Title: Managerial Finance Finance 6335 Lecture 5 Chapter 6
1Managerial Finance Finance 6335Lecture
5Chapter 6 7Alternative Decision
RulesFundamentals of Capital Budgeting Ronald
F. Singer
26.1 NPV and Stand-Alone Projects
- Consider a take-it-or-leave-it investment
decision involving a single, stand-alone project
for Fredrick Feed and Farm (FFF). - The project costs 250 million and is expected to
generate cash flows of 35 million per year,
starting at the end of the first year and lasting
forever.
3NPV Rule
- The NPV of the project is calculated as
- The NPV depends on the discount rate, r
- The Internal Rate of Return (IRR) is that
discount rate that makes the NPV 0
4Alternative Rules Versus the NPV Rule
- Sometimes alternative investment rules may give
the same answer as the NPV rule, but at other
times they may disagree. - When the rules conflict, the NPV decision rule
should be followed.
56.2 Alternative Decision Rules
- The Payback Rule
- The payback period is amount of time it takes to
recover or pay back the initial investment. If
the payback period is less than a pre-specified
length of time, you accept the project.
Otherwise, you reject the project. - The payback rule is used by many companies
because of its simplicity. - However, the payback rule does not always give a
reliable decision since it ignores the time value
of money.
6NPV Rule
- The NPV of the project is calculated as
- Therefore the Internal Rate of Return (IRR) is
14
7Figure 6.1 NPV of FFFs New Project
- If FFFs cost of capital is 10, the NPV is 100
million and they should undertake the investment.
8Measuring Sensitivity with IRR
- For FFF, if their cost of capital estimate is
more than 14, the NPV will be negative, as
illustrated on the previous slide. - In general, the difference between the cost of
capital and the IRR is the maximum amount of
estimation error in the cost of capital estimate
that can exist without altering the original
decision.
9When does IRR work?
- You can take all or no project (stand alone
project) - Normal Project Negative Cash flows first,
followed by positive cash flows - In other cases, the IRR rule may disagree with
the NPV Rule. If that is the case always go with
the NPV Rule
10See excel File IRR, NPV versus Payback
11Practical Problems in Capital Budgeting
- We have stated that we want the firm to take all
projects that generate positive NPV and reject
all projects that have a negative NPV. Capital
budgeting complications arise when you cannot,
either physically or financial undertake all
positive NPV projects. Then we have to devise
methods of choosing between alternative positive
NPV projects.
12Mutually Exclusive Projects
- IF,AMONG A NUMBER OF PROJECTS, THE FIRM CAN ONLY
CHOOSE ONE, THEN THE PROJECTS ARE SAID TO BE
MUTUALLY EXCLUSIVE. - For example Suppose you have the choice of
modifying an existing machine, or replacing it
with a brand new one. You could not do both and
produce the desired amount of output. Thus,
these projects are mutually exclusive. Given the
cash flows below, which of these projects do you
choose?
13Mutually Exclusive Projects
- Time Modify Replace
Difference - 0 -100,000 -250,000
-150,000 - 1 105,000 130,000
25,000 - 2 49,000
253,500 204,500 - IRR .40 .30
.25 -
- Suppose the cost of capital is 10
14Mutually Exclusive Projects
- Time Modify Replace
Difference - 0 -100,000 -250,000
-150,000 - 1 105,000 130,000
25,000 - 2 49,000
253,500 204,500 - IRR .40 .30
.25 - NPV(_at_ 10) 36,000 77,700
41,700 - Notice the conflict that can exist between NPV
and IRR.
15CAPITAL BUDGETING COMPLICATIONS
- Capital Budgeting Complications occur when you
cannot take all positive NPV PROJECTS. Thus, the
firm is faced with the choice of two
possibilities. - Remember Goal is still Max NPV of all
possibilities
16Differences in Scale
- If a projects size is doubled, its NPV will
double. This is not the case with IRR. Thus, the
IRR rule cannot be used to compare projects of
different scales.
17Differences in Scale (cont'd)
- Identical Scale
- Consider two projects
Girlfriends Business Laundromat
Initial Investment 1,000 1,000
Cash FlowYear 1 1,100 400
Annual Growth Rate -10 -20
Cost of Capital 12 12
18Differences in Scale (cont'd)
- Identical Scale
- Girlfriends Business
19Differences in Scale (cont'd)
- Identical Scale
- Laundromat
- IRR 20
- Both the NPV rule and the IRR rule indicate the
girlfriends business is the better alternative.
20Figure 6.5 NPV of Investment Opportunities
- The NPV of the girlfriends business is always
larger than the NPV of the single machine
laundromat. The IRR of the girlfriends business
is 100, while the IRR for the laundromat is 20.
21Differences in Scale (cont'd)
- Changes in Scale
- What if the laundromat project was 20 times
larger? - The NPV would be 20 times larger, but the IRR
remains the same at 20. - Give an discount rate of 12, the NPV rule
indicates you should choose the 20-machine
laundromat (NPV 5,000) over the girlfriends
business (NPV 4,000).
22Figure 6.6 NPV of Investment Opportunities with
the 20-Machine Laundromat
- The NPV of the 20-machine laundromat is larger
than the NPV of the girlfriends business only
for discount rates less than 13.9.
23Differences in Scale (cont'd)
- Percentage Return Versus Impact on Value
- The girlfriends business has an IRR of 100,
while the 20-machine laundromat has an IRR of
20, so why not choose the girlfriends business? - Because the 20-machine laundromat makes more
money - It has a higher NPV.
24Differences in Scale (cont'd)
- Percentage Return Versus Impact on Value
- Would you prefer a 200 return on 1 dollar or a
10 return on 1 million? - The former investment makes only 2, while the
latter opportunity makes 100,000. - The IRR is a measure of the average return, but
NPV is a measure of the total dollar impact on
value, and thus stockholders wealth.
25Timing of Cash Flows
- Another problem with the IRR is that it can be
affected by changing the timing of the cash
flows, even when that change in timing does not
affect the NPV. - It is possible to alter the ranking of projects
IRRs without changing their ranking in terms of
NPV. - Hence you cannot use the IRR to choose between
mutually exclusive investments.
26Timing of Cash Flows (cont'd)
- Assume you are offered a maintenance contract on
the laundromat machines which would cost 250 per
year per machine. With this contract, you would
not have to pay for maintenance and so the cash
flows from the machines would not decline. - The expected cash flows would then be
- 400 250 150 per year per machine
27Timing of Cash Flows (cont'd)
- The time line would now be
- The NPV of the project remains 5,000 but the IRR
falls to 15.
28Figure 6.7 NPV With and Without the Maintenance
Contract
29Timing of Cash Flows (cont'd)
- The NPV without the maintenance contract exceeds
the NPV with the contract for discount rates that
are greater than 12. - The IRR without the maintenance contract (20)
is larger than the IRR with the maintenance
contract (15). - The correct decision is to agree to the contract
if the cost of capital is less than 12 and to
decline the contract if the cost of capital
exceeds 12. With a 12 cost of capital, you are
indifferent.
30Capital Rationing
- In this situation, the decision maker is faced
with a limited capital budget (or limitations on
some other input). As a result, it may not be
possible to take all positive net present value
projects. Under this scenario, the problem is to
find that combination of projects (within the
capital budgeting constraint) that leads to the
highest Net Present Value. - The problem here is that the number of
possibilities become very large with a relatively
small number of projects. Thus, in order to make
the problem "manageable", we can systematize the
search.
31Capital Rationing
- Since we have a constraint, what we want to do is
invest in those projects which gives us the
highest BENEFIT per dollar invested. (The
highest bang per buck). What is the benefit?, it
is the Present Value of the Cash Flows. So that
we would want to choose that set of projects
within the capital budgeting constraint that
gives the highest - Net Present Value
- INVESTMENT
- This ratio is called the profitability Index.
32Capital Rationing
- For example, suppose we have a 13 million
capital budgeting constraint, with 7 alternative
capital budgeting projects with the following
projections. - Project NPV Investment
- A 10 15
- B 8 10
- C 4 2.5
- D 6 5
- E 5 2.5
- F 7 5
- G 4.5 3
33Capital Rationing
- Rank by Profitability Index (NPV/INV
- Project Profitability Index
Investment Total -
- E 2.0
2.5 2.5 - C 1.6 2.5 5.0
- G 1.5 3
8.0 - F 1.4
5 13.0 D
1.2 5 - B .8 10
- A .667 15
- COMBINATION WITH HIGHEST PROFITABILITY INDEX
WITHIN THE CAPITAL BUDGET - (E,C,G,F) has a NPV of 20.5 million, and a cost
of 13 million.
34See Spreadsheet
35Capital Rationing
- However, if the budget were 15 million rather
than 13 million we would have a problem. Adding
D would go over the budget and be infeasible, but
the combination CDEF has a higher NPV (22
million) than the chosen combination of ECGF.
This is because the amount spent was only 13
million leaving 2 million in unspent funds. In
this case, we are better off choosing a
combination which spends all the funds. - THE ONLY WAY TO DO THIS RIGHT IS TO DO A FULL
BLOWN LINEAR PROGRAMING PROBLEM WITH CONSTRAINTS.
36Capital Budgeting
- We are now ready to consider the capital
budgeting decision. - As we said repeatedly, the idea is to invest in
such a way that you maximize the Net Present
Value of your decision. - What we mean by the NPV is the Present Value of
the Cash Flow from Operations generated by the
project less the initial Cash Investment
37Cougar Enterprises
- Pro-Forma Income Statement
- (Year ending December 31, 2006)
- ( thousand)
- Sales 5,000
- Less Operating Expenses (COGS)
2,000 - Depreciation Amortization
500 - Allocated G A Costs
300 - Operating Income (EBIT)
2,200 - Less Interest Expense
770 - Earnings Before Tax(taxable income)
1,430 - Less Tax (_at_ 40)
572 - Net Income (Earnings after Tax)
858 - Earnings per Share (EPS) Net Income/Shares
0.858
38Cougar Enterprises
- Pro-Forma Cash Flow Statement
- (Year ending December 31, 2006)
- ( thousand)
- Earnings Before Interest and Taxes 2,200
- Less Tax on Operations (_at_ 40) (Note
not 572)
880 - Operating Income after Tax (EBIT(1-t) )
1,320 - Plus Non-Cash Expenses (Depreciation
Amortization)
500 - Less Change in Working Capital
300 - (Change a/c receivable 200
- Change in Inventory
100 - Change other ST Assets 100
- Less Change in a/c payable 150
- Change in ST Liabil.
(50) - Change in Working Capital
- Free Cash Flow from Operations 1,520
- Plus Interest Tax Shield
(707 times 0.40)
308 - CASH FLOW
1828 - Less Net New Investment (net of capital
gains tax)
400
- Less Cash Flow to Bondholders (Interest,
principal, Bond Repurchase, Call) 770
39Capital Budgeting Decisions Check List
- 1. Net Present Value is the "Discounted value
of incremental cash flow - 2. Cash flow is
- CASH MONEY IN - CASH MONEY OUT
40Capital Budgeting Decisions Check List
- 3. Consider only if it is an incremental cash
flow, and consider all incremental cash flows - (a) not historical, or averages
- (b) consider only cash flows that appear as a
result of the project - (c) consider the impact of the project on cash
flows from other projects - (d) exclude fixed or sunk costs
- (e) exclude allocated overhead unless it will
change as a result of the project.
41Capital Budgeting Decisions Check List
- 4. Treat inflation consistently
- Make sure that you have considered the impact of
inflation on Cash Flows - 5. All Cash Flow should be on an After-Tax
basis. - Use actual tax changes when paid!
- Don't forget to allow for the tax on capital
gains Use future marginal tax rates applied to
future taxable income -
42Capital Budgeting Decisions Check List
- 6. Include the opportunity cost of the project,
even if there is no explicit cash flow realized - Account for assets sold and not sold as a result
of adoption of a project. - 7. Account for changes in working capital and
only changes in working capital. Recognize that
working capital will in general be re-cooped at
the end of the project. - 8. Ignore financing including the tax shield on
interest
43Capital Budgeting Decisions Check List
- 9. Include Asset's Entire Life
- 10. Include the depreciation tax shield, but not
depreciation itself.
44Capital Budgeting Decisions Check List
- No matter how complicated the decision What is
important? -
- MAXIMIZE NPV
- PLAN TO TAKE ALL PROJECTS WITH A POSITIVE NET
PRESENT VALUE AND REJECT ALL PROJECTS WITH A
NEGATIVE NET PRESENT VALUE
45Application of the NPV Rule and Capital Budgeting
- For now we are going to assume that the
appropriate discount rate is known. - The problem we want to tackle is to forecast the
relevant cash flows.
46Only Cash Flows Affect Wealth.
- What is and is not Cash Flow
- -Expenses are cash flow regardless of whether
the accountant capitalizes and depreciates them
or expenses them. - -Capital expenditures are cash outflows
regardless of the fact that accountants
depreciate them over a period.
47Only Incremental cash flows are relevant
- Not historical cash flows, not averages, not sunk
costs! - Example 1 Consider a firm having made an
investment one year in the past. The project
required an initial investment of 10,000- with
the expectation of 14,000 to be generated within
two years. At a discount rate of 10 should the
firm have made the investment?
48Only Incremental cash flows are relevant
-
14,000 - -1---------------0-----------------1
-
- 10,000
-
- Of course it should have. The NPV was NPV
1,564
49Only Incremental cash flows are relevant
- NOW THINGS CHANGE. A NEW DEVICE INTRODUCED BY A
COMPETITOR MAKES THE PRODUCT OBSOLETE. THUS
EXPECTED CASH FLOWS DECLINE TO 7,000. THAT IS
THE INVESTMENT, DID NOT PAY OFF AS EXPECTED AND
THE PROJECT IS NOW A LOSER. - SUPPOSE THAT FOR AN ADDITIONAL INVESTMENT OF
5,000, YOU CAN REGAIN YOUR COMPETITIVE POSITION,
SO THAT EXPECTED CASH FLOW INCREASES TO THE
ORIGINAL 14,000. SHOULD YOU MAKE THE NEW
INVESTMENT?
50Only Incremental cash flows are relevant
-
14,000 - -1---------------0-----------------1
- -10,000
-5,000 - Note that the project, looked at as a whole is
still a loser - NPV(-1) -10,000 -
5,000 14,000 -
(1.1) (1.1)2 - - 2,975
- BUT the additional investment should be
made. - Determine the incremental cash flows.
- Determine Net Present Value of the incremental
cash flows - Incremental Cash Flow -5,000 7,000/(1.1)
1,363.65 -
51Only Incremental cash flows are relevant
- Example 2 Assume that the original cash flow
estimates were accurate. But, that you can, by
making an additional investment of 1,000 generate
total second period cash flow of 15,050. Should
the additional investment be made? - (Still Assume r 10)
52Only Incremental cash flows are relevant
-
14,000 - -1---------------------0-----------------
------1 initial - -10,000 -5,000
-
1,050 - -1---------------------0-----------------
------1 Incremental - -1,000
- NPV (of Additional Investment) -1000
1050 - 45.45 -
1.1 - Even though, the original project is a winner, do
not make the additional investment - Y0u must Ignore Sunk Costs, and consider only
incremental cash flows.
53Treat inflation consistently
- MAKE SURE THAT INFLATION IS ACCOUNTED FOR IN A
CONSISTENT MANNER. EITHER - Revenues and Expenses are not necessarily
effected uniformly by inflation - Depreciation expense is not effected by inflation
54Tying up assets uses a valuable resource and must
be accounted for.
- Example A firm is considering installing a
brick manufacturing kiln. The initial investment
will require 300,000 in building and equipment.
The kiln will be located on a vacant lot having
an estimated market value of 1,000,000. The
project is expected to generate net cash flow of
50,000 per year for 20 years. After 20 years,
the kiln will be worthless. It is anticipated
that the lot could be sold for 2,653,000 at the
end of 20 years. At a 10 discount rate, is this
a good investment? (Ignore taxes)
55Tying up assets uses a valuable resource and must
be accounted for.
- ALTERNATIVE ONE
- Ignoring the opportunity cost of the (tied-up)
land. - NET PRESENT VALUE CALCULATION
- NPV-300,000 PMT(50,000, 10, 20)
- -300,000 425,693.05 125,693.05
- ACCEPT PROJECT
- The problem with this is that you ignore the fact
that you lose the use of 1,000,000 that you
could have had if you had not adopted the project
and sold the land (or used it in an alternative
project).
56Tying up assets uses a valuable resource and must
be accounted for.
- ALTERNATIVE TWO
- Explicitly consider the land as part of the
inputs You estimate that the land will be worth
2,653,000 in 20 years. - PRESENT VALUE CALCULATION
- NPV -1,000,000 -300,000 PMT(50,000, 10,
20) - PV(2,653,000, 10,20)
- - 1,300,000 425,678 394,352
- - 479,970
- REJECT PROJECT
- NOTICE HOW THE TIED UP LAND IS TREATED!
57Rule 4 Tying up assets uses a valuable resource
and must be accounted for.
- Other Incremental Costs Are
- Increases in overhead costs as a result of
project. - Increases in working capital as a result of
project. - Notice the reduction in working capital would be
a cash inflow at that time. - Do not use allocated overhead, or allocated
working capital.
58Changes in Working Capital Should be accounted for
- Example
- Suppose, due to the adoption of the project,
the firm is required to increase working capital
from 100,000 to 110,000 per annum for the life
of the project. How do you account for the
working capital? - So you see that this is simply a timing problem
59Remember taxes
- 1. Calculate all cash flows after taxes
- 2. Include non-cash expenses (depreciation) for
its effect on taxes, but not as a cash flow
itself. - HOW TO HANDLE THE DEPRECIATION TAX SHIELD
- We want the project's AFTER TAX CASH FLOW
- Equals Before Tax Cash Flow Less Corporate
Taxes - Taxes tc Cash revenue - Cash Expenses -
Depreciation -
- Therefore, for each year
- After Tax Cash Flow (Cash Revue - Cash
Expenses)(1 - tc) tc Depr - Where tc x Depr is the Depreciation Tax Shield)
60Remember taxes on Capital Gains
- 3. Tax on gains/losses from sale of assets is an
additional negative/positive
cash flow - Tax on
- Gains/Losses tc x (Market Value - Book
Value) - On sale
-
- If Market Value gt Book Value, then tax on gain is
cash outflow. - If Market Value lt Book Value, then we have a loss
on sale, tax is negative, and there is a cash
inflow.
61Remember taxes on Capital Gains
- Example
- XYZ Corp. has a project which is going to last 5
years. P E for this project of 1,000,000 can
assume a scrap value of 300,000 at the end of 5
years. On a straight line basis, that means the
firm depreciates the assets _at_ 140,000 per year,
leaving 300,000 when the project ends.
62Remember taxes and the effect of selling assets
- However, you expect that you can sell the asset
for 500,000 at the end of 5 years. Thus there
is a taxable capital gain of (MV-BV) 200,000.
- At a 35 Corporate Capital Gain Tax rate, that
means that after tax cash flow from the disposal
of PE is - 0.35 200,000 70,000
- Thus the Cash flow from selling the asset is
- 500,000 -70,000 430,000
- (Remember to add back Book Value)
63Ignore the means of financing both as a direct
cash flow and as its effect on taxes.
- Interest payment is not a cash flow. Discounting
already takes the value of time into account. To
deduct interest would be double counting. - Example Suppose that you borrow 500, and put
in 500 of your money into the following project.
(Bank charges 8 on loan) -
0 1 - Cash Flow -1000 1125
- Interest
-40 - Net -1000
1085 - To say that we reject the project since NPV (of
net cash flow) is negative at 10 (NPV -13) is
double counting. We penalize the project twice,
one by deducting interest, second by discounting. - The NPV of this project is- 1,000 (1,125) X
(0.909) 23
64STEPS IN PROJECT ANALYSIS
- 1. MAKE INITIAL PROJECTIONS
- Made by operations manager
- Generally in form of income statement
- Clarify assumptions
- 2. ADJUST FOR INFLATION IF APPROPRIATE
- 3. REARRANGE IN CASH FLOW FORM
- 4. PERFORM NET PRESENT VALUE CALCULATIONS
- 5. PERFORM "WHAT IF" CALCULATIONS