International Center For Environmental Finance'

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International Center For Environmental Finance.
Environmental Finance Policy Presentation ?
Capital Budgeting Decisions
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CAPITAL BUDGETING

• Capital Budgeting is used to describe how
  managers plan projects that have long-term
  implications such as the purchase of new
  equipment and the introduction of new products or
  services.
• Managers have many potential projects that can be
  funded, hence, they must carefully select those
  projects that promise the greatest future return.

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Typical Capital Budgeting Decisions

• Cost reduction decisions. Should new equipment be
  purchased to reduce costs?
• Expansion decisions. Should a new plant,
  warehouse, or other facility be acquired or built
  to increase capacity and sales?
• Equipment selection decisions. Which of several
  available machines would be the most cost
  effective purchase?
• Lease or buy decisions. Should new equipment be
  leased or purchased ?
• Equipment replacement decisions. Should old
  equipment be replaced now or later?

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Discounted Cash Flow

• There are two approaches to making capital
  budgeting decisions by means of discounted cash
  flow.
• The net present value
• The internal rate of return

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The Net Present Value Method

• Net present value is the difference between an
  investments market value and its cost.
• In other words, net present value is a measure of
  how much value is created or added today by
  undertaking an investment, which will determine
  whether or not the project is an acceptable
  investment.

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The Net Present Value Method

• Example 1
• Moscow City Vodokanal is considering the
  purchase of a machine that will bring cash
  revenues of 20,000 per year. Cash costs
  (including taxes) will be 14,000 per year. The
  life of the machine is 8 years and its salvage
  cost will be 2,000. The project cost 30,000 to
  launch. We will use 15 discount rate.
• Should the machine be purchased?
• If there are 1,000 shares of stock outstanding,
  what will be the effect on price per share for
  taking this investment?

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The Net Present Value Method

• It may appear that the answer is obvious, since
  we pay only 30,00 for revenue of
  8x(20,000-14,000)2,00050,000
• However, it is not that obvious.
• To see if this investment is acceptable we have
  to perform Net Present Value Analysis

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The Net Present Value Method

• We need to calculate the present value of the
  future cash flows at 15 percent.
• The net cash inflow will be 20,000 cash income
  less 14,000 in costs per year for eight years.
• We have an eight-year annuity of
• 20,000-14,0006,000 per year, along with a
  single lump-sum inflow of 2,000 in eight years.

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The Net Present Value Method
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The Net Present Value Method

• Present Value 6,000x1-(1/1.158)/0.15
• (2,000/1.158)(6,000 x 4.4873)
• (2,000/3.0590)26,924654
• 27,578
• When we compare this to the 30,000 estimated
  cost ,we se that the NPV is
• NPV-30,000 27,578 -2,422
• Therefore, this is not a good investment

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The Net Present Value Method

• Now, lets answer the question regarding how this
  investment affect the value of our stock.
• It will decrease the total value of our stock by
  2,422. With 1,000 shares outstanding, we should
  expect a loss of value of
• 2,422/1,000 2,42 per share

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The Net Present Value Method

• Summary

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The Net Present Value Method

• Example 2
• Now let us consider an example that has
  different cash inflows in different periods.
• Suppose we are asked to decide whether or not a
  new consumer service product should be launched.
• Based on projected sales and costs, we expect
  that the CF over the 5 year life of the project
  will be 2,000 in the first two years, 4,000 in
  the next two, and 5,000 in the last year.
• It will cost 10,000 to begin operation and we
  use 10 discount rate.
• WHAT SHOULD WE DO?

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The Net Present Value Method

• Given the cash flows and discount rate, we can
  calculate the total value of the product by
  discounting the cash flows back to the present.
• Present Value (2,000/1.1) (2,000/1.12)
• (4,000/1.13) (4,000/1.14) (5,000/1.15)
• 1,818 1,653 3,005 2,732 3,105
• 12,313
• NPV 12,313 10,000 - 2,313

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Importance of Cash Flows

• Although, the accounting net income figure is
  useful for many things, it is not used in
  discounted cash flow analysis.
• The reason is that accounting net income is based
  on accrual concepts that ignore the timing of
  cash flows into and out of an organization.
• The timing of cash flows is important, since a
  dollar received today is more valuable than a
  dollar received in the future.
• Therefore, instead of determining accounting net
  income, the manager must concentrate on
  identifying the specific cash flows associated
  with an investment project.

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Cash Outflows

• Most projects will have an immediate cash outflow
  in the form of an initial investment in equipment
  or other assets.
• In addition, some projects require expansion of
  the working capital.
• Also, many projects require periodic repairs and
  maintenance and additional periodic costs these
  should be treated as cash outflows.

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Cash Outflows

• Cash Outflows
• Initial investment
• Increased working capital needs
• Repairs and maintenance
• Incremental operating costs

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Cash Inflows

• Any sound project will normally either increase
  revenues or reduce costs. And the amount involved
  should be treated as a cash inflow.
• Cash inflows are also frequently realized from
  salvage of equipment when the project is
  terminated.
• Also, upon termination of a project, any working
  capital that was tied up to the project can be
  released to for use elsewhere and should be
  trayed as cash inflow.

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Cash Inflows

• Cash Inflows
• Incremental revenues
• Reduction in costs.
• Salvage value
• Release of working capital

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Choosing a Discount Rate

• To use the net present value method, we must
  choose some rate of return for discounting cash
  flows to their present value.
• The firms cost of capital is usually regarded as
  the most appropriate choice for the discount
  rate.
• The cost of capital is the average rate of return
  the company must pay to its long term creditors
  for the use of their funds.

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Extended Example of the NPV Method

• Example 3
• GorVodokanal has an opportunity to offer new
  service to an industrial client, but has to
  purchase supplies and equipment from a chemical
  manufacturer in order to provide that service.
• The contract between all 3 parties is for 5 years
  with an option for renew.
• GorVodokanal is responsible for all costs of
  promotion and distribution of its new service.
• After careful study, GorVodokanal has estimated
  that the following costs and revenues would be
  associated with the new service

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Extended Example of the NPV Method
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Extended Example of the NPV Method

• At the end of the five-year period, the working
  capital would be released for investment
  elsewhere if contract will not be renewed.
• GorVodokanals discount rate and cost of capital
  is 20.
• Would you recommend that GorVodokanal undertakes
  this project?

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Extended Example of the NPV Method
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Extended Example of the NPV Method
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Extended Example of the NPV Method

• From Present Value and Present Value of an
  Annuity Tables
• Notice how working capital is handled in this
  exhibit. It is counted as a cash outflow at the
  beginning of the project and as a cash inflow
  when it is released at the end of the project.

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• Discounted Cash Flows The Internal Rate of
  Return Method

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The Internal Rate of Return Method

• The internal rate of return (IRR) method can be
  defined as the interest yield promised by an
  investment project over its useful life.
• The IRR is computed by finding the discount rate
  that equates the present value of a projects
  cash outflows with the present value of its cash
  inflows.
• In other words, the IRR is that discount rate
  that will cause the NPV of a project to be equal
  zero.

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The Internal Rate of Return Method

• Example 4
• GorVodokanal is considering the purchase of
  automatic water purification machine. At present,
  water is purified in a small labor intensive
  machine.
• The new machine would cost 16,950 and will have a
  useful life of 10 years.
• The new machine would do the job much more
  quickly and would result in labor savings of
  3,000 per year

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The Internal Rate of Return Method
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The Internal Rate of Return Method

• To compute IRR promised by the new machine, we
  must find the discount rate that will cause NPV
  of the project to be zero.
• To do that, we need to divide the investment in
  the project by the expected net annual cash
  inflow. This computation will give us a factor
  from which the IRR can be determined.

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The Internal Rate of Return Method

• Thus, from our computations, the discount factor
  that will equate a series of 3,000 cash inflows
  with a present investment of 16,950 is 5.65.
• Now, we need to find this factor in Present Value
  of an Annuity Table to see what rate of return it
  represents.
• We should use the 10 period line in Present Value
  of an Annuity Table since the cash flows for the
  project continue for 10 years.

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Present Value of an Annuity Table
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The Internal Rate of Return Method

• As we can see from Present Value of Annuity Table
  the internal rate of return promised by the water
  purification machine project is 12.
• We can verify this by computing the projects net
  present value using a 12 discount return

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The Internal Rate of Return Method
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The Internal Rate of Return Method

• Once the IRR has been computed, what does the
  manager should do with the information?
• The IRR should be compared to the companys
  required rate of return, which is the minimum
  rate of return that an investment project must
  yield to be acceptable.
• If the IRR is equal or greater than the required
  rate of return, then the project is acceptable.
• If the IRR is less than the required rate of
  return, then the project is rejected.

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The NPV of Return Method

• The NPV method can be used to compare competing
  investment projects in two ways.
• total-cost approach
• incremental-cost approach

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The Total Cost Approach

• Example 5
• GorVodokanal has one of its pipe networks in poor
  condition. This pipe network can be renovated at
  an immediate cost of 20,000. Further repairs and
  maintenance will be needed five years from now at
  a cost of 8,000. In all, this pipe network will
  be usable for 10 years if this work is done. At
  the end of 10 years, the pipe network will be
  scrapped at a salvage value of 6,000. The scrap
  value now is 7,000. It will cost 30,000 each
  year to operate pipe network, and revenues will
  total 40,000 annually

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The Total Cost Approach

• Alternative GorVodokanal can purchase a new pipe
  network at a cost of 36,000. The new pipe
  network will have a life of 10 years and will
  require some repairs at the end of 5 years and
  will amount to 3,000. At the end of 10 years, it
  is estimated that the scrap value would be
  6,000. It will cost 21,000 each year to
  operate the pipe network, and revenues will total
  40,000 annually.
• GorVodokanal requires a return of at least 18 on
  all investment capital.

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The Total Cost Approach
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The Total Cost Approach
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The Total Cost Approach
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The Total Cost Approach
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The Incremental Cost Approach

• When only two alternatives are being considered,
  the incremental cost approach offers a simpler
  and more direct decision.
• Unlike the total cost approach, it focuses only
  on differential costs.

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The Incremental Cost Approach
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The Ranking of Investment Projects

• When considering investment opportunities,
  managers must make two types of decisions
• screening, and
• preference decisions.
• Screening decisions pertain whether or not
  proposed investments are acceptable.
• Preference decisions come after screening
  decisions and attempt to rank selected projects
  in terms of preference.

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The Ranking of Investment Projects

• Internal rate of Return Method
• When using IRR to rank competitive investment
  projects, the preference rule is The higher the
  IRR, the more desirable the project.
• For example, an investment project with an IRR of
  18 is preferable to another project that
  promises a return of only 15.

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The Ranking of Investment Projects

• Net Present Value Method
• If the NPV method is used to rank projects, the
  NPV of one project cannot be compared directly to
  NPV of another project unless the investments in
  the projects are of equal size.

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The Ranking of Investment Projects NPV Method

• Example 6

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The Ranking of Investment Projects NPV Method

• Each project has a net present value of 1,000,
  but they are not equally desirable.
• The project requiring an investment of only
  5,000 is much more desirable (especially when
  funds are limited) than the project requiring
  80.000.
• However, there is a way to compare the two
  projects on a valid basis its called
  Profitability Index.

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The Ranking of Investment Projects NPV Method

• To calculate profitability index we need to
  divide the present value of all cash inflows by
  the investment required.
• The formula for profitability index is

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The Ranking of Investment Projects NPV Method
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• Other Approaches to Capital Budgeting Decisions
• The Payback Method
• The Simple Rate of Return

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The Payback Method

• The payback method centers on a spam of time
  known as the 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 is less than some prespecified number
  of years.
• The payback period is a flawed criterion,
  primarily because it ignores risk, the time value
  of money, and cash flows beyond the cutoff point.

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The Payback Method

• Example 7
• GorVodokanal needs a new piece of equipment and
  considers two machines machine A and Machine B.
• Machine A costs 15,000 and will reduce operating
  costs by 5,000 per year.
• Machine B costs 12,000 and will also reduce
  operating costs by 5,000 per year
• Which Machine should be purchased?

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The Payback Method
GorVodokanal should purchase machine B, since it
has a shorter payback period than A.
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Evaluation of the Payback Method

• The payback method is not a true measure of the
  profitability of an investment.
• Managers should not make investment decisions
  based on this method alone. Instead it should be
  used as a screening tool to determine which
  projects are worth further consideration.

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Evaluation of the Payback Method

• Payback method does not take into account
  differences between useful lives between
  investments.
• Furthermore, payback method does not consider the
  time value of money. A cash inflow to be received
  several years in the future is weighed equally
  with a cash inflow received today.