Capital Budgeting Models

Handouts for Corporate Finance 1 Capital Budgeting Introduction

A logical prerequisite to the analysis of investment opportunities is the creation of investment opportunities. Unlike the field of investments, where the analyst more or less takes the investment opportunity set as a given, the field of capital budgeting relies on the work of people in the areas of industrial engineering, research and development, and management information systems (among others) for the creation of investment opportunities. As such, it is important to suggest that students keep in mind the importance of creativity in this area, as well as the importance of analytical techniques. Because a project is financially sound, it must be ethically sound, right? Well . . . the question of ethical appropriateness is less frequently discussed in the context of capital budgeting than that of financial appropriateness. Consider the following simple example: The American Association of Colleges and Universities estimates that 10 percent of all college students cheat at some time during their postsecondary education careers. You might pose the ethical question of whether it would be proper for a publishing company to offer a new book How to Cheat: A User's Guide. The company has a cost of capital of 8% and estimates it could sell 10,000 volumes by the end of year one and 5,000 volumes in each of the following two years. The immediate printing costs for the 20,000 volumes would be $20,000. The book would sell for $7.50 per copy and net the company a profit of $6.00 per copy after royalties (which would, of course, be quite small!), marketing costs, and taxes. Year one net would be $60,000. From a capital budgeting standpoint, is it financially wise to buy the publication rights? What is the payback of this investment? (Payback = $20,000/$60,000 = .33 years). The project has a quick payback - looks good, right? Now ask the class if the publishing of this book would encourage cheating and if the publishing company would want to be associated with this text and its message. Some students may feel that one should accept these profitable investment opportunities while others might prefer that the publication of this profitable text be rejected due to the behavior it could encourage. Although the example is admittedly simplistic, this type of issue is not particularly uncommon in real life.

Generating Ideas for Capital Budgeting

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Project Classification
Replacement: Maintenance of Business Replacement: Cost Reduction Expansion of Existing Products or Markets Expansion into New Markets Safety and Environmental Projects Other

Similarities between Capital Budgeting and Security Valuation

NPV Gordon Model IRR Bond Model

Capital Budgeting requires 3 components:

The Models The Cash Flows The WACC The Models: NPV: IRR Payback Accept the project if the NPV is positive. Accept the highest positive NPV when analyzing mutual exclusive projects. Accept the project if the IRR is greater than the WACC. The IRR model can provide conflicting results when analyzing mutual exclusive projects. Accept the project if the payback is less than a predetermined limit.

We evaluate each model using the following criteria: NPV Does the model consider TVM? Does the model consider risk? Does the model provide information on whether we are creating value for the firm? IRR Payback

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Payback Period Payback period-length of time until the accumulated cash flows equal or exceed the original investment. Payback period rule-investment is acceptable if its calculated payback is less than some prespecified number of years. Advantages Easy to understand Adjusts for uncertainty of later cash flow Biased toward liquidity Disadvantages Ignores time value of money Doesn't consider risk differences How to determine the cutoff point Biased against long-term projects Ignores cash flow beyond payback period

Teaching the payback rule seems to put one in a delicate situation, the rule is a flawed indicator of project desirability, at best. And yet, surveys continue to suggest that it is widely used by practitioners. How does one explain this apparent discrepancy between theory and practice? While the payback rule is widely used in practice, it is not often the only measure of desirability used; rather, it is typically used in conjunction with one of the other "better" (i.e., DCF) rules. As William Baumol pointed out in the early 1960s, the payback rule serves as a crude "risk screening" device - the longer one's funds are "out there", the greater the likelihood, they will not be returned, all else equal. The payback technique is particularly useful in comparing mutually exclusive projects. Given two similar projects, the one which returns the initial investment sooner is likely to be (though certainly not always) the better project. Simple to use (mostly by ignoring the long run) - Bias for short-term promotes liquidity - Can be adjusted for risk in some sense (altering the cutoff) Interestingly, enough, the payback period technique is used quite heavily in determining the viability of certain investment projects in the health care industry. Why? Consider the nature of the health care industry: the technology is rapidly changing, some of the equipment (e.g., magnetic resonance imaging - MRI - machines) tends to be extremely expensive, and the industry itself is increasingly competitive. What this means is that, in many cases, an equipment purchase is complicated by the fact that, while the machine may be able to perform its function for, say, 6 years or more, new and improved equipment is likely to be

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developed (and announced in the press) which will supersede the 'old' equipment long before its useful life is over. Demand from patients and physicians for 'cutting edge technology' can drive a push for new investment. In the face of such a situation, many hospital administrators then focus on how long it will take to recoup the initial outlay, in addition to the NPV and IRR of the equipment. The payback period can be interpreted as a naive form of discounting if we consider the class of investments with level cash flows over arbitrarily long lives. Since the present value of a perpetuity is the payment divided by the discount rate, a payback period cut-off can be seen to imply a certain discount rate. That is, Cost/annual cash flow = payback period cut-off Cost = annual cash flow x payback period cut-off. Since the PV of a perpetuity is: PV = annual cash flow x (1/r), the correspondence between the discount rate, r, and the payback period cut-off is obvious. The longer the payback period, the lower the implied value of r, and vice versa. Consider the manufacture of oilfield equipment. The firm had plants in several politically unstable countries (e.g., Libya and Venezuela). Because of the possibility that the firm's assets would be confiscated by foreign governments via "nationalization" at any given time, the firm was quite concerned with how long the foreign plants would have to operate before they "paid themselves back". Thus, the payback period approach was heavily relied upon as a decision tool. In these cases, the term cash flow "cut-off" was taken literally!

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Net Present Value Here's another perspective on the meaning of NPV. If we accept a project with a negative NPV of -$2,422, this is financially equivalent to investing $2,422 today and receiving nothing in return. Therefore, the total value of the firm would decrease by $2,422. This, of course, assumes that the various components (cash flow estimates, discount factor, etc.) used in the computation are correct. In practice, financial managers are rarely presented with zero-NPV projects for at least two reasons. First, in an abstract sense, zero is just another of the infinite number of values the NPV can take; as such, the likelihood of obtaining any particular number is small. Second, (and more pragmatically), in most large firms, capital investment proposals are submitted to the Finance group from other areas (e.g., the industrial engineering group) for analysis. Those submitting proposals recognize the ambivalence associated with zero NPVs and are less likely to send them to the Finance group in the first place. Conceptually, a zero-NPV project earns exactly its required return. Assuming that risk has been adequately accounted for, investing in a zero-NPV project is equivalent to purchasing a financial asset in an efficient market. In this sense, one would be indifferent between the capital expenditure project and the financial asset investment. Further, since firm value is completely unaffected by the investment, there is no reason for shareholders to prefer either one. However, several real-world considerations make comparisons such as the one above difficult. For example, adjusting for risk in capital budgeting projects can be problematic. And, some investment projects may be associated with benefits that are difficult to quantify, but exist, nonetheless. (Consider, for example, an investment with a low or zero NPV but which enhances a firm's image as a good corporate citizen.) Additionally, the secondary market for most physical assets is substantially less efficient than the secondary market for financial assets. While, in theory, one could adjust for differences in liquidity, the adjustment is, again, problematic. Finally, some would argue that, all else equal, some investors prefer larger firms to smaller; if true, investing in any project with a nonnegative NPV may be desirable.

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Internal Rate of Return Internal rate of return (IRR) is the rate that makes the present value of the future cash flows equal to the initial cost or investment. In other words, it is the discount rate that gives a project a $0 NPV. IRR rule-the investment is acceptable if its IRR exceeds the required return. Assume: To comply with the Air Quality Control Act of 1989, a company must install three smoke stack scrubber units to its ventilation stacks at an installed cost of $355,000 per unit. An estimated $100,000 per unit could be saved each year over the five-year life of the ventilation stacks. The cost of capital is 14% for the firm. The analysis of the investment results in a NPV of -$11,692. Despite the financial assessment dictating rejection of the investment, public policy might suggest acceptance of the project. By fiat, certain types of pollution controls are required. But should the firm exceed the minimum legal limits and be responsible for the environment, even if this responsibility leads to a wealth reduction for the firm? Is environmental damage merely a cost of doing business? Could investment in a healthier working environment result in lower long-term costs in the form of lower future health costs? If so, might this decision result in an increase in shareholder wealth? Notice that if the answer to this second question is yes, it suggests that our original analysis omitted some side benefits to the project. Advantages People seem to prefer talking about rates of return to dollars of value. NPV requires a market discount rate; IRR relies only on the project cash flows. Disadvantages Nonconventional cash flows- Multiple rates of return-if cash flows alternate back and forth between positive and negative (in and out), more than one IRR is possible. NPV rule still works just fine. Also,if the cash flows are of loan type, meaning money in at first and cash out later, the IRR is really a borrowing rate and lower is better. The IRR is sometimes called the IBR (internal borrowing rate) in this case. Mutually exclusive investment decisions-if taking one project means another is not taken, the projects are mutually exclusive. The IRR can provide conflicting rankings when mutual exclusive projects are analyzed.

Comparison of the NPV and IRR Methods

NPV Profiles Net present value profile is a graph of an investment's NPV at various discount rates. The graph illustrates the NPV changes as the cost of capital changes. The IRR is not a function of the cost of capital.

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Conclusions on Capital Budgeting Methods

Capital budgeting decisions are analyzed using computer programs and it is easy to calculate all of the measure we have talked about. Although NPV is a strong model, the other models provide information that is useful. Payback and discounted payback provide an indication of the risk and liquidity of a project. The longer the payback means that the investment dollars will be tied up for more years, therefore the project is relative illiquid. In addition, the longer payback indicates that project cash flows must be forecast far into the future increasing the risk of the project. NPV is important because it gives a direct measure of the dollar benefit of the project to the shareholders. This makes NPV the best single measure of profitability. IRR is a measure of profitability, but it is expressed as a rate of return. IRR provides a measure of a projects safety margin. Consider the following two projects. Time 0 1 NPV IRR Project S Cash Flow -$10,000 16,500 $5,000 65.0% Project L Cash Flow -$100,000 115,500 $5,000 15.5%

There is a greater margin of error for Project S relative to L and the IRR provides an indication safety margin.

Business Practices
All large firms use some type of DCF method. It is common practice among large firms to employ a discounted cash flow technique such as IRR or NPV along with payback period or average accounting return. It is suggested that this is one way to resolve the considerable uncertainty over future events that surrounds estimating the NPV. Payback method is used in many large firms, but is not the primary method. Most companies give the greatest weight to a DCF method. IRR is the most used method with NPV a close second. Most firms calculate a WACC. A few use the same WACC for every project, but most adjust the WACC to reflect the project risk Small companies do not use DCF models to the extent of large companies. The use of various financial incentives (e.g., reduction or elimination of property taxes for ten or more years) to induce firms to locate (i.e., invest) in a given municipality raises some interesting issues in the capital budgeting area. From the viewpoint of the firm's analysts, how does one estimate the impact of such incentives? A reduction in the initial outlay? Increases in future cash inflows? And what discount rate should
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be assigned to these tax reductions? Are these promises riskless? And what about the municipal officials who offer such incentives? Stated reasons are typically related to 'employment growth,' or 'increased economic activity.' But, from a capital budgeting standpoint, have you ever seen a fully developed cash flow analysis of the stated benefits relative to the costs? Consider the following example taken from a Federal Reserve publication. "Alabama offered Mercedes-Benz a package valued at more than the cost of the plant itself. To lure the $300 million plant, with about 1,500 jobs, the state promised to buy the site for $30 million, and lease it to Mercedes for $100. Surrounding communities will contribute an additional $5 million each, and the University of Alabama will offer German language and culture classes to the children of plant employees. On top of this, the state will provide a package of tax breaks valued at more than $300 million, which will, among other things, allow the plan to be paid for with money that would have been paid to the state." Several of the incentives described above directly affect the costs and the benefits of the proposed project, and would have to be accounted for in the capital budgeting analysis performed by Mercedes. However, the other side of the coin is that state officials should perform their own capital budgeting analysis - they too are incurring economic costs in the hope for future benefits. But at least one aspect is different: when the corporate decision-maker makes a poor investment, shareholders suffer. When the state's decision-makers foul up, all of the residents of the state suffer. Thus, the ethics of the capital budgeting decision come into play more clearly in the latter case. Situations like this provide a good springboard for discussions not only of the financial aspects of capital budgeting, but also related issues. While uncertainty about inputs and interpretation of the outputs help explain why multiple criteria are used to judge capital investment projects in practice, another reason is managerial performance assessment. When managers are judged and rewarded primarily on the basis of periodic accounting figures (quarterly profits, annual earnings, etc.), there is an incentive to evaluate projects with methods such as payback or average accounting return. On the other hand, when compensation is tied to firm value, it makes more sense to use NPV as the primary decision tool.

The Post-Audit
The post-audit is an important aspect of the capital budgeting process. The firm compares actual results with the forecast and explains any differences. Many firms require monthly reports for an initial time period followed by quarterly reports. The purpose of the post audit is: Improve Forecasts When individuals tend to be more diligent when they know the results of their efforts will be compare to actual results. Biases are observed and eliminated; new techniques are test and incorporated when appropriate when these actions are monitored.

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Improve Operations When a division has made a forecast and undertaken a project, their reputation is at risk. If costs are above projections and sales are below projection, the division can and will make an effort to bring the results into line with the forecasts.

This is not a simple process. There are many inputs to the cash flow forecast and each is subject to uncertainty. A number of projects will be disappointing. This must be considered when evaluating the managers performance. Projects can fail to meet expectations for reasons beyond the control of the operating executives. It is often difficult to separate the operating results of one project from those of a larger system. A few projects are stand alone types, but most projects are interrelated. Example: computer systems The individuals responsible for initiating a project may have moved on before the results are known. Many firms downplay the importance of a post audit because of these problems, but firms that have post-audits tend to be the more successful organizations.

Using Capital Budgeting in Other Contexts

Capital budgeting techniques can be applied to a number of different types of decisions. Mergers and Acquisitions Downsizing Sale of assets

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Examples:
Independent Projects Project A and B have the following cash flows: Year 0 1 2 A 500 325 325 B 400 325 200

Which project do we accept using the IRR model when the cost of capital is 10 percent? Year 0 1 2 Cpt. IRR Which project do we accept using the NPV model when the cost of capital is 10 percent? Year 0 1 2 I Cpt. NPV Project A CF0 CF1 CF2 500 325 F1 1 325 F2 1 I 0 10 19.4 3 20 NPV A -500 325 325 10% B -400 325 200 10% A -500 325 325 B -400 325 200

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Project B CF0 CF1 CF2 400 325 F1 1 200 F2 1 I 0 10 20 22.1 7

$200.00

NPV

$150.00

$100.00

$50.00

$0.00 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24 0.25

($50.00) Project A Project B

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Mutually Exclusive Projects Project A and B have the following cash flows: Year 0 1 2 A 500 325 325 B 400 325 200

Which project do we accept using the IRR model? Year 0 1 2 Cpt. IRR Which project do we accept using the NPV model when the cost of capital is 10 percent? Year 0 1 2 I Cpt. NPV I am confused, which project do we accept? Perhaps drawing the NPV Profile will help. Project A CF0 CF1 CF2 500 325 F1 1 325 F2 1 I 0 10 19.4 3 NPV A -500 325 325 10% B -400 325 200 10% A -500 325 325 B -400 325 200

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20 Project B CF0 CF1 CF2 400 325 F1 1 200 F2 1 I 0 10 20 22.1 7

$200.00

NPV

$150.00

$100.00

$50.00

$0.00 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24 0.25

($50.00) Project A Project B

The point where the profiles cross is called the crossover point or crossover rate. How can we calculate it?

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We calculate the delta project and calculate the IRR of the delta project. A 0 1 2 -500 325 325 B -400 325 200 Delta

Lets look at the NPV Profile of Projects A, B, and the Delta Project:
$200.00

$150.00

$100.00

$50.00

$0.00 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24 0.25

($50.00) Proj A Proj B Delta Project

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Non-Normal Cash Flows 1. Project A has the following cash flows: 0 1 2 3 -$90,000 $132,000 $100,000 -$150,000

How many IRRs does this project have? Calculate the IRRs. CF0 CF1 CF2 CF3 -90,000 132,000 100,000 150,000 F1 1 F2 1 F3 1 I 0 1 0 2 0 3 0 I 12% 4 0 5 0 NPV

CPT NPV CPT IRR

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NPV $4,000.00

$2,000.00

$0.00
0 0. 02 0. 04 0. 06 0. 08 0. 1 0. 12 0. 14 0. 16 0. 18 0. 2 0. 3 0. 32 0. 34 0. 36 0. 38 0. 4 0. 42 0. 44 0. 46 0. 48 0. 22 0. 24 0. 26 0. 28 0. 5

($2,000.00)

($4,000.00)

($6,000.00)

($8,000.00)

($10,000.00) NPV

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