Capital Budgeting

FINANCIAL MANAGEMENT3-credit 30-hour Core Course for MBA (IB) 2013-15Dr. Niti Nandini ChatnaniAssociate ProfessorIndian Institute of Foreign Trade, New DelhiSessions 9, 10 and 11

Recap of Session 8:

___________ is the composite number that represents the claims of all suppliers of capital to the firm on an aggregate basis.

Cost of ______ is the rate that equates the internal rate of return of the cash flows of a bond with its market price.

If a firm with a tax rate of 40% can borrow by issuing bonds carrying an annual coupon of 16%, the cost of debt for this firm is __________.

The approximate cost of preference capital for a firm that has issued preference shares with a face value of Rs.100 and a promised dividend of Rs. 12 per annum is _________ if its issue costs are 3%.

Retained earnings, though like equity capital, are cheaper because there are no __________ and ___________ costs and no ___________

6. The shares of firm a quoted in the market at Rs.220. If this firm ahs paid a dividend of Rs.10 last year, and the expected dividend this year is Rs.11, the firms cost of equity capital is _________.

7. Market price in excess of the issue price of a bond implies an increase in the cots of debt and vice versa. True/False

8. When using the CAPM to estimate cost of equity for an unlisted firm, the beta used must be

That of the firm itselfThat of a similar listed firmWeighted average of A and BAverage of A and B

Case: Gupta Bricks - I

Capital Budgeting Decisions:

These are the long-term investment decisions of a firm

Include expansion, replacement or renewal of long-term assets

Involve an exchange of current funds for future benefits, wherein future benefits come to the firm for a long time in the future and the funds are invested in long-term assets

These decisions are involve sizeable capital outlays, and commit the firm to some course of action

The decisions can be risky, difficult to make, irreversible to a large extent, and may affect the risk complexion of a firm

Firms treat their Capital Budgeting and Financing Decisions separately, without regard to the specific method of financing used

Capital Budgeting Process

Proposal Generation

Review and Analysis

Decision Making

Implementation

Follow-upMost Time and Effort consumingMostly ignored

Key motives for making capex:

ExpansionReplacementRenewalOthers a. Advertisingb. Research & Developmentc. Management Consultingd. Installation of Pollution Control and Safety Devices

Basic Terminology:

Independent versus Mutually Exclusive ProjectsUnlimited Funds versus Capital RationingAccept- Reject versus Ranking ApproachesConventional versus Non-Conventional Cash Flow Patterns

Investment Evaluation:

Requires:

Estimation of cash flows (not profits)Estimation of the required rate of return on investments Application of an evaluation technique (or a decision rule)

Evaluation Techniques:

Non-discounted Methods:Payback Period (PBP)Accounting Rate of Return (ARR)*

2. Discounted MethodsNet Present Value (NPV)Internal Rate of Return (IRR)Profitability Index (PI) *based on profits; not used in practice

Cost of Capital Return on CapitalThe cost of capital, or discount rate, or required rate of return, or opportunity cost, is an important link between the investment decision and the financing decision It is the minimum or hurdle rate for the return a firms investment must earnCost of Capital

Pay Back Period (PBP):

The amount of time required for a firm to recover its initial investment in a project, as calculated from its cash flows

Decision Criterion:

If PBP < Minimum Acceptable PBP, then accept the projectIf PBP > Minimum Acceptable PBP, then reject the project

Pros and Cons of PBP:

Simple to compute and easy to understand Can be viewed as a measure of risk exposure

Minimum Acceptable PBP is set subjectively Time Value of money is not integrated into PBP calculations Cash flows that occur after PBP are not considered

Net Present Value (NPV):

The value left after subtracting a projects initial investment from the present value of its cash inflows, discounted at a rate equal to the firms cost of capital

NPV= CFt - CF0 (1+k)t

Decision Criterion:

If NPV > 0, then accept the projectIf NPV < 0, then reject the project

Pros and Cons:

Integrates time value of money into calculations Is in sync with the wealth maximization goal

Absolute Measure

t=1n

Internal Rate of Return (IRR):

The discount rate that equates NPV of a project with 0. The compound annual rate of return a firm will earn it it invests in the project and earns the cash inflows

CFt - CF0 (1+ IRR)t

Decision Criterion:

If IRR > the firms cost of capital, then accept the projectIf IRR < the firms cost of capital, then reject the project

Pros and Cons:

Easy to communicate and compare

Difficult to compute Assumes intermediate cash flows are reinvested at IRR Multiple IRRs can result in case of non-conventional cash flows Provides conflicting rankings for mutually exclusive projectst=1n

DETERMINING THE NPV and IRRFirm's Cost of Capital10%Year End Cash FlowYear Project AProject B0-42000-450001140002800021400012000314000100004140001000051400010000PV of Cash Flows$53,071.01 $55,924.40 NPV$11,071.01 $10,924.40 Choice of ProjectIRR20%22%Choice of Project

NPV IRR

DETERMINING THE NPV and IRRNPV Profiles

Firm's Cost of Capital10%

Year End Cash FlowDiscount RateNPV of ANPV of B

YearProject AProject B0%$25,000.0028000

0-42000-450005%1861217251

1140002800010%1107110924

2140001200015%49305686

3140001000020%0

4140001000022%0

51400010000

PV of Cash Flows$53,071.01$55,924.40

NPV$11,071.01$10,924.40

Choice of Project

IRR20%22%

Choice of Project

NPV at 0$46,930.17$50,686.01

$4,930.17$5,686.01

MIRR14%0.1374375048

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Sheet3

Modified Internal Rate of Return (MIRR):

An improved version of the internal rate of return (IRR) approach MIRR = [nSum of Terminal Cash Flows other than Initial Investment ] -1Initial Investment

Decision Criterion:

If MIRR > the firms cost of capital, then accept the projectIf MIRR < the firms cost of capital, then reject the project

In case of mutually exclusive projects, the project with higher MIRR should be preferred.

Does not require the assumption that the project cash flows are reinvested at the IRR Factors in a discrete reinvestment rate into the model

MIRR Example:

You are an assistant to Rajan, the corporate finance director at BTC, a civil engineering firm. Two of the company's recent bids are accepted. The first relates to construction of a new airport in Jaipur. The second relates to construction of a motorway connecting Jaipur with Ahmedabad. Both the projects are expected to take 3 years. The applicable finance rate is 10% and the project's cash flows are given below:

YearAirportMotorway0(12,000,000)(18,000,000)16,000,0008,000,00028,000,00010,000,00034,000,00010,000,000

The company submitted bids for both projects because both had positive net present values.The CEO of BTC has asked Rajan to recommend which project the company should accept. The CEO is a fan of the IRR approach. Rajan, on the other hand, is worried about the shortcomings of the IRR approach. He believes that the economy might slow down a little in next few years and a lower reinvestment rate should be factored in. He has asked you to calculate MIRR for both the projects.You double-check whenever and wherever possible, so you decide to calculate the MIRR using the manual formula approach and then verify the results using MS Excel MIRR function.

NPV Profiles:

Depict project NPVs for various discount ratesAllow projects to be compared graphically

NPV ProfilesDiscount RateNPV of ANPV of B0%25000 280005%186121725110%110711092415%4930568620%022%0

Example:Consider the following two projects:

The firms WACC is 10%. For each project, find its:

PBP and Discounted PBPNPVIRRPIMIRRComment on the acceptability of both A and B in each case.

Cash flowProject AProject BYear 0-1000-1000Year 1500100Year 2400300Year 3300400Year 4100600

Choosing projects under Capital Rationing:

Exists when budgets are created for long-term investments Soft versus hard forms of capital rationingTwo approaches:

IRR ApproachInvolves graphing project IRRs in descending order against total initial investment, to determine the group of acceptable projects

2. NPV ApproachBased on the use of present values to determine the group of projects that will maximise owners wealth

Budgeted for investment = 250,000Cut-off Rate = 10%The objective of a firm that operates under capital rationing is to use its budget to generate the highest present values of inflows

ProjectInitial InvestmentIRR in %PV of Cash FlowsA80,00012100,000B70,00020112,000C100,00016145,000D40,000836,000E60,0001579,000F110,00011126,500

1. Using the IRR Approach

Selected Projects = B, C and ETotal Investment = 230,000Total Present Value = 336,000NPV of Projects B, C and E = 106,000

2. Using NPV Approach

Selected Projects = B, C and ATotal Investment = 250,000Total Present Value = 357,000NPV of Projects B, C and A = 107,000

Project F is not selected under the NPV approach due to budget constraints.

Estimation of Cash Flows:

Cash flows are different from accounting profitsRelevant Cash Flows are the firms Incremental Cash Flows, which are

Cf to firm with project Cf to firm without project

Major Components of Cash Flows: 1. Initial Investment; 2. Operating Cash Inflows 3. Terminal Cash Flows

Expansion versus Replacement Cash FlowsAll Capital Budgeting Decisions can be viewed as Replacement Decisions. Expansion Decisions are merely Replacement Decisions in which all cash flows from old asset are zero.

Cash Flows for Replacement Decisions:

Initial Investment =

Initial investment needed - After-tax cash inflows to acquire new asset from liquidation of old asset

Operating Cash Inflows =

Operating cash inflows - Operating cash inflows from new asset from old asset

Terminal Cash Flow =

After-tax cash flows from termination of new asset

Determining a projects incremental cash flows:

A note on Sunk Costs and Opportunity Costs

Sunk Costs: Cash outlays that have already been made (past outlays) and therefore, have no effect on the cash flows relevant to a current decision. These are not considered as incremental cash flows.

Opportunity Costs: Cash flows that could be realized from the best alternative use of an owned asset. These are considered as incremental cash flows.

Step 1: Finding the Initial Investment

Occurs ate time 0 when expenditure is madeIncludes all cash outflows occurring at time 0 reduced by all cash inflows occurring at time 0

Installed cost of new asset = Cost of new asset +Installation Cost- After-tax proceeds from sale of old asset =Proceeds from sale of old asset Tax on sale of old assets Changes in Net Working Capital______________________________________Initial Investment

Installed Cost: The cost of an asset plus its installation cost, equals the assets depreciable value

Book Value: the strict accounting value of an asset, calculated by subtracting its accumulated depreciation from its installed cost

Tax on Sale of old asset: Tax that depends on the relationship between the old assets sale price, initial purchase price and book value, and on existing government tax rules

Recaptured depreciation: The portion of an assets sale price that is above its book value and below it initial purchase price

Changes in Net Working Capital: The difference between a change in current assets and a change in current liabilities. Accompany capex

Finding the Operating Cash Inflows:

These occur over the projects life Are measured as cash flows, not accounting profits

Revenues Expenses (excluding depreciation)_______________________________Profits Before Depreciation and Tax- Depreciation_______________________________Net Profits Before Tax- Tax_______________________________Net Profits After Tax+ Depreciation_______________________________Operating Cash Inflows

Finding the Terminal Cash Flow:

This occurs in terminal year of projects lifeResults from termination/liquidation of project

After-tax proceeds from sale of new asset = Proceeds from sale of new asset Tax on sale of new asset Changes in Net Working Capital ____________________________________ Terminal Cash Flow

Identifying the relevant cash flows:

Initial capex, includes costs of fixed assets including shipping and installation costsNon Cash Charges (typically depreciation) are included only for tax shields offered Changes in Net Working Capital, are costs over and above capex and usually accompany capexInterest Expenses are not included in project cash flows and are treated as financing cash flowsSunk costs are not incremental costs and are ignoredOpportunity costs inherent in use of assetsSide effects impact the incremental cash flows and are includedTiming of cash flows are relevant because of TVoMTerminal cash flow includes working capital released and salvage value of assets realized

Example:

Given the following background information for a project, calculate its NPV:Installed Cost: 600Required NWC Investment: 400Life: 3 yearsAnnual Sales: 1000Annual Costs: 500Straight Line Depreciation to 0; Salvage Value: 100Tax Rate: 34%Required Return: 12%

Project Cash Flows:

Initial cash flows:Capex = 600NWC = 400

Annual and Terminal Cash flows:

Year 0Year 1Year 2Year 3Sales-1000 (Initial C/F)100010001000Cost of Sales500500500EBIDT500500500Depreciation200200200EBIT300300300Salvage Value100 (BV=0)Taxes102102136PAT198198264CFAT(add Depcn. + NWC )-1000398398864

Dealing with Inflation:

When cash flows are expressed in terms of the time of their receipt, they are nominal cash flows

When cash flows are expressed in year 0 terms, they are real cash flows

Inflation must be treated consistently in capital budgeting

Nominal cash flows must be discounted at nominal rates and real cash flows at real rates

Fisher Effect Formula:

1+Nominal Rate = (1 + Real Rate)(1 + Inflation Rate)

Nominal Cash Flow = Real Cash Flow (1 + Inflation Rate)t

The approximation, Nominal Rate = Real Rate + Inflation Rate works well when Real Rate + Inflation Rate is small

Example:Initial Investment = 300, depreciated to 0 by SLM; no salvage valueSales = 140 units; SP = 2; CP = 1Tax Rate = 35%; WACC = 15%

Case1: Real Cash flows and Nominal WACC

Year0123Initial Investment-300Revenues !40 @ 2280280280Costs 140 @ 1140140140Gross Profits140140140Depreciation (to 0)100100100PBT404040Tax @ 35%141414NPAT262626CFAT126126126PV @ 15%$287.69 NPV($12.31)

Case 2: Nominal Cash flows and Nominal WACC

Year0123Initial Investment-300Revenues 140 @ 2294308.7324.135Costs 140 @ 1147154.35162.0675Gross Profits147154.35162.0675Depreciation (to 0)100100100PBT4754.3562.0675Tax @ 35%16.4519.022521.72363NPAT30.5535.327540.34388CFAT130.55135.3275140.3439PV @ 15%$308.13 NPV$8.13

Case 3: Real Cash flows and Real WACC (Using Fisher Formula)

Year0123Initial Investment-300Revenues !40 @ 2280280280Costs 140 @ 1140140140Gross Profits140140140Depreciation (to 0)100100100PBT404040Tax @ 35%141414NPAT262626CFAT126126126PV @ 10%$313.34 NPV$13.34

Dealing with Project Risk:

Sensitivity Analysis

A behavioural approach that uses several possible values for a given variable to assess that variables impact on the projects NPV. Helps establish a range for NPV and the variable NPV is most sensitive to

2. Scenario Analysis

A behavioural approach that evaluates the impact of the simultaneous change in a number of variables on the projects NPV

3. Break-Even Analysis

An approach that asks what is the minimum level of sales that must be achieved for project NPV to be 0

4. Risk Adjusted Discount Rates

The discount rate that must be earned on a given project to compensate the firm for the risk inherent in a project. Logic closely linked to the CAPM. Widely used in practice

5. Pay Back Period