Corporate Finance

.

.

What is the NPV of a project?

NPV = PV of all positive Cash Flows - PV of costs

When do you invest according to the NPV rule? And how can we interpret a positive NPV?

Invest if the NPV of a project is positive.

A positive NPV implies that the rate of return on the investment is bigger than the opportunity cost of capital r (which could be earned on the financial markets)

.

Optimal investment decisions of a firm are not related to the consumption preferences of its shareholders

Capital markets serve to separate the two decisions (when perfect!!)

A firm can best act in its shareholders' interest by investing in all positive NPV projects

.

.

Two main reasons for capital rationing

1. Soft Rationing (internally):
Management restricts investments because of different reasons: focus on other parts of the company, prevention of overtaxation of the organization and using capital rationing to achieve slower but more predictable growth

2. Hard Rationing (externally):
Investors may be reluctant or unable to give the firm all the capital it needs because they find it difficult to disentangle worthy projects from projects that primarily serve management's own interest

Payback Rule

Internal Rate of Return (IRR)

• Accept a project if the initial investment is recoverable in N years
• Drawbacks:
  • Ignores CFs after the cutoff date
  • Gives equal weight to all CFs
  • No guidance on what the appropriate cutoff is
  • Ignores the time value of money
• Still used because:
  • Simple and intuitive
  • Investors want to see results quickly
  • If there is capital rationing, firms might prefer projects with earlier payouts

-> Examples for when Payback Rule might be used:

• A manger plans on leaving the company in N years and his bonus is based on earnings...
• A company is short on cash and needs money in the short term
• Small firms with problems going to the capital markets to raise money might use Payback Rule more often

IRR is the discount rate at which the NPV is equal to 0

• IRR is a close relative to NPV and gives the same result, but ONLY if applied carefully!!
• Manually you have to use trial and error (no straightforward way), use Excel

-> Do NOT confuse IRR with the opportunity cost of capital r. IRR is a project characteristic while r is determined by the financial market

-> The IRR rule leads to the same decision as the NPV rule AS LONG AS the NPV is a downward sloping function of the discount rate r

BUT there are some instances when a blind application of IRR leads to undesirable solutions:

• Borrowing vs. Lending
• Multiple IRRs
• Mutually exclusive projects
• Capital rationing

Lending (s. example 1):

NPV is a downward sloping function of r. An increase in the discount rate does not affect the negative CF C₀ in t=0 but reduces the PV of the positive CF C¹ in t=1.

-> Lending because you lend $1 in t=0 and get back $1.1 in t=1

ONLY IF INITIAL CF IS NEGATIVE AND ALL SUBSEQUENT CFS ARE POSITIVE

Borrowing (s. example 2):

NPV is an upward sloping function of r. An increase in the discount rate does not affect the positive CF C₀ in t=0 but reduces the PV of the negative CF C₁ in t=1.

-> Borrowing because you borrow $1 in t=0 and pay back $1.1 in t=1

ONLY IF INITIAL CF IS POSITIVE AND ALL SUBSEQUENT CFS ARE NEGATIVE

When the CFs switch sign, there can be more than one IRR

The example shows a hump shaped function of r
-> if there are two IRRs and the NPV is a hump-shaped function of r, accept the project if the opportunity cost of capital lies between the two IRRs.
-> if there are two IRRs and the NPV is a U-shaped function of r, accept the project if the opportunity cost of capital lies either below the first or above the second IRR.

• Considerable disadvantages of the IRR rule and the Payback Rule
• To use the NPV rule you only need to compute the NPV at the prevailing opportunity cost of capital. Hence you only need to locate ONE specific point on the NPV function to check whether at this point the NPV is positive or negative
• To use the IRR rule you need to compute ALL IRRs of the NPV function and you also need to know what the entire NPV function looks like (increasing, decreasing, hump- or U-shaped...)

-> The only case where the IRR rule is relatively straightforward to apply is when the initial cash flow in t=0 has the opposite sign of all subsequent CFs

.

.

• NPV applies only in those cases in which the investment opportunity disappears if it is not immediately undertaken
• Most real projects hava a significant time period over which they may be undertaken -> embedded optionality 
• Every investment competes with itself delayed in time
• NPV rule must be modified to incorporate optionality to be useful

• Estimate the Cash Flows associated with the project
• Estimate the appropriate Cost of Capital

Why can we not just simply use earnings?

• Managers can engage in legal earnings mangement
• Example why we need CFS: In 2004, FASB adopted a policy mandating companies to epense the cost of their granted employee stock options

How can we obtain the CFs needed to perform NPV analysis?

• Publicly traded companies report their financials in financial reports to the public and their shareholders
  • Most important: annual report
  • Financial Report contains:
    • Balance sheet (stock variables)
    • Shareholder's equity statement (stock variables)
    • Income statement (flow variables)
    • Cash Flow Statement (flow variables)

Use expected cash flows if cash flows are uncertain

• Not most likely cash flows or lowest estimate

Use incremental cash flows, i.e. cash flows that occur at the margin because you invest in the project

• Base case: project is not invested in. Cash flows are the marginal change occuring because of the project relative to the base case
• Include externalities on other parts of the firm (include ALL incremental CFs)

Use cash flows and not accounting measures of revenues and costs

• Some cash flows are not revenues or costs in the accounting sense (e.g. investment)
• Some revenues or costs are not cash flows (e.g. depreciation)

Use after-tax cash flows (tax payments do not go to investors)

Use only non-financial (so-called unlevered) cash flows

• To be able to focus on investment decisions, we assume that the firm is all-equity financed and hence we do not include interest payments
• (We will relax this assumption later in the course and see that financing choices can have an effect on project values)

.

The project ends if there are no more cash flows

• If a facility produces for seven years and is sold in year eight, the project lasts eight years, not seven years.

If a project has an infinite life, we usually choose a time (e.g. ten years) and estimate the cash flows for these years on a yearly basis

• We include cash flows after time T in a project's terminal value, which typically is the present value of a (growing) perpetuity at time T

Investments are non-taxable capital expenditures. They do not reduce taxes (but the associated depreciation does). It is typically assumed that they occur at the beginning of a period

Recoveries include the sale of equipment, machines, etc. The expected salesvalue is also called the "salvage value". The salvage value is not taxable unless it entails a book gain or a book loss

Sunk costs are costs that have already been incurred. They are not reversible and must not be included in the cash flows. 

• "Don't cry over spilled milk."

Opportunity costs are forgone cash flows that are lost if a project is invested in. 

• If a firm owns the land on which it builds a facility, the forgone (after-tax) rental income or revenue from (not) selling the land constitutes an opportunity cost.
• Cannibalizing profits from other parts of your business. What cash flows would you lose relative to the base case in which you do not invest in the project?

-> Opportunity costs have to be incorporated into the project

Inflation measures the relative change in the cost over time of buying the same bundle of goods. Hence if the samebasket of goods costs $100 today and $105 next year, inflation is 5%

Interest rates and cash flows are quoted either in nominal terms or real terms. 
Nominal terms are not adjusted for inflation, real terms are adjusted for inflation.

You can either discount nominal cash flows using nominal rates or real cash flows using real rates but never mix them. Both methods applied correctly lead to the same conclusion

• Depreciation is NOT a cash flow BUT the tax savings due to the tax deductibiity of depreciation represent a cash flow
• Common method: straight-line depreciation

2 methods to account for depreciation (s. example)

• Compute after-tax value of EBIT....
• Compute after-tax value of EBITDA....

-> the 2 methods lead to the same outcome

The book value of an assset is equal to the initial investment cost minus the cumulative depreciation

• If you buy a machine for $900 under straight-line depreciation over three years, the book value of the machine is $600, $300, and 0 in one, two, and three years from now

Tax consequences when selling an asset:

• If you sell an asset and the book value equals the sales price, there are no tax consequences
• If you sell an asset and the sales price exceeds the book value, this difference constitutes a taxable book gain
• If you sell an asset and the book value exceeds the sales price, the difference constitutes a book loss which gives you a tax credit

What is NWC?

Net Working Capital is the difference between short-term assets and short-term liabilities. Essentially, Net Working Capital is a short-term investment that must be temporarily financed until the investment is recovered

What are the principal short-term assets and short term liablities?

• The principal short-term assets are accounts receivable and inventories
• The principal short-term liabilities are accounts payable
  • Short-term debt is not included in NWC as we only consider non-financial (unlevered) CFs

What's the connection btw projects, NWC and cash flows?

Most projects entail an additional investment in Net Working Capital and this should be recognized in the cash flows. Similarly, when the project ends, a firm can usually recover some of the investment and this should be treated as a cash inflow.

-> NWC itself is NOT a cash flow but changes in NWC are!
(increasing NWC: cash outflow, decreasing NWC: cash inflow)

-> Including changes in NWC in the cash flows is a way to correct for the fact that the dates at which accounting revenues and costs are booked do typically not coincide with the dates at which the underlying CFs occur

Accruals

The difference btw earnings and cash flows (Rechnungsabgrenzung)

Earnings management

The way in which companies influence this wedge (the accruals). Makes the company more "uncertain"...

Accruals anomality

• Sloan (1996) demonstrates that the “cash-part” of earnings is more trustworthy than the “accruals-part” (high vs. low quality earnings)
• High earnings are less likely to remain high if they are driven by accruals.
• High earnings are more likely to remain high if they are driven by cash flows

Accruals as a measure of opacity

• Hutton et al. (2009) investigate the relationship between “financial statement transparency” and extreme movements in stock prices (“crashes”)
• Managers might try to hide bad firm performance to protect their job and absorb part of firm performance. Following a run of bad news, they cannot (or do not want to) absorb any more losses. They abandon their positions, and all of the unobserved negative information becomes public, resulting in a crash of the stock price.

Why can we not simply use the company’s stock returns, the market return, and apply the CAPM to compute a company’s expected return for project valuation?

• To evaluate a project, we need the project’s cost of capital and not the company’s cost of capital
  • The CAPM gives the expected return on a company’s stock, we also need to take into account other security holders.
  • The CAPM is not valid empirically

What do we know about the CAPM?

• The CAPM is a model postulating that an asset's expected return is proportional to a measure of the asset's systematic risk (the asset’s beta). 
• The CAPM assumes that investors are well diversified, hence diversifiable (or “idiosyncratic”) risks in their portfolio cancel out.
• According to the CAPM, the risk premium on a security is directly proportional to its covariance with the market portfolio and expected assets returns depend only on market risk!

The company cost of capital is the rate of return demanded by market participants to invest in the company, reflecting the riskiness of the cash flows generated by all existing assets

What kind of estimates do we need?

• estimates for the cost of equity and the cost of debt OR estimates for the equity and the debt betas
• estimates for E and D

How can we obtain them?

• Cost of equity and cost of debt:
  • Cost of equity: CAPM (rf with correct maturity, market risk premium, beta)
  • Cost of debt: less clear (YTM from market data)
• Equity and debt betas:
  • Equity beta: slope coefficient of empirical market model regressions
  • Debt beta: 0 for investment grade debt (rating above BBB: little debt and not likely to default) 
• E and D
  • E: easy, market value of equity
  • D: hard, not all debt has a market value (can be approximated by book value)

How do we obtain the cost of capital of a project we are just starting?

Use the identical twin method

How does this method help us?

The identical twin method helps us create the project's beta which we can then use in the CAPM formula to obtain a project's cost of capital