Principles of Finance

BS 2100

ALTERNATIVES TO PV & CORPORATE FINALE

Pete Hahn
Faculty of Finance Room 5012 Cass Building
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Topics Covered
The Basic Investment Decision Making Tools NPV and its Competitors The Payback Period The Book Rate of Return Internal Rate of Return Introduction to Capital Rationing Rights Issues & Dividend Ploys Leasing

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NPV and Cash Transfers

Every possible method for evaluating projects impacts the flow of cash about the company as follows.
Cash

Investment opportunity (real asset) Invest

Firm

Shareholder

Investment opportunities (financial assets) Shareholders invest for themselves

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Alternative: pay dividend to shareholders

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CFO Decision Tools

Survey Data on CFO Use of Investment Evaluation Techniques
NPV, 75%

IRR, 76%

Payback, 57%

Book rate of return, 20% Profitability Index, 12% 0% 20% 40% 60% 80% 100%

SOURCE: Graham and Harvey, The Theory and Practice of Finance: Evidence from the Field, Journal of Financial Economics 61 (2001), pp. 187-243.

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Book Rate of Return

Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.

book income Book rate of return book assets

Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows.
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Payback
The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay. The payback rule says only accept projects that payback in the desired time frame. This method is flawed, primarily because it ignores later year cash flows and the present value of future cash flows.
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Payback
Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.
Project A B C
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C0 - 2000 - 2000

C1 500 500

C2 500 1800 500

C3 5000 0 0

Payback Period

NPV@ 10%

- 2000 1800

Payback
Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.
Project A B C
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C0 - 2000 - 2000

C1 500 500

C2 500 1800 500

Period 5000 3 0 0 2 2

C3

Payback

NPV@ 10% 2,624 - 58 50

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- 2000 1800

Internal Rate of Return

The IRR of a project is the cumulative percentage return achieved on the funds invested in a project using the funds generated by the project. IRR provides a return indicator for an investor to understand how much or how well his/her investment performs financially.

This method has a number of flaws.

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Internal Rate of Return

Example
You can purchase a turbo powered machine tool gadget for 4,000. The investment will generate 2,000 and 4,000 in cash flows for two years, respectively. What is the IRR on this investment?

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Internal Rate of Return

Example You can purchase a turbo powered machine tool gadget for 4,000. The investment will generate 2,000 and 4,000 in cash flows for two years, respectively. What is the IRR on this investment?

2,000 4,000 NPV 4,000 0 1 2 (1 IRR ) (1 IRR )

IRR 28.08%
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Internal Rate of Return

2500 2000 1500

NPV (,000s)

1000 500 0

IRR=28%

-1000 -1500 -2000 Discount rate (%)

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10 0

-500

10

20

30

40

50

60

70

80

90

Internal Rate of Return

Pitfall 1 - Lending or Borrowing?
With some cash flows (as noted below) the NPV of the project increases as the discount rate increases.
This is contrary to the normal relationship between NPV and discount rates.

Project A B
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C0 1,000 1,000

C1 1,500 1,500

IRR 50% 50%

NPV @ 10% 364 364

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Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%. Cash Flows (millions of Australian dollars)

C0 C1...... ...... C9 600 120 120

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C10 150
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Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%. NPV 600 300 0 -30 -600 IRR=-44% IRR=11.6% Discount Rate

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Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
It is possible to have a zero IRR and a positive NPV

Project C

C0 1,000

C1 3,000

C2 2,500

IRR None

NPV @ 10 % 339

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Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects

IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem.

Project D E

C0 10,000 20,000

C1 20,000 30,000

IRR 100% 75%

NPV @ 10% 8,182 11,818

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Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects

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Internal Rate of Return

Pitfall 4 - Term Structure Assumption

We assume that discount rates are stable during the term of the project.
This assumption implies that all funds are reinvested at the IRR. This is a false assumption.

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Capital Constraints: Profitability Index

When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives A set of limited resources and projects can yield various combinations. The highest weighted average PI can indicate which projects to select.
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Profitability Index
Cash Flows ($ millions)

Project A B C D

C0 10 5 5 0

C1 30 5 5 40

C2 5 20 15 60

NPV @ 10% 21 16 12 13

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Profitability Index
Cash Flows ($ millions)

Project Investment($) NPV ($) Profitability Index A B C D 10 5 5 0 21 16 12 13 2.1 3.2 2.4 0.4

Where did the 0.4 (actually 0.35) come from?

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Profitability Index
NPV Profitability Index Investment
Example We only have $300,000 to invest. Which do we select? Proj NPV Investment PI A 230,000 200,000 1.15 B 141,250 125,000 1.13 C 194,250 175,000 1.11 D 162,000 150,000 1.08
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Profitability Index
Example - continued Proj NPV Investment A 230,000 200,000 B 141,250 125,000 C 194,250 175,000 D 162,000 150,000 PI 1.15 1.13 1.11 1.08

Select projects with highest Weighted Avg. PI

WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25) (300) (300) (300) = 1.01
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Profitability Index
Example - continued Proj NPV Investment A 230,000 200,000 B 141,250 125,000 C 194,250 175,000 D 162,000 150,000 PI 1.15 1.13 1.11 1.08

Select projects with highest Weighted Avg PI

WAPI (BD) = 1.01 WAPI (A) = 0.77 WAPI (BC) = 1.12
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Corporations & Finance Decisions

Gearing & Leverage:
Firms borrow different amounts? What are the determining factors? (for example)
1. Industry (Risk) seasonality, cyclicality 2. Maturity (Risk)- growing, stable, cash generative 3. Ownership (Control) strategies for control and profitability

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Corporations & Dividend Decisions

Dividends:
Firms may pay some of their cash (cash flow or reserves) to investors. How do they decide how much? (for example.)
1. Industry 2. Maturity (opportunity of new investments for growth) 3. Owners demands

Another form of dividend is a share buyback.

How do you think this works? And why is it like a dividend?

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Cash Dividends vs Share Buybacks

(assume 100 shares outstanding worth 100p each)
Assets Liabilities

Cash

100 100 Common Equity

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You are the CEO of Dividend Corporation (on the preceding page) and your bonus is based upon increasing earnings per share (EPS). Would that influence your decision to pay a 1) Cash dividend? 2) Share buyback?

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Patterns of Corporate Financing

(US Corporations)
Internal funds
100% 50% 0% -50% -100%

Net equity issues

Net borrowing

Rights Issues
Rights issues are a form of equity issuance used in many European countries (generally not the USA) for companies to raise new equity.
This is a form of selling new shares to existing investors.

Rights are considered almost fundamental in Europe and of no importance in America.

What is the corporate governance argument?

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Pru boss Thiam fights to keep job after FSA steps in to delay 14bn cash call
Pru chairman insists 24bn AIA takeover will go ahead By Jill Treanor, 5 May 2010
Tidjane Thiam, chief executive of Prudential [Insurance Plc], was fighting to keep his job after City regulators forced the insurer to pull details of how it planned to raise the cash for its 24bn takeover of Asian rival AIA.
Barely three hours before Prudential was to push the button on a 7am stock exchange announcement outlining the terms of its [14bn rights issue] record cash call, executives abandoned the update because the Financial Services Authority raised concerns about the capital cushion it would be left with after the takeover. [Prus] largest investor had already been trying to block the deal..

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Leasing
What is a Lease? Why Lease? Operating Leases Financial Leases

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Lease Terms
Lease = A rental agreement that extends for a year or more and involves a series of fixed payments (a form of debt)
Operating Leases
Generally, 1 year or less, often off-balance sheet

Financial Leases (often, appear as debt for accounting)

Rental Lease Net lease Direct lease Leveraged lease

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Why Lease?
Sensible Reasons for Leasing
Access to funding (and capital resources) Short-term leases are convenient Cancellation options are valuable Maintenance may be provided Standardization can lead to low costs Tax benefits are possible

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Why Lease?
Dubious Reasons for Leasing
Leasing avoids capital expenditure controls Leasing preserves capital (avoiding dilution) Leases may be off balance sheet financing Leasing effects book income

Review Operating & Financial Leasing

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GOOD LUCK See you next week

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