1. Introduction

We have assumed that the firm selects positive net present value projects. Our concern was with the financing of the investment projects in terms of the capital structure of the firm and the allocation of cash flows via the dividend decision. In this lecture, we examine in some detail what goes into the decision to accept an investment project. We will apply the technique of net present value and develop some rules known as capital budgeting. There are four basic rules for calculating net cash flows. First, use inflows and outflows of cash when they occur — avoid using accounting variables. Second, use after-tax net cash flows. Third, use only cash exchanges. In general, it is not appropriate to include opportunity costs. Fourth, discount after-tax cash flows at the after-tax interest rate. Some of the common mistakes in capital budgeting are also highlighted. These include mixing real and nominal cash flows, ignoring embedded options in the project, and ignoring the shadow cost of management time to run or oversee the project. Different appraisal methods are then examined. There is some discussion of decision trees and Monte Carlo simulation in project evaluation. Finally, I close with a brief discussion of mergers and acquistions.

2. The Cash Flows that Should be Included in NPV Calculations

The net present value of a project can be represented as: Let’s consider an example of this type of calculation.

A large manufacturing firm is considering improving its computer facility. The firm currently has a computer which can be upgraded at a cost of $200,000. The upgraded computer will be useful for 5 years and will provide cost savings of $75,000 per year. The current market value of the computer is $100,000. The cost of capital is 15%. Should the computer be upgraded?

Solution

The alternatives available to the manufacturing firm are: (1) do not upgrade the computer or (2) upgrade the computer. The NPV of upgrading is:

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The /% R_t = $ cash revenue in time t E_t = $ cash expenses in time t TAX_t = $ taxes in time t D_t = $ depreciation in time t T = $ average and marginal tax rate I_t = $ Investment in time t S_t = $ Salvage value in time t

The net cash flow in period t is: Taxes are defined to be: Substituting the expression for taxes into the first equation yields: Note that we are making a number of simplifying assumptions about the taxation. In an real world application, one would want to consider (1) carry forward and carry back rules, (2) investment tax credits, (3) sufficiency of taxable income, and (4) special tax circumstances (e.g. mining and petroleum).

4. Applications

The /%5. Appraisal Rules

Suppose we are evaluating an investment project. The NPV rule tells us that the project should be accepted. But one of the alternative rules tells us that the project should be rejected. The correct investment decision maximizes the market value of the firm. The initial market value of the firm is:

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The /% In this example, the discounted payback tells us to accept project A but project B has a higher NPV.

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There /% The profitability index suggests that project A is superior to project B. However, the net present value of B far exceeds that of A.