Read and summarize Chapter 13 of your Financial Management text book in at least 600 words. Be sure to be thorough in your summary.
The value of a firm today is the present value of all its future cash flows. These future cash flows come from assets that are already in place and from future investment opportunities. These future cash flows are discounted at a rate that represents investors’ assessments of the uncertainty that they will flow in the amounts and when expected:
Value of firm = Present value of all future cash flows= Present value of cash flows from all assets in place
+ Present value of cash flows from future investment opportunities
The objective of the financial manager is to maximize the value of the firm and, therefore, owners’ wealth. As we saw in the previous chap- ter, the financial manager makes decisions regarding long-lived assets in the process referred to as capital budgeting. The capital budgeting deci- sions for a project require analysis of:
Is Investment A or B more attractive? A shorter payback period is thought to be better than a longer payback period. Yet there is no clear-cut rule for how short is better. Investment A provides a quicker payback than B. But that doesn’t mean it provides the better value for the firm. All we know is that A “pays for itself” quicker than B. We do not know in this particular case whether quicker is better.
In addition to having no well-defined decision criteria, payback period analysis favors investments with “front-loaded” cash flows: An investment looks better in terms of the payback period the sooner its cash flows are received no matter what its later cash flows look like!
Payback period analysis is a type of “break-even” measure. It tends to provide a measure of the economic life of the investment in terms of its payback period. The more likely the life exceeds the payback period, the more attractive the investment. The economic life beyond the pay- back period is referred to as the post-payback duration. If post-payback duration is zero, the investment is worthless, no matter how short the payback. This is because the sum of the future cash flows is no greater than the initial investment outlay. And since these future cash flows are really worth less today than in the future, a zero post-payback duration means that the present value of the future cash flows is less than the project’s initial investment.
Payback should only be used as a coarse initial screen of investment projects. But it can be a useful indicator of some things. Because a dollar of cash flow in the early years is worth more than a dollar of cash flow in later years, the payback period method provides a simple yet crude measure of the value of the investment.
*Explain the dynamics of “MIRR.”
- Its future cash flows,
- The degree of uncertainty associated with these future cash flows, and
- The value of these future cash flows considering their uncertainty.
We looked at how to estimate cash flows in Chapter 12 where we were concerned with a project’s incremental cash flows. These comprise changes in operating cash flows (change in revenues, expenses, and taxes), and changes in investment cash flows (the firm’s incremental cash flows from the acquisition and disposition of the project’s assets).
In the next chapter, we introduce the second required element of capital budgeting: risk. In the study of valuation principles, we saw that the more uncertain a future cash flow, the less it is worth today. The degree of uncertainty, or risk, is reflected in a project’s cost of capital.
400 LONG-TERM INVESTMENT DECISIONS
The cost of capital is what the firm must pay for the funds needed to finance an investment. The cost of capital may be an explicit cost (for example, the interest paid on debt) or an implicit cost (for example, the expected price appreciation of shares of the firm’s common stock).
In this chapter, we focus on the third element of capital budgeting: valuing the future cash flows. Given estimates of incremental cash flows for a project and given a cost of capital that reflects the project’s risk, we look at alternative techniques that are used to select projects.
For now, we will incorporate risk into our calculations in either of two ways: (1) we can discount future cash flows using a higher discount rate, the greater the cash flow’s risk, or (2) we can require a higher annual return on a project, the greater the risk of its cash flows. We will look at specific ways of estimating risk and incorporating risk in the discount rate in Chapter 14.
Exhibit 13.1 shows four pairs of projects for evaluation. Look at the incremental cash flows for Investments A and B shown in the table. Can you tell by looking at the cash flows for Investment A whether or not it enhances wealth? Or, can you tell by just looking at Investments A and B which one is better? Perhaps with some projects you may think you can pick out which one is better simply by gut feeling or eyeballing the cash flows. But why do it that way when there are precise methods to evaluate investments by their cash flows?
To evaluate investment projects and select the one that maximizes wealth, we must determine the cash flows from each investment and then assess the uncertainty of all the cash flows. In this section, we look at six techniques that are commonly used to evaluate investments in long-term assets:
1. Payback period
2. Discounted payback period 3. Net present value
4. Profitability index
5. Internal rate of return
6. Modified internal rate of return
We are interested in how well each technique discriminates among the differ- ent projects, steering us toward the projects that maximize owners’ wealth.
An evaluation technique should consider all the following elements of a capital project:
■ All the future incremental cash flows from the project;■ The time value of money; and
■ The uncertainty associated with future cash flows.
Capital Budgeting Techniques 401
Projects selected using a technique that satisfies all three criteria will, under most general conditions, maximize owners’ wealth. Such a tech- nique should include objective rules to determine which project or projects to select.
In addition to judging whether each technique satisfies these crite- ria, we will also look at which ones can be used in special situations, such as when a dollar limit is placed on the capital budget. We will dem- onstrate each technique and determine in what way and how well it evaluates each of the projects described in Exhibit 13.1.