This model will enable you to use Four methods to evaluate your investment.

Easy step-by-step instructions will guide you through the process. You are wondering, should you invest X amount of money in a new venture or should you reject it? My response is to base your decision on Net Present Value rule: Net present value rule recognizes the time value of money: the fact that a dollar today is worth more than a dollar tomorrow. Today's dollar can be invested right now and start earning interest right now.

Follow these steps: 1. Forecast the cash flow generated by new venture over its economic life. 2. Determine the appropriate opportunity cost of capital. (Look at the stock market and find a firm with comparable level of risk). 3. Discount the cash flow. 4. Find PV (present value) 5. Find NPV (net preset value) You should look at a project as if it is an independent company which assets is project X. The cash flow that you need to analyze is the free cash flow of such company, which is: Expected Earning (revenue) cost investment. The most difficult part is to calculate discount rate. You should see it as a choice between an opportunity of investing in the project and opportunity of investing in the capital market. In other words, instead of giving a green light to the project, you can always give the money to shareholders and let them invest it or you can invest in stock market. Then apply PV and NPV formula. NPV leads to more sound investment decisions. However, I would like to introduce other methods that are used to evaluate investment. 1. Payback method. 2. Average return on book value. 3. Internal rate of return. 1. Payback method initial investment of a project should be recoverable within some specified cutoff period. The payback period is calculated by counting the number of years it takes to forecasted cash flow to equal initial investment. This method does not take into account the fact that different projects have different level of risk. The decision is based on a cutoff year accepted by the company. If a company accepts payback rule of 1, then both projects are unacceptable, if a company accepts payback rule of 4 than both projects are attractive. The rule treats all cash inflows before cutoff date equally and it ignores money coming in after cutoff date.

2. Average return on book value. To calculate the return on book value you need to divide the average estimated profits by the average book value of the investment. The rule does not consider the timing of cash flow but rather only average accounting income. There two series problems with this approach. First, because the method considers only averages, it does not recognize the fact that immediate receipts are more valuable than future ones. The average return on book value treats distant cash flows as valuable as the immediate ones. Second, accounting income and cash flows are usually very different. The decision on either to accept a project or reject it will depend on a company accepted average return on book value, which is usually current book return. As a result, a company with a high book return on existing business may tend to reject a good future project. Or a company with low book returns on existing business may accept bad projects.

3. Internal Rate of Return. The internal rate of return is defined as the discount rate that makes NPV (net present value) equal to zero. The IRR (internal rate of return) rule is to accept a project if the IRR is higher than opportunity cost of capital. If it is than it means that the project has positive NPV.

There are a couple of drawbacks when applying IRR rule. 3.1 The IRR rule, to accept projects with IRR higher than opportunity cost of capital, works only if we are investing money (landing it). If we analyze project where we are borrowing money, we would look for IRR which is lower than opportunity cost of capital. 3.2 The IRR rule may not work with projects that have double change in the flow of cash stream (mixed inflows and outflows throughout the project life). - IRR rule may show a rate which is higher than opportunity cost of capital, however NRV may be negative. - A project may have multiple internal rates of return. - A project may not have IRR. In such cases IRR method will not be adequate.

Chapter 11 Where do Positive NPV Projects come from? (Capital Budgeting and Economics) Skip section 11.3

This chapter is concerned with answering the question: Where do positive NPV projects come from? In a competitive world, positive NPV projects should be difficult to find.

Therefore, you should carefully evaluate projects that purport to produce a positive NPV.

We focus on using our "economic intuition" in order to critically evaluate the assumptions used in calculating the project NPV. In particular we will:

1) Understand why (and when) we should trust market values.

2) Understand when it is likely we might earn "positive economic rents," and why, in general, they should not be expected.

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In order to determine a projects NPV, we need to determine the initial investment, expected future cash flows, and the discount rate(s). Estimation errors are unavoidable. For example, consider Project A (from the Chapter 7 notes)

Time 0 cash flow (initial investment) = -$100

Project A time one expected cash flow calculation (from Chapter 7 notes): Boom economy cash flow = $155, probability = 20% Normal economy cash flow = $135, probability = 60% Recession economy cash flow = $40, probability = 20%

Expected time one cash flow = $120 Beta = 1.80887 Discount rate = 20.1945% NPV = -$100 + $120 / 1.201945 = -$0.1618 Based on the project NPV, the project is rejected.

Now, consider the estimation error

Assume that the economy for the next year ends up being a booming economy. So the projects time 1 cash flow would have been $155. In retrospect, the project should have been accepted. However, based on the information available at time 0, the project was correctly rejected. In general, the expected cash flows that you calculate for an individual project are likely to be an overestimate or an underestimate of actual project cash flows.

In the previous example, the actual cash flow would have been higher than the expected cash flow. However, over time and over many projects, overestimates from some projects should cancel out underestimates with other projects. Therefore, these estimation errors are diversified away to a certain extent. Even though you cant estimate with 100% accuracy, the estimates of the expected future cash flows need to be unbiased.

That is, actual cash flows should, on average, be equal to the expected cash flow. In the same way, you need to make an unbiased estimate of the discount rate.

How do you know if a person is making unbiased estimates of future cash flows?
If you make unbiased estimates of future cash flows, then these unbiased estimates should, on average, be equal to actual future cash flows (assuming you have enough observations across many projects and many years). Evidence of unbiased estimates of future cash flows refer back to Project A and ignore inflation. Over a 100-year period of time, you would expect to see (roughly):

20 booming years with a $155 cash flow 60 normal years with a $135 cash flow 20 recession years with a $40 cash flow

Total cash flows for 100 projects = $12,000 Average per project = $120

Example of biased estimates of future cash flows an overly optimistic manager makes the following estimates for the cash flows in the three different types of economies. (Another possible error for the optimistic manager would have been to overestimate the probability of a booming economy.) Boom economy cash flow = $160 Normal economy cash flow = $140 Recession economy cash flow = $45 Effects on the NPV calculation for Project A: Using the unbiased estimates of economy probabilities Using the biased estimates of economy probabilities

Expected cash flow Beta Discount rate NPV

$120 1.80887 20.1945% -$0.1618

Only over time (and many projects) will we be able to determine that the manager is making biased estimates. Problems associated with making a biased estimate.

No problem exists if there is no change in project selection due to the bias.

A bias towards overestimating expected cash flows (or underestimating the discount rate) will make a good project look great. (Project is still accepted.) A bias towards underestimating expected cash flows (or overestimating the discount rate) will make a bad project look horrible. (Project is still rejected.) Problems occur in the following two circumstances:

A bias towards overestimating expected cash flows (or underestimating the discount rate) can make a bad project look good. (Negative NPV project accepted.) This problem is compounded if a manager has an incentive to overestimate cash flows (or underestimate the discount rate). When would a manager have the incentive to do this?

A bias towards underestimating expected cash flows (or overestimating the discount rate) can make a good project look bad. (Positive NPV project rejected.) This problem is compounded if a manager has an incentive to underestimate cash flows (or overestimate the discount rate). When would a manager have the incentive to do this?

How do you prevent (or minimize) forecast errors?

1) Use market values. In other words, use the information that is available from the current market value (as established by investors that buy and sell the asset in question) in your analysis of the project.

To use this approach, you need current market values from an asset that trades in an active and competitive market. Why do we want to use market values? If you try to estimate expected future cash flows (and discount rates) for an asset that trades in an active and competitive market, you might let your optimistic (or pessimistic) estimates bias your NPV calculations. This could cause you to accept a bad project (or reject a good project).

We are assuming that the current market value established by numerous investors is a more reliable estimate of the assets true value than your own estimate. An example You plan to invest in ABC stock and sell in one year. ABC stock does not currently pay dividends (and will not for the next several years). Assume the financial market where ABC stock trades is perfect, efficient, and in equilibrium.

Current stock price = $10 Expected sales price at time 1 = ??? Beta = ??? Risk-free rate = 5% Market risk premium = 8.4% What is the NPV of the one-year investment? To answer, you need to know: What is the expected time 1 sales price? What is the discount rate?

However, take advantage of the fact that ABC stock trades is perfect, efficient, and in equilibrium market. Thus:

What is the NPV of the investment? Therefore, what is the present value of the time one stock price?

Another example Joe is offering the sale of the mining rights for gold on his property for $40 million. The right to mine gold will be for 10 years and the purchaser must restore the property after the end of the 10-year period. The expected extraction and restoration costs (and PVs of these costs) have already been estimated. Geologists have determined that 100,000 ounces of gold can be extracted from the land. You plan to extract 10,000 ounces of gold each year for 10 years. (Assume that the gold market is perfect, efficient, and in equilibrium.)

Present value of extraction costs = $4 million Present value of restoration costs = $2 million

NPV = -$40 million - $4 million - $2 million + PV of revenue

You work for a potential purchaser and your job is to estimate the PV of revenue.

To determine the PV of the revenue (and ultimately the NPV of the project), you need:

The expected price of gold at the end of each of the next 10 years The beta of the gold revenue cash flows (and associated discount rate) Additional fact: the current price of gold = What is the NPV of the project?

Does the present value of the expected cash revenue increase or decrease if you extract the gold quicker (i.e, 20,000 ounces of gold per year for 5 years)?

What if the market is not active or competitive? Then the price is not necessary an equilibrium price.

Example A house has been for sale for the last six months for $150,000. Should you buy the house for the purpose of reselling at a later date?

What is the expected future selling price? What is the discount rate? What is the NPV of this project?

Example A house just went on the market for $150,000. Should you buy the house for the purpose of reselling at a later date?

Does it make a difference that the house hasnt been exposed to the market yet? 2) Economic Rents - Summary of this section - Why hasn't anyone else thought of this idea?

In a competitive industry that has been operating for a long period of time, projects that involve entering and exiting this industry have a zero NPV (i.e., the IRR equals the opportunity cost of capital).

Why? If entering the industry really had a positive NPV, then competitors will also enter the industry. The impact of this is:

Supply of items to be sold will _________. This will cause a _________ in price This will cause a _________ in the NPV of a project that involves entering this industry

The opposite would occur if entering (and staying in) the industry were a negative NPV project. In this case competitors will withdraw from the industry. The impact of this is:

Supply of items to be sold will _________. This will cause a _________ in price This will cause a _________ in the NPV of a project that involves entering this industry

The competitive equilibrium would therefore occur when there is no advantage to entering (or exiting) the industry (NPV = $0). In this case, economic rents equal zero.

Example - Based on current cotton prices and the costs of farming, land used for cotton farming should be priced such that the NPV of cotton farming is a zero-NPV project. Therefore, there is no incentive to purchase land to farm cotton.

However, notice that you can expect to earn a fair rate of return (based on the beta risk of farming), therefore it would not necessarily be bad to enter farming. Corollary: If cotton prices increase, what should happen to the price of land used for farming cotton?

Lesson - Be suspicious of projects that involve long-run competitive industries that purport to produce a positive (or negative) NPV.

A side issue What if you have developed a new machine that allows you to plant and harvest cotton at a lower cost than your competitors?

Where are you likely to find positive NPV projects?

1) Positive economic rents can be expected during the start-up phase of an industry (i.e., the industry has not entered its long-term equilibrium). However, these positive rents should only be temporary until enough competitors enter the new industry. The book uses the term economic rents instead of positive economic rents. That is, positive is implied. Before entering a "start-up" industry, you should carefully evaluate how long the excess profit period will last. The addition of competitors to the industry can be swift (and the more profitable the project, the faster competitors will enter). Read the article by Warren Buffett on page 291 for some further insight. 2) Positive economic rents are also likely for participants in an industry if they are able to enforce some type of monopoly. Monopolies can occur because of: A) Legal constraints (patents, regulatory).

B) Market power (size of your company in relation to the total market). Example: Microsoft

C) Some other competitive advantage (superior management/personnel, location, etc.).

Flip the argument around for another perspective

Assume that you are the low-cost producer (perhaps because of a patent, or because of some competitive advantage) in a growing industry. Further assume your NPV analysis says that expansion is a negative NPV project? What should you do?

In summary, remember that a positive NPV project must produce positive economic rents!

Therefore, if your analysis shows that a project has a positive NPV, you must be able to explain to yourself why the project produces positive economic rents. In addition to analyzing the spreadsheet for computational errors, determine if there are any logical errors!

If the NPV from the spreadsheet is positive (or negative) ask if it is logical that the company should capture positive (or negative) economic rents with this project.

Selected quiz questions from the Chapter 11 of the textbook

11.1, 11.2, 11.3, 11.4, 11.5

Chapter 11 Review Questions

1. What is estimation error? What is an unbiased estimate of future expected cash flows? What is a biased estimate of future expected cash flows? How would we know if a manager were making biased or unbiased estimates of future expected cash flows? How could a manager's compensation package give the incentive for a manager to make biased estimates of a projects future expected cash flows? What type of compensation scheme would give managers the incentive to overestimate future expected cash flows? What type of compensation scheme would give managers the incentive to underestimate future expected cash flows? How can cash-flow estimation bias cause managers to make bad capital budgeting decisions (i.e., accept negative NPV projects or reject positive NPV projects)? Given a tendency for a particular manager to overestimate (or underestimate) future project cash flows, which of his (or her) projects should you review for accuracy of the NPV calculation - projects which he (she) calculates a positive NPV or a negative NPV? What does it mean to "use market values"? How does using market values reduce the chance of making an error in calculating the NPV of a project? What are "economic rents"? Understand and be able to explain why you should expect to earn zero economic rents from investing in a project in a long-run competitive industry. Given this assumption, what should happen to the price (value) of assets as the future expected cash flows associated with the use of those assets change? For example, other things equal, what should happen to the value of cotton farmland if cotton prices increase? (Note: For the same reason, changes in the discount rate should also have an impact on cotton farmland prices.) Know the circumstances when positive economic rents should be expected.

2.

3. 4.

5.

Chapter 11 Practice Questions

1. Assume financial markets are perfect, efficient, and in equilibrium. Using the following information, what is the
expected price of XYZ stock in 10 years? Answer: Expected stock price in 10 years = $75.89. What is the present value of this time 10 stock price? Answer: $15. XYZ stock does not currently pay dividends (and will not for at least the next 10 years). Current stock price = $15 Beta = 1.5 Risk-free rate = 5% Market risk premium = 8.4%

2. Your uncle said that he will give you 100 ounces of gold when you turn 25 (five years from today).
You want to calculate the present value of this gift. Using the concept of using market values, a discount rate of 3% per year, and a current gold price of $275.85 per ounce, what is the present value of this gift? 100 * $275.85 = $27,585 3. Refer back to the previous problem. Assume that the gift will be at age 30 instead of age 25. Keeping the rest of the information the same, how does this change in assumption affect the present value of the gift?

A. The present value of the gift is now higher than the correct answer to the previous problem. B. The present value of the gift is now the same as than the correct answer to the previous C.
problem. (Correct) The present value of the gift is now lower than the correct answer to the previous problem.

4.

Assume that you just started working for a gold mining company. As part of your employment, the company will give you 10 ounces of gold at the end of each year that you work for the company. You plan to work for the company for only one year, get your 10 ounces of gold, then quit. What is the present value of these 10 ounces of gold that you will receive in one year? 10 * $385 = $3850 Other information Current gold price = $385 Assume that the gold markets are perfect, efficient, and in equilibrium. Because of this, the NPV of investment in gold is $0. Beta of gold = -0.2 CAPM discount rate = 5% - 0.2 (8.4%) = 3.32%

5.

Assume that you just started working for a gold mining company. As part of your employment, the company will give you 10 ounces of gold at the end of each year that you work for the company. You plan to work for the company for only one year, get your 10 ounces of gold, then quit. What is the expected value of the 10 ounces of gold that you will receive in one year? (Hint: I am not asking for the present value of the gold. I am asking for the value in one year, i.e., at the time you receive the gold.) [(10)$430]* 1.0332 Other information Current gold price = $430 Assume that the gold market is perfect, efficient, and in equilibrium. Because of this, the NPV of investment in gold is $0. Beta of gold = -0.2 CAPM discount rate = 5% - 0.2 (8.4%) = 3.32%

6.

Your company is considering a gold mining project. It will cost $10 million to buy the mining rights for the property. The present value of the extraction and restoration costs are $5 million, so the total present value of the mining rights, extraction, and restoration costs is $15 million. (There are no other costs or expenses for this project.) The only revenue for the project will be the sale of the gold mined from the property. Assume that there are 40,000 ounces of gold on the property. It will take four years to mine the gold out of the ground and all 40,000 ounces will be sold at the end of the 4th year. Assume that the gold market is perfect, efficient, and in equilibrium. Because of this, the NPV of an investment in gold is $0. Additional information: Beta for gold = -0.1 Risk free rate = 5%, market risk premium = 8.4% CAPM discount rate = 5% + -0.1(8.4%) = 4.16% Current price of gold = $460 / ounce Using the concept of using market values, what is the NPV of the gold mining project? $3,400,000

7.

In class, we discussed how you can use market values to prevent (or minimize) forecast errors. Assume you own one ounce of gold and plan to sell the gold either today or in one year. Further assume that the gold market is perfect, efficient, and equilibrium, so you can use market values in your analysis and there is no cost associated with storing the gold for the next year. Other information about gold and the financial markets: Current price of gold = $470 per ounce Appreciation in gold prices over the last year = 15% Beta of gold = 0.2 Risk free rate = 5%, market risk premium = 8.4%, use the CAPM to calculate required rates of return Obviously, if you sell today, you would receive $470. What is the present value of selling in one year? $470

8.

Assume that you invest $1,000,000 in a one-year project in a long-run competitive industry and that the opportunity cost of capital for this project is 10%. Based on our discussions in class, an investment in a project in a long-run competitive industry should have a zero net present value (assuming the industry is in equilibrium). If this project does have a zero net present value, then A. The expected return (or internal rate of return) for this project is less than 0%. B. The expected return (or internal rate of return) for this project is equal to 0%.

C. The expected return (or internal rate of return) for this project is greater than 0%. (Correct)