Finc 7311 Capital Budgeting

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Finc 7311 - Capital Budgeting
Finance 7311Lecture 5Capital Budgeting
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Outline

• Projects
• Investment Criteria
• NPV v. IRR
• Sources of NPV
• Project Cash Flow Checklist

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Projects

• A project is any potential real investment
  opportunity
• Distinguish real from financial
• Mutually Exclusive - can do only one
• Independent - decision about one does not affect
  decision w/r/t the others
• Replacement - special case

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Investment Criteria

• Investment criteria are the rules by which we
  decide whether or not to accept a particular
  project consider the following

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Accounting Rate of Return

• ARR Avg. Income / Avg. Investment
• Uses Income rather than Cash Flow
• Ignores Time Value of Money

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Payback

• Years needed to recover initial investment
• To Find Calculate where cumulative cash flows
  become positive
• Project A 2 1/6 years
• Project B 2 6/7 years

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Problems with Payback

• Ignores Time Value of Money
• Can use Discounted Payback Why?
• Ignores CFs after payback
• To see Assume Project Bs cash flow in year 4 is
  1,000,000 how does this affect payback

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Net Present Value

• This rule is always consistent with maximizing
  the value of the firm
• Economically, take all projects for which
  benefits costs (in PV dollars)
• Mathematically, sum the present values of all the
  cash flows

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Net Present Value
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NPV example(cost of capital 12)
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Internal Rate of Return (IRR)

• IRR - That rate which causes NPV to 0.

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IRR

• Independent Projects - select all projects for
  which IRR Cost of Capital
• Mutually Exclusive - select project with highest
  IRR
• Use well-designed spreadsheet

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Example IRR

• Project B annuity
• PV (10,000)
• Pymt 3,500
• N 4
• I ? 14.96
• Project A ? use spreadsheet or calculator
• IRR 18

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Comparison of NPV IRR

• Business people are accustomed to thinking in
  rates of return, so does it matter which of NPV
  or IRR we use?
• Independent - the two rules are equivalent
• NPV 0 IRR Cost of Capital

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NPV Profile
NPV
4000
3500
A
B
967
630
15

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12
6
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Comparison of NPV IRR

• Mutually Exclusive Projects - can get different
  answers
• NPV Profile for Example
• Reinvestment Assumption

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NPV v. IRR Example

• Cost Return
• Project 1 (100,000) 125,000
• Project 2 (1,000) 2,000
• NPV IRR
• Project 1 13,636 25
• Project 2 818 100

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NPV v. IRR Example

• Cost Return
• Project 1 - 2 (99,000) 123,000
• NPV IRR
• Project 1- 2 12,818 24

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NPV v. IRR, cont.

• IRR Do Project 2
• NPV Do Project 1
• Problem Reinvestment Assumption
• What are you going to do with the other 99,000?

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Profitability Index

• PV Cash Inflows / PV Cash Outflows
• Independent Choose all with PI 1
• Mutually Exclusive Choose highest PI
• Project 1 1.136 (113,363/100,000)
• Project 2 1.818 (1,818/1,000)
• May be useful for capital rationing

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Projects with Unequal Lives

• Replicate one or both projects, then compute NPV
• Lowest common denominator
• Equivalent annual annuity ? what annuity over the
  projects life has the same NPV
• Like repeating the projects indefinitely

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Projects with Unequal Lives

• Consider a project with
• Life 15 yrs
• NPV 228
• Cost of capital 10
• PV 228
• N 15
• I 10
• Pymt ? ( 51.80)

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Other Real Options

• Option to Expand (buy call)
• Option to Abandon (sell put)
• Strategic Options
• Excluding biases NPV down
• Decision Tree Capital Budgeting should be
  dynamic, not static

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Real Options Variables

• Value of Underlying - project
• Time
• Exercise price investment required
• Volatility of underlying
• Time value of money
• Relative Option value greatest when at the
  money NPV close to 0

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Source of NPV

• What is the economic implication of a positive
  NPV project?
• Market Opportunities - deviations from
  equilibrium
• Economies of Scale
• Cost Advantages
• Product differentiation (brand, niche)
• Distribution Advantage
• Regulatory Protection

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Relevant Cash Flows

• We can always write
• EBIT
• Depreciation
• - Taxes (t x EBIT)
• Operating Cash Flow
• - ? NWC
• - Capital Spending
• FCF

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Cash Flows

• Focus on Cash Flows not accounting s
• Depreciation
• Not a cash flow
• Affects Cash Flow through depreciation
• Capital spending
• Capitalized for accounting purposes
• Cash outflow for finance purposes

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Project Cash Flows

• Focus on Incremental Cash Flows
• What is different if project is accepted?
• Sunk Costs - those costs which have been
  incurred and are not affected by project decision
• Opportunity Cost - highest value use of an asset
  if not used in project

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Project CFs, cont.

• Externalities - less obvious costs/benefits which
  should be included in analysis
• Change in NWC - often a cash outflow initially
  and cash inflow at end
• Cash flows should be after tax
• ?Rev/Exp x (1-t)
• Depreciation x t
• Do not include interest as a cash flow

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Project CFs, cont.

• Replacement problem - should you keep an
  existing asset, or replace it with a new one
• ? in Cash Flows
• Change in revenues/expenses, net of tax
• ? in depreciation x tax rate
• Net of tax proceeds from disposal of existing
  asset
• Loss of future salvage on existing asset