Capital Budgeting Chapter 8

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Capital Budgeting(Chapter 8)
Professor Dr. Rainer Stachuletz Corporate
Finance Berlin School of Economics
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The Capital Budgeting Decision Process
Managers should separate investment and financing
decisions.
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Capital Budgeting Decision Techniques
Accounting rate of return (ARR) focuses on
projects impact on accounting profits
Payback period most commonly used
Net present value (NPV) best technique
theoretically difficult to calculate
realistically
Internal rate of return (IRR) widely used with
strong intuitive appeal, theoretically
inappropriate.
Profitability index (PI) related to NPV
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A Capital Budgeting Process Should
Account for the time value of money
Account for risk
Focus on cash flow
Rank competing projects appropriately, and
Lead to investment decisions that maximize
shareholders wealth.
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Accounting Rate Of Return (ARR)
Can be computed from available accounting data
ARR uses accounting numbers, not cash flows no
time value of money.
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Payback Period
Management determines maximum acceptable payback
period.
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Net Present Value
The present value of a projects cash inflows and
outflows
Discounting cash flows accounts for the time
value of money.
Choosing the appropriate discount rate accounts
for risk.
Accept projects if NPV gt 0.
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Calculating NPVs for Global Wireless Projects

• Assuming Global Wireless uses 18 discount rate,
  NPVs are

Western Europe project NPV 75.3 million
Southeast U.S. project NPV 25.7 million
Should Global Wireless invest in one project or
both?
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Pros and Cons of Using NPV as Decision Rule
NPV is the gold standard of investment decision
rules.
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Internal Rate of Return
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Calculating IRRs for Global Wireless Projects
Global Wireless will accept all projects with at
least 18 IRR.
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Calculating IRRs for Global Wireless Projects
27.91
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Advantages and Disadvantages of IRR

• Advantages of IRR

• Properly adjusts for time value of money (???)
• Uses cash flows rather than earnings
• Accounts for all cash flows
• Project IRR is a number with intuitive appeal

Disadvantages of IRR

• Mathematical problems multiple IRRs, no real
  solutions
• Scale problem
• Timing problem

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Multiple IRRs
NPV ()
NPVgt0
IRR
NPVgt0
Discount rate
NPVlt0
NPVlt0
IRR
When project cash flows have multiple
sign changes, there can be multiple IRRs.
With multiple IRRs, which do we compare with the
cost of capital to accept/reject the project?
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No Real Solution
Sometimes projects do not have a real IRR
solution.
Project is a bad idea based on NPV. At r 18,
project has negative NPV, so reject!
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Conflicts Between NPV and IRR
NPV and IRR do not always agree when ranking
competing projects.
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The Timing Problem

• The NPV of the long-term project is more
  sensitive to the discount rate than the NPV of
  the short-term project is.

• Long-term project has higher NPV if the cost of
  capital is less than 13. Short-term project has
  higher NPV if the cost of capital is greater than
  13.

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Profitability Index
Calculated by dividing the PV of a projects cash
inflows by the PV of its outflows
Like IRR, PI suffers from the scale problem.
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Cash FlowandCapital Budgeting(Chapter 9)
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Cash Flow VersusAccounting Profit
Capital budgeting concerned with cash flow, not
accounting profit.
The timing and magnitude of cash flows and
accounting profits can differ dramatically.
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Financing Costs
Financing costs are captured in the discounting
future cash flows to present.
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Cash Flow and Non-Tax Expenses

• Accountants charge depreciation to spread a fixed
  assets costs over time to match its benefits.
• Capital budgeting analysis focuses on cash
  inflows and outflows when they occur.
• Non-cash expenses affect cash flow through their
  impact on taxes
• Compute after-tax net income and add depreciation
  back, or
• Ignore depreciation expense but add back its tax
  savings.

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Depreciation
Many countries allow one depreciation method for
tax purposes and another for reporting purposes.

• Accelerated depreciation methods (such as MACRS)
  increase the present value of an investments tax
  benefits.
• Relative to MACRS, straight-line depreciation
  results in higher reported earnings early in an
  investments life.

For capital budgeting analysis, the depreciation
method for tax purposes matters most.
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The Initial Investment

• Initial cash flows
• Cash outflow to acquire/install fixed assets
• Cash inflow from selling old equipment
• Cash inflow (outflow) if selling old equipment
  below (above) tax basis generates tax savings
  (liability)

Initial investment outflow of 10.5 million, and
after-tax inflow of 0.60 million from selling
the old equipment
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Working Capital Expenditures

• Many capital investments require additions to
  working capital.
• Net working capital (NWC) current assets
  current liabilities.
• Increase in NWC is a cash outflow decrease a
  cash inflow.

• An example
• Operate booth from November 1 to January 31
• Order 15,000 calendars on credit, delivery by
  Nov 1
• Must pay suppliers 5,000/month, beginning Dec 1
• Expect to sell 30 of inventory (for cash) in
  Nov 60 in Dec 10 in Jan
• Always want to have 500 cash on hand

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Terminal Value
Terminal value is used when evaluating an
investment with indefinite life-span
Construct cash-flow forecasts for 5 to 10 years
Forecasts more than 5 to 10 years have high
margin of error use terminal value instead.

• Terminal value is intended to reflect the value
  ofproject at a given future point in time.
• Large value relative to all the other cash flows
  of the project.

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Terminal Value
JDS Uniphase cash flow projections for
acquisition of SDL Inc.
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Terminal Value of SDL Acquisition

• Assume that cash flow continues to grow at 5 per
  year (g 5, r 10, cash flow for year 6 is
  3.41 billion)

• Terminal value is 68.2 billion value of entire
  project is

• 42.4 billion of total 48.7 billion from
  terminal value

• Using price-to-cash-flow ratio of 20 for
  companies in the same industry as SDL to compute
  terminal value
• Terminal Value 3.25 x 20 65 billion
• Warning ! market multiples fluctuate over time

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Incremental Cash Flow
Incremental cash flows versus sunk costs
Capital budgeting analysis should include only
incremental costs.
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Incremental Cash Flow

• At end of two years assume that Norm receives a
  salary offer of 90,000, which increases at 8
  per year
• Expected tuition, fees and textbook expenses for
  next two years while studying in MBA 35,000
• If Norm worked at his current job for two years,
  his salary would have increased to 66,150
• Yr 2 net cash inflow 90,000 - 66,150 23,850
• After-tax inflow 23,850 x (1-0.35) 15,503
• Yr 3 cash inflow
• MBA has substantial positive NPV value if 30 yr
  analysis period

What about Norms opportunity cost?
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Opportunity Costs
Cash flows from alternative investment
opportunities, forgone when one investment is
undertaken.
If Norm did not attend MBA program, he would
haveearned
Second Year 63,000 (40,950 after taxes)
First year 60,000 (39,000 after taxes)
NPV of a project could fall substantially if
opportunity costs are recognized!
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Risk and Capital Budgeting(Chapter 10)
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Choosing the Right Discount Rate
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A Simple Case
In this case, the appropriate discount rate
equals the cost of equity.
Cost of equity estimated using the CAPM
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Carbonlite Inc. Cost of Equity
Carbonlite Inc., an all-equity firm, is
evaluating a proposal to build a new
manufacturing facility.

• Firm manufactures bicycle frames.
• As a luxury good producer, firm is very sensitive
  to economy (product demand is elastic).
• Carbonlites stock has a beta of 1.5

E(Re ) Rf ?(E(Rm) - Rf) 5 1.5(11-5)
14 cost of equity
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Cost of Equity
Beta plays a central role in determining whether
a firms cost of equity is high or low.
What factors influence a firms beta?
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Carbonlite Inc. vs. Fiberspeed Corp.
The two firms are in the same industry.
Carbonlites EBIT increases faster because it has
high operating leverage.
What if sales volume increases by 10 ?
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Operating Leverage for Carbonlite and Fiberspeed
?EBIT
Carbonlite
 
Fiberspeed
?Sales
Other things equal, higher operating leverage
means that Carbons beta will be higher than
Fibers beta.
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The Effect of Financial Leverage on Beta
Financial leverage makes Firm 2s ROE more
volatile, so its beta will be higher .
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The Weighted Average Cost of Capital (WACC)
Cost of equity applies to projects of an
all-equity firm.

• But what if firm has both debt and equity?
• Problem is akin to finding expected return of
  portfolio.

Use weighted average cost of capital (WACC) as
discount rate.

• Lox-in-a-Box is a chain of (very) fast food
  stores.
• Firm has 100 million equity (E), with cost of
  equity re 15
• Also has bonds (D) worth 50 million, with rd
  9.
• Cost structure / financial structure remains
  unchanged.

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Rules for Selecting an Appropriate Project
Discount Rate
Cost of equity is the appropriate discount rate
for an all-equity firm.
When a levered firm invests in a project similar
to its existing projects, the WACC is the right
discount rate.
When a firm invests in a project different than
its existing projects, using the WACC may lead to
mistakes.
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Accounting for Taxes in Finding WACC
Accounting for taxes doesnt change the rules for
selecting the discount rate.
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A Closer Look at RiskBreak-Even Analysis
Managers often want to assess business value
drivers.
Finding the break-even point is often useful for
assessing operating risk.
Break-even point (BEP) is level of output where
all operating costs (fixed and variable) are
covered.
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Break-Even Point for Carbonlite
Carbonlite has high fixed costs (5,000,000), but
also high contribution margin (600/bike). High
BEP, but once FC covered, profits grow rapidly.
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Break-Even Point for Fiberspeed
Fiberspeed has low fixed costs (2,000,000), but
also low contribution margin (300/bike). Low
BEP, but profits grow slowly after FC covered.
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Sensitivity Analysis
GTI has developed a new skateboard. Base case
assumptions yield NPV 236,000.

• 1.   The projects life is five years.
• 2.   The project requires an up-front investment
  of 7 million.
• 3.   GTI will depreciate initial investment on
  straight line basis for five years.

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Sensitivity Analysis
4. One year from now, the skateboard industry
will sell 500,000 units. 5.  Total industry unit
volume will increase by 5 per year. 6.  GTI
expects to capture 5 of the market in the first
year. 7. GTI expects to increase its market
share one percentage point each year after year
one. 8. The selling price will be 200 in year
one 9.  Selling price will decline by 10 per
year after year one. 10. Variable production
costs will equal 60 of the selling price. 11.
The appropriate discount rate is 14 percent.
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Sensitivity Analysis of Skateboard Project
Dollar values in thousands except price
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Real Options in Capital Budgeting
Option pricing analysis is helpful in examining
multi-stage projects.
Embedded options arise naturally from
investment are called real options to distinguish
from financial options.
Value of a project equals value captured by NPV,
plus option.
Can transform negative NPV projects into
positive NPV!
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Real Options in Capital Budgeting
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Risk And Capital Budgeting

• All-equity firms can discount their standard
  investment projects at cost of equity.
• Firms with debt and equity can discount their
  standard investment projects using WACC.
• A variety of tools exist to assist managers in
  understanding the sources of uncertainty of a
  projects cash flows.