The Basics of Capital Budgeting: Evaluating and Estimating Cash Flows Should we

Corporate Finance
Dr. A. DeMaskey build this plant?

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 cash flows? What types of cash flows must be considered when evaluating a proposed project?
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Capital Budgeting

Investment decision making process, which involves fixed assets.

Capital Capital budget

Long-term decisions
Sizable cash outlays Difficult to reverse

Important to firms future

Profitability Growth and Survival Future direction

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

Project Classification

According to economic life:

Short-term Long-term

According to dependence on other projects:

Independent projects Mutually exclusive projects Contingent projects Complementary projects

According to risk:
Replacement projects Expansion projects New products and markets Mandated projects

According to cash flows:

Normal cash flow projects Nonnormal cash flow projects
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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.
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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)

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.

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

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.

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Discounted Payback Period

Uses discounted rather than raw CFs.
The length of time it takes to recover the

projects investment in terms of discounted cash flows, where the discount rate is the cost of capital.

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Evaluation of Discounted Payback Period

Strengths

Considers the time value of money. Considers the riskiness of the cash flows involved in the payback.
Weaknesses

Requires estimate of cost of capital. Ignores cash flows beyond the payback.

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Net Present Value (NPV)

The sum of the present value of all expected

cash flows, where the discount rate is the cost of capital. n CFt NPV . t t 0 1 k Cost often is CF0 and is negative. n CFt NPV CF0 . t t 1 1 k
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Rationale for NPV Method

NPV =

PV inflows Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

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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.
Weaknesses

Requires estimate of cost of capital. Expressed in terms of dollars, not as a percentage.

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Net Present Value Profile

Graphical depiction of the NPV for different

discount rates.
Downward sloping Slightly curved Crossover discount rate

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Profitability Index (PI)

Ratio of the present value of the change in

operating cash flows to the present value of the investment cash outflow. n CFt t 1 k t 1 PI CF0 PI vs. NPV
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Rationale for PI Method

PI = PV inflows / Cost

= Benefit-cost ratio Accept project if PI > 1 Useful in case of capital rationing

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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.
Weaknesses

Requires estimate of cost of capital. May not give correct decision for mutually exclusive projects.
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Internal Rate of Return

The discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.
NPV: Enter k, solve for NPV. n CFt NPV. t t 0 1 k IRR: Enter NPV = 0, solve for IRR.

CFt 0. t t 0 1 IRR

Annualized yield on an investment.

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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.
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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 NPV method is best. NPV should be used to choose between mutually exclusive projects.

Causes:
Different timing in cash flows Scale differences
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Evaluation of IRR 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.

Weaknesses
Requires estimate of cost of capital. May not give value-maximizing decisions for mutually exclusive projects. May not give value-maximizing decisions under capital rationing. May produce multiple IRRs.
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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 at WACC. The internal rate of return on a project assuming that cash inflows are reinvested at some specified rate.
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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.

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Evaluation of MIRR 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.

Weaknesses
May not give value-maximizing decisions for mutually exclusive projects. May not give value-maximizing decisions under capital rationing.
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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.

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Principles of Estimating Cash Flows

Incremental Cash Flows
After-Tax Cash Flows Ignore Sunk Costs Include the Opportunity Cost Include Externalities

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Assumptions
End-of period cash flows
Project assets are purchased and put to work

immediately Equally-risky cash flows

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Types of Cash Flows

Initial Investment Outlay
Operating Cash Flows Terminal Cash Flows Net Cash Flows

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Project Cash Flows

0
Initial Outlay
NCF0

1
OCF1

2
OCF2

3
OCF3

4
OCF4
+ Terminal CF

NCF1

NCF2

NCF3

NCF4
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Net Investment

Cost of Asset + Shipping Costs + Installation Costs PLUS Increase/decrease in Working Capital

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Operating Cash Flows

Method 1:
DOCF = (DR -DE - DD)(1 - T) + DD

Method 2:

DOCF = (DR - DE)(1 - T) + DDT

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Terminal Cash Flows

Funds Realized from Sale of New Asset + Tax Consequences from the Sale of the Asset
PLUS Recovery of Net Working Capital

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Real vs. Nominal Cash Flows

In DCF analysis, k includes an estimate of

inflation. If cash flow estimates are not adjusted for inflation (i.e., are in todays dollars), this will bias the NPV downward. This bias may offset the optimistic bias of management.
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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.

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