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Chapter 17
Capital Budgeting Analysis
© 2011 John Wiley and Sons
2
Chapter Outcomes
Explain how the capital budgeting process should be related to a firm’s mission and strategies.
Identify and describe the five steps in the capital budgeting process.
Identify and describe the methods or techniques used to make proper capital budgeting decisions.
3
Chapter Outcomes, continued
Explain how relevant cash flows are determined for capital budgeting decision purposes.
Discuss how a project’s risk can be incorporated into capital budgeting analysis.
4
Capital Budgeting Projects
Seek investment opportunities to enhance a firm’s competitive advantage and increase shareholder wealth– Typically long-term projects– Should be evaluated by time value of
money techniques– Large investment– Relate to firm’s mission
Mutually exclusive versus independent
5
Identifying Potential Capital Budget Projects
Time value concepts tell us:
Value = present value of expected cash flows
Separating out the initial up-front cost, we have:
Net Present Value = Present value of expected cash flows – cost of project
6
Identifying Potential Capital Budget Projects
Net Present Value = Present value of expected cash flows – cost of project
If NPV >0 the project adds value to the firm.
Where do firms find attractive capital budgeting projects with potentially positive NPVs?
7
Identifying Potential Capital Budget Projects
Planning tools: MOGS: Mission, Objectives, Goals,
Strategies SWOT: (Internal to firm):Strengths,
Weaknesses
(External to firm): Opportunites, Threats
8
Capital Budgeting Process
Identification Development Selection Implementation Follow-up
9
Data Needs
Economic and Political Data
Financial Data
Non-Financial Data
10
Oil/Gas Company ProjectsRanking of items from most to least
important on capital spending:
1. Natural gas price forecast
2. Crude oil price forecast
3. Natural gas demand forecast
4. Crude oil demand forecast
5. Availability and cost of capital
6. Regulatory requirements on projects
7. Tax considerations
11
Forecasts
Note the multiple uses of the word “forecast” in the previous list
Managers must make educated guesses about the future to estimate future cash flows
12
Capital Budgeting Techniques
Net Present Value
NPV = Present value of all cash flows minus cost of project
Inputs: cash in/outflows, required rate of return or “cost of capital”
13
Cash Flow Data
YEAR PROJECT A PROJECT B
0 (today) -20,000 -25,000
1 5,800 4,000
2 5,800 4,000
3 5,800 8,000
4 5,800 10,000
5 5,800 10,000
14
NPV of Project ACASH 10% PRESENT
YR FLOW x PVIF = VALUE
0 –$20,000 1.000 –$20,000
1 5,800 0.909 5,272
2 5,800 0.826 4,791
3 5,800 0.751 4,356
4 5,800 0.683 3,961
5 5,800 0.621 3,602
Net Present Value =$ 1,982
15
16
NPV of Project BCASH 10% PRESENT
YR FLOW x PVIF = VALUE
0 -$25,000 1.000 -$25,000
1 4,000 0.909 3,636
2 4,000 0.826 3,304
3 8,000 0.751 6,008
4 10,000 0.683 6,830
5 10,000 0.621 6,210
Net Present Value = $ 988
17
What Does the NPV Represent?
NPV represents the dollar gain in shareholder wealth from undertaking the project
If NPV > 0, do the project as shareholder wealth rises
If NPV <0, do not undertake; it reduces shareholder wealth
18
Internal Rate of Return
It is the discount rate that causes NPV to equal zero
N
NPV = [CFt / (1 + IRR)t ] – Inv = 0 t = 1
19
NPV Profile
Figure 13.1 Relationship Between NPV and Discount Rates: NPV Profile
-2000.00
0.00
2000.00
4000.00
6000.00
8000.00
10000.00
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12 0.13 0.14 0.15 0.16 0.17
Discount Rate (in decimal)
NP
V (
$)
20
Solution Methods
Compute the IRR by:
–Trial and error
–Financial calculator
–Spreadsheet software Accept the project if IRR > minimum
required return on the project
21
22
What Does the IRR Measure?
IRR measures the return earned on funds that remain internally invested in the project
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(1) (2) (3) (4) (5) (6)
Year Beginning Cash 10% Return Reduction Ending
Investment Inflow on the in the Value of
Value (savings) Invested Invested Invested
Funds Funds Funds
(2) x 0.10 (3) - (4) (2) - (5)
1 $5,000.00 $2,010.57 $500.00 $1,510.57$3,489.43
2 3,489.43 2,010.57 348.94 1,661.63 1,827.80
3 1,827.80 2,010.57 182.78 1,827.79 0.01*
*Value is not 0.00 due to rounding.
24
NPV vs. IRR They will always agree on whether to
accept or reject a project So if projects are independent: either
method is acceptable Problem: they may rank projects
differently What to do if projects are mutually
exclusive and the rankings conflict? Answer: use NPV as it measures the
change in shareholder wealth occurring because of the project.
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NPV vs. IRR
Another issue with IRR: a project may have more than one IRR!
Can occur if project has alternative positive and negative cash flows.
Most likely to occur if project requires substantial renovations or maintenance during its life or if end-of-life shut-down costs are high.
26
Modified Internal Rate of Return
MIRR developed to solve some of the issues associated with IRR.
MIRR will agree with NPV on the accept/reject decision
MIRR gives a single answer—there is only one MIRR
MIRR agrees with NPV rankings when the initial investments are of comparable size.
27
Modified Internal Rate of Return:Three step process
1. Find the present value of all cash outflows
2. Find the future value of all cash inflows at the end of the project’s life at year n. This lump sum is called the terminal value.
3. MIRR is the discount rate which equates the present value of the outflows and the future value of the inflows:FV at year n = PV (1 + MIRR)n
28
MIRR for Project A
1. Present value of outflows = 20,000 (no additional calculation needed)
2. Find FV as of year 5 for cash inflows from years 1-5:5800 (1.10)4 = 8491.785800 (1.10)3 = 7719.805800 (1.10)2 = 7018.005800 (1.10)1 = 6380.00 5800 (1.10)0 = 5800.00
Terminal value (sum of FV) = 35,409.58
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MIRR for Project A PV of outflows: 20,000 Terminal value (sum of FV of inflows)
= 35,409.58 Step 3: FV = PV(1 + MIRR)n
= $35,409.58= $20,000(1 + MIRR)5
Solving, we find the MIRR is 12.10 percent
Accept project as MIRR>10% required return
30
Profitability Ratio (Benefit/Cost Ratio)
Profitability Index = Present value of cash flows/initial cost
Accept project if PI > 1.0 Reject project if PI < 1.0 Interpretation: Measures the present
value of dollars received per dollar invested in the project
31
Project A and B
Project A’s profitability ratio:
PI = $21,982/$20,000 = 1.099
Project B’s profitability ratio:
PI = $25,988/$25,000 = 1.040
32
Relationships
NPV, IRR, PI will always agree on the Accept/Reject decision
If one indicates we should accept the project, they will all indicate “accept”
NPV > 0 always means that: IRR>minimum required return and that the: PI > 1
33
Reject Decision, too
If one indicates we should reject the project, they will all indicate “reject”
NPV < 0 always means that the
IRR < minimum required return and that the
PI < 1
34
Conflicts Between NPV, IRR, MIRR, Profitability Index
May occur as different rankings may occur if projects are mutually exclusive. Most likely when projects have:
Different cash flow patterns– Projects with larger and earlier cash
flows may have higher IRR rankings than those with larger later cash flows
35
Conflicts Between NPV, IRR, MIRR, Profitability Index
Different time horizons– Project Long and Project Short require
$100 investment– Short: returns $200 in 2 years IRR =
41.42% and NPV (at 10% required return) = $65.29.
– Long: returns $2,000 in 20 years IRR =16.16% NPV (at 10% required return) = $197.29.
36
Conflicts Between NPV, IRR, MIRR, Profitability Index
Different Sizes– Projects with smaller initial investments may
have higher IRR and higher PI and smaller NPV than projects with larger initial investments.
Initial PV of Cash Profitability
Project Outlay Cash Flows NPV Index
Small $100 $150 $50 1.5
Large 1,000 1,100 $100 1.1
37
Conflicts Between NPV, IRR, MIRR, Profitability Index
Four discounted cash flow methods: NPV, IRR, MIRR, profitability index Goal in capital budgeting is to select
projects that will help maximize shareholder wealth.
NPV is the best as it measures the absolute dollar change in shareholder wealth.
The others are relative measures of project attractiveness.
38
A popular, but flawed, measure...
Payback period = number of years until the cash flows from a project equal the project’s cost
Accept project is payback period is less than a maximum desired time period
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Project A Payback ExampleInvestment: $20,000
Cash Cumulative Dollars
YR Flow Cash flow Needed
1 5,800 5,800 14,200
2 5,800 11,600 8,400
3 5,800 17,400 2,600
4 5,800
Fraction of year: 2,600/5,800 = 0.45
Payback = 3.45 years
40
Payback’s Drawbacks
Ignores time value of money Any relationship between the
payback, the decision rule, and shareholder wealth maximization is purely coincidental!
It ignores the cash flows beyond the payback period
41
What Managers Use
75% of CFOs used NPV, IRR or both to evaluate projects
IRR is most popular Over half still use payback as a
secondary or supplementary method of analysis
42
Why Are IRR and Payback Used So Much?
Safety margin– IRR gives managers an intuitive feel for
a project’s “safety margin”—amount by which cash flows can be incorrect and the project can still increase shareholder wealth.
Project Size Managerial flexibility and options
43
Estimating Project Cash Flows
Important concepts: Stand-alone principle Incremental after-tax cash flows
from the base case Cannibalization or enhancement
effects Opportunity costs
44
Ignore….
Sunk costs
Financing costs
45
Project Cash Flows
Project sales (generally a cash inflow)- Project costs (generally a cash outflow)- Depreciation (a noncash expense) EBIT = EBT (earnings before interest and taxes,
which also equals earnings before taxes as financing costs are ignored in cash flow analysis)
- Taxes (a cash outflow) Net income
46
Firm versus Project Statement of Cash Flows The Firm's Cash Flow Statement A Project's Cash Flow Statement Cash Flow from Operations Cash Flow from Operations
Net Income Net Income+Depreciation +Depreciation+current asset/liability sources +current asset/liability
sources
-current asset/liability uses -current asset/liability uses
Cash Flow from Investment Activities Cash Flow from Investment
Activities-change in gross fixed assets -Funds invested in the
project-change in investments
Cash Flow from Financing Activities Cash Flow from Financing
Activities-Dividends paid Not applicable+net new bond issues+net new stock issues
47
Project Cash Flows
Cash flows from operations: Net income + depreciation – change in net working capital
Cash flows from investment activities: change in gross fixed assets
Cash flows from financing activities: ignoreRecall, as the cash account is always zero,
that the change in NWC does not include the cash account
48
Operating Cash Flow OCF = Net Income + Depreciation – ΔNWC From the project’s income statement, this
is the same as: (Sales-Costs-Depreciation) – Taxes +
Depreciation – ΔNWC If the firm’s tax rate is t then Taxes = t(pre-tax income) = t(Sales-Costs-
Depreciation) so operating cash flow is:
49
Operating Cash Flow
OCF = Sales-Costs-Depreciation – t(Sales-Costs-
Depreciation) + Depreciation – ΔNWC Simplifying, we have a general formula for
estimating operating cash flow: OCF = (Sales-Costs-Depreciation)(1– t)
+ Depreciation – ΔNWC
50
Why do we subtract the change in NWC (ΔNWC) ?
Recall NWC = Current Assets (excluding the cash account) minus Current Liabilities
If NWC rises: either CA has risen, CL has fallen, or both
Example: Cash is used to pay AP; cash flows out of the firm and NWC (CA-CL) rises
A use of cash leads to an increase of NWC; to measure operating cash flow, this amount is subtracted.
51
Why do we subtract the change in NWC (ΔNWC) ?
If NWC falls: either CA has fallen, CL has risen, or both.
Example: Cash comes into the firm if a customer pays their AR. AR falls, CA falls, and NWC falls
A source of cash leads to a decrease of NWC; when we subtract this negative change in NWC it becomes a positive addition to OCF.
52
The Depreciation Tax ShieldWith Deprec Without Deprec Expense Expense
Sales $1000 $1000-Costs -300 -300-Deprec -100 0EBT $600 $700-Taxes (40%) 240 280Net Income $360 $420OCF=Net Income + Depreciation
$460 $420Difference is $40—which equals tax rate x
depreciation (04.0) ($100) = $40
53
Reality: Keeping Managers Honest
Pet projects can be accepted into the capital budget by inflating cash flow estimates so their NPV is positive
Possible solutions:– Review spending in implementation stage;
additional requests for funds needed in case of overruns
– Compare forecasted cash flows with actuals– Record names of those issuing forecasts
54
Risk-related Considerations
Expected return/risk tradeoff
Higher (lower) than average risk projects should have a higher (lower) than average discount rate
55
Cost of Capital
Required return on average risk project = firm’s cost of capital, or cost of financing
For average risk projects, use this number as the discount rate (NPV, PI) or the minimum required rate of return (IRR)
56
Risk-adjusted Discount Rate
Adjust the project’s discount rate up or down from the firm’s cost of capital for projects of above-average or below-average risk
57
An Example
Below-average risk:
Discount rate = cost of capital –2%
Average risk:
Discount rate = cost of capital
Above-average risk:
Discount rate = cost of capital + 2%
High risk:
Discount rate = cost of capital + 5%
58
Web Links
www.benjerry.com
www.wendys.com
www.wellsfargo.com
www.merck.com
www.dell.com
www.ebay.com
www.salvagesale.com
59
Learning Extension 17: Estimating Project Cash Flows
60
Up-front or “time zero” investment
Investment =
cost + transportation, delivery, and installation charges
61
Project Stages and Cash Flow Estimation
Initial Outlay– Engineering estimates (designs,
modifications)– Current market prices of new items– Bid prices from possible supplies or
construction firms–Will be reduced if new project is
replacing old equipment/building that can be sold
62
Project Stages and Cash Flow Estimation
Cash Flows During the Project’s Life For each period of time during the
project’s life, use the general equation: OCF = (Sales-Costs-Depreciation)(1– t)
+ Depreciation – ΔNWC Estimating the inputs: marketing studies,
production cost estimates, suppliers
63
Project Stages and Cash Flow Estimation
Salvage Value and NWC Recovery– After-tax salvage value = Asset selling
price – t (selling price – book value)– Project’s NWC may be assumed to be
liquidated (converted to cash) and returned to the firm as a cash flow
64
Project Stages and Cash Flow Estimation
Salvage value example. Asset purchased for $100; depreciation of $10/year. Sold in year 7. Book value will be $30. Tax rate is 25%.
After-tax salvage value if selling price is $50: $50 – .25 ($50-30) = $45
After-tax salvage value if selling price is $30: $30 – .25 ($30-30) = $30
After-tax salvage value if selling price is $10: $10 – .25 ($10-30) = $15
65
Project Stages and Cash Flow Estimation
If project is expected to continue indefinitely:
Estimate operating cash flows for several years and then estimate its “going concern value” using the constant dividend (cash flow) growth model:
Dividendtime t+1
Valuetime t = ----------------------- r - g
66
Example: Revenue-Expanding Project
Initial outlay:
t = 0
Depreciable Outlays ‑$4.5
Expensed Cash Outlays, after tax ‑0.4
‑‑‑‑‑‑‑
‑$4.9
67
Annual Project Income Statement years 1-5
Sales $3.000
-Costs -0.635
-Depreciation -0.900
EBT $1.465
-Taxes (40%) -0.586
Net income $0.879
68
OCF estimatestax rate = 40%
Year 1 Year 2-4 Year 5Saless $3.000 $3.000 $3.000 -Cost -$0.635 -$0.635 -$0.635 -Depreciation -$0.900 -$0.900 -$0.900SUM $1.465 $1.465 $1.465 x (1-t) $0.879 $0.879 $0.879+Depreciation $0.900 $0.900 $0.900 -change NWC -$0.100 $0.000 $0.100Operating CF $1.679 $1.779 $1.879
69
Salvage Value
Market value in year 5 of project assets: $1 million
They will be fully depreciated at that time. After-tax salvage value = Asset selling
price – t (selling price – book value) = $1 million – (0.40)($1 million-0) = $0.600 million
70
Cash Flow Summary Initial Operating Salvage Total
Year Outlay Cash Flows Value Incremental Cash Flows
0 $-4.9 $ 0.000 $ 0.0 $-4.90 1 0.0 1.679 0.0 1.679 2 0.0 1.779 0.0 1.779 3 0.0 1.779 0.0 1.779 4 0.0 1.779 0.0 1.779 5 0.0 1.879 0.6 2.479At 10%, NPV = $2.20 million
71
Other Examples
Cost-saving project Setting a minimum bid price on a
project so NPV=0 Tables, data in textbook