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The Basics of Capital Budgeting: Evaluating and Estimating Cash Flows

The Basics of Capital Budgeting: Evaluating and Estimating Cash FlowsCorporate FinanceDr. A. DeMaskey

Should we build thisplant?

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Learning ObjectivesLearning 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 BudgetingCapital Budgeting Investment decision making process, which involves fixed

assets.CapitalCapital budget

Long-term decisionsSizable cash outlaysDifficult to reverse

Important to firm’s future ProfitabilityGrowth and SurvivalFuture direction

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The Five Stages of Capital BudgetingThe 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

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Project ClassificationProject Classification According to economic

life:Short-termLong-term

According to risk:Replacement projectsExpansion projectsNew products and marketsMandated projects

According to dependence on other projects:

Independent projectsMutually exclusive projectsContingent projectsComplementary projects

According to cash flows:Normal cash flow projectsNonnormal cash flow projects

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StepsSteps

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 TechniquesInvestment 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)

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Characteristics of an Evaluation TechniqueCharacteristics 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.

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Payback Period Payback Period

The length of time it takes to recover the initial investment outlay.

Equal cash flowsUnequal cash flows

Payoff or capital recovery period

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Evaluation of Payback PeriodEvaluation of Payback Period

StrengthsProvides an indication of a project’s risk and liquidity.Easy to calculate and understand.

WeaknessesIgnores the TVM.Ignores CFs occurring after the payback period.

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Discounted Payback PeriodDiscounted Payback Period

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

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

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Evaluation of Discounted Payback PeriodEvaluation of Discounted Payback Period

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

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

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Net Present Value (NPV)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 CF0 and is negative.

NPVCF

kt

nt

t 0 1

.

.CF

k1

CFNPV 0t

tn

1t

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Rationale for NPV MethodRationale 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 NPVEvaluation 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.

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Net Present Value ProfileNet Present Value Profile

Graphical depiction of the NPV for different discount rates.

Downward slopingSlightly curvedCrossover discount rate

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Profitability Index (PI)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 1CF

k

CF

PI

n

tt

t

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Rationale for PI MethodRationale 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 MethodEvaluation 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 exclusive projects.

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Internal Rate of ReturnInternal 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.

IRR: Enter NPV = 0, solve for IRR.

Annualized yield on an investment.

t

nt

t

CF

kNPV

0 1.

t

nt

t

CF

IRR

0 10.

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Rationale for IRR MethodRationale for IRR Method

If IRR > WACC, then the project’s 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. NPVIRR 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 MethodEvaluation 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.

WeaknessesRequires 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)Modified Internal Rate of Return (MIRR)

The discount rate which causes the PV of a project’s 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. IRRMIRR 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 MethodEvaluation 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.

WeaknessesMay 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 PracticeCapital 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 FlowsPrinciples of Estimating Cash Flows

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

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AssumptionsAssumptions

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 FlowsTypes of Cash Flows

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

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0 1 2 3 4

InitialOutlay

OCF1 OCF2 OCF3 OCF4

+ Terminal CF

NCF0 NCF1 NCF2 NCF3 NCF4

Project Cash FlowsProject Cash Flows

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Net InvestmentNet Investment Cost of Asset

+ Shipping Costs + Installation Costs PLUS

Increase/decrease in Working Capital

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Operating Cash FlowsOperating Cash Flows

Method 1: OCF = (R -E - D)(1 - T) + D

Method 2:OCF = (R - E)(1 - T) + DT

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Terminal Cash FlowsTerminal 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 FlowsReal 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 today’s dollars), this will bias the NPV downward.

This bias may offset the optimistic bias of management.

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Multinational Capital BudgetingMultinational 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.