ESSEC

FINE12117

FINANCE I

CLASS HANDOUTS

TOPIC #4

Rick Marchese

1/11
 How To Make Good Investments

Outline

§ The Net Present Value (NPV) Rule

§ Capital Budgeting with the NPV rule

2/11
 The Net Present Value (NPV) Rule

§ NPV = PV of Cash Inflow - PV of Cash Outflow

The cash flows depend on the investment project. If they
are subject to uncertainty, we use the expected (or
average) cash flow we anticipate receiving in every period.

T CFt
PV0 = å
t =1 (1 + r )
t

The discount rate on a risky project is the return that one can expect to earn on an
alternative investment of comparable risk. This discount rate is often referred to as an
opportunity cost, since investment in the project takes away the investor’s opportunity to
invest in an alternative project with the same risk.
Depending on context, the discount rate can be referred to as required rate of return, cost
of capital, or opportunity cost of funds.

The discount rate reflects:

• compensation for delay of consumption (“rate of time preference”)
• inflation
• risk
• other characteristics

§ The NPV rule: Accept a project if the NPV is greater than

zero

§ Accepting a positive NPV project increases the value of the

firm, as the project is going to earn a rate of return superior
to what the firm can currently obtain in the market.

§ The value of the firm is merely the sum of the values of the
different projects, divisions, or other entities within the firm.
This property is called value additivity. This implies that the
contribution of any project to a firm’s value is simply the NPV
of the project.

§ Accepting positive NPV projects benefits shareholders.

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 The Net Present Value (NPV) Rule

§ In financial markets, we usually assume that the NPV of a

transaction is zero. This is the same as saying that financial
markets are efficient – the price is very close to its fundamental
value.
Fundamental
T Value
CFt
å (1 + r )
Market
Price P » PV0 = t
Future Cash
t =1
inflows of the
financial asset

§ Note that the fact that the NPV is zero does not mean that
the investor made a bad deal. It just means that the investor
will earn his/her required rate of return on his investment
and breakeven. Accepting a Zero NPV project leaves the firm
value unchanged.

§ Positive NPV opportunities are possible because

entrepreneurs keep finding creative new ways of using
existing physical assets.

§ In reality, firms may have constraints on the amount of

funds which can be raised and projects may be mutually
exclusive.

NPV Rule: Choose projects to maximize the sum of NPVs.

§ If we have unlimited resources and the projects are not

mutually exclusive, choose all projects with positive NPV.

§ If we have limited resources and/or some of the projects are

mutually exclusive, choose the projects that can be invested
together and for which, the sum of initial investments is
feasible and the sum of the NPVs is positive and maximal.
4/11
 The Net Present Value (NPV) Rule

§ Example - The Marx Brewing Company has three projects.

Project B is an independent project whose acceptance or
rejection is independent of the acceptance and rejection of
the other two projects, while A and C are mutually
exclusive. The cash flows ($ in million) are as follows:

Time (CFT)
Project 0 1 2 3
A -65 30 30 25
B -55 25 25 25
C -50 30 30 0

The discount rate is 10%. The company can raise only $115
millions to invest. What is the most profitable strategy?

§ Identify Incremental Cash Flows of the project

1. Cash flows matter — not accounting earning or income.

2. Only cash flows that are incremental (that occur as a direct

consequence of accepting the project) are relevant.

3. Sunk costs (any cash flow that has already occurred) should
not be considered.

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 Capital Budgeting with the NPV Rule

1. Any opportunity costs (opportunities foregone because the

project is made) and/or opportunity benefits (opportunities that
arise because the project is made) should be included

2. Any side effects (impacts of the project in other areas of the

firm) like synergy and erosion should be included

3. Taxes matter: we want incremental after-tax cash flows.

4. Allocated cost should be viewed as a cash outflow of a project

only if it is an incremental cost of the project.

§ Estimating Cash Flows

1) Cash flow from operations:

EBIT (= Operating revenue – cost of goods sold – general expenses -

Depreciation and amortization + other income)
–Taxes
+Depreciation and amortization
= Operating Cash Flow

2) Capital Spending:

–Acquisitions of Fixed Assets

+Sales of Fixed Assets
= –Capital Spending

6/11
 Capital Budgeting with the NPV Rule

3) Addition to net working capital (NWC is the difference

between short-term assets and short-term liabilities)
− Change of operating cash
− Change in accounts receivable
− Change in inventory
− Change in other current assets
+ Change in accounts payable
+ Change in notes payable
+ Change in taxes payable
+ Change in accrued expenses
= −Change in net working capital (-Investment in NWC)

Total Cash flow = Operating Cash Flow − Capital Spending

− Investment in Net Working Capital

Operating CF = EBIT – Taxes + Depreciation and amortization

= EBIT (1 – τ) + Depreciation and amortization
= (Revenue – Cost − Depr) × (1 – τ) + Depr
= Revenue × (1 – τ) – Cost × (1 – τ) + Depr × τ
*Later we will deal with the impact of debt. For now, it’s enough
to assume that the firm’s level of debt (hence interest expense)
is independent of the project at hand.

(Depreciation and amortization) × τ is called the tax shield on

depreciation

7/11
 Capital Budgeting with the NPV Rule

Net Capital Spending: Don’t forget after tax salvage value (the
estimated value that an asset will realize upon its sale at the
end of its useful life).

Investment in Net Working Capital (= Change of NWC) arises

from inventory increases, cash kept in the project as a buffer
against unexpected expenditure, sales on credit, decreases in
account payable, etc.

§ Example:

A robotics firm is deciding whether to start the production of a new

vacuum-cleaning robot, the Fab1. The necessary manufacturing
equipment costs $6,000 and has an expected economic life of six years.
The equipment will be depreciated using the straight-line method over
six years. At the end of the five years, the equipment can be sold for
$1,500. The marketing department provides the following forecast:

Year 1 2 3 4 5
Sales Revenue 12,000 14,000 14,000 14,000 10,000
Costs 8,000 9,000 9,000 9,000 7,000

Net Working Capital requirements at the end of each year are expected to
be 10% of sales, but in the last year of the project they will be brought to
$0. The company pays 40% corporate taxes, and its weighted average cost
of capital is 10%. What is the NPV of the Fab1 project?

8/11
 Capital Budgeting with the NPV Rule
Answer:
Year 0 1 2 3 4 5
+ Sales Revenue 12,000 14,000 14,000 14,000 10,000
– Costs 8,000 9,000 9,000 9,000 7,000
= Margin 4,000 5,000 5,000 5,000 3,000
Margin ´ (1–τ) 2,400 3,000 3,000 3,000 1,800
Dep. Tax Shield [τ ´ Dep.] 400 400 400 400 400
Operating CF 2,800 3,400 3,400 3,400 2,200
NWC (10% ´ sales) 1,200 1,400 1,400 1,400 0
– Change of NWC –1,200 –200 0 0 1,400
Investment –6,000
Asset Sales, after tax 1,300*
– Capital Spending –6,000 0 0 0 0 1,300

Total CF –6,000 1,600 3,200 3,400 3,400 4,900

*At the end of the fifth year, the book value of the equipment is 1,000, but the price of the
equipment is expected to be 1,500. If the firm sells the equipment, it needs to pay tax on the
difference between the sale price of 1,500 and the book value of 1,000 and the tax is
(1,500−1,000)×0.4=200. So, the aftertax salvage value of the equipment, a cash inflow to the
company, is 1,500−200=1,300

Discount rate = 0.1

NPV of project = – 6,000 + 1,600 × (1+ 0.1)–1 + 3,200 × (1+ 0.1)–2 + 3,400 × (1+ 0.1)–3
+ 3,400×(1+ 0.1)–4 + 4,900×(1+ 0.1)–5
= 6,018.40 > 0

§ Inflation: Nominal and real interest rates

§ Inflation is a generalized increase in prices over time. As a

result, interest rates can be nominal or real

§ The nominal rate of interest is the one we observe every

day, in the financial press and in financial contracts,
because it refers to current (inflated) prices

§ The real rate of interest is the one an investor actually

obtains after excluding the effects of inflation

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 § The exact relationship between nominal and real rates is
given by the Fisher equation:
(1 +Capital
rNOM ) =Budgeting
(1 + rREALwith
) ´ (1the ) Rule
+ pNPV

§ Like interest rates, cash flows can be expressed in either

nominal or real terms
§ A cash flow is expressed in nominal terms if the actual
dollars to be received (or paid) are given
§ A cash flow is expressed in real terms if the current or
date of purchasing power of the cash flow is given

§ Rules to follow

§ Discount nominal cash-flows using the nominal rate

§ Discount real cash-flows using the real rate

§ The value of a project should be the same, irrespectively of using

nominal or real cash-flows

Example:

-$1000 -$600 -$650

$600
0 1 2

Considering the following nominal cash flows on a project:

10/11
The nominal interest rate is 14%, the inflation rate is expected to
be 5%. What is the value of the project?

§ Good Attributes of the NPV Rule

Capital Budgeting with the NPV Rule

1) Uses cash flows

2) Uses ALL cash flows of the project

3) Discounts ALL cash flows properly

Reinvestment assumption: the NPV rule assumes that all

cash flows can be reinvested at the discount rate.

11/11