The Basics of Capital Budgeting.13-14st

8/13/2019 The Basics of Capital Budgeting.13-14st

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The Basics of Capital Budgeting:

Evaluating and Estimating Cash

FlowsCorporate FinanceDr. A. DeMaskey

Should we

build this

plant?


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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 cashflows?

What types of cash flows must be considered whenevaluating a proposed project?


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Capital Budgeting

Investment decision making process, which involvesfixed assets.

Capital

Capital budget

Long-term decisionsSizable cash outlays

Difficult to reverse Important to firms future

Profitability

Growth and Survival

Future direction


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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


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Project Classification

According to economiclife:

Short-term

Long-term

According to risk:Replacement projects

Expansion projectsNew products andmarkets

Mandated projects

According to dependence on

other projects:

Independent projectsMutually exclusive projects

Contingent projects

Complementary 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)


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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.


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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


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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 cashflows, where the discount rate is the cost of

capital.


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Evaluation of Discounted

Payback Period

Strengths


Considers the riskiness of the cash flows involved inthe 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.

Cost often is CF0and is negative.

NPV CF

kt

nt

t 0 1 .

.CFk1CF

NPV0t

t

n

1t


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Rationale for NPV Method

NPV = PV inflowsCost

= 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.

WeaknessesRequires 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.

PI vs. NPV

0

1 1

CF

k

CF

PI

n

t

t

t


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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.


WeaknessesRequires estimate of cost of capital.May not give correct decision for mutually exclusiveprojects.


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Internal Rate of Return

The discount rate that forces PV inflows = cost. This isthe 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 .

tn

t

tCFIRR

0 1 0.


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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 NPVmethod is best. NPV should be used to choose betweenmutually exclusive projects.

Causes: Different timing in cash flows

Scale differences


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Evaluation of IRR Method

StrengthsTells 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 exclusiveprojects.

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 atWACC.

The internal rate of return on a project assuming

that cash inflows are reinvested at somespecified 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

StrengthsTells whether firm value is increased.

Considers all cash flows.



Weaknesses

May not give value-maximizing decisions for mutuallyexclusive projects.

May not give value-maximizing decisions under capitalrationing.


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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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0 1 2 3 4

Initial

Outlay

OCF1 OCF2 OCF3 OCF4

+ TerminalCF

NCF0 NCF1 NCF2 NCF3 NCF4

Project Cash Flows


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Net Investment

Cost of Asset

+ Shipping Costs

+ Installation CostsPLUS

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 forinflation (i.e., are in todays dollars), this will bias

the NPV downward.

This bias may offset the optimistic bias ofmanagement.


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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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The Basics of Capital Budgeting.13-14st

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