Notes on Capital Budgeting

I. CAPITAL BUDGETING METHODS.

A. Payback method. Number of years to recover the investment amount. 1. Example: Project A Project B Investment ($1000) ($1000) Year 1 $500 $100 Year 2 400 200 Year 3 300 300 Year 4 200 400 Year 5 100 500 Year 6 10 600 Year 7 10 0 2. Decision rule: Accept project if the payback years < years set by corporate policy 3. Problems with payback method a) Ignores income beyond payback period. b) Does not account for time value of money. B. Net Present Value method. Find the present value of future cash flows then subtract the initial investment amount. 1. Example: Project C Project D Investment ($1000) ($1000) PV factor @ 10% PV Year 1 $500 .9091 =454.55 $100 Year 2 400 .8264 =330.56 200 Year 3 300 .7513 =225.39 300 Year 4 100 .6830 = 68.30 400 Year 5 10 .6209 = 6.21 500 Year 6 10 .5645 = 5.65 600 PV = 1091 PV = 1404 -Inv = 1000 NPV = 91 2. Decision rule: If independent project: Accept project if NPV > 0 Reject project if NPV < 0 If mutually exclusive project: Accept the project with the highest NPV C. Internal Rate of Return (IRR): That rate of return which makes the NPV of the future cash flows equal to zero.

1.

Example: Use trial and error or your financial calculator Project C ($1000) PV factor @ 10% PV $500 .9091 =454.55 400 .8264 =330.56 300 .7513 =225.39 100 .6830 = 68.30 10 .6209 = 6.21 10 .5645 = 5.65 PV = 1091 -Inv = -1000 NPV = 91

Investment

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

$500 400 300 100 10 10

PV factor @ 15% .8696 = 434.80 .7561 = 302.44 .6575 = 197.25 .5718 = 57.18 .4972 = 4.97 .4323= 4.32 PV = 1000 -Inv = -1000 $ 0

2. Decision rule: If independent projects: Accept if IRR > opportunity cost of capital Reject if IRR < opportunity cost of capital If mutual exclusive projects: Accept the project with the highest IRR. 3. Problems with IRR methods. a) Size problem if projects are mutually exclusive: Project Large Project Small Investment ($1.0 million) ($1.00) Year 1 CF $1.25 million $1.50 Using IRR Using NPV @ 10% rate b) Multiple solutions problem. Project Investment: ($22) Yrs 1 4 +$15 Yr 5 -$40 IRR = 6% and 28% Suppose opportunity cost of capital is 10%?

c)

Reinvestment Assumption: The IRR implicitly assumes that all future cash flows from the project are reinvested at the IRR rate of return. The NPV implicitly assumes that all future cash flows are reinvested at the opportunity cost of capital.

If projects are mutually exclusive, the IRR assumption will lead to conflicting decisions compared to the NPV.

II.

Capital Budgeting Issue - PROJECTS WITH DIFFERENT LIVES.

A. Example: Machine 1 (M1) Investment ($1000) Years 1 6 $400 Year 6 Year 7 12 NPV @ 10% NPV(M1) =$742 NPV(M1+M1*) = $1048 M1* Machine 2 (M2) ($1800) $400 $400 NPV(M2) =$926

($1200) $400

B. Main issue: 1. The important point is that it is not the life of the machine that dictates the investment decision, but the investment horizon of what the machine is used for. For example, if this machine is used to produce Pokemon cards, we must decide on which machine to invest in based on how long we expect the Pokemon craze to last. 2. Alternatively for a high tech firm, it is important to decide how long their latest product will be marketable before it becomes obsolete. For the investment decision we will consider the sale of the production machine at the 3 year point or put it to other use.

3. An Alternative Method. Use EAC (Equivalent Annual Cost) to evaluate machines with different lives. EAC is defined as an annuity cash flow that is equivalent to the NPV of a project. It is calculated as: EAC = PV of cost / (PV of annuity at k% for the life of machine) where k% is the opportunity cost of capital. Annuity of the NPV(M1) = $1000 / (PV of annuity at 10% for 6 yrs) = $1000 / (4.355) = $229.62 Calculate the annuity of the NPV(M2) = $ Think of EAC as the RENTAL COST if you were to rent (or lease) the machine instead of purchasing it. Choose the machine that is less costly.

Try another problem: Machine A Cost of machine $15 Cost to maintain In year 1 $ 4 In year 2 4 In year 3 4

Machine B $10 $ 6 6 0

III. INCREMENTAL CASH FLOW ANALYSIS FOR CAPITAL BUDGETING A. Existing firm Sales $10,000 - CofGS 4,000 Gross Profits $ 6,000 - Operating Exp - 1,000 - Depreciation Exp 1,000 Operating Profits $ 4,000 - Interest Exp ------Profits Bef taxes $ 4,000 Taxes (40%) -1,600 PAT $ 2,400 New product $1,000 300 $ 700 - 300 - 200 $ 200 ----$ 200 - 80 $ 120

Incremental Cash Flow = PAT + Depreciation Exp = (1-T)[Sales-CoGS-OE-D] + D = (1 - T)[Sales - CoGS-OE] - (1-T)D + D -D +TD +D Incremental Cash Flow = CF= (1-T)[Sales - CoGS - OE] + TD B. Additional Net Working Capital Existing firm New product Accounts Receivable $4,000 $ 100 Inventory 5,000 600 Accounts Payable 6,000 $3,000 300 $ 400

C. EXCLUDE: Research & Development, Test marketing, Survey, etc. that are SUNK COST or costs that are irreversible. D. INCLUDE: Indirect (or incidental costs/benefits) effects that could arise because of the NEW PRODUCT.

E. INCLUDE: Opportunity Costs such as opportunity cost of leasing land or building if project is rejected. 1. Example: WRONG WAY TO COMPARE is to look at before & after project. Before Take Project Firm owns land After Firm still owns land CF before vs after $0

2. CORRECT WAY TO COMPARE is with or without project: Before Take Project Firm owns land Before Rejects Project Project Firm owns land 3. Another example: EROSION If SUN Microsystems introduces SUN4 it will erode the sale of SUN3. Before Take on Sun4 Sun sells $1m SUN3 Before Rejects Sun4 Sun sells $1m SUN3 After Sun sells $0.5 m SUN3 CF with SUN4 ($0.5 m) After Firm still owns land After CF with Project $0 CF w/o

Firm sells land for $1mil $1 mil Incremental CF = +$1 mil

After CF without SUN4 Sun sells $0.5 m SUN3 ($0.5 m) (Apollo's Domain4000) technological advancement takes SUN3's mkt share) Incremental CF = $ 0 m

4. KEY QUESTION: Will this cost/benefit exist only because of the Project? If your answer is NO then it is an irrelevant cost/benefit. If your answer is YES, then it is a relevant cost/benefit. The cost/benefit can be directly attributable to the Project

To answer the question above depends on: Barriers to entry: How costly is it for competitors to enter the "new" market? Competition: How competitive is the market for the "new" product? Substitutability: What other products can be substituted for the "new" product? If Barriers are very costly then EROSION is probably attributable to the new Project. If competition is fierce then EROSION is probably not attributable to the new Project. If substitutability is easy, then EROSION is probably not attributable to the new Project. F. INCLUDE Real overhead costs but not Accounting Allocated Overhead costs. G. INCLUDE: EXCESS CAPACITY using the EAC method. 1. Example 1: Suppose Sun has a silicon compression machine (SCM) that is used to manufacture Sun3. If Sun4 is produced, it will also use the SCM to produce it and will share the existing SCM. The SCM is a year old with a 5 year life and cost $100 million. Sun3 is using half of its SCM capacity and is expected to grow at 15% annually. A new SCM could be purchased for $150 million today. The new SCM would have a 5 year life and the opportunity cost is 10%. IF Sun3 and Sun4 are produced at the same time using the existing SCM, it will reach full capacity in 3 years. How should the excess capacity issue be resolved? STEP 1: Calculate EAC for the old SCM: EAC = PV of cost/[PV of AN, 10%, 5] STEP 2: Calculate EAC for the new SCM: STEP 3: Calculate the number of years it takes to reach full capacity with SUN3 only. 100 units (1+g)T = 200 units STEP 4: Determine the incremental cost if Sun4 is adopted. Again use the "With or without" principle. Year Only Sun3 Sun3&Sun4 0 1 2 3 4 5

Cost to Sun4 2. Example 2: Suppose a billing company, Bill-4-You, uses Computer A to provide a billing service to small businesses in a regional area. Computer A was purchased 2 years ago at the cost of $100,000 and has 5 year life (3 years left). The firm currently uses about 1/3 of its capacity for their current clients. Bill-4-You is considering a new client who is a medium sized firm and would use much of Computer A. In fact, if the new client is accepted, the firm will reach full capacity on Computer A in 3 years. Without the new client, the current clients of Bill-4-You will increase its billings at a rate of 10% per year. If a new computer is purchased to support a bigger client base, the firm would consider purchasing Computer B at a cost of $300,000 with a 7 year life. Discount rate is 8%. What are the relevant costs associated with the adoption of the new client. NOTE: The New Client is the New Project. STEP 1:

STEP 2: STEP 3:

STEP 4: Year 0 Only Old Clients Old & New Clients Cost to New Client 1 2 3 4 5