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- Managerial Economics Practice Set 1 2018
- Capital Budgeting
- Poject Analysis and Appraisal Notes
- Lecture 5 Project Analysis and Selection
- Question1-5 16 April
- Untitled
- Capital Budgeting
- QUBEE
- Project Selection
- Unit7-e(A2)
- Capital Investment
- RWJ Chapter 6
- Capital Budgeting RK 1
- 1813_06
- Capital Investment Appraisal
- FAP ch25 summary
- Assig 2.docx
- Chap009.pptx
- Final Presentation
- ACCT230_Ch14

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Decision Rules

Logic of the NPV Decision Rule:

When making an Investment Decision, take the alternative with

the highest NPV, which is equivalent to receiving its NPV in cash

today.

Example:

In exchange for $500 today, your firm will receive $550

in one year.

The interest rate is 8% per year:

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Value.

In exchange for $500 today, your firm will receive $550 in one

year. If the interest rate is 8% per year:

PV (Benefit)

= ($550 in one year) ($1.08 $ in one year/$ today) = $509.26 today

This is the amount you would need to put in the bank today to generate

$550 in one year

NPV = $509.26 - $500 = $9.26 today

You should be able to borrow $509.26 and use the $550 in one year to repay the

loan.

This transaction leaves you with $509.26 - $500 = $9.26 today

As long as NPV is positive, the decision increases the value of the firm regardless of

current cash needs or preferences.

The NPV Decision Rule implies that we should:

Accept positive-NPV projects, because accepting them is equivalent to

receiving their NPV in cash today, and

Reject negative-NPV projects, because accepting them would

reduce the value of the firm, whereas rejecting them has no

cost (NPV = 0)

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Problem:

After saving $1,500 waiting tables, you are about to buy a 42-inch plasma

TV. You notice that the store is offering one-year same as cash deal. You

can take the TV home today and pay nothing until one year from now, when you

will owe the store the $1,500 purchase price. If your savings account earns 5% per

year, what is the NPV of this offer? Show that its NPV represents cash in your

pocket.

Solution Plan:

You are getting something (the TV) worth $1,500 today and in exchange will need to

pay $1,500 in one year.

Think of it as getting back the $1,500 you thought you would have to spend today

to get the TV. We treat it as a positive cash flow.

Cash flows:

Today

$ 1,500

In one year

$ 1,500

The Discount Rate for calculating the Present Value of the payment in one year is

your interest rate of 5%. You need to compare the present value of the cost

($1,500 in one year) to the benefit today (a $1,500 TV).

+++ MCO 201 +++ Finance +++ Spring 2016 +++

1,500

NPV = +1,500

= 1,500 1, 428.57 = $71.43

(1.05)

You could take $1,428.57 of the $1,500 you had saved for the TV and put it in your

savings account. With interest, in one year it would grow to $1,428.57 (1.05) =

$1,500, enough to pay the store. The extra $71.43 is money in your pocket to spend

as you like (or put toward the speaker system for your new media room).

Evaluate:

By taking the delayed payment offer, we have extra net cash flows of $71.43 today.

If we put $1,428.57 in the bank, it will be just enough to offset our $1,500

obligation in the future.

Therefore, this offer is equivalent to receiving $71.43 today, without any future net

obligations.

Execute:

Problem:

After saving $2,500 waiting tables, you are about to buy a 50-inch LCD TV.

You notice that the store is offering one-year same as cash deal. You can take the

TV home today and pay nothing until one year from now, when you will owe the

store the $2,500 purchase price. If your savings account earns 4% per year, what is

the NPV of this offer? Show that its NPV represents cash in your pocket.

Solution Plan:

You are getting something (the TV) worth $2,500 today and in exchange will need to

pay $2,500 in one year. Think of it as getting back the $2,500 you thought you

would have to spend today to get the TV. We treat it as a positive cash flow.

Cash flows:

$ 2,500 $ 2,500

The discount rate for calculating the present value of the payment in one year is

your interest rate of 4%. You need to compare the present value of the cost ($2,500

in one year) to the benefit today (a $2,500 TV).

$1,500

NPV = +$2,500

= $2,500 $2,403.85 = $96.15

1.04

You could take $2,403.85 of the $2,500 you had saved for the TV and put it in your

savings account. With interest, in one year it would grow to $2,403.85 (1.04) =

$2,500, enough to pay the store. The extra $96.15 is money in your pocket to spend

as you like.

Evaluate:

By taking the delayed payment offer, we have extra net cash flows of $96.15 today.

If we put $2,403.85 in the bank, it will be just enough to offset our $2,500

obligation in the future. Therefore, this offer is equivalent to receiving $96.15 today,

without any future net obligations.

Execute:

A take-it-or-leave-it decision:

Fredericks, a fertilizer company can create a new environmentally

friendly fertilizer at a large savings over the companys existing fertilizer.

The fertilizer will require a new factory that can be built at a cost of $81.6

million. Estimated return on the new fertilizer will be $28 million after the

first year, and last four years.

Computing NPV

The following timeline shows the estimated return:

NPV = 81.6 +

28

28

28

28

+

+

+

1 + r (1 + r ) 2 (1 + r )3 (1 + r ) 4

28

1

NPV = 81.6 + 1

4

r

(1 + r )

If the companys Cost of Capital is 10%, the NPV is $7.2 million and they should

undertake the investment.

The NPV depends on Cost of Capital

NPV profile graphs the NPV over a range of discount rates

Based on this data the NPV is positive only when the discount rates are less

than 14%

NPV of Fredericks New Project

investment, called the payback period.

Accept if the payback period is less than required.

Reject if the payback period is greater than required.

is based on the notion that an opportunity, that pays back

the initial investment quickly is the best idea.

Solution Plan:

In order to implement the payback rule, we need to know whether the sum of the

inflows from the project will exceed the initial investment before the end of 2 years.

The project has inflows of $28 million per year and an initial investment of $81.6

million.

Execute:

The sum of the cash flows from year 1 to year 2 is $28m x 2 = $56 million, this will

not cover the initial investment of $81.6 million. Because the payback is > 2 years

(3 years required $28 x 3 = $84 million) the project will be rejected.

Evaluate:

While simple to compute, the payback rule requires us to use an arbitrary cutoff

period in summing the cash flows. Also note that the payback rule does not discount

future cash flows. Instead it simply sums the cash flows and compares

them to a cash outflow in the present. In this case, Fredricks would have

rejected a project that would have increased the value of the firm.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Problem:

Assume Fredericks requires all projects to have a payback period of two

years or less. Would the firm undertake the project under this rule?

Year

-$10,000

$1,000

$1,000

$12,000

Solution Plan:

In order to implement the payback rule, we need to know whether the sum of the

inflows from the project will exceed the initial investment before the end of 3 years.

The project has inflows of $1,000 for two years, an inflow of $12,000 in year three,

and an initial investment of $10,000.

Problem:

Assume a company requires all projects to have a payback period of three

years or less. For the project below, would the firm undertake the project under this

rule?

Evaluated:

While simple to compute, the payback rule requires us to use an arbitrary cutoff

period in summing the cash flows.

Further, also note that the payback rule does not discount future cash flows.

Instead it simply sums the cash flows and compares them to a cash outflow in the

present.

Execute:

The sum of the cash flows from years 1 through 3 is $14,000. This will

cover the initial investment of $10,000. Because the payback is less than 3 years the

project will be accepted.

Problem:

Assume a company requires all projects to have a payback period of three

years or less. For the project below, would the firm undertake the project under this

rule?

Year Expected Net Cash Flow

0

-$10,000

$1,000

$1,000

$1,000

$1,000,000

Solution Plan:

In order to implement the payback rule, we need to know whether the sum of the

inflows from the project will exceed the initial investment before the end of 3 years.

The project has inflows of $1,000 for three years, an inflow of $1,000,000 in year

four, and an initial investment of $10,000.

Execute:

The sum of the cash flows from years 1 through 3 is $3,000.

This will not cover the initial investment of $10,000.

Because the payback is more than 3 years the project will not be accepted, even

though the 4th cash flow is very high!

Evaluated:

While simple to compute, the payback rule requires us to use an arbitrary cutoff

period in summing the cash flows.

Further, also note that the payback rule does not discount future cash flows in this

case, a huge mistake!

Instead it simply sums the cash flows and compares them to a cash outflow in the

present.

Problem:

When choosing between two projects, assume a company chooses the one

with the lowest payback period. Which of the following two projects would the firm

undertake the project under this rule?

Project A

Project B

Year

Expected Net

Expected Net

Cash Flow

Cash Flow

-$10,000

-$10,000

$1,000

$5,000

$1,000

$5,000

$8,000

$5,000

$1,000,000

$5,000

Solution Plan:

In order to implement the payback rule, we need to know when the sum of the inflows

from the project will equal the initial investment.

Project A has inflows of $1,000 for two years, an inflow of $8,000 in year 3,

and an inflow of $1,000,000 in year four. Initial investment is $10,000.

Project B has inflows of $5,000 for four years with an initial investment of

$10,000.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Execute:

For Project A:

The sum of the cash flows from years 1 - 3 is $10,000.

This will cover the initial investment of $10,000 at the end of year 3.

For Project B:

The sum of the cash flows from years 1 and 2 is $10,000.

This will cover the initial investment of $10,000 at the end of year 2.

Because the payback for Project B is faster than for Project A, Project B will be

chosen, even though the 4th cash flow for Project A is very high!

Evaluate:

While simple to compute, the payback rule requires us to use an arbitrary cutoff

period in summing the cash flows.

Further, also note that the payback rule does not discount future cash flows in this

case, a huge mistake!

Instead it simply sums the cash flows and compares them to a cash

outflow in the present.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Ignores the time value of money

Ignores cash-flows after the payback period

Lacks a decision criterion grounded in economics

Weakness in IRR

In most cases IRR rule agrees with NPV for stand- alone

projects if all negative cash flows precede positive cash

flows.

In other cases the IRR may disagree with NPV.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Take any investment opportunity where IRR exceeds the

opportunity Cost of Capital.

Two competing endorsements:

Offer A: single payment of $1million upfront

Offer B: $500,000 per year at the end of the next three years

Estimated cost of capital is 10%

Opportunity timeline:

The NPV is:

Given:

Solve for:

1,000,000

-500,000

23.38

= RATE(3,-500000,1000000,0)

NPV = 1, 000,000

2

3

1+ r

(1 + r )

(1 + r)

NPV = 1, 000,000

= $243,426

2

3

1.1

1.1

1.1

To resolve the conflict we can show a NPV Profile

23.38% > the 10% opportunity cost of capital, so according to IRR,

Option A best.

Given:

Solve for:

1,000,000

-500,000

23.38

= RATE(3,-500000,1000000,0)

+++ MCO 201 +++ Finance +++ Spring 2016 +++

received in the future. In these Cases a low rate is best.

When cash is upfront a high interest rate is best.

Picking the investment opportunity with the largest IRR

can lead to a mistake

In general, it is dangerous to use the IRR in choosing between

projects

Always rely on NPV

TABLE 1.1

Cash Flows ($ Thousands) for Network Server Options

TABLE 1.2

Cash Flows ($ Thousands) for Network Server Options,

expressed as Equivalent Annual Annuities

solutions to the same problem.

Solution:

In order to compare this new option to Server A, we need to put it an equal footing

by computing its annual cost. We can do this

1. Computing its NPV at the 10% discount rate we used above

2. Computing the equivalent 4-year annuity with the same present value.

Problem:

You are about to sign the contract for Server A from Table 1.1 when a third

vendor approaches you with another option that lasts for 4 years. The cash flows for

Server C are given below. Should you choose the new option or stick with Server A?

1

1

= 17.80

PV = 14 1.2

4

.10

.10 (1.10 )

PV

17.80

Cash Flow =

=

= 5.62

1

1

1

1

4

4

.10 .10 (1.10 ) .10 .10 (1.10 )

Its annual cost of 5.62 is greater than the annual cost of Server A (5.02), so we

should choose Server A.

Evaluate:

In this case, the additional cost associated with purchasing and maintaining Server C

is not worth the extra year we get from choosing it. By putting all of these costs into

an equivalent annuity, the EAA tool allows us to see that.

Execute:

Problem:

You considering a maintenance contract from two vendors. Vendor Y

charges $100,000 upfront and then $12,000 per year for the three-year life of the

contract. Vendor Z charges $85,000 upfront and then $35,000 per year for the twoyear life of the contract. Compute the NPV and EAA for each vendor assuming an

8% cost of capital.

0

-$100,000

0

-$12,000

1

-$12,000

2

-$12,000

-$35,000

-$35,000

Vendor Y

Vendor Z

-$75,000

Solution:

In order to compare the two options, we need to put both on an equal footing by

computing its annual cost. We can do this

1. Computing its NPV at the 8% discount rate we used above

2. Computing the equivalent annual annuity with the same PV

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Execute:

1

PVY = $100,000 $12,000

= $130,925

3

.

08

.

08

(

1

.

08

)

PVY

$130,925

Cash Flow Y =

=

= $50,803

1

1

1

1

1

PVZ = $75,000 $35,000

= $137,414

2

.

08

.

08

(

1

.

08

)

PVZ

$137,414

Cash Flow Z =

=

= $77,058

1

1

1

1

The annual cost of Vendor Z is greater than the annual cost of Vendor Y, so we

should choose Vendor Y.

Evaluate:

In this case, the higher upfront cost associated with Vendor Y is worth the

extra year we get from choosing it. By putting all of these costs into an

equivalent annuity, the EAA tool allows us to see that.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

different amounts of a particular resource.

If there is a fixed supply of the resource so that you cannot undertake

all possible opportunities, simply picking the highest-NPV opportunity

might not lead to the best decision.

Possible Projects for $200 Million Budget

=

=

Problem:

Your division at NetIt, a large networking company, has put together a project

proposal to develop a new home networking router. The expected NPV of the

project is $18.8 million, and the project will require 50 software engineers.

NetIt has a total of 190 engineers available, and is unable to hire additional qualified

engineers in the short run. Therefore, the router project must compete with the

following other projects for these engineers:

Project

NPV ($ Millions)

Engineering Headcount

Router

18,8

50

Project A

22,7

47

Project B

8,1

44

Project C

14,0

40

Project D

11,5

61

Project E

20,6

58

Project F

Total

12,9

108,6

32

332

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Project

Router

Project A

Project B

Project C

Project D

Project E

Project F

Total

NPV ($ Millions)

18,8

22,7

8,1

14,0

11,5

20,6

12,9

107,5

Engineering Headcount

50

47

44

40

61

58

32

332

PI

0,38

0,48

0,18

0,35

0,19

0,36

0,40

to the profitability index.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Solution:

The goal is to maximize the total NPV we can create with 190 employees (at most).

Use the profitability index equation for each project. In this case, since engineers are

our limited resource, we will use Engineering Headcount in the denominator. Once

we have the profitability index for each project, we can sort them based on the index.

Execute:

Execute:

Project

Project A

Project F

Router

Project E

Project C

Project D

Project B

NPV ($ Millions)

22,7

12,9

18,8

20,6

14,0

11,5

8,1

Engineering Headcount

47

32

50

58

40

61

44

PI

0,48

0,40

0,38

0,36

0,35

0,19

0,18

Cumulative Engineering

Headcount

47

79

50

108

148

209

253

By ranking projects in terms of their NPV per engineer, we find the most value we

can create, given our 190 engineers.

There is no other combination of projects that will create more value without using

more engineers than we have.

This ranking also shows us exactly what the engineering constraint costs

usthis resource constraint forces NetIt to forgo two otherwise valuable

projects (D, and B) with a total NPV of $19.6 million.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Solution:

The final column shows the cumulative use of the resource as each project

is taken on until the resource is used up.

Execute:

Project

Project A

Project F

Router

Project E

Project C

Project D

Project B

NPV ($ Millions)

22,7

12,9

18,8

20,6

14,0

11,5

8,1

Engineering Headcount

47

32

50

58

40

61

44

PI

0,48

0,40

0,38

0,36

0,35

0,19

0,18

Cumulative Engineering

Headcount

47

79

129

187

227

288

332

By ranking projects in terms of their NPV per engineer, we find the most value we

can create, given our 190 engineers.

There is no other combination of projects that will create more value without using

more engineers than we have.

This ranking also shows us exactly what the engineering constraint costs

usthis resource constraint forces NetIt to forgo three otherwise valuable

projects (C, D, and B) with a total NPV of $33.6 million.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Solution:

The final column shows the cumulative use of the resource as each project

is taken on until the resource is used up.

Problem:

AaronCo is considering several projects to undertake. All of the projects currently

under consideration have a positive NPV, but AaronCo has a fixed capital budget of

$300 million. The company does not believe they will be able to raise any additional

funds. How should AaronCo prioritize the projects?

Project

A

B

C

D

E

F

G

Total

NPV ($ Millions)

$15

$25

$110

$60

$25

$20

$35

$290

$25

$75

$200

$150

$50

$35

$40

$575

Execute:

Project

A

B

C

D

E

F

G

Total

NPV ($ Millions)

$15

$25

$110

$60

$25

$20

$35

$290

$25

$75

$200

$150

$50

$35

$40

$575

to the profitability index.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

PI

0,60

0,33

0,55

0,40

0,50

0,57

0,88

Solution:

The goal is to maximize the total NPV we can create with $300 million (at most).

In this case, since money is our limited resource, we will use Initial Cost in the

denominator. Once we have the profitability index for each project, we can sort them

based on the index.

Execute:

Project

G

A

F

C

E

D

B

NPV ($ Millions)

$35

$15

$20

$110

$25

$60

$25

$40

$25

$35

$200

$50

$150

$75

PI

0,88

0,60

0,57

0,55

0,50

0,40

0,33

Millions)

$40

$65

$100

$300

$350

$500

$575

By ranking projects in terms of their NPV per initial cost, we find the most value we

can create, given our $300 million budget.

There is no other combination of projects that will create more value without using

more money than we have.

This ranking also shows us exactly what the budget constraint costs us

this resource constraint forces AaronCo to forgo three otherwise valuable

projects (B, D, and E) with a total NPV of $110 million.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Solution:

The final column shows the cumulative use of the resource as each project

is taken on until the resource is used up.

Putting it Together

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