WEEK 10

MBAF 605: CORPORATE FINANCE

•INSTRUCTORS:
Dr. James Ntiamoah Doku,
Dr. Isaac Boadi,
Dr. Maryam Kriese &
Dr. Baah Boamah

Service Excellence
 WEEK 10

Capital Budgeting and Risk

Service Excellence
 LEARNING OUTCOME
At the end of this segment, students should be able to:

•evaluate Capital Investments

•evaluate Mutually Exclusive and Independent Projects
•Understand and apply investment decision making under limited Capital
•Evaluate Capital Investment under Uncertainty
•Make Asset Replacement Decision

Service Excellence
 Independent investments are the exception…
4

 In all of the examples we have used so far, the

investments that we have analyzed have stood alone.
Thus, our job was a simple one. Assess the expected
cash flows on the investment and discount them at the
right discount rate.
 In the real world, most investments are not
independent. Taking an investment can often mean
rejecting another investment at one extreme (mutually
exclusive) to being locked in to take an investment in the
future (pre-requisite).
 More generally, accepting an investment can create side
costs for a firm’s existing investments in some cases and
benefits for others.

4
 I. Mutually Exclusive Investments
5

 We have looked at how best to assess a stand-alone

investment and concluded that a good investment will have
positive NPV and generate accounting returns (ROC and ROE)
and IRR that exceed your costs (capital and equity).
 In some cases, though, firms may have to choose between
investments because
 They are mutually exclusive: Taking one investment makes the other
one redundant because they both serve the same purpose
 The firm has limited capital and cannot take every good investment
(i.e., investments with positive NPV or high IRR).
 Using the two standard discounted cash flow measures, NPV
and IRR, can yield different choices when choosing between
investments.
Aswath Damodaran
5
 Comparing Projects with the same (or similar)
lives..
6

 When comparing and choosing between investments

with the same lives, we can
 Compute the accounting returns (ROC, ROE) of the investments
and pick the one with the higher returns
 Compute the NPV of the investments and pick the one with the
higher NPV
 Compute the IRR of the investments and pick the one with the
higher IRR
 While it is easy to see why accounting return measures
can give different rankings (and choices) than the
discounted cash flow approaches, you would expect NPV
and IRR to yield consistent results since they are both
time-weighted, incremental cash flow return measures.

Aswath Damodaran
6
 Case 1: IRR versus NPV
7

 Consider two projects with the following cash flows:

Year Project 1 CF Project 2 CF
0 -1000 -1000
1 800 200
2 1000 300
3 1300 400
4 -2200 500

Aswath Damodaran
7
 Project’s NPV Profile
8

Aswath Damodaran
8
 What do we do now?
9

 Project 1 has two internal rates of return. The first is

6.60%, whereas the second is 36.55%. Project 2 has one
internal rate of return, about 12.8%.
 Why are there two internal rates of return on project 1?

 If your cost of capital is 12%, which investment would

you accept?
a. Project 1
b. Project 2
 Explain.
Aswath Damodaran
9
 Case 2: NPV versus IRR
10

Project A

Cash Flow $ 350,000 $ 450,000 $ 600,000 $ 750,000

Investment $ 1,000,000

NPV = $467,937
IRR= 33.66%

Project B

Cash Flow $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000

Investment $ 10,000,000
NPV = $1,358,664
IRR=20.88%

Aswath Damodaran
10
 Which one would you pick?
11

 Assume that you can pick only one of these two projects.
Your choice will clearly vary depending upon whether
you look at NPV or IRR. You have enough money
currently on hand to take either. Which one would you
pick?
a. Project A. It gives me the bigger bang for the buck and more
margin for error.
b. Project B. It creates more dollar value in my business.
 If you pick A, what would your biggest concern be?

 If you pick B, what would your biggest concern be?

Aswath Damodaran
11
 Capital Rationing, Uncertainty and Choosing a
Rule
12

 If a business has limited access to capital, has a stream

of surplus value projects and faces more uncertainty in
its project cash flows, it is much more likely to use IRR as
its decision rule.
 Small, high-growth companies and private businesses are much
more likely to use IRR.
 If a business has substantial funds on hand, access to
capital, limited surplus value projects, and more
certainty on its project cash flows, it is much more likely
to use NPV as its decision rule.
 As firms go public and grow, they are much more likely
to gain from using NPV.

Aswath Damodaran
12
 The sources of capital rationing…
13

Aswath Damodaran
13
 An Alternative to IRR with Capital Rationing
14

 The problem with the NPV rule, when there is capital

rationing, is that it is a dollar value. It measures success
in absolute terms.
 The NPV can be converted into a relative measure by
dividing by the initial investment. This is called the
profitability index.
 Profitability Index (PI) = NPV/Initial Investment
 In the example described, the PI of the two projects
would have been:
 PI of Project A = $467,937/1,000,000 = 46.79%
 PI of Project B = $1,358,664/10,000,000 = 13.59%
 Project A would have scored higher.

Aswath Damodaran
14
 Case 3: NPV versus IRR
15

Project A

Cash Flow $ 5,000,000 $ 4,000,000 $ 3,200,000 $ 3,000,000

Investment $ 10,000,000

NPV = $1,191,712
IRR=21.41%

Project B

Cash Flow $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000

Investment $ 10,000,000
NPV = $1,358,664
IRR=20.88%

Aswath Damodaran
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 Why the difference?
16

 These projects are of the same scale. Both the NPV

and IRR use time-weighted cash flows. Yet, the
rankings are different. Why?

 Which one would you pick?

a. Project A. It gives me the bigger bang for the buck and
more margin for error.
b. Project B. It creates more dollar value in my business.

Aswath Damodaran
16
 NPV, IRR and the Reinvestment Rate
Assumption
17

 The NPV rule assumes that intermediate cash flows on

the project get reinvested at the hurdle rate (which is
based upon what projects of comparable risk should
earn).
 The IRR rule assumes that intermediate cash flows on
the project get reinvested at the IRR. Implicit is the
assumption that the firm has an infinite stream of
projects yielding similar IRRs.
 Conclusion: When the IRR is high (the project is creating
significant surplus value) and the project life is long, the
IRR will overstate the true return on the project.

Aswath Damodaran
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 Solution to Reinvestment Rate Problem
18

Aswath Damodaran
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 Why NPV and IRR may differ.. Even if projects
have the same lives
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 A project can have only one NPV, whereas it can have

more than one IRR.
 The NPV is a dollar surplus value, whereas the IRR is a
percentage measure of return. The NPV is therefore
likely to be larger for “large scale” projects, while the IRR
is higher for “small-scale” projects.
 The NPV assumes that intermediate cash flows get
reinvested at the “hurdle rate”, which is based upon
what you can make on investments of comparable risk,
while the IRR assumes that intermediate cash flows get
reinvested at the “IRR”.

Aswath Damodaran
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 Comparing projects with different lives..
20
Project A

$400 $400 $400 $400 $400

-$1000
NPV of Project A = $ 442
IRR of Project A = 28.7%

Project B
$350 $350 $350 $350 $350 $350 $350 $350 $350 $350

-$1500 NPV of Project B = $ 478

IRR for Project B = 19.4%
Hurdle Rate for Both Projects = 12%

Aswath Damodaran
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 Why NPVs cannot be compared.. When projects
have different lives.
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 The net present values of mutually exclusive projects

with different lives cannot be compared, since there
is a bias towards longer-life projects. To compare the
NPV, we have to
 replicate the projects till they have the same life (or)
 convert the net present values into annuities
 The IRR is unaffected by project life. We can choose
the project with the higher IRR.

Aswath Damodaran
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 Solution 1: Project Replication
22

Project A: Replicated
$400 $400 $400 $400 $400 $400 $400 $400 $400 $400

-$1000 -$1000 (Replication)

NPV of Project A replicated = $ 693

Project B
$350 $350 $350 $350 $350 $350 $350 $350 $350 $350

-$1500
NPV of Project B= $ 478

Aswath Damodaran
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 Solution 2: Equivalent Annuities
23

 Equivalent Annuity for 5-year project

 = $442 * PV(A,12%,5 years)
 = $ 122.62
 Equivalent Annuity for 10-year project
 = $478 * PV(A,12%,10 years)
 = $ 84.60

Aswath Damodaran
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 What would you choose as your investment
tool?
24

 Given the advantages/disadvantages outlined for each of

the different decision rules, which one would you choose
to adopt?
a. Return on Investment (ROE, ROC)
b. Payback or Discounted Payback
c. Net Present Value
d. Internal Rate of Return
e. Profitability Index
 Do you think your choice has been affected by the
events of the last quarter of 2008? If so, why? If not, why
not?

Aswath Damodaran
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 What firms actually use ..
25

Decision Rule % of Firms using as primary decision rule in

1976 1986 1998
IRR 53.6% 49.0% 42.0%
Accounting Return 25.0% 8.0% 7.0%
NPV 9.8% 21.0% 34.0%
Payback Period 8.9% 19.0% 14.0%
Profitability Index 2.7% 3.0% 3.0%

Aswath Damodaran
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 26

EVALUATION OF MUTUALLY
EXCLUSIVE AND INDEPENDENT
PROJECTS
Selection rule under single-period rationing

• Independent but divisible projects

• Rank projects based on Profitability Index (PI)
• Allocate funds first to the project with the highest PI then,
the project to the second highest PI; in that order
• Independent but indivisible projects
• A trial and error approach aimed at allocating funds to a
single project or a combination of projects that produces
the highest NPV
• Mutually exclusive projects
• Allocate funds to the project with the highest NPV

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 Illustration: Single-period capital rationing

Arkbase Ventures has identified

five projects with positive NPV but
Advise the company can raise only GHS150,000 in
which project(s) to finance for the coming year.
Below are the NPVs of the
accept if the projects
projects:
are: Project A B C D E
independent and
(a)
NPV 500 400 350 200 280
divisible
(GHS’000)
independent and
(b)

indivisible Investment @ 90 120 60 40 45

time 0
mutually exclusive
(c) (GHS’000)
 Illustration: Solution to (a)
(a) Independent and divisible
Ranking
Project NPV Investment PI PI = NPV / Investment
based on PI
A 500 90 5.6 3
B 400 120 3.3 5
C 350 60 5.8 2
D 200 40 5.0 4
E 280 45 6.2 1

Order of Balance of
Investment Allocation NPV
Allocation fund
E 45 45 105 280
C 60 60 45 350
A 90 45 0 250 <--= 45/90 *500
Total NPV 880

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Illustration 7.4: Solution to (b) and (c)

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Selection rule under multi-period rationing

 The problem can be solved using linear programming

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Capital Budgeting
under Risk and
Uncertainty
Risk, DCF and CEQ

Ct CEQt
PV  t

(1  r ) (1  rf ) t

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 Risk, DCF and CEQ
Example
Project A is expected to produce CF = GH¢100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and
beta of .75, what is the PV of the project?

r  rf  B( rm  rf )
 6  .75(8)
 12%

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 Risk, DCF and CEQ
Example
Project A is expected to produce CF = GH¢100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and
beta of .75, what is the PV of the project?

Project A
Year Cash Flow PV @ 12%
1 100 89.3
2 100 79.7
r  r f  B ( rm  rf )
 6  .75(8) 3 100 71.2
 12% Total PV 240.2

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 Risk, DCF and CEQ
Example
Project A is expected to produce CF = GH¢100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and
beta of .75, what is the PV of the project?

Project A
Year Cash Flow PV @ 12%
1 100 89.3 Now assume that the
2
3
100
100
79.7
71.2
cash flows change, but
Total PV 240.2 are RISK FREE. What is
r  r f  B ( rm  rf ) the new PV?
 6  .75(8)
 12%

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 Risk, DCF and CEQ
Example
Project A is expected to produce CF = GH¢100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?.. Now assume that the cash
flows change, but are RISK FREE. What is the new PV?

Project A Project B
Year Cash Flow PV @ 12% Year Cash Flow PV @ 6%
1 100 89.3 1 94.6 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2

37
 Risk, DCF and CEQ
Example
Project A is expected to produce CF = GH¢100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?.. Now assume that the cash
flows change, but are RISK FREE. What is the new PV?

Project A Project B
Year Cash Flow PV @ 12% Year Cash Flow PV @ 6%
1 100 89.3 1 94.6 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2

Since the 94.6 is risk free, we call it a Certainty Equivalent

of the 100.

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 Example
Risk, DCF and CEQ
Project A is expected to produce CF = GH¢100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? DEDUCTION FOR RISK

• Thus, when we discount cash flows with the same cost of capital, we are implicitly giving later cash flows a bigger hair cut for risk.
In year 1 project A has a risky cash flow of 100. This has the same PV as the safe cash flow of 94.6 from project B. Therefore 94.6 is the certainty equivalent of 100. Since the two cash flows have the same PV, investors must be willing to give up 100-94.6=5.4 in expected year-1 income in order to get rid of the uncertainty. In year 2
project A has a risky cash flow of 100, and B has a safe cash flow of 89.6. Again both flows have the same PV. Thus, to eliminate the uncertainty in year 2, investors are prepared to give up 100-89.6=10.4 of future income. To eliminate uncertainty in year 3, they are willing to give up 100-84.8 =15.2 of future income.

Deduction
Year Cash Flow CEQ
for risk
1 100 94.6 5.4
2 100 89.6 10.4
3 100 84.8 15.2

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 Risk, DCF and CEQ
Example
Project A is expected to produce CF = GH¢100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project? RATIO OF CEQ TO CASHFLOW

Ratio of CEQ
Year Cash Flow CEQ
to Cash flow
1 100 94.6 .946
2 100 89.6 .896
3 100 84.8 .848

40
 Risk, DCF and CEQ
Example
Project A is expected to produce CF = GH¢100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?.. Now assume that the cash
flows change, but are RISK FREE. What is the new PV?

The difference between the 100 and the certainty

equivalent (94.6) is 5.4%…this % can be considered the
annual premium on a risky cash flow
Risky cash flow
 certainty equivalent cash flow
1.054

41
 Risk, DCF and CEQ
Example-Project A is expected to produce CF = GH¢100 mil for each of
three years. Given a risk free rate of 6%, a market premium of 8%,
and beta of .75, what is the PV of the project?.. Now assume that
the cash flows change, but are RISK FREE. What is the new PV?
100
Year 1   94.6
1.054

100
Year 2   89.6
1.054 2

100
Year 3   84.8
1.054 3

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A Common Mistake

 You often hear people say that because distant cash

flows are riskier, they should be discounted at a higher
rate than earlier cash flows.
 That is quite wrong!
 We have just seen that using the same discount rate for
each year’s cash flow implies a larger deduction for risk
from the later cash flows!

 The reason is that the discount rate compensates for the

risk borne per period. The more distant the cash flows,
the greater the number
 of periods and the larger the total risk adjustment.

43
 Risk, DCF and CEQ

Example
A Project has a forecasted cashflow of GH¢110 in year 1 and
GH¢121 in year 2. The interest rate is 5%, the estimated risk
premium on the market is 10%, and the project has a beta of
0.5. If you use a constant risk-adjusted discount rate, what is
a) the PV of the project?
b) the CEQ cashflow in years 1 and 2?
c) the ratio of the CEQ cashflows to the
expected cashflows in years 1 and 2?

44
 Risk,DCF and CEQ

Example
A Project has the ff forecasted cashflows:
C0 = -100, C1 = +40, C2 = +60, C3 = +50
The estimated project beta is 1.5. The market return rm is 16%, and the
risk-free rate rf is 7%.
a) Estimate the opportunity cost of capital and the
project’s PV.
b) What is the CEQ cashflow in each year?
c) What is the ratio of the CEQ cashflows to the
expected cashflows in year each?
d) Explain why this ratio declines.

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ASSET REPLACEMENT
Introduction

 As part of ongoing efficient management, assets

currently held by the firm must be reviewed periodically
to determine whether they are still viable. If the firm will
continue to produce the same output at the same level
and in the same style, then the asset review decision will
be an asset replacement decision.

 For example, a trucking company should review its truck

fleet periodically. Whilst a new truck may represent
some improvement in performance and safety, it will
essentially provide the same services, albeit at a lesser
cost. In this case, existing forecasts of revenues and costs
can be used.

47
Introduction
 However, if the firm replaced a current truck with one of
markedly increased capacity, then new forecasts of future
cash flows would have to be made. In this case, the
investment decision is an ‘upgrade’ decision, and would have
to be viewed as new investment to replace the existing
investment.
 
 The relevant cash flows in the replacement decision will be
the future changeable flows. Past cash flows, current book
values, and past cash spent on the asset will not be relevant.
The relevant cash flows will be concerned with the earning
power of the asset in place, against the earning power of a
similar replacement asset.

48
 Introduction

 These decisions are part of the asset review process. A

firm should evaluate assets to see whether the future
benefits warrant the continuation of the asset, or
whether the cash released by the sale of the asset could
be better employed elsewhere. The relevant cash flows
in this case are the current cash flows from the asset in
place, and the present value of the cash from sale.

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Replacement Terminology

 Defender: an old machine

 Challenger: a new machine

 Current market value: selling price of the defender in the

market place

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Replacement Terminology

 Sunk cost: any past cost unaffected by any future decisions

 Trade-in allowance: value offered by the vendor to reduce the

price of a new equipment

51
 Replacement Decisions

 Replacement projects are decision problems involve the

replacement of existing obsolete or worn-out assets.
 When existing equipment should be replaced with more efficient
equipment.
 Once the decision has been made to acquire an asset for a long-
term project, it is quite likely that the asset will need to be replaced
periodically throughout the life of the project.

52
 Replacement Decisions

 Where there are competing replacements for a particular asset it is

important for a company to compare the possible replacement
strategies available.

A problem arises
 where equivalent assets available are likely to last for different

lengths of time or
 an asset, once bought, must be replaced at regular intervals.

53
 Key assumptions

 Cash inflows from trading are ignored since they will be similar
regardless of the replacement decision. In practice using an older
asset may result in lower quality, which in turn could affect sales.
 The operating efficiency of machines will be similar with differing
machines or with machines of differing ages.
 The assets will be replaced in perpetuity or at least into the
foreseeable future.
 In most questions tax and inflation are ignored.
 As with all NPV calculations non-financial aspects such as pollution
and safety are ignored. An older machine may have a higher chance
of employee accidents and may produce more pollution.

54
Optimum Replacement Cycle

The decision is how often should the asset be replaced?

Determining the optimum replacement period (cycle) will largely be

influenced by:
the capital cost/resale value of the asset as the longer the period, the

less frequently these will occur

the annual operating costs of running the asset as the longer the

period, the higher these will become.

55
Optimum Replacement Cycle

The optimum replacement period (cycle) will be the period that has

the lowest EAC, although in practice other factors may influence the
final decision.

The method can be summarised as:

(1)calculate the NPV of each strategy or replacement cycle
(2)calculate the EAC for each strategy
(3)choose the strategy with the lowest EAC.

56
 Equivalent Annual Cost

 This is the cost per year for owing and operating an asset
over its entire lifespan. EAC is often uses as a decision
making tool when company investment projects of
unequal life spans.

 In order to deal with the different time-scales, the NPV of

each option is converted into an annuity or an EAC.

 The EAC is the equal annual cash flow (annuity) to which a

series of uneven cash flows is equivalent in PV terms.

57
Equivalent Annual Cost

58
 Example

 Running costs (payable at the end of the year):

Year 1 5000
Year 2 5500

Disposal after year 1 16,000

Disposal after year 2 13,000

59
Example
0 1
Buy asset -20,000
Running Costs -5000
Trade-in 16,000
Net Cash flow -20,000 11,000
DF @ 10% 1 0.909
PV 20,000 9,999
NPV -10001

EAC 10,001
0.909
11,002

60
Example
0 1 2
Buy asset -20,000
Running Costs -5000 -5,500
Trade-in 13,000
Net Cash flow -20,000 -5,000 7500
DF @ 10% 1 0.909 0.826
PV 20,000 -4,545 6195
NPV -18,350

EAC 18,350
1.736
10,570

61
 Example 2

The following information is relevant to fleet to a fleet of

10 vehicles, which a company is considering buying to
replace its existing fleet. The cost of each vehicle is GHȼ
12,000. The expected maintenance cost of the fleet and
expected year-end trade-in-values of fleet are:

62
 Example 2
Expected Expected Trade-in-
Year Maintenance Cost Value
GHȼ GHȼ
1 2,000 8,000
2 4,000 6,000
3 8,000 3,000
The appropriate cost of capital is 10%

Required:
What is the economic useful life of the fleet?

63
Example 2

0 1
Buy asset -12,000
Maintenance Costs -2000
Trade-in-value 8,000
Net Cash flow -12,000 6,000
DF @ 10% 1 0.909
PV -12,000 5,454
NPV -6546

EAC 6,546
0.909
7,201

64
Example 2
0 1 2
Buy asset -12,000
Maintenance Costs -2000 -4000
Trade-in-value 6000
Net Cash flow -12,000 -2,000 2000
DF @ 10% 1 0.909 0.826
PV -12,000 -1,818 1652
NPV -12166

EAC 12,166
1.735
7,012

65
Example 2
0 1 2 3
Buy asset -12,000

Maintenance Costs -2000 -4000 -8000

Trade-in-value 3000
Net Cash flow -12,000 -2,000 -4000 -5000
DF @ 10% 1 0.909 0.826 0.751
PV -12,000 -1,818 -3304 -3755
NPV -20877

EAC 20,877
2.486
8,397

66
 Limitations of Replacement Analysis

 The model assumes that when an asset is replaced, the

replacement is in all practical respects identical to the last
one and that this process will continue for the
foreseeable future. However in practice this will not hold
true owing to:
 changing technology
 Inflation
 changes in production plans.

67
 End of Unit Quiz
68

1) You are a small business owner considering two

alternatives for your phone system:
  Plan A Plan B
Initial Cost, $ 50,000.00 120,000.00
Annual Maintenance Cost, $ 9,000.00 6,000.00
Salvage Value, $ 10,000.00 20,000.00
Useful Life 20 yrs 40 yrs

 The discount rate is 8%. Which alternative would

you pick?

68
 End of Unit Quiz, Cont’d
69

2) You have been asked to compare three alternative

investments and make a recommendation.
• Project A has an initial investment of $5 million and after-tax

cash flows of $2.5 million a year for the next five years.
Project B has no initial investment, after-tax cash flows of $1

million a year for the next 10 years, and a salvage value of $2

million (from working capital).
• Project C has an initial investment of $10 million, another

investment of $5 million in 10 years, and after-tax cash flows of

$2.5 million a year forever. The discount rate is 10% for all three
projects. Which of the three projects would you pick? Why?

69
 End of Unit Quiz, Cont’d
70

3) You are the manager of a pharmaceutical company and are

considering what type of laptop computers to buy for your
salespeople to take with them on their calls.
• You can buy fairly inexpensive (and less powerful) older

machines for about $2,000 each. These machines will be obsolete

in three years and are expected to have an annual maintenance
cost of $150.
• You can buy newer and more powerful laptops for about $4,000

each. These machines will last five years and are expected to have
an annual maintenance cost of $50.
If your cost of capital is 12%, which option would you pick and

why?
70