İŞLETME FİNANSI II

“To decide which investments to undertake, managers need an analytical tool that: 1) is easy to apply and easy to explain to non-financial personnel; 2) focuses on cash flow, not accounting-based measures such as profit; 3) accounts for the time value of money; 4) adjusts for differences in risk across projects; and 5) leads to higher firm value in any company (and higher stock prices in public firms)” (Megginson, Smart, Graham, 2010:232).

As also understood from the information given, the answer is E. All of them are the characteristics of an analytical tool which managers need to decide which investments to undertake.

Techniques explained in this section do not incorporate the concept of “risk” in the evaluation. In other words, they all assume that all investment projects the same same level of risk. All calculations are based on this assumption. Information about how risk can be incorporated in the evaluation process will be provided in the next section. Commonly applied capital investment project analysis techniques are payback period, discounted payback period, net present value, internal rate of return, modified internal rate of return, and profitability index.

As also understood from the information given, the answer is E. All of them are commonly applied capital investment project analysis techniques.

Payback period tells the length of time it takes to get initial cash outflow back, that is the period from the initial cash outflow to the time when the investment project’s cash inflows add up to the initial cash outflow. This technique is a simple, easy to use and easy to understand technique. It is commonly used among managers because it quickly tells when a project pays the initial cash outflow back. It is also easy to explain to managers who are not experts in finance. All you have to do is find when cumulative cash inflows will be equal to initial cash outflow. The assumption is that cash flow occurs at a constant rate throughout the year. It means that you can use a fraction of year while equaling cumulative total amount of cash inflows and the initial cash outflow. This technique also assumes that all investment projects have the same level of risk. Actually, it does not account for the risk of the project at all. Risk is not inherited in the calculation of payback period. Moreover, this technique does not account for the time value of money.

Payback period technique tells the length of time it takes to get the initial cash outflow back.

The decision rule for the payback period technique is simple. Only a project with a payback period shorter than (or equal to) the management’s specified payback period can be approved. And, a project with shorter payback period is better than a project with longer payback period. Besides its easiness, payback period technique has important drawbacks. It does not account for the cash flows after the payback period. However, a project may be very valuable to a company, but since it provides a big cash inflow after the cutoff point in time, a manager would miss it. Besides this drawback, payback period technique is criticized because it does not account for the time value of money and for the risk differences among projects. In order to consider the time value of money, discounted payback period technique is developed.

If a project is independent, approve the project(s) that pays the initial investment back less than a specified payback period.

If a project is mutually exclusive, choose the project that provides the shortest payback period.

As also understood from the information given, the answer is E. All of the statements above related to payback period technique are correct.

Same as payback period, discounted payback tells the length of time it takes to get the initial cash outflow back, that is the period from the initial cash outflow to the time when the investment project’s cash inflows add up to the initial cash outflow. The only difference is cumulative present values of cash inflows (rather than numerical sum values) will be equal to the initial cash outflow. Projected cash flows are discounted at an appropriate discount rate and their present values are used to calculate payback period. Assumptions are the same with payback period technique. This technique assumes that cash flow occurs at a constant rate throughout the year, and assumes that all investment projects have the same level of risk. Note that it accounts for the risk which is inherited in the discount rate. However, it does not account for the risk differences of different projects.

Discounted payback period technique tells the length of time it takes cumulative present values of cash inflows will be equal to the initial cash outflow.

If a project is independent approve the project(s) that pays the initial investment back less than a specified payback period.

If a project is mutually exclusive, choose the project that provides the shortest discounted payback period. Discounted payback period technique has the same drawback with payback period technique. It does not account for the cash flows after the payback period. However, a project may be very valuable to a company, but since it provides a big cash inflow after the cutoff point in time, a manager would miss it.

“Discounted payback does correct the payback rule’s problem of implicity applying a 0% discount rate to all cash flows that occur before the cutoff point” (Megginson, Smart, Graham, 2010: 237).

As also understood from the information given the answer is E. All of the statements above related to discounted payback period technique are correct.

Net present value of a project is the sum of present value of all cash inflaws and cash outflows of a project over its life. If the NPV is greater than zero (positive NPV) for a project, it means that the project will increase the shareholder value by that amount. If the NPV is smaller than zero (negative NPV) for a project, it means that the project will decrease the shareholder value by that amount. There are three steps of calculating NPV:

1. Estimating cash flows

2. Discounting cash flows by an appropriate discount rate

3. Adding up the discounted cash flows to obtain NPV

In order to find the present value of cash flows, discounting is used. So, we can say that net present value technique accounts for the time value of money. On the other hand, this technique assumes that all investment projects have the same level of risk. Note that it accounts for the risk which is inherited in the discount rate. However, it does not account for the risk differences of different projects. Nevertheless, risk differences may be considered in the technique by using different discount rates for projects with different levels of risk. One should use a higher discount rate for finding the NPV of riskier projects and reflect the extra amount of return demanded by investors in order to compensate for the risk. That is because the riskier the project, the higher the expected rate of return. Decision rule for net present value technique is quite straightforward. For independent projects, approve projects with positive NPV . Reject projects with negative NPV For mutually exclusive projects, choose the project with the biggest NPV. “A positive NPV means the project’s cash inflows are sufficient to repay the initial upfront (time zero) costs as well as the financing cost (at discount rate) over the project’s life. Since NPV is greater than zero, project’s return is greater than the cost of capital (the discount rate)… Projects with negative net present values are not acceptable to a firm. They provide returns lower than the cost of capital and would cause the value of the firm to fall” (Melicher, Nortan, 2011: 486-487).

Net present value technique finds the sum of present value of all cash inflaws and cash otflows of a project over its life.

If a project is independent, approve the project(s) that provide a positive net present value.

If a project is mutually exclusive, choose the project that provides the biggest net present value.

As also understood from the information given, the answer is E. All of the statements above related to net present value technique are correct.

Internal rate of return is the rate of return that causes the net the present value of a project to be zero. It means that present value of cash inflows equals the present value of cash outflows. Numerical value of this rate can be used by a trial and error process or by a financial calculator. Details of how to calculate internal rate of return is not explained here. Instead, just its meaning and its use in project evaluation is explained.    Internal rate of return technique assumes that all investment projects have the same level of risk. Decision rule for internal rate of return technique is as follows. If a project is independent, approve the project(s) that provides IRR that is greater than the expected rate of return (discount rate used in NPV technique). If a project is mutually exclusive, choose the project that provides the highest IRR (that is greater than the expected rate of return (discount rate used in NPV technique)).

Internal rate of return technique finds the rate of return that causes the net present value of a project to be zero.

If a project is independent, approve the project(s) that provides IRR that is greater than the expected rate of return (discount rate used in NPV technique).

If a project is mutually exclusive, choose the project that provides the highest IRR (that is greater than the expected rate of return (discount rate used in NPV technique)).

As also understood from the information given, the answer is E. All of the statements above related to Internal rate of return technique are correct.

IRR technique is sometimes criticized because of a main reason. When the capital investment projects are mutually expensive, IRR may conflict with the results of NPV if cash outflows and inflows are not created respectively.

Modified internal rate of return technique was developed in order to overcome these drawbacks. There is a three-step calculation as follows.

Modified internal rate of return technique assumes that all investment projects have the same level of risk. The decision rule is similar to IRR. If a project is independent, approve the project(s) that provides MIRR that is greater than the minimum rate of return (discount rate used in NPV technique). If a project is mutually exclusive, choose the project that provides the highest MIRR (that is greater than the minimum rate of return (discount rate used in NPV technique)).

Modified internal rate of return technique finds the rate of return that equates the future value of all cash outflows with the sum of the future value of all cash inflows as of the end of the project’s life.

Terminal value refers to the sum of the future value of all cash inflows as of the end of the project’s life.

If a project is independent approve the project(s) that provides MIRR that is greater than the minimum rate of return (discount rate used in NPV technique).

If a project is mutually exclusive, choose the project that provides the highest MIRR (that is greater than the minimum rate of return (discount rate used in NPV technique)).

As also understood from the information given, the answer is E. All of the statements above related to modified internal rate of return technique are correct.

Profitability index is the ratio between the present value of all cash inflows and the present value of all cash outflows. This ratio is also project’s benefit/cost ratio. Profitability index technique assumes that all investment projects the same same level of risk. Decision rule is as follows. In order a project to be approved, profitability index have to exceed 1. Projects with profitability index less than 1 should be rejected. If a project is mutually exclusive, the project that provides the biggest profitability index (which is also greater than 1) should be chosen.

Profitability index technique tells the ratio of the present value of a project’s cash inflows to the present value of all cash outflows or initial cash outflow.

If a project is independent, approve the project(s) that provides profitability index greater than 1.

If a project is mutually exclusive, choose the project that provides the biggest profitability index (which is also greater than 1).

As also understood from the information given, the answer is E. All of the statements above related to profitability index technique are correct.

Until this point, capital budgeting evaluation techniques_ “Payback period”, “Discounted payback period”, “Net present value”, “Internal rate of return”, “Modified internal rate of return”, “Profitability index”_have assumed that all investment project alternatives of a firm have the same level of risk. There are three kinds of risk sources when we talk about the risk of an investment project. The first one is stand-alone risks that a project exhibits when evaluated alone rather than as part of a combination or portfolio of assets. The second one is within-firm risks that a project has on the total overall riskiness of the company. The third one is market risks that a project has and assessed from the standpoint of a stockholder who has a portfolio of assets (Besley and Brigham, 2012: 522). A simple approach to incorporate risk differences among alternative investment projects to evaluation process is making adjustments to either cash flows or the discount rate according to the risk of the projects. After adjustments, net present value is calculated. This way, net present values includes the information about riskiness of the project, and also risk differences between projects.

One can account for risk differences among alternative investment projects by making adjustments to either cash flows or the discount rate.

Estimating project cash flows is a task which already includes these kinds of adjustments only to a certain degree. Nevertheless, a special attention to incorporate risk into project evaluation is needed. Certainty-equivalent coefficient, which has values between 0 and 1, is used in order to reflect the risk of a project to evaluation. With an increase of the riskiness of the future cash inflow, certaintyequavalent coefficient approaches to 0, and with a decrease of the riskiness of the future cash inflow, certainty-equivalent coefficient approaches to 1. In finding net present value of a project, present value of each year’s expected cash inflow is simply multiplied by the specified certainty-equivalent coefficient that is associated with that cash inflow which is called adjusted cash flow. Note that one should use risk-free interest rate as a discount rate while calculating net present value with adjusted cash flows, because the risk of a project is already included in cash flow adjustment.

Certainty-equivalent coefficient refers to a number between 0 and 1 which is used in order to reflect the risk of a project to evaluation.

In adjusted cash flow approach, one should use risk-free interest rate as a discount rate while calculating net present value because risk of a project is already included in cash flow adjustment.

Establishing discount rate for a project is another task that also includes these kinds of adjustments. Remember that financing of an investment project is the starting point for establishing a discount rate The discount rate should be at least as much as a weighted average cost of capital (WACC). This is the cost of a project’s financing rather than the whole company’s financing. If a project’s risk is substantially above the firm’s general risk, discount rate will be above the WACC. If a project’s risk is substantially below the firm’s general risk, discount rate will be below the WACC. When we think of Net Present Value, we can remember that conceptions about the risk of projects are reflected in the discount rate. The discount rate can be adjusted in a way that it represents the risk differences. That is, when the risk of a project increases, we should increase the discount rate accordingly which is called adjusted discount rate. How much to increase the discount rate is quite subjective and judgmental. Actually, it depends on whether the financial manager who evaluates the project is risk seeking, risk-neutral, or risk-averse. For a given capital investment project, it would be appropriate to expect that a manager who is risk-averse adds a greater risk premium to discount rate than a manager who is risk-seeking.  

If a project’s risk is substantially above the firm’s general risk, discount rate will be above the WACC.

If a project’s risk is substantially below the firm’s general risk, discount rate will be below the WACC.

For a given capital investment project, it would be appropriate to expect that a manager who is risk-averse adds a greater risk premium to discount rate than a manager who is risk-seeking.

Most of the time, because of the nature of risk, making adjustments to cash flows or discount rates is not enough for financial managers. They want to know the sources and possible effects of certain risks of a project. They want to measure a project’s risks coming from various sources rather than in general manner. Further analysis is needed to do that. Sensitivity analysis, scenario and simulation analysis, and decision trees are used for this purpose.

As also understood from the information given, the answer is E. All of the statements above related to incorporating risk in capital budgeting are correct.

One or more of the before mentioned analyses (sensitivity, scenario, simulation, and decision tree) sometimes lead(s) financial managers to consider real options available in a capital investment project because in reality there are various types of uncertainties that exist about these projects. Real options approach is getting more attention from managers as it allows them to include uncertainty and other strategic quantitative factors to their valuation of an investment project. Moreover, managers can price those strategic quantitative factors by using option-pricing methods, and include this price to the net present value of projects. What can be considered as an option? Shapiro (2005:94) has an answer for this question. “Any investment that requires an additional infusion of funds for its completion and offers an uncertain payoff can be viewed as an option”.

Real options refer to the options of managers about capital investment projects which can be priced by using stock option-pricing methodologies.

Exhibit: Typical Options Embedded in Capital Investment Projects (Megginson et al., 2010:340)

Real options are valued, or priced in other words, the same as stock options. However, we do not go deep into option pricing methodologies in this section of the book. You can do further reading by searching Black-Scholes Option Pricing Model. We just shall remember that real options are priced in a similar way like stock options which is called real option valuation (ROV). Peterson and Fabozzi (2002: 153) list five factors that are important in the valuation of a stock option. Then, they list the real option correspondent of each factor as follows. 1. Effect of stock’s price in stock options is the effect of the present value of cash flows from the investment opportunity in real options. 2. Effect of the exercise (strike) price of the option in stock options is the effect of the present value of the delayed capital expenditure of future cost savings in real options. 3. Effect of the risk-free interest rate in stock options is the same risk-free interest rate in real options. 4. Effect of the volatility of stock’s price in stock options is uncertainty of the project’s cash flows in real options.

“Consider the value of a patent on an untested cure for cancer. The price of obtaining the patent is the option price; the cost of developing, producing, and marketing the drug is the strike price; and the market value of profits on sales of the drug is equivalent to the stock price. The extra funds required to start production will be invested only if this cost is less than the payoff in the form of subsequent profits from the sale of the drug” (Shapiro, 2005:94).

After considering real options associated with a capital investment project, the value of the option will be calculated with an option pricing methodology, and then, value of the option is added up to the traditional net present value (NPV) of the project. After that, decision rule of NPV will be applied in the same way. If projects are independent, positive net present value projects will be approved, but negative net present value projects will be rejected. If projects are mutually exclusive, the project providing the biggest NPV will be prefered.

The type of projects in which selecting one project prevents other projects from being undertaken are referred to as mutually exclusive projects.

The process of evaluating and selecting longterm investments which are consistent with the firm’s main objective of maximizing shareholders’ wealth is referred to as ......

The sum of present value of all cash inflaws and cash outflows of a project over its life shows the net present value of the project.

The present value of cash inflows equals the present value of cash outflows at the internal rate of return of the project. Hence, the NPV is 0 when cashflows are discounted at IRR.

When NPV is greater than zero, project’s return (IRR) is greater than the cost of capital (the discount rate).  When NPV is smaller than zero, project’s return (IRR) is smaller than the cost of capital (the discount rate).

The discount rate which equates the present value of all cash outflows with the future value of all cash inflows (tern-minal value) is referred to as modified internal rate of return.

The greater the risk of an investment project, the greater will be the requried rate of return from the project and accordingly the greater will be discount rate since there is a positive relationship between risk and return.

analysis is likely to generate relatively more realistic results

Effect of the volatility of stock’s price in stock options is uncertainty of the project’s cash flows in real options.

Contary to the payback period method, discounted payback period method DOES conisder time value of money as projected cash flows are discounted at an appropriate discount rate and their present values are used to calculate payback period.