Unformatted text preview: se are variable and
changes with the size of
project What determines the discount rate r r = rf + ri + rr
Where:
r
rf
ri
rr r is the discount rate
the risk free interest rate. Normally government bond
Rate of inflation. It is measured by either by consumer price index or GDP deflator.
Risk factor consisting of market risk, industry risk, firm specific risk and project risk
Market Risk
Industry Risk r
= Firm specific Risk Project Risk Example: If risk free interest is 5%, inflation 3% then nominal rate of interest is 8%. In
addition if we add 5% risk premium then our discount rate is 11%
Later we argue that weighted average cost of capital would make a good indicator for discount
rate Example: Meehan to accept road construction project Meehan corp. is a civil engineering company with annual revenue of $8
billion per year. The company is a multinational with operation in Latin
America and South East Asia. Meehan was established in 1962, and since
then it has experienced a high rate of growth. The company is involved in
infrastructure development, commercial property development and oil
exploration and development. Company is currently considering whether or
not to accept a road construction project.
Meehan has collected the following information about the project;
which will take four years to complete and Meehan must initially invest about
$64 million on equipment and $26 million on buying the necessary property,
for a total of $90 million. The annual operation cost is $20 million a year,
which include labor cost, and other operational cost. The company uses
straight line 8 years depreciation. The salvage value of equipment is
calculated at the cost. The tax rate of the Meehan is 34%. Example: Meehan to accept road construction project The contract calls for payment of $32 million at the end of first three years and $100 million upon completion at the end of the four year period. The project will commence in January 2007. Therefore all initial expenses such as purchase of land and equipment must take place prior to the start of the project. However, operational revenue and costs are calculated for the end of each subsequent year. Should Meehan accept this project, if the discount rate is 10%? What if Meehan used 8% discount rate? What if Meehan needed a $5 million working capital that it would recapture at the end of the project? Meehan Construction
2007 2008 2009 2010 2011 Revenue 32 32 32 100 Operation Cost
Depreciation Cost 20
8 20
8 20
8 20
8 Total Cost 28 28 28 28 4 4 4 72 Tax (0.34) 1.36 1.36 1.36 24.48 Profit after Tax 2.64 2.64 2.64 47.52 10.64 10.64 10.64 55.52 Earning Before tax Add back depreciation
Salvage Value 32 Initial Investment I 90 Working Capital
Cash Flow 90 10.64 10.64 10.64 87.52 Discount Factor 0.909 0.826 0.751 0.683 Present Value of Cash Flow 9.673 8.793 7.994 59.777 80.327 71.534 63.540 3.763 NPV
NPV (10%)
IRR =
NPV (8%) ($3.4205)
9%
$1.62 Meehan Construction
2007 2008 2009 2010 2011 Revenue 32 32 32 100 operation Cost
Depreciation Cost 20
8 20
8 20
8 20
8 Total Cost 28 28 28 28 4 4 4 72 Tax (0.34) 1.36 1.36 1.36 24.48 Profit after Tax 2.64 2.64 2.64 47.52 10.64 10.64 10.64 55.52 Earning Before tax Add back depreciation
Salvage Value 32 Initial Investment I 90 Working Capital 5 Cash Flow 95 5
10.64 10.64 10.64 92.52 Discount Factor 0.909 0.826 0.751 0.683 Present Value of Cash Flow 9.673 8.793 7.994 63.192 80.327 71.534 63.540 0.347 NPV
NPV (10%)
IRR = NPV (8%) ($4.8614)
8% $0.39 Points about NPV
• • • • • Timing: Analysis should be on accrued bases
Working Capital must be taken into account
Separation of current from capital expense
Overhead cost should be allocated to the project Salvage value of plant and equipment must be
considered NPV • NPV and Internal rate of return are superior method of
calculation of investment relative to payback period, since
they recognize the time value of money
• NPV and IRR depend solely on forecasted cash flow and
opportunity cost of capital and does rely on management
taste and accounting practices
• NPV of independent projects are additive obtain total NPV.
That is the NPV of two different independent projects can be
summed up to. For two projects A and B
NPV (A+B) =NPV(A)+NPV(B)
• The additive condition is an important aspect. For two
project, A and B, one with positive NPV, A, and the other with
negative NVP, B, we do not have to take both because they
are packaged together. NPV • There are however circumstances that A and B are two
different stages of project. In this case, if the second stage
depends on the first stage then the additive condition is
violated.
• An example is when a construction company may bid for a
project with negative NPV in order to be able to get second
project which is substantially larger and would have
potentially a very high NPV. [for this types of investment
there is other analytical instrument called Real Option. Real
Option will be discussed subsequently].
• Or that a project opens other opprtunities that have positive
NPV Breakeven Analysis – Breakeven structure and lumpiness of capacity
• What is breakeven for a firm? It determine at what level of activities a
project can cover all its cost.
• Breakeven Point: Fixed cost + Variable cost = Re...
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This note was uploaded on 07/25/2012 for the course ECON 111 taught by Professor King during the Spring '12 term at CSU Bakersfield.
 Spring '12
 King

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