CFA® Program Curriculum, Volume 4, page 68 Because the NPV method is a direct measure of the expected change in firm value from undertaking a capital project, it is also the criterion most related to stock prices. In theory, a positive NPV project should cause a proportionate increase in a company’s stock price.
In reality, the impact of a project on the company’s stock price is more complicated than the previous example. A company’s stock price is a function of the present value of its expected future earnings stream. As a result, changes in the stock price will result more from changes in expectations about a firm’s positive NPV projects. If a company announces a project for which managers expect a positive NPV but analysts expect a lower level of profitability from the project than the company does (e.g., an acquisition), the stock price may actually drop on the announcement. As another example, a project announcement may be taken as a signal about other future capital projects, raising expectations and resulting in a stock price increase that is much greater than what the NPV of the announced project would justify.
MODULE QUIZ 34.2
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Use the following data to answer Questions 1 through 3.
A company is considering the purchase of a copier that costs $5,000. Assume a required rate of return of 10% and the following cash flow schedule:
Year 1: $3,000.
Year 2: $2,000.
Year 3: $2,000.
1. What is the project’s payback period?
A. 1.5 years.
B. 2.0 years.
C. 2.5 years.
2. The project’s discounted payback period is closest to:
A. 1.4 years.
B. 2.0 years.
C. 2.4 years.
3. What is the project’s profitability index (PI)?
A. 0.72.
B. 1.18.
C. 1.72.
4. Which of the following statements about the payback period method is least
4. Which of the following statements about the payback period method is least accurate? The payback period:
A. provides a rough measure of a project’s liquidity.
B. considers all cash flows throughout the entire life of a project.
C. is the number of years it takes to recover the original cost of the investment.
5. Which of the following statements is least accurate? The discounted payback period:
A. frequently ignores terminal values.
B. is generally shorter than the regular payback.
C. is the time it takes for the present value of the project’s cash inflows to equal the initial cost of the investment.
6. The NPV profiles of two projects will intersect:
A. at their internal rates of return.
B. if they have different discount rates.
C. at the discount rate that makes their net present values equal.
7. Fullen Machinery is investing $400 million in new industrial equipment. The present value of the future after-tax cash flows resulting from the equipment is
$700 million. Fullen currently has 200 million shares of common stock
outstanding, with a current market price of $36 per share. Assuming that this project is new information and is independent of other expectations about the company, what is the theoretical effect of the new equipment on Fullen’s stock price? The stock price will:
A. decrease to $33.50.
B. increase to $37.50.
C. increase to $39.50.
KEY CONCEPTS
LOS 34.a
Capital budgeting is the process of evaluating capital projects, projects with cash flows over more than one year.
The four steps of the capital budgeting process are: (1) Generate investment ideas; (2) Analyze project ideas; (3) Create firm-wide capital budget; and (4) Monitor decisions and conduct a post-audit.
Categories of capital projects include: (1) Replacement projects for maintaining the business or for cost reduction; (2) Expansion projects; (3) New product or market
development; (4) Mandatory projects to meet environmental or regulatory requirements;
(5) Other projects, such as research and development or pet projects of senior management.
LOS 34.b
Capital budgeting decisions should be based on incremental after-tax cash flows, the expected differences in after-tax cash flows if a project is undertaken. Sunk (already incurred) costs are not considered, but externalities and cash opportunity costs must be included in project cash flows.
LOS 34.c
Acceptable independent projects can all be undertaken, while a firm must choose between or among mutually exclusive projects.
Project sequencing concerns the opportunities for future capital projects that may be created by undertaking a current project.
If a firm cannot undertake all profitable projects because of limited ability to raise capital, the firm should choose that group of fundable positive NPV projects with the highest total NPV.
LOS 34.d
NPV is the sum of the present values of a project’s expected cash flows and represents the increase in firm value from undertaking a project. Positive NPV projects should be undertaken, but negative NPV projects are expected to decrease the value of the firm.
The IRR is the discount rate that equates the present values of the project’s expected cash inflows and outflows and, thus, is the discount rate for which the NPV of a project is zero. A project for which the IRR is greater (less) than the discount rate will have an NPV that is positive (negative) and should be accepted (not be accepted).
The payback (discounted payback) period is the number of years required to recover the original cost of the project (original cost of the project in present value terms).
The profitability index is the ratio of the present value of a project’s future cash flows to its initial cash outlay and is greater than one when a project’s NPV is positive.
LOS 34.e
An NPV profile plots a project’s NPV as a function of the discount rate, and it intersects the horizontal axis (NPV = 0) at its IRR. If two NPV profiles intersect at some discount rate, that is the crossover rate, and different projects are preferred at discount rates higher and lower than the crossover rate.
For projects with conventional cash flow patterns, the NPV and IRR methods produce the same accept/reject decision, but projects with unconventional cash flow patterns can produce multiple IRRs or no IRR.
Mutually exclusive projects can be ranked based on their NPVs, but rankings based on other methods will not necessarily maximize the value of the firm.
LOS 34.f
The NPV method is a measure of the expected change in company value from
undertaking a project. A firm’s stock price may be affected to the extent that engaging in a project with that NPV was previously unanticipated by investors.
ANSWER KEY FOR MODULE QUIZZES
Module Quiz 34.1
1. A A post-audit identifies what went right and what went wrong. It is used to improve forecasting and operations. (LOS 34.a)
2. A Cash flows are based on opportunity costs. Financing costs are recognized in the project’s required rate of return. Accounting net income, which includes non- cash expenses, is irrelevant; incremental cash flows are essential for making correct capital budgeting decisions. (LOS 34.b)
3. C Independent projects accept all with positive NPVs or IRRs greater than cost of capital. NPV computation is easy—treat cash flows as an annuity.
Project Y: N = 5; I = 12; PMT = 5,000; FV = 0; CPT → PV = –18,024 NPVA = 18,024 – 15,000 = $3,024
Project Z: N = 4; I = 12; PMT = 7,500; FV = 0; CPT → PV = –22,780 NPVB = 22,780 – 20,000 = $2,780 (LOS 34.c)
4. B Accept the project with the highest NPV. (LOS 34.c)
5. C If IRR is less than the cost of capital, the result will be a negative NPV.
(LOS 34.d)
6. B CF0 = –5,000; CF1 = 3,000; CF2 = 2,000;
CF3 = 2,000; I/Y = 10; NPV = $883. (LOS 34.d)
7. C CF0 = –5,000, CF1 = 3,000, CF2 = 2,000, CF3 = 2,000. IRR = 20.64%.
(LOS 34.d) Module Quiz 34.2
1. B Cash flow (CF) after year 2 = –5,000 + 3,000 + 2,000 = 0. Cost of copier is paid back in the first two years. (LOS 34.d)
2. C Year 1 discounted cash flow = 3,000 / 1.10 = 2,727 Year 2 DCF = 2,000 / 1.102 = 1,653
Year 3 DCF = 2,000 / 1.103 = 1,503
CF required after year 2 = –5,000 + 2,727 +1,653 = –$620
620 / year 3 DCF = 620 / 1,503 = 0.41, for a discounted payback of 2.4 years.
Using a financial calculator:
Year 1: I = 10%; FV = 3,000; N = 1; PMT = 0; CPT → PV = –2,727 Year 2: N = 2; FV = 2,000; CPT → PV = –1,653
Year 3: N = 3; CPT → PV = –1,503
5,000 – (2,727 + 1,653) = 620, 620 / 1,503 = 0.413, so discounted payback = 2 + 0.4 = 2.4. (LOS 34.d)
3. B PI = PV of future cash flows / CF0 (discounted cash flows years 0 to 3 calculated in Question 2). PI = (2,727 + 1,653 + 1,503) / 5,000 = 1.177.
(LOS 34.d)
4. B The payback period ignores cash flows that go beyond the payback period.
(LOS 34.d)
5. B The discounted payback is longer than the regular payback because cash flows are discounted to their present value. (LOS 34.d)
6. C The crossover rate for the NPV profiles of two projects occurs at the discount rate that results in both projects having equal NPVs. (LOS 34.e)
7. B The NPV of the new equipment is $700 million − $400 million = $300 million.
The value of this project is added to Fullen’s current market value. On a per-share basis, the addition is worth $300 million / 200 million shares, for a net addition to the share price of $1.50. $36.00 + $1.50 = $37.50. (LOS 34.f)
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The following is a review of the Corporate Finance (1) principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #35.