPV becomes positive. Clearly, abandonment option possibilities must be
considered to obtain valid assessments for different projects.
Investment Timing Options (The analysis in the remainder of this tab deals with timing,
growth, and flexibility options as discussed in Web Appendix 12G)
An "investment timing option" involves the decision of when to commit to a project. If the
project can be delayed, then the expected NPV might be increased. Perhaps new technology
will become available to cut costs, or perhaps the firm can get a better idea of the size of the
market before committing to the project. In any event, timing options can be valuable.
Problem: Assume that Williams Inc. is considering a project that requires an initial investment
of $5 million in 2007. The project is expected to generate a constant stream of cash flows for
the next 4 years. However, the size of the cash flows would depend on future market
conditions. If the product were well received, then sales would be strong in the coming year
and would remain strong for the duration of the project's life. However, if the project performs
poorly in the coming year, cash flows would remain weak into the future. Under good
conditions, the annual net cash flow would be $2.5 million at the end of each of the next 4
years. Under bad conditions, cash flows would be $1.2 million per year. The probabilities of
strong and weak demand are both 50%, and the firm's cost of capital is 10%. The decision tree
is shown below. (All dollar figures are in millions.)
Proceed Immediately, i.e., Invest Now
Good Conditions
Bad Conditions
Prob.
50%
50%
2007
-$5.0
-$5.0
2008
$2.5
$1.2
End of Period:
2009
2010
$2.5
$2.5
$1.2
$1.2
2011
$2.5
$1.2
With an expected NPV of $.864 million, the project appears to be profitable, but it does have a
high SD and CV, hence it is risky. That risk might warrant the use of a higher WACC, which
might make the NPV turn negative. However, note that the project's risk arises because we do
not know how demand will turn out next year. If we could wait until we had more information
about demand, the project's risk could be reduced. The expected NPV would be either high, in
which case we would accept the project, or low, in which case we would reject it. How should
the project be analyzed under this condition?
Problem: Suppose Williams can wait until next year to make the decision. If it waits, it will
have more information about market conditions. Whereas today it can only guess what
demand will be, if it waits a year it will know precisely what conditions actually are. All other
aspects of the project would be identical to conditions in the"Go Now" scenario shown above
with the sole exception that the decision will be delayed until 2008. What is the NPV if the
project is delayed for a year?
Delay Decision: Invest Only If Conditions Are Good
Good Conditions
Bad but irrelevant
50%
50%
Delay
Delay
2008
-$5.0
$0.0
2009
$2.5
$0.0
End of Period:
2010
2011
2012
$2.5
$2.5
$2.5
$0.0
$0.0
$0.0
Expected NPV
Standard Deviation
Coefficient of Variation
Discount the expected NPV back 1 year to make it comparable to "go now" NPV
Value of the Timing Option:
Growth Options
Some projects provide the firm with opportunities to pursue other profitable projects in the
future. Although a project appears to have a negative conventional NPV, it could be attractive
if it opens the door to new products or markets.
To illustrate, assume that Crum Corporation is considering a Chinese distribution center that
requires an initial investment of $3 million. If conditions are strong, it will provide 3 annual
cash flows of $1.5 million each. However, if conditions are weak, each annual cash flow will
only be $0.75 million. There is a 50% probability for each condition. Crum's WACC is 12%.
Management believes that if conditions are strong, this investment would lead to subsequent
investment opportunities in Year 2 that would cost $10 million, and the investment could be
sold for $20 million at the end of Year 3. What's the distribution center's NPV if we disregard
the potential new investment? What would the NPV be giving consideration to the option?
Analysis of a Growth Option
Project Disregarding the Growth Option:
End of Period
NPV@
Distr Ctr
Good
Bad
50%
50%
0
-$3.0
-$3.0
1
$1.500
$0.750
2
3
$1.500
$1.500
$0.750
$0.750
Expected NPV:
12%
$0.603
-$1.199
-$0.298
End of Period
0
1
2
-$3.000
$1.500
$1.500
-$10.000
-$3.000
$1.500
-$8.500
Bad
-$3.000
Good
Distr Ctr
New Inv.
Distr Ctr
50%
50%
$0.750
3
$1.500
$20.000
$21.500
$0.750
$0.750
Total Expected NPV:
NPV@
12%
$6.866
-$1.199
$2.834
$2.834
-$0.298
$3.132
Flexibility Options
Flexibility options, where plants are designed to use alternative inputs and/or to produce
alternative outputs depending on market conditions, are also important. For example,
suppose BQC is considering a new plant with a cost of $5 million. There is a 50% probability of
strong demand, in which case the project will provide annual cash flows of $2.5 million for 3
years, and a 50% probability of weak demand and cash flows of only $1.5 million. However, if
demand is weak, the company can convert the plant and produce an alternative product, and
in this case the cash flows in Years 2 and 3 would be $2.2 million. The situation is set forth in
the decision tree below. In a conventional NPV analysis, only the upper tree would be
considered, the NPV would be -$0.278, so the project would be rejected. However, if the
flexibility option were considered, the lower tree would be relevant, the expected NPV would
be $0.239, and the project would be accepted.
Project Disregarding the Flexibility Option:
Strong demand
Weak demand
50%
50%
0
-$5.0
-$5.0
End of Period
1
2
3
$2.5
$2.5
$2.5
$1.5
$1.5
$1.5
Expected NPV:
50%
0%
50%
0
-$5.0
-$5.0
-$5.0
End of Period
1
2
3
$2.5
$2.5
$2.5
$1.5
$1.5
$1.5
$1.5
$2.2
$2.2
Expected NPV:
lars in Thousands)
NPV @
10%
$2.92
-$1.20
$0.864
$2.060
2.38
NPV @
10%
$2.92
$0.00
$1.462
$1.462
1.00
$1.329
$1.329
$0.864
$0.465
NPV@
13%
$0.903
-$1.458
-$0.278
NPV@
13%
$0.903
-$1.458
-$0.425
$0.239
A
B
C
D
E
F
1 REPLACEMENT PROJECT ANALYSIS (WEB APPENDIX 12B)
2
This model analyzes decisions related to replacing assets that are currently being used with
more efficient assets. While the mechanics of the analysis are somewhat different from that
3 used for a new project, the concepts are identical.
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
Input Data
Cost of the new machine
Reduction in operating costs
New machine's salvage value at end of Year 5
Old machine's current market value
Old machine's current book value
Increase in net operating working capital
Tax rate
WACC
$12,000
$5,000
$2,000
$1,000
$2,500
$1,000
40%
11.5%
Depr'n
1
33%
$3,960
2
45%
$5,400
3
15%
$1,800
4
7%
$840
$3,000
3,960
500
$3,460
1,384
$4,384
$3,000
5,400
500
$4,900
1,960
$4,960
$3,000
1,800
500
$1,300
520
$3,520
$3,000
840
500
$340
136
$3,136
$3,000
0
500
-$500
-200
$2,800
Years
-$12,000
1,000
600
(1,000)
$2,000
-800
1,000
$2,200
-$11,400
$4,384
$4,960
0
($11,400)
-
1
($7,016)
-
$3,520
$3,136
$5,000
$3,991
25.03%
18.40%
2.58
Years
2
3
($2,056)
$1,464
2.58
4
$4,600
-
5
$9,600
-
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
The net present value method is used to analyze the advantages of refunding. The firm should refund
only if the present value of the savings exceeds the cost of the refunding. The after-tax cost of debt
should be used as the discount rate, since there is relative certainty to the cash flows to be received.
Using the example laid out in Web Appendix 12C, we will now evaluate such a scenario.
$60,000
$3,000
25
5
10%
12%
5.4%
New
New
New
New
bond issue
flotation cost
bond maturity
cost of debt
Tax rate
Short-term interest rate
$60,000
$2,650
20
9%
40%
6%
After-tax
-$6,000
-2,650
2,400
-600
300
-$3,600
-2,650
960
-360
180
-$5,470
$133
-120
$13
$53
-48
$5
$7,200
-5,400
$1,800
$4,320
-3,240
$1,080
Since the annual flotation cost tax effects and interest savings occur for the next 20 years, they
represent annuities. To evaluate this project, we must find the present values of these savings. Using
the function wizard and solving for present value, we find that the present values of these annuities
36 are:
37
38 Calculating the annual flotation cost tax effects and the annual interest savings
39
40 Annual flotation Cost Tax Effects
Annual Interest Savings
41 Maturity of the new bond
20
Maturity of the new bond
20
42 After-tax cost of new debt
5.4%
After-tax cost of new debt
5.4%
43 Annual flotation cost tax savings
$5
Annual interest savings
$1,080
44
45 NPV of flotation cost savings
$60
NPV of annual interest savings
$13,014
46
Hence, the net present value of this bond refunding project will be the sum of the initial outlay and the
47 present values of the annual flotation cost tax effects and interest savings.
48
49
50 Bond Refunding NPV = Initial Outlay +
PV of flot. costs +
PV of interest savings
51 Bond Refunding NPV =
($5,470)
+
$60
+
$13,014
52
53 Bond Refunding NPV =
$7,604
54
A
B
C
D
E
F
G
H
I
Our refunding analysis tells us that should the firm proceed with the bond refunding, the project will
have a positive net present value. However, unlike traditional capital budgeting decisions, the positive
NPV does not tell the firm if it should refund the bond issue now. That decision is dependent upon
55 several external factors, including interest rate expectations.
56
57
58
CAPITAL BUDGETING WHEN ASSETS HAVE UNEQUAL LIVES (WEB APPENDIX 12F)
A firm is considering two mutually exclusive projects, a conveyor system (Project C) or a fleet
of forklift trucks (Project F), for moving materials. The cost of capital is 12%. We show a
traditional analysis in Part I and modified analyses in Parts II and III.
Two modifications can be used: The Replacement Chain method or the Equivalent Annual
Annuity (EAA) method. These two approaches always reach the same conclusion.
WACC =
12%
End of Period:
1
$8,000
Project F
2
3
$14,000 $13,000
IRRC = 17.5%
4
$12,000
5
$11,000
6
$10,000
End of Period:
0
($20,000)
NPVF = $5,155
1
$7,000
2
3
$13,000 $12,000
IRRF = 25.2%
Based on a traditional analysis, Project C appears to be the better investment. However, if the
firm chooses Project F, it would have the opportunity (which is a real option) to repeat the
investment 3 years from now. Therefore, we can reevaluate Project F using an extended life of
6 years. The time lines are shown below. Note that only F is changed. If the projects had had
lives of say 3 and 7 years, then it would have been necessary to extend the analysis out to a
common year, when both end, in this case to Year 21.
II. Replacement Chain Method for Adjusting for Unequal Lives
Project C: No change in the analysis
0
($40,000)
NPVC =
1
$8,000
$6,491
2
$14,000
WACC =
3
4
$13,000 $12,000
IRRC = 17.5%
12%
5
$11,000
6
$10,000
$7,000
$7,000
25.2%
$13,000
$13,000
$12,000
$12,000
1
$7,000
2
$13,000
($20,000)
NPVF =
$7,000
$8,824
$13,000
3
$12,000
($20,000)
($8,000)
IRRF =
On the basis of the replacement chain analysis, we see that Project F is the better choice.
The unequal life problem was first tackled by electrical engineers who were designing power
plants and distribution lines where they could use either assets with relatively low costs but
relatively short lives or high initial costs and longer lives. The facilities were expected to be
used forever (or at least as far as one could forecast), so the issue became this: Which choice
would result in the higher NPV over an infinite life?
The engineers decided to do an analysis where they took the varying annual cash flows and
converted them into a constant cash flow stream whose NPV was equal to, or equivalent to,
the NPV of the varying stream.
To apply the EAA method to Projects C and F, we first find the constant cash flow that has the
same NPV as the NPV we found using the traditonal analysis. For Project C, we need to find
the constant CF for 6 years that results in the same NPV.
III. Equivalent Annual Annuity (EAA) Method for Adjusting for Unequal Lives
For Project C, insert these values into a calculator: N = 6, I/YR = 12%, PV = 6491, FV = 0, and
then press PMT to find the constant annuity payment whose PV is $6,491. This payment is:
EAAC =
$1,578.78
Then do the same thing with Project F, using N = 3, I = 12%, PV = 5155, and FV = 0:
FV = 0, getting PMT
=
EAAF =
$2,146.28
APPENDIX 12F)
SECTION 12.2
SOLUTIONS TO SELF-TEST QUESTIONS
1a If the WACC increased to 15% in Table 12-1, what would the new NPV be?
WACC
15%
CFs
0
-$26,000
NPV =
$2,877
1
$6,702
Years
2
$7,149
3
$6,733
4
$23,116