Capital Budgeting

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Capital Budgeting
Prof. Larry Tan Asian Institute of
Management Franklin Baker Co. of the Phils.
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Capital Budgeting

• USING THE NET PRESENT VALUE RULE TO MAKE
  VALUE-CREATING INVESTMENT DECISIONS

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Background

• A good investment decision
• One that raises the current market value of the
  firms equity, thereby creating value for the
  firms owners
• Capital budgeting involves
• Comparing the amount of cash spent on an
  investment today with the cash inflows expected
  from it in the future
• Discounting is the mechanism used to account for
  the time value of money
• Converts future cash flows into todays
  equivalent value called present value or
  discounted value
• Apart the timing issue, there is also the issue
  of the risk associated with future cash flows
• Since there is always some probability that the
  cash flows realized in the future may not be the
  expected ones

4
Background

• After this session, participants should
  understand
• The major steps involved in a capital budgeting
  decision
• How to calculate the present value of a stream of
  future cash flows
• The net present value (NPV) rule and how to apply
  it to investment decisions
• Why a projects NPV is a measure of the value it
  creates
• How to use the NPV rule to choose between
  projects of different sizes or different useful
  lives
• How the flexibility of a project can be described
  with the help of managerial options

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The Capital Investment Process

• Capital investment decision (capital budgeting
  decision, capital expenditure decision) involves
  four steps
• Identification
• Evaluation
• Selection
• Implementation and audit
• Investment proposals are also often classified
  according to the difficulty in estimating the key
  valuation parameters
• Required investments
• Replacement investments
• Expansion investments
• Diversification investments

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EXHIBIT 1 The Capital Investment Process.
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Assessing a Capital Budget

• Without time value of money
• Payback period
• Bailout payback
• With time value of money
• Discounted payback
• Net present value
• Profitability index
• Internal rate of return
• Annuity equivalent cash flow

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Why The NPV Rule Is A Good Investment Rule

• The NPV rule is a good investment rule because
• Measures value creation
• Reflects the timing of the projects cash flows
• Reflects its risk
• Additive

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A Measure Of Value-Creation

• The present value of a projects expected cash
  flows stream at its cost of capital
• Estimate of how much the project would sell for
  if a market existed for it
• The net present value of an investment project
  represents the immediate change in the wealth of
  the firms owners if the project is accepted
• If positive, the project creates value for the
  firms owners if negative, it destroys value

10
Adjustment For The Timing Of The Projects Cash
Flows

• NPV rule takes into consideration the timing of
  the expected future cash flows
• Demonstrated by comparing two mutually exclusive
  investments with the same initial cash outlay and
  the same cumulated expected cash flows
• But with different cash flow profiles
• Exhibit 2 describes the two investments
• Exhibit 3 shows the computation of the two
  investments net present values

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EXHIBIT 2 Cash Flows for Two Investments with
CF0 1 Million and k 0.10.
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EXHIBIT 3 Present Values of Cash Flows for Two
Investments.Figures from Exhibit 2
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Adjustment For The Risk Of The Projects Cash
Flows

• Risk adjustment is made through the projects
  discount rate
• Because investors are risk averse, they will
  require a higher return from riskier investments
• As a result, a projects opportunity cost of
  capital will increase as the risk of the
  investment increases
• By discounting the project cash flows at a
  higher rate, the projects net present value will
  decrease

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EXHIBIT 4 Cash Flows for Two Investments with
CF0 1 Million, k 0.12 for Investment C, and
k 0.15 for Investment D.
Exhibit 4 describes two investments with the same
initial cash outlay, the same cumulative cash
flows, the same cash flow profile, but with
different cost of capital.
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EXHIBIT 4a Present Values of Cash Flows for Two
Investments.Figures from Exhibit 4
Exhibit 4 shows the computation of the two
investments net present values.
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EXHIBIT 4b Present Values of Cash Flows for Two
Investments.Figures from Exhibit 1.3
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Additive Property

• If one project has an NPV of 100,000 and another
  an NPV of 50,000
• The two projects have a combined NPV of 150,000
• Assuming that the two projects are independent
• Additive property has some useful implications
• Makes it easier to estimate the impact on the net
  present value of a project of changes in its
  expected cash flows, or in its cost of capital
  (risk)
• An investments positive NPV is a measure of
  value creation to the firms owners only if the
  project proceeds according to the budgeted
  figures
• Consequently, from the managers perspective, a
  projects positive NPV is the maximum present
  value that they can afford to lose on the
  project and still earn the projects cost of
  capital

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Special Cases Of Capital Budgeting

• Comparing projects with unequal sizes
• If there is a limit on the total capital
  available for investment
• Firm cannot simply select the project(s) with the
  highest NPV
• Must first find out the combination of
  investments with the highest present value of
  future cash flows per dollar of initial cash
  outlay
• Can be done using the projects profitability
  index

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Special Cases Of Capital Budgeting

• Firm should first rank the projects in decreasing
  order of their profitability indexes
• Then select projects with the highest
  profitability index
• Until it has allocated the total amount of funds
  at its disposal
• However, the profitability index rule may not be
  reliable
• When choosing among mutually exclusive
  investments
• When capital rationing extends beyond the first
  year of the project

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EXHIBIT 5 Cash Flows, Present Values, and Net
Present Values for Three Investments of Unequal
Size with k 0.10.
Exhibit 5 describes the analysis of three
investment projects of different sizes.
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EXHIBIT 6 Profitability Indexes for Three
Investments of Unequal Size.Figures from
Exhibit 6.12
Exhibit 6 shows the profitability index of the
three investments.
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Special Cases Of Capital Budgeting

• Comparing projects with unequal life spans
• If projects have unequal lives
• Comparison should be made between sequences of
  projects such that all sequences have the same
  duration
• In many instances, the calculations may be
  tedious
• Possible to convert each projects stream of cash
  flows into an equivalent stream of equal annual
  cash flows with the same present value as the
  total cash flow stream
• Called the constant annual-equivalent cash flow
  or annuity-equivalent cash flow
• Then, simply compare the size of the annuities

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EXHIBIT 7a Cash Outflows and Present Values of
Cost for Two Investments with Unequal Life Spans.
Exhibit 7 illustrates the case of choosing
between two machines, one having an economic life
half that of the other.
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EXHIBIT 7b Cash Outflows and Present Values of
Cost for Two Investments with Unequal Life Spans.
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EXHIBIT 8Original and Annuity-Equivalent Cash
Flows for Two Investments with Unequal Life
Spans.Figures from Exhibit 6.14 and Appendix 6.1
Exhibit 8 shows how to apply the
annuity-equivalent cash flow approach to the
choice between the two machines.
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Limitations Of The Net Present Value Criterion

• Although the net present value criterion can be
  adjusted for some situations
• It ignores the opportunities to make changes to
  projects as time passes and more information
  becomes available
• NPV rule is a take-it-or-live-it rule
• A project that can adjust easily and at a low
  cost to significant changes such as
• Marketability of the product
• Selling price
• Risk of obsolescence
• Manufacturing technology
• Economic, regulatory, and tax environments
• Will contribute more to the value of the firm
  than indicated by its NPV
• Will be more valuable than an alternative project
  with the same NPV, but which cannot be altered as
  easily and as cheaply
• A projects flexibility is usually described by
  managerial options

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Managerial Options Embedded In Investment
Projects

• The option to switch technologies
• Discussed using the designer desk lamp project of
  Sunlight Manufacturing Company (SMC) as an
  illustration
• The option to abandon a project
• Can affect its net present value
• Demonstrated using an extended version of the
  designer-desk lamp project
• Although the project was planned to last for five
  years, we assume now that SMCs management will
  always have the option to abandon the project at
  an earlier date
• Depending on if the project is a success or a
  failure

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Dealing With Managerial Options

• Above options are not the only managerial options
  embedded in investment projects
• Option to expand
• Option to defer a project
• Managerial options are either worthless or have a
  positive value
• Thus, NPV of a project will always underestimate
  the value of an investment project
• The larger the number of options embedded in a
  project and the higher the probability that the
  value of the project is sensitive to changing
  circumstances
• The greater the value of those options and the
  higher the value of the investment project itself

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Dealing With Managerial Options

• Valuing managerial options is a very difficult
  task
• Managers should at least conduct a sensitivity
  analysis to identify the most salient options
  embedded in a project, try at valuing them and
  then exercise sound judgment

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EXHIBIT 10 Steps Involved in Applying the Net
Present Value Rule.
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Capital Budgeting

• ALTERNATIVES TO THE NPV RULE

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Background

• We will examine four alternatives to the NPV
  method
• Ordinary payback period
• Discounted payback period
• Internal rate of return
• Profitability index
• You should understand
• The four alternatives to NPV method and how to
  calculate them
• How to apply the alternative rules to screen
  investment proposals
• Major shortcomings of the alternative rules
• Why these rules are still used even though they
  are not as reliable to the NPV rule

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Conditions of a Good Investment Decision

• Does it adjust for the timing of the cash flows?
• Does it take risk into consideration?
• Does it maximize the firms equity value?

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The Payback Period

• A projects payback period is the number of
  periods required for the sum of the projects
  cash flows to equal its initial cash outlay
• Usually measured in years

35
The Payback Period Rule

• According to this rule, a project is acceptable
  if its payback period is shorter than or equal to
  the cutoff period
• For mutually exclusive projects, the one with the
  shortest payback period should be accepted

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Does the payback period rule meet the conditions
of a good investment decision?

• Adjustment for the timing of cash flows?
• Ignores the time value of money
• Adjustment for risk?
• Ignores risk
• Maximization of the firms equity value?
• No objective reason to believe that there exists
  a particular cutoff period that is consistent
  with the maximization of the market value of the
  firms equity
• The choice of a cutoff period is always arbitrary
  
• The rule is biased against long-term projects

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Why Do Managers Use The Payback Period Rule?

• Payback period rule is used by many managers
• Often in addition to other approaches
• Redeeming qualities of this rule
• Simple and easy to apply for small, repetitive
  investments
• Favors projects that pay back quickly
• Thus, contribute to the firms overall liquidity
• Can be particularly important for small firms
• Makes sense to apply the payback period rule to
  two investments that have the same NPV
• Because it favors short-term investments, the
  rule is often employed when future events are
  difficult to quantify
• Such as for projects subject to political risk

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The Discounted Payback Period

• The discounted payback period, or economic
  payback period
• Number of periods required for the sum of the
  present values of the projects expected cash
  flows to equal its initial cash outlay
• Compared to ordinary payback periods
• Discounted payback periods are longer
• May result in a different project ranking

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The Discounted Payback Period Rule

• The discounted payback period rule says that a
  project is acceptable
• If discounted payback period is shorter or equal
  to the cutoff period
• Among several projects, the one with the shortest
  period should be accepted

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Does the discounted payback period rule meet the
conditions of a good investment decision?

• Adjustment for the timing of cash flows?
• The rule considers the time value of money
• Adjustment for risk?
• The rule considers risk
• Maximization of the firms equity value?
• If a projects discounted payback period is
  shorter than the cutoff period
• Projects NPV when estimated with cash flows up
  to the cutoff period is always positive
• The rule is biased against long-term projects
• The discounted payback period rule cannot
  discriminate between the two investments

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The Discounted Payback Period Rule Vs. The
Ordinary Payback Period Rule

• The discounted payback period rule is superior to
  the ordinary payback period rule
• Considers the time value of money
• Considers the risk of the investments expected
  cash flows
• However, the discounted payback period rule is
  more difficult to apply
• Requires the same inputs as the NPV rule
• Used less than the ordinary payback period rule

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The Internal Rate Of Return (IRR)

• A project's internal rate of return (IRR) is the
  discount rate that makes the net present value
  (NPV) of the project equal to zero
• An investments IRR summarizes its expected cash
  flow stream with a single rate of return that is
  called internal
• Because it only considers the expected cash flows
  related to the investment
• Does not depend on rates that can be earned on
  alternative investments

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The IRR Rule

• A project should be accepted if its IRR is higher
  than its cost of capital and rejected if it is
  lower
• If a projects IRR is lower than its cost of
  capital, the project does not earn its cost of
  capital and should be rejected

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Does the IRR rule meet the conditions of a good
investment decision?

• Adjustment for the timing of cash flows?
• Considers the time value of money
• Adjustment for risk?
• The rule takes risk into consideration
• The risk of an investment does not enter into the
  computation of its IRR, but the IRR rule does
  consider the risk of the investment because it
  compares the projects IRR with the minimum
  required rate of return--a measure of the risk of
  the investment

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The IRR Rule May Be Unreliable

• The IRR rule may lead to an incorrect investment
  decision when
• Two mutually exclusive projects are considered
• A projects cash flow stream changes sign more
  than once

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Investments With Some Negative Future Cash Flows

• Negative cash flows can occur when an investment
  requires the construction of several facilities
  that are built at different times
• When negative cash flows occur a project may have
  multiple IRRs or none at all
• Firm should ignore the IRR rule and use the NPV
  rule instead

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Why Do Managers Usually Prefer The IRR Rule To
The NPV Rule?

• IRR calculation requires only a single input (the
  cash flow stream)
• However, applying the IRR rule still requires a
  second inputthe cost of capital
• When a projects cost of capital is uncertain,
  the IRR method may be the answer
• Most managers find the IRR easier to understand
• Managers usually have a good understanding of
  what an investment should "return
• Advice Compute both a projects IRR and NPV
• If they agree, use the IRR
• If they disagree, trust the NPV rule

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The Profitability Index (PI)

• The profitability index
• Benefit-to-cost ratio equal to the ratio of the
  present value of a projects expected cash flows
  to its initial cash outlay

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The Profitability Index Rule

• According to the PI rule a project should be
  accepted if its profitability index is greater
  than one and rejected if it is less than one

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Does the PI rule meet the conditions of a good
investment decision?

• Adjustment for the timing of cash flows?
• Takes into account the time value of money
• Projects expected cash flows are discounted at
  their cost of capital
• Adjustment for risk?
• The PI rule considers risk because it uses the
  cost of capital as the discount rate
• Maximization of the firms equity value?
• When a projects PI gt 1 the projects NPV gt 0 and
  vice-versa
• Thus, it may appear that PI is a substitute for
  the NPV rule
• Unfortunately, the PI rule may lead to a faulty
  decision when applied to mutually exclusive
  investments with different initial cash outlays

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Use Of The Profitability Index Rule

• The PI is a relative measure of an investments
  value
• NPV is an absolute measure
• Thus, the PI rule can be a useful substitute for
  the NPV rule when presenting a projects benefits
  per dollar of investment

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Capital Budgeting

• IDENTIFYING AND ESTIMATING
• A PROJECTS CASH FLOWS

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Background

• Fundamental principles guiding the determination
  of a projects cash flows and how they should be
  applied
• Actual cash-flow principle
• Cash flows must be measured at the time they
  actually occur
• With/without principle
• Cash flows relevant to an investment decision are
  only those that change the firms overall cash
  position

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Background

• Participants should understand
• The actual cash-flow principle and the
  with/without principle and how to apply them when
  making capital expenditure decisions
• How to identify a projects relevant and
  irrelevant cash flows
• Sunk costs and opportunity costs
• How to estimate a projects relevant cash flows

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The Actual Cash-flow Principle

• Cash flows must be measured at the time they
  actually occur
• If inflation is expected to affect future prices
  and costs, nominal cash flows should be estimated
• Cost of capital must also incorporate the
  anticipated rate of inflation
• If the impact of inflation is difficult to
  determine, real cash flows can be employed
• Inflation should also be excluded from the cost
  of capital
• A projects expected cash flows must be measured
  in the same currency

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The With/Without Principle

• The relevant cash flows are only those that
  change the firms overall future cash position,
  as a result of the decision to invest
• AKA incremental, or differential, cash flows
• Equal to difference between firms expected cash
  flows if the investment is made (the firm with
  the project) and its expected cash flows if the
  investment is not made (the firm without the
  project)

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Identifying A Projects Relevant Cash Flows

• Sunk cost
• Cost that has already been paid and for which
  there is no alternative use at the time when the
  accept/reject decision is being made
• With/without principle excludes sunk costs from
  the analysis of an investment
• Opportunity costs
• Associated with resources that the firm could use
  to generate cash, if it does not undertake the
  project
• Costs do not involve any movement of cash in or
  out of the firm

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Identifying A Projects Relevant Cash Flows

• Costs implied by potential sales erosion
• Another example of an opportunity cost
• Sales erosion can be caused by the project, or by
  a competing firm
• Relevant only if they are directly related to the
  project
• If sales erosion is expected to occur anyway,
  then it should be ignored
• Allocated costs
• Irrelevant as long as the firm will have to pay
  them anyway
• Only consider increases in overhead cash expenses
  resulting from the project

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Estimating A Projects Relevant Cash Flows

• The expected cash flows must be estimated over
  the economic life of the project
• Not necessarily the same as its accounting
  lifethe period over which the projects fixed
  assets are depreciated for reporting purposes

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Measuring The Cash Flows Generated By A Project

• Classic formula relating the projects expected
  cash flows in period t to its expected
  contribution to the firms operating margin in
  period t
• CFt EBITt(1-Taxt) Dept - ?WCRt -
  Capext
• Where
• CFt relevant cash flow
• EBITt contribution of the project to the Firms
  Earnings Before Interest and Tax
• Taxt marginal corporate tax rate applicable to
  the incremental EBITt
• Dept contribution of the project to the firms
  depreciation expenses
• ?WCRt contribution of the project to the firms
  working capital requirement
• Capext capital expenditures related to the
  project

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Estimating the Projects Initial Cash Outflow

• Projects initial cash outflow includes the
  following items
• Cost of the assets acquired to launch the project
• Set up costs, including shipping and installation
  costs
• Additional working capital required over the
  first year
• Tax credits provided by the government to induce
  firms to invest
• Cash inflows resulting from the sale of existing
  assets, when the project involves a decision to
  replace assets, including any taxes related to
  that sale

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Estimating The Projects Intermediate Cash Flows

• The projects intermediate cash flows are
  calculated using the cash flow formula

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Estimating The Projects Terminal Cash Flow

• The incremental cash flow for the last year of
  any project should include the following items
• The last incremental net cash flow the project is
  expected to generate
• Recovery of the projects incremental working
  capital requirement, if any
• After-tax resale value of any physical assets
  acquired in relation to the project
• Capital expenditure and other costs associated
  with the termination of the project

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Sensitivity Analysis

• Sensitivity analysis is a useful tool when
  dealing with project uncertainty
• Helps identify those variables that have the
  greatest effect on the value of the proposal
• Shows where more information is needed before a
  decision can be made