CH6.

How do I know that the PV of project X will actually show up in Vegetron’s market value? You: Suppose we set up a new, independent firm X, whose only asset
is project X. What would be the market value of firm X? Investors would forecast the dividends that firm X would pay and discount those dividends by the
expected rate of return of securities having similar risks. We know that stock prices are equal to the present value of forecasted dividends. The discount rate
is the opportunity cost of investing in the project rather than in the capital market. In other words, instead of accepting a project, the firm can always return
the cash to the shareholders and let them invest it in financial assets. Book rate of return (accounting rate of return) [avg/avg] book income
Some managers are reluctant (უხალისო) to undertake projects that will reduce their companies’ book rate of return. book rate of return 
book assets
The accountant labels some cash outflows as capital investments and others as operating expenses. The operating expenses are, of course, deducted
immediately from each year’s income. The capital expenditures are put on the firm’s balance sheet and then depreciated. The annual depreciation charge is
deducted from each year’s income. Thus the book rate of return depends on which items the accountant treats as capital investments and how rapidly they
are depreciated. Book income, unlike cash flows, is subject to the influence of accounting choices in terms of income recognition and expense classification.
The same project evaluated by different accountants may have different book rates of return. Relying on book rate of return may lead to bad investment decisions.
Managers may forego +NPV projects if they simply pass up projects that will reduce their company’s book rate of return | Managers may undertake -NPV
projects if they simply accept projects that will increase their company’s book rate of return. A project’s payback period is the number of years it takes before
the project’s cumulative future cash flows equal or exceed the initial investment outlay. The payback rule says “only accept projects that payback before a
selected cutoff date”. What is wrong with the “payback rule”? 1. It ignores the time value of money. 2. It ignores the cash flows after the cutoff date.
Senior managers don’t truly believe that all cash flows after the payback period are irrelevant. First, payback may be used because it is the simplest way to
communicate an idea of project profitability. Investment decisions require discussion and negotiation among people from all parts of the firm, and it is
important to have a measure that everyone can understand. Second, managers of larger corporations may opt for projects with short paybacks because
they believe that quicker profits mean quicker promotion - the need to align the objectives of managers with those of shareholders. Finally, owners of family
firms with limited access to capital may worry about their future ability to raise capital. These worries may lead them to favor rapid payback projects even
though a longer-term venture may have a higher NPV. Discounted-payback rule: Determine how long it takes for the project’s cumulative discounted future
cash flows to equal or exceed the initial investment outlay. Thus a discounted payback rule will never accept a negative-NPV project. On the other hand, it
still takes no account of cash flows after the cutoff date, so that good long-term projects such as A continue to risk rejection.
The IRR stands for internal rate of return. The technique of evaluation of capital budgeting proposal is known as IRR technique. The IRR is the discount rate
which represents NPV as zero. It is the discount rate, which evaluate the present value of inflows and outflow cash. In analyzing a project using IRR and Cost of
Capital, a project should be accepted if the IRR is greater than the opportunity cost. The internal rate of return is a profitability measure that depends solely
on the amount and timing of the project cash flows. The opportunity cost of capital is a standard of profitability that we use to calculate how much the project
is worth. The opportunity cost of capital is established in capital markets. It is the expected rate of return offered by other assets with the same risk as the
project being evaluated. Pitfall 1 - Lending or borrowing? The basic IRR rule leads to wrong investment decisions for Project C0 C1 IRR NPV @10%
certain types of projects. The modified IRR rule: For a “lending” project like A, you want to accept it if its IRR is higher A  1,000  1,500  50 %  364
than its opportunity cost of capital. For a “borrowing” project like B, you want to accept it if its IRR is lower than its B  1,000  1,500  50%  364
Project C0 C1 IRR NPV @10%
opportunity cost of capital. Pitfall 2 - Multiple IRRs Some projects have multiple IRRs. C0 C1 ...... ......C9 C10 D  10,000  20,000 100%  8,182
For example, the project with the following cash flows has two IRRs, -44% and 11.6%.  60 12 12  15 E  20,000  35,000 75%  11,818
Sometimes, projects have no IRR. Pitfall 3 - Mutually exclusive projects. The IRR rule ignores the magnitude or scale of the project.
With uncertain future cash flows, IRR gives managers an idea about how much margin for error there is for a project to have a positive NPV.
Capital Rationing: Managers maximize shareholder value by undertaking all projects with +NPV. When the capital is limited, firms sometimes cannot
undertake all such projects. Solution: Select a subset of projects that fits under the company’s budget and generates the highest total NPV. Under capital
rationing, we cannot always choose the project with the highest NPV. Instead, we must pick the projects that offer the highest NPV per dollar of initial outlay,
which is also called Profitability index (PI) = NPV/initial investment. The simple ranking of projects based on PI breaks down when more than one resource is
rationed. Capital investment 84.00
A rule of thumb Working capital 2.30 4.40
A project typically has more than one IRR, if its cash flow stream changes sign more than once.
Sales 27.00
Cost of goods sold 9.20
Ch 7 Other costs 15.50
Depreciation 0.00 12.00
To go from accounting income to cash flow, you need to add back depreciation (which is not a cash outflow) and Pre-tax profit 0.00 -9.70
subtract capital expenditure (which is a cash outflow). Changes in working capital affect cash flows: Working Tax 0.00 -3.40
After-tax profit 0.00 -6.31
capital = short-term assets – short-term liabilities = cash + inventory + account receivables – account payables.
Working capital injection at the beginning of a project - Increases in working capital reduce cash flows. Working After-tax profit 0.00 -6.31
Depreciation 0.00 12.00
capital wind-down near the end of a project - Decreases in working capital increase cash flows. Net cash flow = Changes in working capital 2.30 2.10
cash flow from capital investment and disposal + cash flow from changes in working capital + operating cash Investment in fixed assets 84.00 0.00
flow( = revenues − cash expenses – taxes) After-tax cash flow -86.30 3.60

Cash flow = profit after tax + depreciation - increases in working capital - investment in fixed assets NPV 15.77
Depreciation, as a non-cash expense, will reduce taxable income, resulting in tax savings and increases in cash
Depreciable life (years) 7
flow. Tax savings or tax shield = depreciation expenses × marginal tax rate. Accelerated depreciation schedules Corporate tax rate 35.00%
will increase the present value of tax savings from depreciations. Opportunity cost of capital 11%
Shareholder book- Straight - line depreciation. Tax book - Accelerated deprecation. In early years of project life, the reported earnings in the shareholder book
are higher than those in the tax book. In capital budgeting only the tax books are relevant, but to an outside analyst only the shareholder books are available.
Tax Shield: if the cost can be expensed, then tax shield is larger, so that the after tax cost is smaller. It is proven that the longer the recovery peropd, the less
the PV of depreciation tax shields. This is true regardless of the discount rate.
We can use the equivalent annual cost approach to compare two or straight-line schedule:
Period
more streams of cash flows with different length or time patterns. 1 2 3 4 5 6 7 sum
Application: choose between long- and short-lived equipment. Do the Depreciation
Tax savings
expenses 12.00
4.20
12.00
4.20
12.00
4.20
12.00
4.20
12.00
4.20
12.00
4.20
12.00
4.20
84.00
29.40
calculation in real terms - Remove the effect of inflation from the PV(tax savings) 19.79

discount rate and cash flows 1.25

Equivalent annual cost=Present value of total cost/Annuity factor accelerated schedule:
Period
Equivalent annual cash flow=Net present value of the 1 2 3 4 5 6 7 sum
project/Present value of annuity factor EBIT=Sales-Cost-Depr Depreciation schedule 0.21 0.19 0.16 0.14 0.12 0.10 0.08
Depreciation expenses 17.64 15.96 13.44 11.76 10.08 8.40 6.72 84.00
Tax savings 6.17 5.59 4.70 4.12 3.53 2.94 2.35 29.40
PV(tax savings) 21.05
 Ch 11
Annual capital budget is a list of investment projects planned for the coming year. Firms begin the capital budgeting process by establishing consensus
forecasts of economic indicators, such as inflation and growth in national income, as well as forecasts of particular items that are important to the firm’s
business, such as housing starts or the prices of raw materials. These forecasts are then used as the basis for the capital budget. A firm’s capital investment
choices should reflect both bottom-up and top-down views of the business—capital budgeting and strategic planning, respectively. Plant and division
managers, who do most of the work in bottom-up capital budgeting, may not see the forest for the trees. Strategic planners may have a mistaken view of the
forest because they do not look at the trees one by one.
Sensitivity analysis boils down to expressing cash flows in terms of key project variables and then calculating the consequences of misestimating the variables.
It forces the manager to identify the underlying variables, indicates where additional information would be most useful, and helps to expose inappropriate
forecasts. One drawback to sensitivity analysis is that it always gives somewhat ambiguous results.
For example, what exactly does optimistic or pessimistic mean? The marketing department may be interpreting the terms in a different way from the
production department. Ten years from now, after hundreds of projects, hindsight may show that the marketing department’s pessimistic limit was exceeded
twice as often as the production department’s; but what you may discover 10 years hence is no help now. Of course, you could specify that, when you use the
terms “pessimistic” and “optimistic,” you mean that there is only a 10% chance that the actual value will prove to be worse than the pessimistic figure or
better than the optimistic one. However, it is far from easy to extract a forecaster’s notion of the true probabilities of possible outcomes. Another problem
with sensitivity analysis is that the underlying variables are likely to be interrelated. What sense does it make to look at the effect in isolation of an increase in
market size? If market size exceeds expectations, it is likely that demand will be stronger than you anticipated and unit prices will be higher. And why look in
isolation at the effect of an increase in price? If inflation pushes prices to the upper end of your range, it is quite probable that costs will also be inflated.
Problems with sensitivity analysis: 1. Cross-sectional and time-series ambiguity in defining optimistic and pessimistic, 2. In reality, variables affecting cash
flows often change together. Solution - scenario analysis (If the variables are interrelated, it may help to consider some alternative plausible scenarios.
). Examine the effect on NPV of consistent combinations of variable changes. (E.g., a larger market and a higher unit price go together, because of higher
demand)
Break-even analysis - How bad do things have to get for a project to have a negative NPV? Solve for conditions that make NPV equal to zero! Accounting VS
PV-based BE: When we work in terms of accounting profit, we deduct depreciation of X each year to cover the cost of the initial investment. If company sells s
scooters a year, revenues will be sufficient both to pay operating costs and to recover the initial outlay of ¥15 billion. But they will not be sufficient to repay
the opportunity cost of capital on that ¥15 billion. A project that breaks even in accounting terms will surely have a negative NPV. A project’s break-even point
depends on the extent to which its costs vary with the level of sales.
Costs = (market size × market share × variable unit cost) + fixed cost
Revenues = market size × market share × unit price
Pretax Profits=Sales – total V.C.-FC-Depr.exp Aftertax profit=pretax – tax after tax CF=after tax profit +dep.exp
After tax Cash flow = (revenues − costs − depreciation) × (1 − tax rate) + depreciation
Set y=break even # of units sold Sales=y * unit price VC=y*UVC FC Dep.exp Pretax=Sales-VC-FC-Dep
After tax prof=pretax*(1-tax) Aftertax CF=af.t.prof+depr | NPV=0=-invest+CF’*annuity rate CF’=x Aftertax CF=X, find Y
We prefer the PV-based breakeven variable cost, because the PV-based breakeven analysis takes into account the opportunity cost of capital while the
accounting-based breakeven does not. To see the effect of not taking into account the opportunity cost of capital, let’s compute the project’s NPV if the
variable cost is at the accounting-based breakeven level, ¥330,000.
Ch 12
• Forecasts of future cash flows associated with a project inevitably contain some errors: Errors
due to innocent mistake, Errors due to biases or deliberate manipulations
• Some projects have positive NPVs only because of forecasting errors, and some projects have
negative NPVs precisely for the same reason.
• To ferret out mistaken NPV calculations, financial managers need to understand the economic
reasons why a given project has a positive or negative NPV.
• Economic rents are profits in excess of competitive level
– Competitive-level profits are just enough to cover costs of capital
• Therefore, economic rents are alternatively defined as profits in excess of
what is required to cover costs of capital
• A project has a positive NPV  A project generates economic rents
• Firms need to have competitive advantages in order to earn economic rents
– Firms can secure competitive advantages through
• Cost leadership
• Product differentiation
• Focus on a particular market niche
• Before accepting a positive-NPV project, managers should see whether they can justify the
positive NPV economically
– Do their companies enjoy any competitive advantage in the project?
• Similar considerations apply before managers reject a negative-NPV project
When forecasting a project’s future cash flows, Financial managers should not assume that other
companies will simply watch passively. Instead, they should ask the following questions. How will
their rivals react? Price cutting or product imitation? How long a lead do they have over their
rivals? What will happen to prices when that lead disappears?
• Do not be obsessed with the DCF analysis.
– Project NPVs are computed by discounting forecasted cash flows, but cash flow
forecasts inevitably contain errors.
Whenever possible, use market values or market prices for assets with competitive markets.
• Here is a special offer from a dealership: for $45,001, you get a brand new Cadillac plus the
chance to shake hands with your favorite movie star. You want to determine how much you are paying for that handshake.
– First approach: estimate the costs of parts and labor needed to build a Cadillac and come up with a value for the car. Subtract the car’s value from
$45,001.
Second approach: Subtract the prevailing market price for the car from $45,001