The Basics of Capital Budgeting

1
The Basics of Capital Budgeting

• FIL 404
• Keldon Bauer

2
Capital Budgeting Basics

• Definition Planning and evaluating expenditures
  on assets whose cash flows are expected to extend
  beyond a year.
• Any purchase of long-lived assets should be
  justified by the techniques discussed in this
  chapter.

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Capital Budgeting Basics

• Project In the lingo of capital budgeting any
  purchase of long-lived assets is called a
  project.
• Projects can only be justified if the purchase is
  expected to enhance shareholder wealth (if the
  value of the firm will increase after adoption of
  the project).

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Steps in Capital Budgeting

• Estimate cash flows (inflows outflows).
• Assess risk of cash flows.
• Determine r WACC for project.
• Evaluate cash flows.

5
Independent versus Mutually Exclusive Projects

• Projects are
• independent, if the cash flows of one are
  unaffected by the acceptance of the other.
• mutually exclusive, if the cash flows of one can
  be adversely impacted by the acceptance of the
  other.

6
Evaluation Techniques

• Six methods to evaluate capital budgeting
  projects
• Payback period,
• Discounted payback period,
• Net present value (NPV),
• Internal rate of return (IRR),
• Modified internal rate of return (MIRR).
• Profitability Index

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Payback Period

• Meant to measure the time it takes to recoup the
  initial investment (ignoring the time value of
  money).
• The quicker the payback period (smaller the
  number), the better!
• To calculate payback period follow the following
  4 steps

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Payback Period - Steps

• Create cash flow time line.
• Add a line for cumulative cash flow.
• Identify the last year that cumulative cash flow
  is negative, we will call it A.
• Payback period is calculated as follows

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Payback Period - Example

• As the Chief Financial Officer of Spamway, Corp.,
  you have been presented with the following two
  potential projects.

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Payback Period - Example 1
Step 3 Last negative year is 3 È
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Payback Period - Example 2
Step 3 Last negative year is 3 È
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Discounted Payback Period

• Meant to adjust payback period for the time value
  of money.
• Still the quicker the payback period (smaller the
  number), the better!
• To calculate payback period follow the following
  5 steps

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Payback Period - Steps

• Create cash flow time line.
• Convert cash flow to present value.
• Add a line for cumulative PV(CF).
• Identify the last year that cumulative PV(CF) is
  negative, we will call it A.
• Payback period is calculated as follows

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Discounted Payback - Example

• As the Chief Financial Officer of Spamway, Corp.,
  you have been presented with the following two
  potential projects. Assume a 9 discount rate.

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Discounted Payback - Example 1
Step 4 Last negative year is 3 È
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Discounted Payback - Example 2
Step 4 Last negative year is 4
È
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Net Present Value

• The philosophy behind the net present value (NPV)
  is how much should adoption of the project have
  on the overall value of the firm.
• NPV is the sum of all outlays in present value
  terms.
• Since outlays are negative, and inflows are
  positive, the net represents addition to value of
  the firm.

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NPV - Example

• As the Chief Financial Officer of Spamway, Corp.,
  you have been presented with the following two
  potential projects. Assume a 9 discount rate.

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NPV - Example 1
321.45 Net Present Value
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NPV - Example 2
643.83 Net Present Value
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NPV - Excel

• Excel has some unnecessary challenges doing NPV.
• The NPV function assumes that all cash flows
  begin in year 1 (not in year 0), so the easiest
  way of getting it to do NPV correctly is
• NPV(Rate, Range of CF1 CFn) CF0
• For example NPV(9,A3A7)A2

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NPV - Example
Excel Formula NPV(18, B3B7)B2 321.45
Excel Formula NPV(18, C3C7)C2 643.83
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Internal Rate of Return

• The internal rate of return (IRR) represents the
  effective interest earned on the investment.
• The internal rate of return, therefore, is
  defined as the discount rate at which NPV equals
  zero.
• The only way to solve this problem is for a
  computer or a calculator to iterate to the answer.

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IRR - Example

• As the Chief Financial Officer of Spamway, Corp.,
  you have been presented with the following two
  potential projects.

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IRR - Example
Excel Formula IRR(B2B7) 16.82
Excel Formula IRR(C2C7) 16.37
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IRR Problems

• IRR has two major problems.
• First, it assumes that all cash inflows will earn
  the IRR rate instead of the much more likely
  discount rate.
• Second, depending on the cash flow streams there
  can be more than one IRR.

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Multiple IRRs

• As an example of more than one IRR, lets assume
  you have a project that will return a net 4,000
  in year zero (salvage of old machine, and
  financing, etc.), nets a negative 25,000 in year
  one, and finishes with a positive 25,000 in year
  two.

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Multiple IRRs - Example

• Since the IRR is defined as the discount rate
  which yields an NPV of zero

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Multiple IRRs - Example

• Multiplying both sides by (1k)2 yields

Factoring the above polynomial
k IRR 25 or 400
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Multiple IRRs - Example
31
NPV Profiles

• To create an NPV profile, plot NPV on the Y axis
  and the discount rate on the X axis.
• Since the discount rate should be sensitive to
  changes in project risk, the NPV profile will
  show how sensitive the projected NPV is to the
  appropriate discount rate.

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NPV Profiles
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NPV Profiles

• The crossover rate is the rate at which both
  projects have the same NPV.
• If one knows the crossover rate, then one can
  assess the probability of the discount rate being
  that low (high), and can better rank the priority
  of potential projects.

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NPV Profiles

• The slope of the lines in an NPV profile measures
  the sensitivity of NPV to the discount rate
  chosen.
• In the books example the L represents a longer
  payback and S a shorter payback.
• The longer the payback the more sensitive the NPV
  will be to the discount rate.

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Note on MIRRs

• Modified IRRs (or MIRRs) can be used in place of
  an IRR, and all of the problems will be solved.
• For Excel to yield an IRR, it needs the cash
  flows. You will also need the finance rate (your
  WACC), and the reinvestment rate (the rate at
  which you will be able to reinvest proceeds).
• These two rates can be the same.

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Notes on MIRRs - continued

• To get Excel to calculate an MIRR use the
  following formula
• MIRR(Cash Flow Range, WACC, Reinvest )
• For example MIRR(A2A7, 9, 9)

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MIRR - Example

• As the Chief Financial Officer of Spamway, Corp.,
  you have been presented with the following two
  potential projects. Assume a 9 discount rate.

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MIRR - Example
Excel Formula MIRR(B2B7, 9, 9) 13.32
Excel Formula MIRR(C2C7, 9, 9) 13.32
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Profitability Index

• Measures the benefit per unit cost, based on the
  time value of money
• A profitability index of 1.1 implies that for
  every 1 of investment, we create an additional
  0.10 in value
• This measure can be very useful in situations
  where we have limited capital

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Profitability Index - Example

• As the Chief Financial Officer of Spamway, Corp.,
  you have been presented with the following two
  potential projects. Assume a 9 discount rate.

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Profitability Index - Example

• Step 1 Calculate the present value of all
  future cash flows
• PV of G 1,821.45
• PV of Y 3,643.83
• Step 2 Divide the present value from step 1 by
  the initial outlay

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S and L are mutually exclusive and will be
repeated. r 10.
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NPVL gt NPVS. But is L better?
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Put Projects on Common Basis

• Note that Project S could be repeated after 2
  years to generate additional profits.
• Use replacement chain to put on common life.

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Replacement Chain Approach (000s).Franchise S
with Replication
46
Or, use NPVs
0
1
2
3
4
4,132 3,415 7,547
4,132
10
Compare to Franchise L NPV 6,190.
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Suppose cost to repeat S in two years rises to
105,000.
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Economic Life versus Physical Life

• Consider another project with a 3-year life.
• If terminated prior to Year 3, the machinery will
  have positive salvage value.
• Should you always operate for the full physical
  life?
• See next slide for cash flows.

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Economic Life versus Physical Life
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CFs Under Each Alternative (000s)
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NPVs under Alternative Lives (Cost of capital
10)

• NPV(3) -123.
• NPV(2) 215.
• NPV(1) -273.

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Conclusions

• The project is acceptable only if operated for 2
  years.
• A projects engineering life does not always
  equal its economic life.

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Choosing the Optimal Capital Budget

• Finance theory says to accept all positive NPV
  projects.
• Two problems can occur when there is not enough
  internally generated cash to fund all positive
  NPV projects
• An increasing marginal cost of capital.
• Capital rationing

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Increasing Marginal Cost of Capital

• Externally raised capital can have large
  flotation costs, which increase the cost of
  capital.
• Investors often perceive large capital budgets as
  being risky, which drives up the cost of capital.

(More...)
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Increasing Marginal Cost of Capital

• If external funds will be raised, then the NPV of
  all projects should be estimated using this
  higher marginal cost of capital.

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Capital Rationing

• Capital rationing occurs when a company chooses
  not to fund all positive NPV projects.
• The company typically sets an upper limit on the
  total amount of capital expenditures that it
  will make in the upcoming year.

(More...)
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Capital Rationing

• Reason Companies want to avoid the direct costs
  (i.e., flotation costs) and the indirect costs of
  issuing new capital.
• Solution Increase the cost of capital by enough
  to reflect all of these costs, and then accept
  all projects that still have a positive NPV with
  the higher cost of capital.

(More...)
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Capital Rationing

• Reason Companies dont have enough managerial,
  marketing, or engineering staff to implement all
  positive NPV projects.
• Solution Use linear programming to maximize NPV
  subject to not exceeding the constraints on
  staffing.

(More...)
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Capital Rationing

• Reason Companies believe that the projects
  managers forecast unreasonably high cash flow
  estimates, so companies filter out the worst
  projects by limiting the total amount of projects
  that can be accepted.
• Solution Implement a post-audit process and tie
  the managers compensation to the subsequent
  performance of the project.