Capital Capital BudgetingBudgeting

Cash

Investment

opportunity (real asset)

Firm

Shareholder

Investment opportunities

(financial assets)

Invest Pay dividend to shareholders

Shareholders invest for

themselvesInvestment return must exceed the return on investing in a financial asset of equivalent risk to accept the project

Investment Decision

Net Present ValueNet Present Value

Project Market Value - Project CostProject Market Value - Project Cost1. Estimate all cash flows, positive and negative1. Estimate all cash flows, positive and negative

2. Estimate project’s required return2. Estimate project’s required return

3. Find the present value of the cash flows3. Find the present value of the cash flows

Discount all future cash flows Discount all future cash flows

NPV > 0 : AcceptNPV > 0 : Accept NPV < 0 : NPV < 0 : RejectReject

NPV

k

CFt

tn

t

10

NPV: Value to Equity NPV: Value to Equity HoldersHolders Investors:Investors:

– You $20,000 & Brother $30,000You $20,000 & Brother $30,000

Buy a thoroughbred horse $50,000Buy a thoroughbred horse $50,000 Present value of sale $60,000Present value of sale $60,000

– NPV =NPV = Gain for equity holdersGain for equity holders

– Brother’s share =Brother’s share =– Your share =Your share =

Negative NPVNegative NPV

Air Quality Control Act requires a Air Quality Control Act requires a firm to install 3 cleaner ventilation firm to install 3 cleaner ventilation systemssystems

Cash FlowsCash Flows– Cost: $350,000/unitCost: $350,000/unit– Value: Avoid $100,000/unit in fines Value: Avoid $100,000/unit in fines

annually over the 5 year life of the annually over the 5 year life of the units.units.

At r =14%, NPV = -$20,075At r =14%, NPV = -$20,075

Project Analysis

Alternative analysis of cash flow estimates– Payback– Internal Rate of Return

Supplements to NPV analysis – Sensitivity Analysis– Break-even Analysis– Monte Carlo Simulation– Decision Trees

PaybackPayback

Payback Period Payback Period – Number of years it takes before the Number of years it takes before the

cumulative forecasted cash flow cumulative forecasted cash flow equals the initial outlayequals the initial outlay

Payback Rule Payback Rule – Only accept projects that “payback” Only accept projects that “payback”

in the desired time framein the desired time frame

Fixed & Variable CostsFixed & Variable Costs

Total Costs = Fixed + Variable CostsTotal Costs = Fixed + Variable Costs– Total variable costs = quantity * cost per unitTotal variable costs = quantity * cost per unit– Fixed costs are constant over some time Fixed costs are constant over some time

periodperiod Ex: Your firm pays $3000 per month in Ex: Your firm pays $3000 per month in

fixed costs. You also pay $15 per unit to fixed costs. You also pay $15 per unit to produce your product.produce your product.– What is your total cost if you produce 1000 What is your total cost if you produce 1000

units?units?

– What if you produce 5000 units?What if you produce 5000 units?

ExampleExample

New experimental laser medical treatmentNew experimental laser medical treatment– Purchase of new laser costs $250,000Purchase of new laser costs $250,000– Installation will cost $20,000Installation will cost $20,000– Hourly labor costs are $830 (doctor, nurse, Hourly labor costs are $830 (doctor, nurse,

tech)tech)– Charge $3,000 vs. $1,500 for traditional Charge $3,000 vs. $1,500 for traditional

treatmenttreatment Break-even CalculationBreak-even Calculation

– Fixed costs = Fixed costs = – Variable costs = Variable costs = – Break-even =Break-even =

Internal Rate of Internal Rate of ReturnReturn

NPV

r

CFt

tn

t

10

IRR is the discount rate that forces PV of the inflows equal to the initial outflow (cost).

0

10

t

tn

t IRR

CF

NPV: IRR:Enter r, solve for NPV. Enter NPV=0, solve for IRR.

IRR RationaleIRR Rationale

IRR > Opportunity Cost of Capital– Project’s rate of return is greater than

its cost– Extra return is left after repaying

financing to boost stockholders’ returns

IRR > r : AcceptIRR > r : Accept

IRR < r : Reject

Mutually Exclusive Mutually Exclusive ProjectsProjects

PerioPeriodd

Project Project AA

Project Project BB

00 -500-500 -400-400

11 325325 325325

22 325325 200200

IRRIRR 19.43%19.43% 22.17%22.17%

NPVNPV 64.0564.05 60.7460.74

Req. return for both projects is 10%.

Which project should you accept and why?

NPV: choose the project with the higher NPVIRR: choose the project with the higher IRR

Relevant Cash FlowsRelevant Cash Flows

Incremental cash flows Incremental cash flows – Any and all changes in cash flows due Any and all changes in cash flows due

to accepting a projectto accepting a project– ““Will this cash flow occur Will this cash flow occur ONLYONLY if we if we

accept the project?”accept the project?” Stand-alone principle Stand-alone principle

– Analyze each project in isolation from Analyze each project in isolation from the firm the firm

Common Cash FlowsCommon Cash Flows

Sunk costs Sunk costs – Costs that have accrued in the pastCosts that have accrued in the past

Opportunity costs Opportunity costs – Costs of lost optionsCosts of lost options

Side effectsSide effects– Positive: benefits to other projectsPositive: benefits to other projects– Negative: costs to other projectsNegative: costs to other projects

TaxesTaxes

Incremental Cash Incremental Cash FlowsFlows Luxury Car currently sells Luxury Car currently sells

– 30,000 cars at $45,000 and 12,000 SUVs at 30,000 cars at $45,000 and 12,000 SUVs at $85,000$85,000

Introduces a motorcycleIntroduces a motorcycle Expects to sell 21,000 at $12,000 = $252 milExpects to sell 21,000 at $12,000 = $252 mil

Changes brandChanges brand– SUVs decrease: -1,300 * $85,000 = - $110.5 SUVs decrease: -1,300 * $85,000 = - $110.5

milmil– Cars increase: 5,000 * $45,000 = $225 milCars increase: 5,000 * $45,000 = $225 mil– Net sales Net sales

Evaluating NPV Evaluating NPV EstimatesEstimates NPV estimates are just that – NPV estimates are just that – estimatesestimates– NPV ≠ Actual ProfitabilityNPV ≠ Actual Profitability

Forecasting risk Forecasting risk – More sensitive NPV estimates, the More sensitive NPV estimates, the

greater the forecasting riskgreater the forecasting risk– Sources of value Sources of value

Sensitivity AnalysisSensitivity Analysis

NPV impact when vary one NPV impact when vary one variablevariable

Vary inputs separately – Determines project’s realizations

with better/worse outcomes of key variables

Shows sensitivity to forecasting errors

ScenarioScenario Unit Unit SalesSales

Cash Cash FlowFlow

NPVNPV IRRIRR

BaselineBaseline 60006000 59,80059,800 15,5615,5677

15.115.1%%

Worst caseWorst case 55005500 53,20053,200 --8,2268,226

10.310.3%%

Best caseBest case 65006500 66,40066,400 39,3539,3577

19.719.7%%

Sensitivity AnalysisSensitivity Analysis

Must identify key variablesMust identify key variables– Determines where additional Determines where additional

information is neededinformation is needed– Exposes confused forecastsExposes confused forecasts

Results are often ambiguousResults are often ambiguous– Difficult to evaluate true probability Difficult to evaluate true probability

distribution of outcomes distribution of outcomes How likely is each state of the world?How likely is each state of the world?

– Interactions?Interactions? Strong demand higher market Strong demand higher market

size / pricesize / price

Scenario AnalysisScenario Analysis

Alternative to sensitivity analysisAlternative to sensitivity analysis

Examines outcome given certain Examines outcome given certain eventsevents– Ex: Increased oil prices and car marketEx: Increased oil prices and car market

Consider at leastConsider at least– Best case: high revenues, low costsBest case: high revenues, low costs– Worst case: low revenues, high costsWorst case: low revenues, high costs– Measure of the range of possible Measure of the range of possible

outcomesoutcomes

Simulation Analysis

Managers can consider many possible combinations

Generates a probability distribution and estimates probability of positive NPV.

Discounting & Risk

High Risk Project with Cost of High Risk Project with Cost of $125,000$125,000– If successful, firm will build a $1 million If successful, firm will build a $1 million

plant which would generate $250,000/yr plant which would generate $250,000/yr after taxesafter taxes

– Otherwise, project will be droppedOtherwise, project will be dropped– 50% probability of success50% probability of success

Expected cash flows:Expected cash flows:

CC00 = -125 = -125

CC11 = .5(-1,000) + .5(0) = -500 = .5(-1,000) + .5(0) = -500

CCtt for t=2,3,…=.5(250) + .5(0) = 125 for t=2,3,…=.5(250) + .5(0) = 125

Discounting & Risk

High risk so management uses a project discount rate of 25%.

NPV– All: -125 - 500/1.25 +(125/.25)/1.252 =negative

Problematic approach– If the test is a failure, then there is no risk at

all! – If successful, there may be normal risk

afterwards.

Decision Tree Analysis

Low risk if pilot is successful– Discount rate of 10%

Success NPV= -1000 + (250/.1)/1.1 =

1,272

Failure NPV = 0

50%

50%

Pilot productionand test marketing