This Lecture….
Today we will give detailed consideration to the application
FINM2001 Corporate Finance /
FINM8003 Applied Corporate Finance
Valuation Methods II
Estimation of Cash Flows
As a reminder, when estimating cash flows, it is important
to remember the following points:
{ Focus on incremental cash flows and include taxes if
relevant. Specifically, use after-corporate-tax cash flows in a
classical tax system and the after-effective-tax cash flows in
an imputation system.
{ Exclude sunk costs as they are already incurred and are
therefore irrelevant.
{ Exclude financing charges: The required rate of return used
to discount cash flows incorporates the cost of equity and
debt, so including financing charges in the cash flows would
be double counting;
{ Include residual values;
{ Ensure consistency in the treatment of inflation; and,
{ Recognise the timing of the cash flows.
Difference in Lives Adjustments II
The fact that the present value of cash outlays for
Machine A are less than for Machine B, it doesn’t
necessarily mean that the former should be
preferred. This is because:
{If purchased, Machine A will need to be replaced two
years earlier than B; and,
{Therefore, the alternatives are not directly comparable
as the differences in lives means they involve different
future cash flows which have not been considered.
of the NPV valuation tools discussed last week and, in
doing so, discuss:
{ How to estimate cash flows for the purpose of project evaluation;
{ Multiple approaches that can be employed in comparing
mutually exclusive projects with different lives;
{ How NPV analysis can be used in situations more complex than
simply deciding when to accept / reject a project, namely
deciding when to retire / replace existing projects;
{ The importance of undertaking sensitivity and break-even
analysis as part of the NPV evaluation; and,
{ The use of decision-tree analysis in NPV evaluation.
Difference in Lives Adjustments I
As discussed briefly in FINM1001, companies will
frequently have to compare mutually exclusive projects that
have different economic lives. This is necessary because
such projects will often involve equipment of different
quality and therefore also of a different cost. However, the
better quality machines should last longer. Consider the
following example for a furniture manufacturer:
{ Machine A has a life of 3 years and Machine B has a life of 5
years;
{ Both Machines can perform the required tasks satisfactorily;
{ Both Machines generate the same cash flows; and,
{ The present value of post-tax cash outflows for Machine A is
$18,000 and for Machine B is $21,000.
Difference in Lives Adjustments III
Given the preceding, the question arises as to how
we actually compare Machines A and B
appropriately. Two approaches could be
employed:
{Assume that the company will reinvest in a project
identical to currently under consideration, or make
the constant chain of replacement assumption; or,
{Make assumptions about the reinvestment
opportunities that will be available in the future.
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Difference in Lives Adjustments IV Difference in Lives Adjustments V

Whilst the second approach is the most
realistic:
OIn practice, this approach would be impossible
to implement given we are unable to see into
the future and therefore don’t know about the
opportunities that will become available; and,
OTherefore, the constant chain of replacement
approach is often used.
Under this assumption, each project is
assumed to be replaced with an identical
project at the end of its economic life. As
valid comparison can only be made when
chains are of equal length, this can be
achieved by employing:
{The equivalent annual value (EAV) method;
{The constant chain of replacement in perpetuity
method; or,
{The lowest common multiple method.

Difference in Lives Adjustments VI Difference in Lives Adjustments VII

Recall from FINM1001 and last week that the EAV A variant of this approach, which will rank projects
method involves calculating the annual cash flow of identically, is the constant chain of replacement in
an annuity that has the same life as the project and perpetuity method. This method assumes that
whose present value equals the net present value of both chains continue indefinitely. Under this
the project, or: approach
{ The lengths of the chains are equal insofar as they are both
infinite;
NPV
EAV = { If the NPV of each replacement project is $N and the life of each
⎡1 − (1 + k )− n ⎤ project is n years, the constant chain of replacement is
⎢ ⎥ equivalent to receiving an inflow of $N at 0, n, 2n, etc; and,
⎣ k ⎦ { Therefore, the NPV of the chain comprises $N at 0 plus a
perpetuity of $N payable every n years, or….

Difference in Lives Adjustments VIII Difference in Lives Adjustments IX

To compare the two methods, consider the following example: Chocolate
N N
NPV = N + + + ... Heaven Ltd, producers of fine quality chocolates, need to replace a chocolate
(1 + k ) n (1 + k ) 2 n mixing machine. Two competing machines, A and B are available. Both
⎡ 1 1 ⎤ machines are considered adequate in terms of their ability to complete the
= N ⎢1 + + + ...⎥ required tasks. Forecasted cash flows for each machine are provided below.
⎣ (1 + k ) (1 + k )
n 2n
⎦ Given Chocolate Heaven operates in a classical tax system, where the tax
⎡ ⎤ rate is 40%, and has an after-tax required rate of return of 10% p.a., which
⎢ 1 ⎥ machine would you recommend Chocolate Heaven should purchase? In
=N⎢ ⎥ providing an answer, show which option is preferable using both the EAV
⎢1 − 1 ⎥ and NPV to infinity methods of adjusting for differences in lives.
⎣⎢ (1 + k ) ⎦⎥
n
A B
⎡ (1 + k ) n ⎤ Estimated life 3 years 6 years
=N⎢ ⎥
⎣ (1 + k ) − 1 ⎦
n Cost 13000 22000
Net Cash Inflows (pre tax) 10000 14000
More.generally :
Salvage Value 1000 4000
⎡ (1 + k ) n ⎤ Depreciation (p.a.) 4000 3000
NPV ∞ = NPV0 ⎢ ⎥
⎣ (1 + k ) − 1 ⎦
n

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Difference in Lives Adjustments X Difference in Lives Adjustments XI
First, calculate cash flows for each project.
For project A: Using this information, we can calculate the
{ Year 0:
z Cost of new machine: $13,000. NPV for each project:
{ Years 1-3 inclusive:
z Yearly post-tax cash revenues less expenses equalling$10,000 x (1-0.40)=$6,000; ⎡1 − (1.10)−3 ⎤ $1, 000
z Yearly depreciation tax shield of $4,000x0.40=$1,600; NPVA = ($6, 000 + $1, 600) ⎢ ⎥+ 3
− $13, 000
z Salvage value of $1,000 received at the end of year 3; and, ⎣ 0.10 ⎦ (1.10)
z Gain / loss on sale of $0.
For project B:
= $6, 652
{ Year 0:
z Cost of new machine: $22,000.
{ Years 1-6 inclusive: ⎡1 − (1.10) −6 ⎤ $4, 000
z Yearly post-tax cash revenues less expenses equalling$14,000 x (1-0.40)=$8,400; NPVB = ($8, 400 + $1, 200) ⎢ ⎥+ 6
− $22, 000
z Yearly depreciation tax shield of $3,000x0.40=$1,200; ⎣ 0.10 ⎦ (1.10)
z
z
Salvage value of $4,000 received at the end of year 3; and,
Gain / loss on sale of $0.
= $22, 064

Difference in Lives Adjustments XII Difference in Lives Adjustments XIII

We can also use the NPV figures above to calculate the
Using this information, we can then calculate NPV to infinity for each project:
the EAV for each project: ⎡ (1.10)3 ⎤
NPV∞A = $6, 652 ⎢ ⎥
⎣ (1.10) − 1 ⎦
3
$6, 652
EAVA = = $26, 748.68
⎡1 − (1.10) −3 ⎤
⎢ 0.10 ⎥
⎣ ⎦
⎡ (1.10)6 ⎤
= $2, 674.87 NPV∞ B = $22, 064 ⎢ ⎥
⎣ (1.10) − 1 ⎦
6

= $50, 660.57
$22, 064
EAVB =
⎡1 − (1.10) −6 ⎤
⎢ 0.10 ⎥ Based on the preceding results, we can see that,
⎣ ⎦
= $5, 066.06
irrespective of the method employed to adjust for different
lives, Machine B is preferable to Machine A.

Difference in Lives Adjustments XIV Retirement and Replacement Decisions I

The final way of comparing projects with different lives is using the
lowest common multiple (LCM) method. To illustrate how this
approach works, imagine a situation where Project A has a life of 5
years and Project B has a life of 10 years. Here:
{ If A is undertaken four times and B is undertaken two times, the
replacement changes will both be 20 years. Therefore, in this
example, 18 is the lowest common multiple;
{ Based on the above, we would calculate the NPV of four As
undertaken successively and two Bs undertaken successively and
compare them (ie choose the one with the highest NPV); but,
{ While this approach will rank projects identically to the two methods
discussed previously, it can be laborious – imagine if Project A had a
life of 99 years and Project B had a live of 100 years – the LCM would
be 9,900 years!!!!
Projects are not always continued to the end of their
estimated lives, a fact that is a result of management
undertaking periodic reviews of existing projects and often
making subsequent decisions to either retire (abandon) or
replace existing projects and their assets:
{ Retirement decisions is the term used to describe those
situations where assets are used for some time prior to being
sold without being replaced; and,
{ Replacement decisions are those situations where, whilst the
operation is to continue indefinitely, the company is faced with a
decision about when to replace the operation’s existing assets:
Let’s now consider each of these decisions in detail.

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Retirement and Replacement Decisions II
As the retirement of assets is another investment decision,
the NPV approach is valid. Specifically:
{ The choice of an optional abandonment / retirement period can
be treated as a situation of mutually exclusive alternatives as the
decision to retire the asset now precludes retiring it in another
year;
{ Although these mutually exclusive projects have different lives,
NPV without an adjustment for difference in lives should be used
as the assumption of constant replacement is violated; and,
{ Using the NPV rule, a project should be retired if the NPV of all
its future cash flows are less than zero.
Retirement and Replacement Decisions IV
We must start by calculating the net present value
of forgoing the $18,000 residual value now to
receive a post-tax net cash flow of $12,000 and a
residual value of $9,000 one year from now. This
calculation is as follows:
($12, 000 + $9, 000)
NPV = −$18, 000 +
1.10
= $1, 090.91
Retirement and Replacement Decisions VI
When considering when to replace assets, we are
effectively comparing projects with different lives.
Given this, we obviously need to make an
adjustment for this difference, and we can do this
using the constant chain of replacement method
discussed previously. In discussing how to make
replacement decisions in practice, we will consider
two possibilities, namely those involving identical
replacement and those involving non-identical
replacement.
Retirement and Replacement Decisions III
Consider an example where a company owns a machine that is
4 years old and has an estimated remaining life not exceeding 2
years. Further, the post-tax net cash flows and residual value
estimates for the machine are as follows. If the company has
asked you to indicate when the machine should be replaced
given a post-tax required rate of return of 10% p.a…..
Year Post-Tax Residual Value ($)
Net Cash Flow ($)
4 - 18,000
5 12,000 9,000
6 7,500 0
Retirement and Replacement Decisions V
Given the resultant NPV is positive, the machine should be retained
for at least another year. However, the question then becomes
whether the machine should be retained for a period longer than 1
year (ie for 2 years). If this occurs, the company will forgo the
machine’s current residual value of $18,000 in exchange for the
receipt of years 5 and 6 post-tax net cash flows (namely $12,000 and
$7,500) and a $0 residual value, or a net present value of -$892.56.
Given this, unless there is an upward revision of cash flow estimates
for Year 6, the machine should be retired at the end of Year 5:
$12, 000 $7,500
NPV = −$18, 000 + +
1.10 (1.10) 2
= −$892.56
Retirement and Replacement Decisions VII
If identical replacement is being considered,
it is implicitly assumed that the current
project will be replaced by another project
that is identical in every respect. More
specifically, it is assumed that the capital
outlay, net cash flows, physical life and
residual value of the replacement project are
the same as those of the current project.
With this assumption in mind, consider the
following example ….
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Retirement and Replacement Decisions VIII
A machine costing $48,000 with an estimated useful life of 3 years
generates post-tax net cash flows of $24,000 in the first year. Post-tax
net cash flows in each subsequent year decrease by $2,000 per
annum so that Years 2 and 3 post-tax net cash flows are $22,000 and
$20,000 respectively. Given a post-tax required rate of return of 10%
p.a. and the post-tax residual values below, you have been asked to
indicate when the machine should be replaced.
Year Residual Value
($)
1 32,000
2 16,000
3 0
Retirement and Replacement Decisions X
Next, as the previous present values are based on different lives, they
cannot be compared without adjustment. However, this can be
overcome if a constant chain of replacement is assumed. Specifically,
once the following adjustments have been made, the projects are
comparable and it is clear the machine should be replaced every year.
⎡ (1.10) ⎤
NPV1,∞ = $2,909.09 ⎢ ⎥ seen current machinery become obsolete, etc. If
⎣ (1.10) − 1 ⎦
= $32, 000
⎡ (1.10) 2 ⎤
NPV2,∞ = $5, 223.14 ⎢ ⎥
⎣ (1.10) − 1⎦
2
= $30, 095.24
⎡ (1.10)3 ⎤
NPV3,∞ = $7, 026.30 ⎢ ⎥ lecture notes for this week….
⎣ (1.10) − 1⎦
3
= $28, 253.78
Retirement and Replacement Decisions XII
Alternatively, a replacement decision may
involve choosing between two replacement
alternatives, an example of which is given by
the “XYZ Company” case included with this
week’s lecture notes….
Retirement and Replacement Decisions IX
In considering the optimal replacement time, remember that the
decision rule is to select the replacement frequency that maximizes the
projects net present value in perpetuity or its equivalent annual value.
With this in mind, the NPV of the machine if it were sold in each of
years 1 to 3 are as follows:
$24, 000 $32, 000
NPVYr1Re place = −$48, 000 + +
1.10 1.10
= $2,909.09
$24, 000 $22, 000 $16, 000
NPVYr 2Re place = −$48, 000 + + +
1.10 (1.10) 2 (1.10) 2
= $5, 223.14
$24, 000 $22, 000 $20, 000
NPVYr 3Re place = −$48, 000 + + +
1.10 (1.10) 2 (1.10)3
= $7, 026.30
Retirement and Replacement Decisions XI
However, as mentioned previously, it is possible
that existing machines will be replaced by non-
identical alternatives. Such a scenario is possible
in situations where technological advances have
this occurs, the question may amount to when the
old machinery should be replaced by the new. To
answer such a question, consider the “ABC
Company” example included on WebCT with the
Analysing Project Risk I
As discussed in previous lectures, the impact of risk on a
project is generally accounted for by using a required rate
of return reflective of this risk to discount cash flows.
However, a calculated NPV figure is only an estimate that
relies on forecasted project cash flows. In practice:
{ These forecasts will invariably turn out to be different to the
actual cash flows; and,
{ Therefore, projects will need to be analysed to consider what key
variables are likely to determine the success of the project and
how far can variables cash flows fall before the project loses
money. In practice, this analysis is performed using the below
approaches and, as with valuation, is undertaken using
spreadsheets (we will consider how to do this in Lecture 9):
z Sensitivity analysis;
z Break-even analysis; and / or,
z Simulation.
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Analysing Project Risk II
Sensitivity analysis involves assessing the effect of
changes in the estimated variables on a project’s
NPV. This is achieved by recalculating NPV
figures using alternative estimates of variables.
Such analysis is useful as it:
{Provides management with knowledge of the sensitivity
of NPV to changes or errors in variables, allowing them
to decide whether the project is too risky to accept; and,
{Highlights variables that management should estimate
more thoroughly or collect more data in respect of to
reduce forecasting errors.
Analysing Project Risk IV
Break-even analysis is a type of
sensitivity analysis. However, whilst
sensitivity analysis allows questions
such as “what is the project’s NPV if
sales fall to $1 million per annum” to be
answered, break-even analysis allows
consideration of how far sales would
have to fall before the project loses
money.
Qualitative Factors and Project Selection
Thus far, we have only considered the quantitative analysis
associated with project selection. However, whilst the aim
is to maximise shareholder wealth, selection of projects
may not necessarily be based solely on this analysis. This
is because, in reality, management may also consider
qualitative factors when selecting projects. An example
would be the need for greater managerial supervision being
associated with a given project, the cost of which is difficult
to quantify. Management may consider the existence of
these qualitative factors to be sufficiently important to
cause them to accept proposals with lower NPVS.
Analysing Project Risk III
A simple sensitivity analysis could be undertaken by:
{ Making pessimistic, expected and optimistic estimates of each
variable;
{ Calculating NPV using the pessimistic or optimistic value of one
variable and the expected value of others and re-performing this
until a NPV has been calculated using an optimistic and
pessimistic estimate for each specific variable in combination
with the expected values of all other variables; and,
{ Comparing the difference between the optimistic and pessimistic
NPVs for each variable. Small differences suggest NPV is
largely insensitive to changes in that variable, and vice versa.
Decision-Tree Analysis
Next, in some cases, management needs to
evaluate alternatives which occur as a result of a
sequence of decisions over time. In this situation,
decision-tree analysis can be employed, as:
{It takes into account the probability of a given event
taking place and the effect this event would have on
a project’s NPV; and,
{Uses the roll-back procedure, which means the
most distant decision is evaluated first.
Resource Constraints and Project Selection
In undertaking any of the preceding
analysis, it is important to remember that
management is often unable to accept all
positive NPV independent projects or, in the
case of mutually exclusive projects, that
project with the highest NPV. This is
because management may have a shortage
of funds with which to undertake projects
and may therefore be forced to undertake
capital rationing.
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Next Lecture….
After making decisions regarding which project/s to undertake,
management must decide how to finance them.
{ We will discuss the different financing options open to
companies in Lectures 5 and 6;
{ In deciding the sources of funding, managers must also consider
the appropriate mix of sources of finance, or make capital
structure decisions, an issue we will consider in Lecture 7;
{ The financing mix chosen will impact on the cost of capital used
in project evaluation (ie the discount rate). We will consider this
impact in detail in Lecture 8 and, in doing so, learn how to
calculate the cost of capital for use in project evaluation;
{ We will bring the materials from Lectures 2 to 8 together in
Lecture 9, when we will undertake a detailed project valuation,
including cost of capital calculation and sensitivity analysis, in
Excel.