C1 Outline

1
C1 Outline

• Capital Budgeting - Decision Criteria
• Net Present Value
• The Payback Rule
• The Discounted Payback
• The Average Accounting Return
• The Internal Rate of Return
• The Profitability Index
• The Practice of Capital Budgeting

2
C2 Outline (continued)

• Project Cash Flows A First Look
• Incremental Cash Flows
• Pro Forma Financial Statements and Project Cash
  Flows
• More on Project Cash Flows
• Alternative Definitions of Operating Cash Flow
• Some Special Cases of Discounted Cash Flow
  Analysis
• Summary and Conclusions

3
C3 NPV Illustrated

• Assume you have the following information on
  Project X
• Initial outlay -1,100 Required return 10
• Annual cash revenues and expenses are as
  follows
• Year Revenues Expenses
• 1 1,000 500
• 2 2,000 1,000
• Draw a time line and compute the NPV of project
  X.

4
C4 NPV Illustrated (concluded)
0
1
2
Initial outlay (1,100)
Revenues 2,000 Expenses 1,000 Cash flow 1,000
Revenues 1,000 Expenses 500 Cash flow 500
1,100.00 454.55 826.45 181.00
1 500 x 1.10
1 1,000 x 1.10
2
NPV
5
C5 Underpinnings of the NPV Rule

• Why does the NPV rule work? And what does work
  mean? Look at it this way
• A firm is created when securityholders supply
  the funds to acquire assets that will be used to
  produce and sell a good or a service
• The market value of the firm is based on the
  present value of the cash flows it is expected to
  generate
• Additional investments are good if the present
  value of the incremental expected cash flows
  exceeds their cost
• Thus, good projects are those which increase
  firm value - or, put another way, good projects
  are those projects that have positive NPVs!
• Moral of the story Invest only in projects with
  positive NPVs.

6
C6 Payback Rule Illustrated

• Initial outlay -1,000
• Year Cash flow
• 1 200
• 2 400
• 3 600
• Accumulated
• Year Cash flow
• 1 200
• 2 600
• 3 1,200
• Payback period 2 2/3 years

7
C7 Discounted Payback Illustrated

• Initial outlay -1,000
• R 10
• PV
  of
• Year Cash flow Cash flow
• 1 200 182
• 2 400 331
• 3 700 526
• 4 300 205
• Accumulated
• Year discounted cash flow
• 1 182
• 2 513
• 3 1,039
• 4 1,244
• Discounted payback period is just under 3 years

8
C8 Ordinary and Discounted Payback

• Cash Flow
  Accumulated Cash Flow
• Year Undiscounted Discounted
  Undiscounted Discounted
• 1 100 89 100 89
• 2 100 79 200 168
• 3 100 70 300 238
• 4 100 62 400 300
• 5 100 55 500 355

9
C9 Average Accounting Return Illustrated

• Average net income
• 
  Year
• 1
  2 3
• Sales 440 240 160
• Costs 220 120 80
• Gross profit 220 120 80
• Depreciation 80 80 80
• Earnings before taxes 140 40 0
• Taxes (25) 35 10 0
• Net income 105 30 0
• Average net income (105 30 0)/3 45

10
C10 Average Accounting Return Illustrated
(concluded)

• Average book value
• Initial investment 240
• Average investment (240 0)/2 120
• Average accounting return (AAR)
• Average net income 45
• AAR 37.5
• Average book value 120

11
C11 Internal Rate of Return Illustrated

• Initial outlay -200
• Year Cash
  flow
• 1 50
• 2 100
• 3 150
• Find the IRR such that NPV 0
• 50 100
  150
• 0 -200
  
• (1IRR)1 (1IRR)2
  (1IRR)3
• 50 100
  150
• 200
• (1IRR)1 (1IRR)2
  (1IRR)3

12
C12 Internal Rate of Return Illustrated
(concluded)

• Trial and Error
• Discount rates NPV
• 0 100
• 5 68
• 10 41
• 15 18
• 20 -2
• IRR is just under 20 -- about 19.44

13
C13 Net Present Value Profile
Net present value
120
Year Cash flow 0 275 1 100
2 100 3 100 4 100
100
80
60
40
20
0
20
Discount rate
40
2
6
10
14
18
22
IRR
14
C14 Multiple Rates of Return

• Assume you are considering a project for which
  the cash flows are as follows
• Year Cash flows
• 0 -252
• 1 1,431
• 2 -3,035
• 3 2,850
• 4 -1,000

15
C15 Multiple Rates of Return (continued)

• Whats the IRR? Find the rate at which the
  computed NPV 0
• at 25.00 NPV _______
• at 33.33 NPV _______
• at 42.86 NPV _______
• at 66.67 NPV _______

16
C16 Multiple Rates of Return (continued)

• Whats the IRR? Find the rate at which the
  computed NPV 0
• at 25.00 NPV 0
• at 33.33 NPV 0
• at 42.86 NPV 0
• at 66.67 NPV 0
• Two questions
• 1. Whats going on here?
• 2. How many IRRs can there be?

17
C17 Multiple Rates of Return (concluded)
NPV
0.06
0.04
IRR 1/4
0.02
0.00
(0.02)
IRR 2/3
IRR 1/3
IRR 3/7
(0.04)
(0.06)
(0.08)
0.2
0.28
0.36
0.44
0.52
0.6
0.68
Discount rate
18
C18 IRR, NPV, and Mutually Exclusive Projects
Net present value
Year
0 1 2 3
4 Project A 350 50 100 150 200 Project B
250 125 100 75 50
160
140
120
100
80
60
40
Crossover Point
20
0
20
40
60
80
Discount rate
100
2
0
6
10
14
18
22
26
IRR A IRR B
19
C19 Profitability Index Illustrated

• Now lets go back to the initial example - we
  assumed the following information on Project X
• Initial outlay -1,100 Required return 10
• Annual cash benefits
• Year Cash flows
• 1 500
• 2 1,000
• Whats the Profitability Index (PI)?

20
C20 Profitability Index Illustrated (concluded)

• Previously we found that the NPV of Project X is
  equal to
• (454.55 826.45) - 1,100 1,281.00 - 1,100
  181.00.
• The PI PV inflows/PV outlay 1,281.00/1,100
  1.1645.
• This is a good project according to the PI rule.
  Can you explain why?
• Its a good project because the present value of
  the inflows exceeds the outlay.

21
C21 Summary of Investment Criteria

• I. Discounted cash flow criteria
• A. Net present value (NPV). The NPV of an
  investment is the difference between its market
  value and its cost. The NPV rule is to take a
  project if its NPV is positive. NPV has no
  serious flaws it is the preferred decision
  criterion.
• B. Internal rate of return (IRR). The IRR is the
  discount rate that makes the estimated NPV of an
  investment equal to zero. The IRR rule is to take
  a project when its IRR exceeds the required
  return. When project cash flows are not
  conventional, there may be no IRR or there may be
  more than one.
• C. Profitability index (PI). The PI, also called
  the benefit-cost ratio, is the ratio of present
  value to cost. The profitability index rule is
  to take an investment if the index exceeds 1.0.
  The PI measures the present value per dollar
  invested.

22
C22 Summary of Investment Criteria (concluded)

• II. Payback criteria
• A. Payback period. The payback period is the
  length of time until the sum of an investments
  cash flows equals its cost. The payback period
  rule is to take a project if its payback period
  is less than some prespecified cutoff.
• B. Discounted payback period. The discounted
  payback period is the length of time until the
  sum of an investments discounted cash flows
  equals its cost. The discounted payback period
  rule is to take an investment if the discounted
  payback is less than some prespecified cutoff.
• III. Accounting criterion
• A. Average accounting return (AAR). The AAR is
  a measure of accounting profit relative to book
  value. The AAR rule is to take an investment if
  its AAR exceeds a benchmark.

23
C23 A Quick Quiz

• 1. Which of the capital budgeting techniques do
  account for both the time value of money and
  risk?
• 2. The change in firm value associated with
  investment in a project is measured by the
  projects _____________ .
• a. Payback period
• b. Discounted payback period
• c. Net present value
• d. Internal rate of return
• 3. Why might one use several evaluation
  techniques to assess a given project?

24
C24 A Quick Quiz

• 1. Which of the capital budgeting techniques do
  account for both the time value of money and
  risk?
• Discounted payback period, NPV, IRR, and PI
• 2. The change in firm value associated with
  investment in a project is measured by the
  projects Net present value.
• 3. Why might one use several evaluation
  techniques to assess a given project?
• To measure different aspects of the project
  e.g., the payback period measures liquidity, the
  NPV measures the change in firm value, and the
  IRR measures the rate of return on the initial
  outlay.

25
C25 Problem

• Offshore Drilling Products, Inc. imposes a
  payback cutoff of 3 years for its international
  investment projects. If the company has the
  following two projects available, should they
  accept either of them?
• Year Cash Flows A Cash Flows B
• 0 -30,000 -45,000
• 1 15,000 5,000
• 2 10,000 10,000
• 3 10,000 20,000
• 4 5,000 250,000

26
C26 Solution to Problem (concluded)

• Project A
• Payback period 1 1 (30,000 -
  25,000)/10,000
• 2.50 years
• Project B
• Payback period 1 1 1 (45,000 -
  35,000)/250,000
• 3.04 years
• Project As payback period is 2.50 years and
  project Bs payback period is 3.04 years. Since
  the maximum acceptable payback period is 3 years,
  the firm should accept project A and reject
  project B.

27
C27 Another Problem

• A firm evaluates all of its projects by applying
  the IRR rule. If the required return is 18
  percent, should the firm accept the following
  project?
• Year Cash Flow
• 0 -30,000
• 1 25,000
• 2 0
• 3 15,000

28
C28 Another Problem (continued)

• To find the IRR, set the NPV equal to 0 and solve
  for the discount rate
• NPV 0 -30,000 25,000/(1 IRR)1
  0/(1 IRR) 2 15,000/(1 IRR)3
• At 18 percent, the computed NPV is ____.
• So the IRR must be (greater/less) than 18
  percent. How did you know?

29
C29 Another Problem (concluded)

• To find the IRR, set the NPV equal to 0 and solve
  for the discount rate
• NPV 0 -30,000 25,000/(1 IRR)1
  0/(1 IRR)2 15,000/(1 IRR)3
• At 18 percent, the computed NPV is 316.
• So the IRR must be greater than 18 percent. We
  know this because the computed NPV is positive.
• By trial-and-error, we find that the IRR is 18.78
  percent.

30
T30 Fundamental Principles of Project Evaluation

• Fundamental Principles of Project Evaluation
• Project evaluation - the application of one or
  more capital budgeting decision rules to
  estimated relevant project cash flows in order to
  make the investment decision.
• Relevant cash flows - the incremental cash flows
  associated with the decision to invest in a
  project.
• The incremental cash flows for project
  evaluation consist of any and all changes in
  the firms future cash flows that are a direct
  consequence of taking the project.
• Stand-alone principle - evaluation of a
  project based on the projects incremental cash
  flows.

31
T31 Incremental Cash Flows

• Incremental Cash Flows
• Key issues
• When is a cash flow incremental?
• Terminology
• A. Sunk costs
• B. Opportunity costs
• C. Side effects
• D. Net working capital
• E. Financing costs
• F. Other issues

32
T32 Example Preparing Pro Forma Statements

• Suppose we want to prepare a set of pro forma
  financial statements for a project for Norma
  Desmond Enterprises. In order to do so, we must
  have some background information. In this case,
  assume
• 1. Sales of 10,000 units/year _at_ 5/unit.
• 2. Variable cost per unit is 3. Fixed costs are
  5,000 per year. The project has no salvage
  value. Project life is 3 years.
• 3. Project cost is 21,000. Depreciation is
  7,000/year.
• 4. Additional net working capital is 10,000.
• 5. The firms required return is 20. The tax
  rate is 34.

33
T33 Example Preparing Pro Forma Statements
(continued)

• Pro Forma Financial Statements
• Projected Income Statements
• Sales ______
• Var. costs ______
• 20,000
• Fixed costs 5,000
• Depreciation 7,000
• EBIT ______
• Taxes (34) 2,720
• Net income ______

34
T34 Example Preparing Pro Forma Statements
(continued)

• Pro Forma Financial Statements
• Projected Income Statements
• Sales 50,000
• Var. costs 30,000
• 20,000
• Fixed costs 5,000
• Depreciation 7,000
• EBIT 8,000
• Taxes (34) 2,720
• Net income 5,280

35
T35 Example Preparing Pro Forma Statements
(concluded)

• Projected Balance Sheets
• 0 1 2 3
• NWC ______ 10,000 10,000 10,000
• NFA 21,000 ______ ______ 0
• Total 31,000 24,000 17,000 10,000

36
T36 Example Preparing Pro Forma Statements
(concluded)

• Projected Balance Sheets
• 0 1 2 3
• NWC 10,000 10,000 10,000 10,000
• NFA 21,000 14,000 7,000 0
• Total 31,000 24,000 17,000 10,000

37
T37 Example Using Pro Formas for Project
Evaluation

• Now lets use the information from the previous
  example to do a capital budgeting analysis.
• Project operating cash flow (OCF)
• EBIT 8,000
• Depreciation 7,000
• Taxes -2,720
• OCF 12,280

38
T38 Example Using Pro Formas for Project
Evaluation (continued)

• Project Cash Flows
• 0 1 2 3
• OCF 12,280 12,280 12,280
• Chg. NWC ______ ______
• Cap. Sp. -21,000
• Total ______ 12,280 12,280 ______

39
T39 Example Using Pro Formas for Project
Evaluation (continued)

• Project Cash Flows
• 0 1 2 3
• OCF 12,280 12,280 12,280
• Chg. NWC -10,000 10,000
• Cap. Sp. -21,000
• Total -31,000 12,280 12,280 22,280

40
T40 Example Using Pro Formas for Project
Evaluation (concluded)

• Capital Budgeting Evaluation
• NPV -31,000 12,280/1.201 12,280/1.20
  2 22,280/1.20 3 655
• IRR 21
• PBP 2.3 years
• AAR 5280/(31,000 24,000 17,000
  10,000)/4 25.76
• Should the firm invest in this project? Why or
  why not?
• Yes -- the NPV gt 0, and the IRR gt required return

41
T41 Example Estimating Changes in Net Working
Capital

• In estimating cash flows we must account for the
  fact that some of the incremental sales
  associated with a project will be on credit, and
  that some costs wont be paid at the time of
  investment. How?
• Answer Estimate changes in NWC. Assume
• 1. Fixed asset spending is zero.
• 2. The change in net working capital spending is
  200
• 0 1 Change S/U
• A/R 100 200 100 ___
• INV 100 150 50 ___
• -A/P 100 50 (50) ___
• NWC 100 300 Chg. NWC _____

42
T42 Example Estimating Changes in Net Working
Capital

• In estimating cash flows we must account for the
  fact that some of the incremental sales
  associated with a project will be on credit, and
  that some costs wont be paid at the time of
  investment. How?
• Answer Estimate changes in NWC. Assume
• 1. Fixed asset spending is zero.
• 2. The change in net working capital spending is
  200
• 0 1 Change S/U
• A/R 100 200 100 U
• INV 100 150 50 U
• -A/P 100 50 (50) U
• NWC 100 300 Chg. NWC 200

43
T43 Example Estimating Changes in Net Working
Capital (continued)

• Now, estimate operating and total cash flow
• Sales 300
• Costs 200
• Depreciation 0
• EBIT 100
• Tax 0
• Net Income 100
• OCF EBIT Dep. ? Taxes 100
• Total Cash flow OCF? Change in NWC ? Capital
  Spending
• 100 ? ______ ? ______
  ______

44
T44 Example Estimating Changes in Net Working
Capital (continued)

• Now, estimate operating and total cash flow
• Sales 300
• Costs 200
• Depreciation 0
• EBIT 100
• Tax 0
• Net Income 100
• OCF EBIT Dep. ? Taxes 100
• Total Cash flow OCF? Change in NWC ? Capital
  Spending
• 100 ? 200 ? 0
  ? 100

45
T45 Example Estimating Changes in Net Working
Capital (concluded)

• Where did the - 100 in total cash flow come
  from?
• What really happened
• Cash sales 300 - ____ 200
  (collections)
• Cash costs 200 ____ ____ 300
  (disbursements)

46
T46 Example Estimating Changes in Net Working
Capital (concluded)

• Where did the - 100 in total cash flow come
  from?
• What really happened
• Cash sales 300 - 100 200
  (collections)
• Cash costs 200 50 50 300
  (disbursements)
• Cash flow 200 - 300 - 100 ( cash in
  ? cash out)

47
T47 Modified ACRS Property Classes

• Class Examples
• 3-year Equipment used in research
• 5-year Autos, computers
• 7-year Most industrial equipment

48
T48 Modified ACRS Depreciation Allowances

• Property Class
• Year 3-Year 5-Year
  7-Year
• 1 33.33 20.00 14.29
• 2 44.44 32.00 24.49
• 3 14.82 19.20 17.49
• 4 7.41 11.52 12.49
• 5 11.52 8.93
• 6 5.76 8.93
• 7 8.93
• 8 4.45

49
T49 MACRS Depreciation An Example

• Calculate the depreciation deductions on an asset
  which costs 30,000 and is in the 5-year property
  class
• Year MACRS Depreciation
• 1 20 _____
• 2 32 _____
• 3 19.20 5,760
• 4 11.52 3,456
• 5 11.52 3,456
• 6 5.76 1,728
• 100 _____

50
T50 MACRS Depreciation An Example

• Calculate the depreciation deductions on an asset
  which costs 30,000 and is in the 5-year property
  class
• Year MACRS Depreciation
• 1 20 6,000
• 2 32 9,600
• 3 19.20 5,760
• 4 11.52 3,456
• 5 11.52 3,456
• 6 5.76 1,728
• 100 30,000

51
T51 Example Fairways Equipment and Operating
Costs

• Two golfing buddies are considering opening a
  new driving range, the Fairways Driving Range
  (motto We always treat you fairly at
  Fairways). Because of the growing popularity of
  golf, they estimate the range will generate
  rentals of 20,000 buckets of balls at 3 a bucket
  the first year, and that rentals will grow by 750
  buckets a year thereafter. The price will remain
  3 per bucket.
• Capital spending requirements include
• Ball dispensing machine 2,000
• Ball pick-up vehicle 8,000
• Tractor and accessories 8,000
• 18,000
• All the equipment is 5-year ACRS property, and
  is expected to have a salvage value of 10 of
  cost after 6 years.
• Anticipated operating expenses are as follows

52
T52 Example Fairways Equipment and Operating
Costs (concluded)
Working Capital Initial requirement 3,000
Working capital requirements are expected to
grow at 5 per year for the life of the project

• Operating Costs (annual)
• Land lease 12,000
• Water 1,500
• Electricity 3,000
• Labor 30,000
• Seed fertilizer 2,000
• Gasoline 1,500
• Maintenance 1,000
• Insurance 1,000
• Misc. Expenses 1,000
• 53,000

53
T53 Example Fairways Revenues, Depreciation,
and Other Costs

• Projected Revenues
• Year Buckets Revenues
• 1 20,000 60,000
• 2 20,750 62,250
• 3 21,500 64,500
• 4 22,250 66,750
• 5 23,000 69,000
• 6 23,750 71,250

54
T54 Example Fairways Revenues, Depreciation,
and Other Costs (continued)

• Cost of balls and buckets
• Year Cost
• 1 3,000
• 2 3,150
• 3 3,308
• 4 3,473
• 5 3,647
• 6 3,829

55
T55 Example Fairways Revenues, Depreciation,
and Other Costs (concluded)

• Depreciation on 18,000 of 5-year equipment
• Year ACRS Depreciation
  Book value
• 1 20.00 3,600 14,400
• 2 32.00 5,760 8,640
• 3 19.20 3,456 5,184
• 4 11.52 2,074 3,110
• 5 11.52 2,074 1,036
• 6 5.76 1,036 0

56
T56 Example Fairways Pro Forma Income Statement

• 
  Year
• 1
  2 3 4
  5 6
• Revenues 60,000 62,250 64,500 66,750 69,000
  71,250
• Variable costs 3,000 3,150 3,308 3,473 3,647 3,829
  
• Fixed costs 53,000 53,000 53,000 53,000 53,000 53,
  000
• Depreciation 3,600 5,760 3,456 2,074 2,074 1,036
• EBIT 400 340 4,736
  8,203 10,279 13,385
• Taxes 60 51 710 1,230 1,542 2,008
• Net income 340 289 4,026 6,973
  8,737 11,377

57
T57 Example Fairways Projected Changes in NWC

• Projected increases in net working capital
• Year Net working capital
  Change in NWC
• 0 3,000 3,000
• 1 3,150 150
• 2 3,308 158
• 3 3,473 165
• 4 3,647 174
• 5 3,829 182
• 6 4,020 - 3,829

58
T58 Example Fairways Cash Flows

• Operating cash flows
• Operating Year EBIT Depreciation
  Taxes cash flow
• 0 0 0 0 0
• 1 400 3,600 60 3,940
• 2 340 5,760 51 6,049
• 3 4,736 3,456 710 7,482
• 4 8,203 2,074 1,230 9,047
• 5 10,279 2,074 1,542 10,811
• 6 13,385 1,036 2,008 12,413

59
T59 Example Fairways Cash Flows (concluded)

• Total cash flow from assets
• Year OCF Chg. in NWC Cap. Sp.
  Cash flow
• 0 0 3,000 18,000 21,000
• 1 3,940 150 0 3,790
• 2 6,049 158 0 5,891
• 3 7,482 165 0 7,317
• 4 9,047 174 0 8,873
• 5 10,811 182 0 10,629
• 6 12,413 3,829 1,530 17,772

60
T60 Alternative Definitions of OCF

• Let
• OCF operating cash flow
• S sales
• C operating costs
• D depreciation
• T corporate tax rate

61
T61 Alternative Definitions of OCF (concluded)

• The Tax-Shield Approach
• OCF (S - C - D) D - (S - C - D) ? T
• (S - C) ? (1 - T) (D ? T)
• (S - C) ? (1 - T) Depreciation x T
• The Bottom-Up Approach
• OCF (S - C - D) D - (S - C - D) ? T
• (S - C - D) ? (1 - T) D
• Net income Depreciation
• The Top-Down Approach
• OCF (S - C - D) D - (S - C - D) ? T
• (S - C) - (S - C - D) ? T
• Sales - Costs - Taxes

62
T62 Quick Quiz -- Part 1 of 3

• Now lets put our new-found knowledge to work.
  Assume we have the following background
  information for a project being considered by
  Gillis, Inc.
• See if we can calculate the projects NPV and
  payback period. Assume
• Required NWC investment 40 project cost
  60 3 year life
• Annual sales 100 annual costs 50
  straight line depreciation to 0
• Tax rate 34, required return 12
• Step 1 Calculate the projects OCF
• OCF (S - C)(1 - T) Dep ? T
• OCF (___ - __)(1 - .34) (____)(.34) _____

63
T63 Quick Quiz -- Part 1 of 3

• Now lets put our new-found knowledge to work.
  Assume we have the following background
  information for a project being considered by
  Gillis, Inc.
• See if we can calculate the projects NPV and
  payback period. Assume
• Required NWC investment 40 project cost
  60 3 year life
• Annual sales 100 annual costs 50
  straight line depreciation to 0
• Tax rate 34, required return 12
• Step 1 Calculate the projects OCF
• OCF (S - C)(1 - T) Dep ? T
• OCF (100 - 50)(1 - .34) (60/3)(.34) 39.80

64
T64 Quick Quiz -- Part 1 of 3 (concluded)

• Project cash flows are thus
• 0 1 2 3
• OCF 39.8 39.8 39.8
• Chg. in NWC -40 40
• Cap. Sp. -60
• -100 39.8 39.8 79.8
• Payback period ___________
• NPV ____________

65
T65 Quick Quiz -- Part 1 of 3 (concluded)

• Project cash flows are thus
• 0 1 2 3
• OCF 39.8 39.8 39.8
• Chg. in NWC 40 40
• Cap. Sp. 60
• 100 39.8 39.8 79.8
• Payback period 1 1 (100 79.6)/79.8
  2.26 years
• NPV 39.8/(1.12) 39.8/(1.12)2 79.8
  /(1.12)3 - 100 24.06