IM| SciencesFinancial Management Should we build this plant? The Basics of Capital Budgeting:...

IM| Sciences Financial Management

Should we build thisplant?

The Basics of Capital Budgeting: Investment Criteria and Evaluating Cash Flows


What is capital budgeting?

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to firm’s future.


Steps

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.

3. Determine r = WACC for project.

4. Find NPV and/or IRR.

5. Accept if NPV > 0 and/or IRR > WACC.


Incremental Cash Flows

Cash flows matter—not accounting earnings.

Sunk costs don’t matter.

Incremental cash flows matter. (with or without the project)

Opportunity costs matter.

Be cautious about Fixed OH allocation

Side effects like erosion matter.

Taxes matter: we want incremental after-tax cash flows.

Inflation matters.


Cash Flows—Not Accounting Earnings

Consider depreciation expense.

You never write a cheque made out to “depreciation”.

Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.



Sunk costs are not relevant

Just because “we have come this far” does not mean that we should continue to throw good money after old.

Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed.



Side effects matter.

Erosion; If our new product causes existing customers to demand less of current products, we need to recognize that.


Estimating Cash Flows

Cash Flows from Operations

Recall that:

Operating Cash Flow = EBIT – Taxes + Depreciation

Net Capital Spending

Don’t forget salvage value (after tax, of course).

Changes in Net Working Capital

Recall that when the project winds down, we enjoy a return of net working capital.


What is the difference between independent and mutually exclusive

projects?

Projects are:

independent, if the cash flows of one are unaffected by the acceptance of the other.

mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.


An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.


Normal Cash Flow Project:

Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs.Most common: Cost (negativeCF), then string of positive CFs,then cost to close project.Nuclear power plant, strip mine.


Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN

- + + + + + N

- + + + + - NN

- - - + + + N

+ + + - - - N

- + + - + - NN


The Average Accounting Return Rule

Another attractive but fatally flawed approach. Ranking Criteria and Minimum Acceptance Criteria set by

management Disadvantages:

Ignores the time value of moneyUses an arbitrary benchmark cutoff rateBased on boor values, not cash flows and market values

Advantages:The accounting information is usually availableEasy to calculate

Investent of ValueBook Average

IncomeNet AverageAAR


What is the payback period?

The number of years required to recover a project’s cost,

or how long does it take to get the business’s money back?


Payback for Project L(Long: Most CFs in out years)

10 8060

0 1 2 3

-100

=

CFt

Cumulative -100 -90 -30 50

Payback L 2 + 30/80 = 2.375 years

0100

2.4


Project S (Short: CFs come quicrly)

70 2050

0 1 2 3

-100CFt

Cumulative -100 -30 20 40

Payback S 1 + 30/50 = 1.6 years

100

0

1.6

=


Strengths of Payback:

1. Provides an indication of a project’s risk and liquidity.

2. Easy to calculate and understand.

Weaknesses of Payback:

1. Ignores the TVM.

2. Ignores CFs occurring after the payback period.


10 8060

0 1 2 3

CFt

Cumulative -100 -90.91 -41.32 18.79

Discountedpayback 2 + 41.32/60.11 = 2.7 yrs

Discounted Payback: Uses discountedrather than raw CFs.

PVCFt -100

-100

10%

9.09 49.59 60.11

=

Recover invest. + cap. costs in 2.7 yrs.


.

10t

tn

t r

CFNPV

NPV: Sum of the PVs of inflows and outflows.

Cost often is CF0 and is negative.

.

10

1

CFr

CFNPV t

tn

t


What’s Project L’s NPV?

10 8060

0 1 2 310%

Project L:

-100.00

9.09

49.59

60.1118.79 = NPVL NPVS = $19.98.


Rationale for the NPV Method

NPV = PV inflows - Cost= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually exclusive projects on basis ofhigher NPV. Adds most value.


Using NPV method, which project(s) should be accepted?

If Projects S and L are mutually exclusive, accept S because NPVs > NPVL .

If S & L are independent, accept both; NPV > 0.


Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.


.

10

NPVr

CFt

tn

t

t

nt

t

CF

IRR

0 10.

NPV: Enter r, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.


What’s Project L’s IRR?

10 8060

0 1 2 3IRR = ?

-100.00

PV3

PV2

PV1

0 = NPV

Enter CFs in CFLO, then press IRR:IRRL = 18.13%. IRRS = 23.56%.


Rationale for the IRR Method

If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stocrholders’ returns.

Example: WACC = 10%, IRR = 15%.Profitable.


IRR Acceptance Criteria

If IRR > r, accept project.

If IRR < r, reject project.


Decisions on Projects S and L per IRR

If S and L are independent, accept both. IRRs > r = 10%.

If S and L are mutually exclusive, accept S because IRRS > IRRL .


Construct NPV Profiles

Enter CFs in and find NPVL andNPVS at different discount rates:

r

0

5

10

15

20

NPVL

50

33

19

7

NPVS

40

29

20

12

5 (4)


-10

0

10

20

30

40

50

60

0 5 10 15 20 23.6

NPV ($)

Discount Rate (%)

IRRL = 18.1%

IRRS = 23.6%

Crossover Point = 8.7%

r

0

5

10

15

20

NPVL

50

33

19

7

(4)

NPVS

40

29

20

12

5

S

L


NPV and IRR always lead to the same accept/reject decision for independent projects:

r > IRRand NPV < 0.

Reject.

NPV ($)

r (%)IRR

IRR > rand NPV > 0

Accept.


Mutually Exclusive Projects

r 8.7 r

NPV

%

IRRS

IRRL

L

S

r < 8.7: NPVL> NPVS , IRRS > IRRL

CONFLICT r > 8.7: NPVS> NPVL , IRRS > IRRL

NO CONFLICT


Two Reasons NPV Profiles Cross

1. Size (scale) differences. 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.

2. Timing differences. Project with faster paybacr provides more CF in early years for reinvestment. If r is high, early CF especially good, NPVS > NPVL.


Reinvestment Rate Assumptions

NPV assumes reinvest at r (opportunity cost of capital).

IRR assumes reinvest at IRR.

Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.


Managers lire rates--prefer IRR to NPV comparisons. Can we give them a

better IRR?

Yes, MIRR is the discount rate whichcauses the PV of a project’s terminalvalue (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.

Thus, MIRR assumes cash inflows are reinvested at WACC.


MIRR = 16.5%

10.0 80.060.0

0 1 2 310%

66.0 12.1

158.1

MIRR for Project L (r = 10%)

-100.010%

10%

TV inflows-100.0

PV outflowsMIRRL = 16.5%

$100 = $158.1

(1+MIRRL)3


Why use MIRR versus 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.


When there are nonnormal CFs and more than one IRR, use MIRR:

0 1 2

-800,000 5,000,000 -5,000,000

PV outflows @ 10% = -4,932,231.40.

TV inflows @ 10% = 5,500,000.00.

MIRR = 5.6%


Accept Project P?

NO. Reject because MIRR = 5.6% < r = 10%.

Also, if MIRR < r, NPV will be negative: NPV = -$386,777.


S and L are mutually exclusive and will be repeated. r = 10%. Which is

better? (000s)

0 1 2 3 4

Project S:(100)

Project L:(100)

60

33.5

60

33.5 33.5 33.5


S LCF0 -100,000 -100,000CF1 60,000 33,500Nj 2 4I 10 10

NPV 4,132 6,190

NPVL > NPVS. But is L better?Can’t say yet. Need to perform common life analysis.


Note that Project S could be repeated after 2 years to generate additional profits.

Can use either replacement chain or equivalent annual annuity analysis to mare decision.


Project S with Replication:

NPV = $7,547.

Replacement Chain Approach (000s)

0 1 2 3 4

Project S:(100) (100)

60 60

60(100) (40)

6060

6060


Compare to Project L NPV = $6,190.Compare to Project L NPV = $6,190.

Or, use NPVs:

0 1 2 3 4

4,1323,4157,547

4,13210%


If the cost to repeat S in two years rises to $105,000, which is best? (000s)

NPVS = $3,415 < NPVL = $6,190.Now choose L.NPVS = $3,415 < NPVL = $6,190.Now choose L.

0 1 2 3 4

Project S:(100)

60 60(105) (45)

60 60


Year0123

CF ($5,000) 2,100 2,000 1,750

Salvage Value $5,000 3,100 2,000 0

Consider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage

value.


1.751. No termination

2. Terminate 2 years

3. Terminate 1 year

(5)

(5)

(5)

2.1

2.1

5.2

2

4

0 1 2 3

CFs Under Each Alternative (000s)


NPV(no) = -$123.

NPV(2) = $215.

NPV(1) = -$273.

Assuming a 10% cost of capital, what is the project’s optimal, or economic life?


The project is acceptable only if operated for 2 years.

A project’s engineering life does not always equal its economic life.

Conclusions


Choosing the Optimal Capital Budget

Finance 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


If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.


Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%.

Year Project A Project B

0 -$200 -$150

1 $200 $50

2 $800 $100

3 -$800 $150


Example of Investment Rules

Project A Project B

CF0 -$200.00 -$150.00

PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%

PI = 1.2096 1.6053


Example of Investment RulesPayback Period:

Project AProject B

Time CF Cum. CF CF Cum. CF

0 -200 -200-150 -150

1 200 050 -100

2 800 800100 0

3 -800 0150 150

Payback period for project B = 2 years.

Payback period for project A = 1 or 3 years?


The Good-Buy Project Appraisal

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