Topics in Capital Budgeting

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Topics in Capital Budgeting
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Objectives

• Study how to determine cash flows for capital
  budgeting analysis
• Study capital budgeting under uncertainty
• Study how to incorporate risk in capital
  budgeting decisions.

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Guidelines for Capital Budgeting

• Use cash flows rather than accounting profits
• Cash flows correctly reflect the timing of
  benefits and costs
• Examine cash flows on an after-tax basis
• Only include incremental after-tax cash flows
• Cash flows with the new project versus cash flows
  without the new project

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Guidelines for Capital Budgeting

• Beware of cash flows diverted from existing
  products
• Decide if overhead costs are truly incremental
  cash flows
• Ignore interest payments and financing flows as
  they are accounted for when the cash flows are
  discounted back to present

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Inflation Capital Budgeting

• Increased inflation will cause the required rate
  of return on project to rise.
• Both anticipated cash inflows and outflows could
  be affected by inflation.
• The salvage value of the project could be
  affected by inflation.
• The fact that depreciation charges do not change
  with inflation also distorts capital-budgeting
  decisions.

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Measuring The Cash Flows

• A projects cash flows can be classified as
• Initial outlay
• Differential cash flows
• Terminal cash flow

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Example
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Initial Outlays

• The installed cost of the asset
• In case of a replacement decision, the after-tax
  cash flow associated with the sale of the old
  machine
• Additional non-expense outlays incurred, e.g.,
  Working capital investments
• Additional expenses on an after tax basis, e.g.,
  Training

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Initial Outlays
The tax savings is the marginal tax rate times
the difference 15,000 - 10,000, i.e.,
depreciated value minus salvage value.
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Differential Cash Flows

• Incremental after-tax cash flows resulting from
  increased revenue from the proposal
• Any labor and/or material savings incurred
• Increases in overhead incurred
• Do not include any financing charges as they are
  implicitly taken care of in the discounting
  process

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Differential Cash Flows
The increased depreciation charges are
calculated as 12,000 - 3,000.
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Terminal Cash Flows

• The projects salvage value plus any taxable
  gains or losses associated with the project
• Any terminal cash flows needed, perhaps for
  disposal of obsolete equipment
• Recovery of any non-expense cash outlays
  associated with the project, such as recovery of
  increased working-capital needs associated with
  the proposal

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Terminal Cash Flows

• The salvage value of the new machine is zero and
  so there is no terminal cash flow in this example
• The cash flows for the proposed project are as
  shown

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Risk and Investment Decisions

• The risk of an investment project is defined as
  the variability of its cash flows from the
  expected cash flows.
• In capital budgeting, projects risk can be
  looked at in the following three levels
• Project Risk
• Firm Risk
• Systematic Risk

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What measure of risk is relevant for capital
budgeting?

• According to CAPM, systematic risk is the only
  relevant risk for capital budgeting purposes.
• For undiversified shareholders including owners
  of small corporations the relevant measure of
  risk may be the projects contribution-to-firm
  risk. This measure is more appropriate if there
  are cost associated with bankruptcy.

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Methods for Incorporating Risk into
Capital-Budgeting

• Certainty Equivalent Approach
• In this method the financial manager substitutes
  the certain dollar amount that he or she feels is
  equivalent to the expected but risky cash flows
  offered by the project.
• In effect, the manager is indifferent between
  both a safe set of cash flows and the original
  set of risky cash flows.

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Methods for Incorporating Risk into
Capital-Budgeting

• Risk Adjusted Discount Rates
• In this method if the risk associated with the
  project is more then the discount rate is
  adjusted upwards to compensate for the risk.
• The expected cash flows are then discounted back
  to present at the risk-adjusted discount rate.

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Certainty Equivalent versus Risk Adjusted
Discount Rate

• In the certainty equivalent approach, the
  expected cash flows are adjusted downwards to
  incorporate risk of the project.
• In the risk adjusted discount rate approach, the
  expected cash flows are unchanged but the
  required rate of return is adjusted upwards to
  incorporate risk of the project.
• In either case the net result is a decrease in
  the NPV of the investment proposal.

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The Systematic Risk of a Project

• In order to determine the risk adjusted discount
  rate for a project we need to estimate the
  systematic risk, i.e., the project beta.
• Beta can be estimated using
• Accounting Return Data Method
• Pure Play Method

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The Capital Budgeting Decision
m
rf b (ERm rf)
b
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Other Sources and Measures of Risk

• Time Dependence of Cash Flows
• Many times, especially with the introduction of a
  new product the cash flows experienced in the
  early years affect the size of the cash flows
  experienced in later years. This is called time
  dependence of cash flows.
• Skewness
• A distribution that is not symmetric is said to
  be skewed.
• When distributions are skewed, the expected value
  and standard deviation alone may not be enough to
  differentiate between two distributions or risks.

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Methods for Evaluating Risk in Capital Budgeting

• CAPM
• Simulation
• Sensitivity Analysis
• Probability Trees

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Summary

• Measured cash flows
• Incorporated risk
• Considered capital budgeting methods