Upload
hamza-khan
View
226
Download
0
Embed Size (px)
Citation preview
8/13/2019 The Basics of Capital Budgeting.13-14st
1/36
1
The Basics of Capital Budgeting:
Evaluating and Estimating Cash
FlowsCorporate FinanceDr. A. DeMaskey
Should we
build this
plant?
8/13/2019 The Basics of Capital Budgeting.13-14st
2/36
2
Learning Objectives
Questions to be answered:
What is capital budgeting?
How are investments classified?What methods are used to rank projects?
What are the relevant cash flows of a project?
What principles underlie the estimation of cashflows?
What types of cash flows must be considered whenevaluating a proposed project?
8/13/2019 The Basics of Capital Budgeting.13-14st
3/36
3
Capital Budgeting
Investment decision making process, which involvesfixed assets.
Capital
Capital budget
Long-term decisionsSizable cash outlays
Difficult to reverse Important to firms future
Profitability
Growth and Survival
Future direction
8/13/2019 The Basics of Capital Budgeting.13-14st
4/36
4
The Five Stages of Capital
Budgeting
Stage 1: Investment screening and selection
Stage 2: Capital budgeting proposal
Stage 3: Budget approval and authorization
Stage 4: Project tracking
Stage 5: Post completion audit
8/13/2019 The Basics of Capital Budgeting.13-14st
5/36
5
Project Classification
According to economiclife:
Short-term
Long-term
According to risk:Replacement projects
Expansion projectsNew products andmarkets
Mandated projects
According to dependence on
other projects:
Independent projectsMutually exclusive projects
Contingent projects
Complementary projects
According to cash flows:
Normal cash flow projects
Nonnormal cash flow projects
8/13/2019 The Basics of Capital Budgeting.13-14st
6/36
6
Steps
1. Estimate the CFs (inflows & outflows).
2. Assess the riskiness of the CFs.3. Determine the appropriate discount rate, k =
WACC for project.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
8/13/2019 The Basics of Capital Budgeting.13-14st
7/367
Investment Evaluation
Techniques
Payback Period (PB)
Discounted Payback
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)Modified Internal Rate of Return (MIRR)
8/13/2019 The Basics of Capital Budgeting.13-14st
8/368
Characteristics of an Evaluation
Technique
Considers all future incremental cash flows from
a project.
Considers the time value of money.
Considers the uncertainty associated with future
cash flows.
8/13/2019 The Basics of Capital Budgeting.13-14st
9/369
Payback Period
The length of time it takes to recover the initial
investment outlay.
Equal cash flows
Unequal cash flows
Payoff or capital recovery period
8/13/2019 The Basics of Capital Budgeting.13-14st
10/3610
Evaluation of Payback Period
Strengths
Provides an indication of a projects risk and
liquidity.Easy to calculate and understand.
Weaknesses
Ignores the TVM.Ignores CFs occurring after the payback period.
8/13/2019 The Basics of Capital Budgeting.13-14st
11/3611
Discounted Payback Period
Uses discounted rather than raw CFs.
The length of time it takes to recover the
projects investment in terms of discounted cashflows, where the discount rate is the cost of
capital.
8/13/2019 The Basics of Capital Budgeting.13-14st
12/3612
Evaluation of Discounted
Payback Period
Strengths
Considers the time value of money.
Considers the riskiness of the cash flows involved inthe payback.
Weaknesses
Requires estimate of cost of capital.Ignores cash flows beyond the payback.
8/13/2019 The Basics of Capital Budgeting.13-14st
13/36
13
Net Present Value (NPV)
The sum of the present value of all expected
cash flows, where the discount rate is the cost of
capital.
Cost often is CF0and is negative.
NPV CF
kt
nt
t 0 1 .
.CFk1CF
NPV0t
t
n
1t
8/13/2019 The Basics of Capital Budgeting.13-14st
14/36
14
Rationale for NPV Method
NPV = PV inflowsCost
= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually exclusive projects on
basis of higher NPV. Adds most value.
8/13/2019 The Basics of Capital Budgeting.13-14st
15/36
15
Evaluation of NPV
Strengths
Tells whether firm value is increased.
Considers all cash flows.Considers the time value of money.
Considers the riskiness of future cash flows.
WeaknessesRequires estimate of cost of capital.Expressed in terms of dollars, not as a percentage.
8/13/2019 The Basics of Capital Budgeting.13-14st
16/36
16
Net Present Value Profile
Graphical depiction of the NPV for different
discount rates.
Downward sloping
Slightly curved
Crossover discount rate
8/13/2019 The Basics of Capital Budgeting.13-14st
17/36
17
Profitability Index (PI)
Ratio of the present value of the change in
operating cash flows to the present value of the
investment cash outflow.
PI vs. NPV
0
1 1
CF
k
CF
PI
n
t
t
t
8/13/2019 The Basics of Capital Budgeting.13-14st
18/36
18
Rationale for PI Method
PI = PV inflows / Cost
= Benefit-cost ratio
Accept project if PI > 1
Useful in case of capital rationing
8/13/2019 The Basics of Capital Budgeting.13-14st
19/36
19
Evaluation of PI Method
Strengths
Tells whether firm value is increased.
Considers all cash flows.Considers the time value of money.
Considers the riskiness of future cash flows.
WeaknessesRequires estimate of cost of capital.May not give correct decision for mutually exclusiveprojects.
8/13/2019 The Basics of Capital Budgeting.13-14st
20/36
20
Internal Rate of Return
The discount rate that forces PV inflows = cost. This isthe same as forcing NPV = 0.
NPV: Enter k, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
Annualized yield on an investment.
t
nt
t
CF
kNPV
0 1 .
tn
t
tCFIRR
0 1 0.
8/13/2019 The Basics of Capital Budgeting.13-14st
21/36
21
Rationale for IRR Method
If IRR > WACC, then the projects rate of return
is greater than its cost -- some return is left over
to boost stockholders returns.Example: WACC = 10%, IRR = 15%. Profitable.
IRR acceptance criteria:
If IRR > k, accept project.
If IRR < k, reject project.
8/13/2019 The Basics of Capital Budgeting.13-14st
22/36
22
IRR vs. NPV
Ranking conflict for mutually exclusive projects
Reinvestment rate assumption
NPV assumes reinvest at k (opportunity cost of capital). IRR assumes reinvest at IRR.
Reinvest at opportunity cost, k, is more realistic, so NPVmethod is best. NPV should be used to choose betweenmutually exclusive projects.
Causes: Different timing in cash flows
Scale differences
8/13/2019 The Basics of Capital Budgeting.13-14st
23/36
23
Evaluation of IRR Method
StrengthsTells whether firm value is increased.
Considers all cash flows.
Considers the time value of money.Considers the riskiness of future cash flows.
WeaknessesRequires estimate of cost of capital.
May not give value-maximizing decisions for mutually exclusiveprojects.
May not give value-maximizing decisions under capital rationing.
May produce multiple IRRs.
8/13/2019 The Basics of Capital Budgeting.13-14st
24/36
24
Modified Internal Rate of Return
(MIRR)
The discount rate which causes the PV of a
projects terminal value (TV) to equal the PV of
costs. TV is found by compounding inflows atWACC.
The internal rate of return on a project assuming
that cash inflows are reinvested at somespecified rate.
8/13/2019 The Basics of Capital Budgeting.13-14st
25/36
25
MIRR vs. IRR
MIRR correctly assumes reinvestment at
opportunity cost = WACC. MIRR also avoids the
problem of multiple IRRs.Managers like rate of return comparisons, and
MIRR is better for this than IRR.
8/13/2019 The Basics of Capital Budgeting.13-14st
26/36
26
Evaluation of MIRR Method
StrengthsTells whether firm value is increased.
Considers all cash flows.
Considers the time value of money.
Considers the riskiness of future cash flows.
Weaknesses
May not give value-maximizing decisions for mutuallyexclusive projects.
May not give value-maximizing decisions under capitalrationing.
8/13/2019 The Basics of Capital Budgeting.13-14st
27/36
27
Capital Budgeting in Practice
IRR is most commonly used. Managers like
rates -- prefer IRR to NPV comparisons.
More than one evaluation technique is used.
NPV is used most often.
8/13/2019 The Basics of Capital Budgeting.13-14st
28/36
28
Principles of Estimating Cash
Flows
Incremental Cash Flows
After-Tax Cash Flows
Ignore Sunk Costs
Include the Opportunity Cost
Include Externalities
8/13/2019 The Basics of Capital Budgeting.13-14st
29/36
29
Assumptions
End-of period cash flows
Project assets are purchased and put to work
immediately
Equally-risky cash flows
8/13/2019 The Basics of Capital Budgeting.13-14st
30/36
30
Types of Cash Flows
Initial Investment Outlay
Operating Cash Flows
Terminal Cash Flows
Net Cash Flows
8/13/2019 The Basics of Capital Budgeting.13-14st
31/36
31
0 1 2 3 4
Initial
Outlay
OCF1 OCF2 OCF3 OCF4
+ TerminalCF
NCF0 NCF1 NCF2 NCF3 NCF4
Project Cash Flows
8/13/2019 The Basics of Capital Budgeting.13-14st
32/36
32
Net Investment
Cost of Asset
+ Shipping Costs
+ Installation CostsPLUS
Increase/decrease in Working Capital
8/13/2019 The Basics of Capital Budgeting.13-14st
33/36
33
Operating Cash Flows
Method 1:
DOCF = (DR -DE - DD)(1 - T) + DD
Method 2:DOCF = (DR - DE)(1 - T) + DDT
8/13/2019 The Basics of Capital Budgeting.13-14st
34/36
34
Terminal Cash Flows
Funds Realized from Sale of New Asset
+ Tax Consequences from the Sale of
the Asset
PLUS
Recovery of Net Working Capital
8/13/2019 The Basics of Capital Budgeting.13-14st
35/36
35
Real vs. Nominal Cash Flows
In DCF analysis, k includes an estimate of
inflation.
If cash flow estimates are not adjusted forinflation (i.e., are in todays dollars), this will bias
the NPV downward.
This bias may offset the optimistic bias ofmanagement.
8/13/2019 The Basics of Capital Budgeting.13-14st
36/36
Multinational Capital Budgeting
Foreign operations are taxed locally, and then
funds repatriated may be subject to U.S. taxes.
Foreign projects are subject to political risk.
Funds repatriated must be converted to U.S.
dollars, so exchange rate risk must be taken into
account.