CHAPTER 10 & 11

The Basics of Capital Budgeting & Cash Flow Estimation

Should we build this plant?

10-1

Capital Budgeting Overview

Project Classifications Analysis Methods/Decision Rules Comparison of NPV & IRR Optimal Capital Budget

10-2

What is Capital Budgeting?

Long-term Strategic Decisions

Analysis of Future Cash Flows Large Expenditures (Fixed Assets) Basis for Future Growth
10-3

5 Steps to Capital Budgeting

1. 2.

Estimate CFs (inflows & outflows) Assess riskiness of CFs

3.
4. 5.

Determine the Risk-adjusted Cost of Capital

Find NPV and/or IRR (and other methods) Accept if NPV > 0 and/or IRR > WACC
10-4

Project Classifications

Replacement

Maintenance Cost Reduction

Expansion

Existing Products or Markets New Products or Markets

Safety or Environmental R&D (Long-term) Long-term Contracts (Specific Customers)

10-5

Major Capital Budgeting Methods

Payback ( + Discounted Payback) Discounted Cash Flow (DCF or NPV)

Internal Rate of Return (IRR)

Profitability Index (not used in practice) Modified Internal Rate of Return (MIRR)
10-6

Independent vs Mutually Exclusive Projects?

Independent projects if the cash flows of one are unaffected by the acceptance of the other.
Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other.
10-7

Normal vs Nonnormal cash flow streams?

Normal stream Negative CF followed by a series of positive CFs. 1 change of sign Nonnormal stream Two or more changes of sign Most common: Negative CF followed by positive CFs, then negative CF to terminate Nuclear Power, Toxic Waste
10-8

Payback Method

The number of years required to recover a projects cost, or How long does it take to get our money back? Calculated determining when the cumulative cash flow for the project turns positive.
10-9

Calculating Payback
Project L
CFt Cumulative
0
-100 -100

1
10 -90

2
60 -30

2.4
100 0

3 80 50

PaybackL
Project S

= 2 =
0

+
1

30 / 80 1.6
2

= 2.375 years
3 20 40

CFt Cumulative
PaybackS

-100 -100

70 -30

100 50 0 20

= 1 =

30 / 50

= 1.6 years
10-10

Strengths & Weaknesses of Payback

Strengths

Provides an indication of a projects risk and liquidity. Easy to calculate and understand.

Weaknesses

Ignores the time value of money

Discounted Payback Alternative

10-11

Ignores CFs occurring after the payback

Net Present Value (NPV) Method

Sum of the PVs of ALL cash inflows and outflows of a project:

NPV = CFt/(1 + r)t + CF0

OR
n

NPV
t 0

CFt t (1 r )
10-12

Project Ls NPV, r=10%

Year 0 1 2 3 CFt -100 10 60 80 NPVL = PV of CFt -$100 9.09 49.59 60.11 $18.79

NPVS = $19.98
10-13

Rationale for NPV

NPV= PV of inflows PV outflows (Cost) = Net gain in Wealth If projects are independent, accept if the project NPV > 0
If projects are mutually exclusive, accept projects with the highest positive NPV,

Accept S if mutually exclusive (NPVs > NPVL) & both if independent

10-14

Internal Rate of Return (IRR) Method

IRR is the discount rate that forces PV of inflows equal to costs. NPV = 0:

0
t

CFt t IRR ) 0 (1

IRRL = 18.13% and IRRS = 23.56%.

10-15

Project IRR vs Bond YTM

Same Concept YTM on the bond would be the IRR of the bond project EXAMPLE: Assume a 10-year bond with a 9% annual coupon sells for $1,134.20.

Solve for IRR = YTM = 7.08%

10-16

Rationale for IRR

If IRR > WACC, the Projects return is greater than its costs. There is excess Return left over to boost stockholders returns.

10-17

IRR Acceptance Criteria

If IRR > r, accept project. If IRR < r, reject project. If projects are independent, accept both projects, as IRR > r = 10% If projects are mutually exclusive, accept S, because IRRs > IRRL.
10-18

NPV Profiles

A graphical representation of project NPVs at various different costs of capital. r 0 5 10 15 20 NPVL $50 33 19 7 (4) NPVS $40 29 20 12 5
10-19

Drawing NPV profiles

NPV 60 ($)
50

. 40 .
30 20

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

10
0 5 -10

. .
15

20

. .

.
23.6

IRRS = 23.6%
Discount Rate (%)
10-20

Main Reasons why NPV & IRR Decisions may Conflict

Reinvestment Rate Assumptions are different

Size (scale) differences the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects Timing differences the project with faster payback provides more CF in early years for reinvestment. If r is high, early CF good, NPVS > NPVL.
10-21

Reinvestment Rate Assumptions

NPV method assumes CFs are reinvested at r, the opportunity cost of capital.
IRR method assumes CFs are reinvested at IRR.

Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects.
10-22

Profitability Index (PI)

PI is the Ratio of the PV of the Cash Inflows to the PV of Investment PI = [ [CFinflowt/(1+r)t]] CFinvest0

PIL = $158.1/$100 = 1.581

PIs = $159.7/$100 = 1.597

10-23

Optimal Capital Budget

Theory says to accept all positive NPV projects. Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects: An increasing Marginal Cost of Capital. Capital Rationing
10-24

Increasing Marginal Cost of Capital

Externally raised capital can have large flotation costs, which increase the cost of capital.
Investors often perceive large capital budgets as being risky, which drives up the cost of capital.
10-25

Capital Rationing

Capital rationing occurs when a company chooses not to fund all positive NPV projects. The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
10-26

Cash Flow Estimation

Estimating Relevant Cash Flows Adjusting for Inflation

10-27

Relevant Project Cash Flows

2 Cardinal Rules

Use Cash Flows NOT Accounting Income Use Incremental After-tax Cash Flows Opportunity Costs Externalities

Cash Flows Included

Cash Flows NOT Included

Finance Costs Sunk Costs

10-28

Example Project

Initial Investment

Depreciable Investment ($240,000) Changes in Working Capital ($20,000)

Operations (no inflation) New sales: 100,000 units/year @ $2/unit Variable cost: 60% of sales Life of the project Economic life: 4 years Depreciable life: MACRS 3-year class Salvage value: $25,000 Tax rate: 40% WACC: 10%

10-29

Determining Project Value

Estimate relevant Cash Flows

1
OCF1

0
Initial Invest NCF0

2
OCF2

3
OCF3

4
OCF4 + Terminal CFs NCF4
10-30

NCF1

NCF2

NCF3

Investment Cash Flows

Initial Investments (Depreciable Cost)

Equipment Ship/Installation Net Investment CF0 $200,000 40,000 $240,000

Change in Working Capital

Inventories Acct/Payables Net NOWC

$25,000 (Asset) $5,000 (Liability) $20,000

10-31

Annual Depreciation Expense

Year 1 2 3 4 Rate 0.33 0.45 0.15 0.07 1.00 x x x x x Basis $240 240 240 240 Depr $ 79 108 36 17 $240

Due to the MACRS -year convention, a 3-year asset is depreciated over 4 years.
10-32

Annual Operating Cash Flows

Revenues - Op. Costs (60%) - Depr Expense Oper. Income (EBIT) - Tax (40%) Oper. Income (AT)
1 2 3 4 200 200 200 200 -120 -120 -120 -120 -79 -108 -36 -17 1 -28 44 63 -11 18 25 1 -17 26 38

+ Depr Expense Operating CF

79 80

108 91

36 62

17 55
10-33

Terminal Cash Flow

Recovery of NOWC Salvage value Tax on SV (40%) Terminal CF $20,000 25,000 -10,000 $35,000

10-34

Estimated Project CFs (No Inflation)

0
-260

1
80

4
55 35 90 63

91 62 +Terminal CF -89 -27

CCF -260

-180

IRR & NPV at WACC = 10%.

NPV = -$4.01 million IRR = 9.28% Payback = 3.30 yrs

10-35

What if the expected Annual Inflation is 5%. Is NPV biased?

Yes, inflation included in the discount rate (WACC) Inflation NOT included in CFs
CFs should be adjusted for Inflation

10-36

Operating CFs, Inflation = 5%

Revenues Op. Costs (60%) - Depr Expense - Oper. Income (BT) - Tax (40%) Oper. Income (AT) + Depr Expense Operating CF
1 2 3 4 210 220 232 243 -126 -132 -139 -146 -79 -108 -36 -17 5 -20 57 80 2 -8 23 32 3 -12 34 48 79 108 36 17 82 96 70 65
10-37

Estimated Project CFs adjusted for Inflation

0
-260

1
82

2
96

3
70 Terminal CF

4
65 35 100

IRR & NPV at WACC = 10%.

NPV = $14.78 million. IRR = 12.56%. Payback = 3.12 yrs

10-38