Lect 04 Fin 221 web

Lect 04 Fin 221 web - 1 Managerial Finance Lecture 4 Financial Analysis II NPV IRR and Applications 2 Class 3 Takeaways • Relevant cash flows

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Unformatted text preview: 1 Managerial Finance Lecture 4 Financial Analysis II: NPV, IRR and Applications 2 Class 3: Takeaways • Relevant cash flows: Include all cash flows that are caused by a project Crucial comparison: with vs. without the project If a cash-flow is not incremental it should be ignored : sunk costs, fictional overhead cost allocations, etc Adjust for expected changes in the timing of cash-flows Account for cannibalization / strategic effects on other divisions Account for cannibalization / strategic effects on other divisions Include terminal values • Estimates of the value of the project’s assets/investments at the end of the forecasting period (e.g. WIP inventory at the end of year 15) • Sensitivity and scenario analysis: understand the consequences of changes in key value drivers on your recommendation 2 3 Plan of Attack 1. Diamond Chemical B: Merseyside vs. Rotterdam Question: which of the two investment projects, if any, should Mr. Fawn choose? Objectives: examine the merits of alternative investment decision rules: NPV vs. IRR 2. Should We Pay with Cash? Question: should Prof. Keppel buy the car using cash or not? Objective: stress the importance of opportunity costs of funds in financial decision-making 3 4 Diamond Chemicals B: Merseyside versus Rotterdam • Diamond Chemical’s management needs to decide between upgrading either the Merseyside or the Rotterdam plant. 7% increase in output in one of the two plants Doing both positive NPV investments is not an option • The plan proposed for Rotterdam is more ambitious than the enhancements proposed for Merseyside. Rotterdam wants to convert the plant’s polymerization line from batch to continuous-flow technology and install state-of- 4 the-art process controls. The increased output in Rotterdam is expected to be realized gradually over time . 5 Merseyside versus Rotterdam Rotterdam Project Merseyside Project Assumes no business erosion at the sibling plant NPV = £14.9 m IRR = 22.2% NPV = £13.9 m IRR = 31.2% Assumes full erosion NPV = £10.0 m NPV = £8.0 m 5 at the sibling plant IRR = 18.7% IRR = 24.2% Merseyside has higher IRR but lower NPV! 6 CFO Decision Rules Back in the day 1960 1970 1980 Payback Period 0.34 0.12 0.05 Internal Rate of Return 0.19 0.57 0.65 Net Present Value-- 0.17 Average Accounting Return 0.34 0.26 0.11 Back in the day: Last decade: 6 7 Internal Rate of Return (IRR) • The IRR is the discount rate at which the NPV is equal to zero . A measure of the project’s return on investment Calculate by using: • Trial and error • Goal seek • IRR function in Excel • IRR decision rule : accept projects whose IRR exceeds a hurdle rate Very common in practice: easy to communicate Often, hurdle rate = cost of capital Intuition: compare benefits and costs in terms of returns • Important 7 Do not confuse the IRR with the opportunity cost of capital “r”....
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This note was uploaded on 01/08/2012 for the course MS&E 245G taught by Professor Perez-gonzalas during the Fall '11 term at Stanford.

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Lect 04 Fin 221 web - 1 Managerial Finance Lecture 4 Financial Analysis II NPV IRR and Applications 2 Class 3 Takeaways • Relevant cash flows

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