Chapter 17

Capital Budgeting Analysis

© 2000 John Wiley & Sons, Inc.

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Chapter Outcomes

Explain how the capital budgeting process should be related to a firm’s mission and strategies.

Identify and describe the five steps in the capital budgeting process.

Identify and describe the methods or techniques used to make proper capital budgeting decisions.

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Chapter Outcomes, continued

Explain how relevant cash flows are determined for capital budgeting decision purposes.

Describe the importance of determining the correct base case from which to estimate project cash flows.

Discuss how a project’s risk can be incorporated into capital budgeting analysis.

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Capital Budgeting Projects

Seek investment opportunities to enhance a firm’s competitive advantage and increase shareholder wealth– Typically long-term projects– Should be evaluated by time value of

money techniques– Large investment

Mutually exclusive versus independent

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Capital Budgeting Process

Identification Development Selection Implementation Follow-up

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Data Needs

Economic and Political Data

Financial Data

Non-Financial Data

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Capital Budgeting Techniques

Net Present Value

NPV = Present value of all cash flows minus cost of project

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Cash Flow Data

YEAR PROJECT A PROJECT B

1 5,800 4,000

2 5,800 4,000

3 5,800 8,000

4 5,800 10,000

5 5,800 10,000

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NPV of Project ACASH 10% PRESENT

YR FLOW x PVIF = VALUE

0 –$20,0001.000 –$20,000

1 5,800 0.909 5,272

2 5,800 0.826 4,791

3 5,800 0.751 4,356

4 5,800 0.683 3,961

5 5,800 0.621 3,602

Net Present Value =$ 1,982

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NPV of Project BCASH 10% PRESENT

YR FLOW x PVIF = VALUE

0 -$25,0001.000 -$25,000

1 4,000 0.909 3,636

2 4,000 0.826 3,304

3 8,000 0.751 6,008

4 10,000 0.683 6,830

5 10,000 0.621 6,210

Net Present Value = $ 988

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What Does the NPV Represent?

NPV represents the dollar gain in shareholder wealth from undertaking the project

If NPV > 0, do the project as shareholder wealth rises

If NPV <0, do not undertake; it reduces shareholder wealth

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Internal Rate of Return

It is the discount rate that causes NPV to equal zero

N

NPV = [CFt / (1 + IRR)t ] – Inv = 0 t = 1

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Solution Methods

Compute the IRR by:

– Trial and error

– Financial calculator

– Spreadsheet software Accept the project if IRR > minimum

required return on the project

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What Does the IRR Measure?

IRR measures the return earned on funds that remain internally invested in the project

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Profitability Ratio (Benefit/Cost Ratio)

Profitability Index = Present value of cash flows/initial cost

Accept project if PI > 1.0 Reject project if PI < 1.0 Interpretation: Measures the present

value of dollars received per dollar invested in the project

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Relationships

NPV, IRR, PI will always agree on the Accept/Reject decision

If one indicates we should accept the project, they will all indicate “accept”

NPV > 0

IRR>minimum required return

PI > 1

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Reject Decision, too

If one indicates we should reject the project, they will all indicate “reject”

NPV < 0IRR < minimum required return PI < 1

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A popular, but flawed, measure...

Payback period = number of years until the cash flows from a project equal the project’s cost

Accept project is payback period is less than a maximum desired time period

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Payback’s Drawbacks

Ignores time value of money Any relationship between the

payback, the decision rule, and shareholder wealth maximization is purely coincidental!

It ignores the cash flows beyond the payback period

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Estimating Project Cash Flows

Important: Stand-alone principle Incremental after-tax cash flows

from the base case Cannibalization or enhancement

effects Opportunity costs

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Ignore….

Sunk costs

Financing costs

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Up-front or “time zero” investment

Investment =

cost + transportation, delivery, and installation charges

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Cash-Based Income StatementCash revenues $12,000

Cash operating expenses –5,600

Cash earnings before depreciation 6,400

Depreciation –4,000

Cash earnings before taxes 2,400

Income taxes (25%) –600

Cash earnings after taxes $ 1,800

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Periodic after-tax cash flows Cash revenues - cash expenses - tax

= $12,000 - 5,600 - 600 = $5,800 Cash earnings after tax+Depreciation

= $1,800 + 4,000 = $5,800 (Cash revenues-cash expenses) (1-T)

+ T (Depreciation expense)

= ($12,000-5,600)(1-.25) + (.25)($4,000)

= $5,800

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Risk-related Considerations

Expected return/risk tradeoff

Higher (lower) than average risk projects should have a higher (lower) than average discount rate

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Cost of Capital

Required return on average risk project = firm’s cost of capital, or cost of financing

For average risk projects, use this number as the discount rate (NPV, PI) or the minimum required rate of return (IRR)

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Risk-adjusted Discount Rate

Adjust the project’s discount rate up or down from the firm’s cost of capital for projects of above-average or below-average risk

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An Example

Below-average risk:

Discount rate = cost of capital –2%

Average risk:

Discount rate = cost of capital

Above-average risk:

Discount rate = cost of capital + 2%

High risk:

Discount rate = cost of capital + 5%

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Learning Extension 17A: Strategic Analysis and Cash Flow Estimation

Strategic analysis, marketing analysis, and financial analysis should agree on the accept/reject decision of a project

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Common Problem Areas

Determining the correct base case Overvaluing a strategy Define project boundaries at the

corporate level

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Depreciation and Project Cash Flows

Straight-line depreciation MACRS--accelerated depreciation

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Depreciation Classes3-year class

5-year class

7-year class

10-year class27.5-year class

31.5-year class

Designated tools and equipment used in research

Cars, trucks, and some office equipment such as computers and copiers

Other office equipment and industrial machinery

Other long-lived equipmentResidential real estate

Commercial and industrial real estate

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Some MACRS PercentagesAsset class

Year 3-year 5-year 7-year

1 33.33% 20.00% 14.29%

2 44.45 32.00 24.49

3 14.82 19.20 17.49

4 7.40 11.52 12.49

5 11.52 8.93

6 5.76 8.93

7 8.93

8 4.45

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An example

For an asset in the three-year class that originally cost $50,000, the first first year’syear’s depreciation is $50,000 x 0.3333 = $16,665; the second year’ssecond year’s depreciation is $50,000 x 0.4445 = $22,225; for the third yearthird year, depreciation will be $50,000 x 0.1482 = $7,410; the final year’sfinal year’s depreciation expense will be $50,000 x 0.0740 = $3,700.