1 Chapter 6: Using the NPV Rule In this chapter we will learn: 1) How to construct a pro-forma cash flow statement for a project. (The project NPV is calculated by discounting these cash flows back to time 0.) 2) How to use the NPV rule in complicated, but common, situations. ****************************************************************** Steps in the capital investment (capital budgeting) process 1. Generation of investment proposals (research/marketing department). Types of projects (investments associated with real assets) A. New products or expansion/modification of existing products B. Replacement of equipment or building C. Comparison of alternative manufacturing processes D. Safety and environmental projects E. New advertising expenditures F. Abandonment of an existing project G. Other 2. Estimation of the project’s expected cash flows (Chapter 6). In this chapter, we will keep things simple by assuming that future project cash flows are known with certainty (i.e., they are risk free). This allows us to concentrate on the many complications of project cash flow calculations In reality, future cash flows are almost never known with certainty. If there is uncertainty, you need to first calculate the project’s future cash flow in each “state of nature,” then calculate the expected future cash flows and use these expected future cash flows in the NPV analysis. We learned how to calculate expected future cash flows with the windmill project Cash flow with light winds: $4.091 M (20% chance) Cash flow with normal winds: $9.091 M (50% chance) Cash flow with strong winds: $15.455 M (30% chance) Expected cash flow = $10 M 3. Evaluation of cash flows. Determine the riskiness of the project’s expected cash flows and the project’s opportunity cost of capital (Chapters 7 - 9). Higher risk cash flows have a higher opportunity cost of capital. Remember from Chapter 1/2/5 notes that each of the project’s cash flows can have a different risk level (and therefore a different opportunity cost of capital). Example from Chapter 1/2/5 notes: NPV for Project J: -$10,000 + $6,000 / 1.1 + $6,000 / 1.152 = -$8.59 4. Project acceptance or rejection should be based on the NPV method, using the opportunity cost of capital as a discount rate (Chapter 5). If the NPV is positive, then you should accept the project; if negative, then reject.2 Projects (investments in real assets) versus investment in financial assets. A project can have a positive or a negative NPV (although projects with a positive NPV are difficult to find). What about investments in financial assets? Assuming the financial markets are perfect, efficient, and in equilibrium, the present value of the future expected cash flows from a financial asset is equal to the financial asset’s current price. Perfect (Chapter 17) – No taxes, transaction costs, etc. Efficient (Chapter 13) – Prices reflect information Based on this, what is the NPV from an investment in the financial markets? How does competition explain this? • Current stock price = $9 • Expected dividend in one year = $1 Growth rate in dividends (in perpetuity) = 2% Opportunity cost of capital (discount rate) = 12% What is the present value of the stock’s future dividends? What is the NPV? What is the expected return (i.e., IRR) for the stock? How should competition affect the stock price? • Change the current stock price to $11 What is the present value of the stock’s future dividends? What is the NPV? What is the expected return (i.e., IRR) for the stock? How should competition affect the stock price? Based on this discussion, what is the equilibrium stock price? What is the NPV? What is the expected return (i.e., IRR) for the stock using its equilibrium stock price? What implications does this have for allocating firm resources to evaluating investments in real versus financial assets? What about financial assets of different risk levels? Risk Level Opp. Cost of Capital IRR NPV High Low Estimation of cash flows is probably the most important task in capital budgeting. Examine cash flows (rather than income)! Need cash to pay for operating expenses, capital investment, interest, dividends. Remember, income taxes are an additional cash flow.3 Example (1): Assume a project requires a $10,000 initial investment (for the purchase of inventory). The inventory will be sold at the end of the period for $16,000 (sold on credit, collected at time two). Cash wages paid to employees at time one = $4000. Income tax rate = 34%. Corporation is an accrual-basis taxpayer. The opportunity cost of capital is 8%. Income Statement 0 1 2 Revenue CGS Salary expense Earnings before taxes (or taxable income) Income Tax Net Income Cash flows Example (2): What happens if the $16,000 is received at time 1? Income Statement 0 1 2 Revenue CGS Salary expense Earnings before taxes (or taxable income) Income Tax Net Income Cash flows Corporate Income Taxes - Taxes on project income should be computed based on the corporation's incremental (or marginal) income tax rate. Make sure you include the incremental income taxes as an additional project cash flow. Corporate Tax Rates (Federal) Bracket Tax Rate $0 - $50,000 15% $50,000 - $75,000 25% $75,000 - $100,000 34% $100,000 - $335,000 39% $335,000 - $10,000,000 34% $10,000,000 - $15,000,000 35% $15,000,000 - $18,333,333 38% Above $18,333,333 35% The incremental tax rate should be the combination of federal and state marginal income tax rates. Most states have a corporate income tax and the state corporate tax rates vary from state to state. See http://www.taxadmin.org/fta/rate/corp_inc.html for a summary. Texas does not have a corporate income tax. It does have a franchise tax that works like an income tax.4 The computation of the Texas franchise tax is somewhat complicated, but is approximately equal to 4.5% of Federal taxable income. To simplify the discussion, we will ignore state taxes. However, in practice, both federal and state taxes need to be considered in any project selection decision. Examples of the computation of federal taxes for a project Example #1. The year is 2007. What is the federal income tax for a project if the corporation has $70,000 of taxable income without the project and $71,000 of taxable income with the project? (In other words, the