Capital Budgeting Analysis
© 2011 John Wiley and Sons

 Explain how the capital budgeting process should be related to a firm’s mission and strategies.
 Identify and describe the five steps in the capital budgeting process.
 Identify and describe the methods or techniques used to make proper capital budgeting decisions.
2

 Explain how relevant cash flows are determined for capital budgeting decision purposes.

Discuss how a project’s risk can be incorporated into capital budgeting analysis.
3

 Seek investment opportunities to enhance a firm’s competitive advantage and increase shareholder wealth
– Typically long-term projects
– Should be evaluated by time value of money techniques
– Large investment
– Relate to firm’s mission
 Mutually exclusive versus independent
4

Identifying Potential Capital Budget
Projects
 Time value concepts tell us:
Value = present value of expected cash flows
 Separating out the initial up-front cost, we have:
Net Present Value = Present value of expected cash flows – cost of project
5

Identifying Potential Capital Budget
Projects
 Net Present Value = Present value of expected cash flows – cost of project
 If NPV >0 the project adds value to the firm.
 Where do firms find attractive capital budgeting projects with potentially positive NPVs?
6

Identifying Potential Capital Budget
Projects
 Planning tools:
 MOGS: Mission, Objectives, Goals,
Strategies
 SWOT: (Internal to firm):Strengths,
Weaknesses
(External to firm): Opportunites,
Threats
7

 Identification
 Development
 Selection
 Implementation
 Follow-up
8

 Economic and Political Data
 Financial Data
 Non-Financial Data
9

Ranking of items from most to least important on capital spending:
1.
Natural gas price forecast
2.
3.
4.
5.
6.
7.
Crude oil price forecast
Natural gas demand forecast
Crude oil demand forecast
Availability and cost of capital
Regulatory requirements on projects
Tax considerations
10

 Note the multiple uses of the word
“forecast” in the previous list
 Managers must make educated guesses about the future to estimate future cash flows
11

 Net Present Value
 NPV = Present value of all cash flows minus cost of project
 Inputs: cash in/outflows, required rate of return or “cost of capital”
12

YEAR PROJECT A PROJECT B
0 (today) -20,000 -25,000
1
2
5,800
5,800
4,000
4,000
3
4
5
5,800
5,800
5,800
8,000
10,000
10,000
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4
5
2
3
CASH 10% PRESENT
YR FLOW x PVIF = VALUE
0 –$20,000 1.000 –$20,000
1 5,800 0.909
5,272
5,800
5,800
5,800
5,800
0.826
0.751
0.683
0.621
4,791
4,356
3,961
3,602
Net Present Value =$ 1,982
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15

CASH 10% PRESENT
1
2
YR FLOW x PVIF = VALUE
0 -$25,000 1.000 -$25,000
4,000
4,000
0.909
0.826
3,636
3,304
3 8,000 0.751
4 10,000 0.683
6,008
6,830
5 10,000 0.621
6,210
Net Present Value = $ 988
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 NPV represents the dollar gain in shareholder wealth from undertaking the project
 If NPV > 0, do the project as shareholder wealth rises
 If NPV <0, do not undertake; it reduces shareholder wealth
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It is the discount rate that causes NPV to equal zero
NPV =
N

[CF t
/ (1 + IRR) t ] – Inv = 0
t = 1
18

Figure 13.1 Relationship Between NPV and Discount Rates: NPV Profile
10000.00
8000.00
6000.00
4000.00
2000.00
0.00
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.10
0.11
0.12
0.13
0.14
0.15
0.16
0.17
-2000.00
Discount Rate (in decim al)
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 Compute the IRR by:
– Trial and error
– Financial calculator
– Spreadsheet software
 Accept the project if IRR > minimum required return on the project
20

21

22

(1) (2) (3)
Year Beginning Cash
(4)
10% Return
Investment Inflow on the
Value (savings) Invested
Funds Funds
(2) x 0.10
1 $5,000.00
$2,010.57 $500.00
2 3,489.43
2,010.57
348.94
3 1,827.80
2,010.57
182.78
* Value is not 0.00 due to rounding.
(5)
Reduction in the
Invested
(3) - (4)
$1,510.57
1,661.63
1,827.79
(6)
Ending
Value of
Invested
Funds
(2) - (5)
$3,489.43
1,827.80
0.01
*
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




They will always agree on whether to accept or reject a project
So if projects are independent: either method is acceptable
Problem: they may rank projects differently
What to do if projects are mutually exclusive and the rankings conflict?
Answer: use NPV as it measures the change in shareholder wealth occurring because of the project.
24

 Another issue with IRR: a project may have more than one IRR!
 Can occur if project has alternative positive and negative cash flows.
 Most likely to occur if project requires substantial renovations or maintenance during its life or if endof-life shut-down costs are high.
25

 MIRR developed to solve some of the issues associated with IRR.


MIRR will agree with NPV on the accept/reject decision
MIRR gives a single answer —there is only one MIRR
 MIRR agrees with NPV rankings when the initial investments are of comparable size.
26

Modified Internal Rate of Return:
Three step process
1.
2.
3.
Find the present value of all cash outflows
Find the future value of all cash inflows at the end of the project’s life at year n.
This lump sum is called the terminal value.
MIRR is the discount rate which equates the present value of the outflows and the future value of the inflows:
FV at year n = PV (1 + MIRR) n
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1.
2.
Present value of outflows = 20,000 (no additional calculation needed)
Find FV as of year 5 for cash inflows from years 1-5:
5800 (1.10) 4 = 8491.78
5800 (1.10) 3 = 7719.80
5800 (1.10) 2 = 7018.00
5800 (1.10) 1 = 6380.00
5800 (1.10) 0 = 5800.00
Terminal value (sum of FV) = 35,409.58
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 PV of outflows: 20,000
 Terminal value (sum of FV of inflows)
= 35,409.58
 Step 3: FV = PV(1 + MIRR) n
= $35,409.58= $20,000(1 + MIRR) 5
 Solving, we find the MIRR is 12.10 percent
 Accept project as MIRR>10% required return
29

 Profitability Index = Present value of cash flows/initial cost
 Accept project if PI > 1.0
 Reject project if PI < 1.0
 Interpretation: Measures the present value of dollars received per dollar invested in the project
30

Project A’s profitability ratio:
PI = $21,982/$20,000 = 1.099
Project B’s profitability ratio:
PI = $25,988/$25,000 = 1.040
31

 NPV, IRR, PI will always agree on the
Accept/Reject decision
 If one indicates we should accept the project, they will all indicate “accept”
 NPV > 0 always means that:
IRR>minimum required return and that the:
PI > 1
32

 If one indicates we should reject the project, they will all indicate “reject”
 NPV < 0 always means that the
IRR < minimum required return and that the
PI < 1
33

Conflicts Between NPV, IRR, MIRR,
Profitability Index
 May occur as different rankings may occur if projects are mutually exclusive. Most likely when projects have:
 Different cash flow patterns
– Projects with larger and earlier cash flows may have higher IRR rankings than those with larger later cash flows
34

Conflicts Between NPV, IRR, MIRR,
Profitability Index
 Different time horizons
– Project Long and Project Short require
$100 investment
– Short: returns $200 in 2 years IRR =
41.42% and NPV (at 10% required return) = $65.29.
– Long: returns $2,000 in 20 years IRR
=16.16% NPV (at 10% required return) =
$197.29.
35

Conflicts Between NPV, IRR, MIRR,
Profitability Index
 Different Sizes
– Projects with smaller initial investments may have higher IRR and higher PI and smaller NPV than projects with larger initial investments.
Initial PV of Cash Profitability
Project Outlay Cash Flows NPV Index
Small $100 $150
Large 1,000 1,100
$50
$100
1.5
1.1
36

Conflicts Between NPV, IRR, MIRR,
Profitability Index





Four discounted cash flow methods:
NPV, IRR, MIRR, profitability index
Goal in capital budgeting is to select projects that will help maximize shareholder wealth.
NPV is the best as it measures the absolute dollar change in shareholder wealth.
The others are relative measures of project attractiveness.
37

 Payback period = number of years until the cash flows from a project equal the project’s cost
 Accept project is payback period is less than a maximum desired time period
38

Cash Cumulative Dollars
YR Flow Cash flow Needed
1 5,800 5,800 14,200
2 5,800 11,600 8,400
3 5,800 17,400
4 5,800
2,600
Fraction of year: 2,600/5,800 = 0.45
Payback = 3.45 years
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 Ignores time value of money
 Any relationship between the payback, the decision rule, and shareholder wealth maximization is purely coincidental!
 It ignores the cash flows beyond the payback period
40

 75% of CFOs used NPV, IRR or both to evaluate projects
 IRR is most popular
 Over half still use payback as a secondary or supplementary method of analysis
41

Why Are IRR and Payback Used So
Much?
 Safety margin
– IRR gives managers an intuitive feel for a project’s “safety margin”—amount by which cash flows can be incorrect and the project can still increase shareholder wealth.
 Project Size
 Managerial flexibility and options
42


:




43

 Sunk costs
 Financing costs
44

Project sales (generally a cash inflow)
- Project costs (generally a cash outflow)
- Depreciation (a noncash expense)
EBIT = EBT (earnings before interest and taxes, which also equals earnings before taxes as financing costs are ignored in cash flow analysis)
- Taxes (a cash outflow)
Net income
45

Firm versus Project Statement of Cash Flows
The Firm's Cash Flow Statement A Project's Cash Flow Statement
Cash Flow from Operations
Net Income
+Depreciation
+current asset/liability sources
-current asset/liability uses
Cash Flow from Operations
Net Income
+Depreciation
+current asset/liability sources
-current asset/liability uses
Cash Flow from Investment Activities Cash Flow from Investment
Activities
-change in gross fixed assets -Funds invested in the project
-change in investments
Cash Flow from Financing Cash Flow from Financing Activities
Activities
-Dividends paid
+net new bond issues
+net new stock issues
Not applicable
46

Cash flows from operations: Net income + depreciation – change in net working capital
Cash flows from investment activities: change in gross fixed assets
Cash flows from financing activities: ignore
Recall, as the cash account is always zero, that the change in NWC does not include the cash account
47





OCF = Net Income + Depreciation – ΔNWC
From the project’s income statement, this is the same as:
(Sales-Costs-Depreciation) – Taxes +
Depreciation – ΔNWC
If the firm’s tax rate is t then
 Taxes = t(pre-tax income) = t(Sales-Costs-
Depreciation) so operating cash flow is:
48



OCF =
Sales-Costs-Depreciation – t(Sales-Costs-
Depreciation) + Depreciation – ΔNWC


Simplifying, we have a general formula for estimating operating cash flow:
OCF = (Sales-Costs-Depreciation)(1 – t)
+ Depreciation – ΔNWC
49

Why do we subtract the change in NWC ( ΔNWC) ?




Recall NWC = Current Assets (excluding the cash account) minus Current
Liabilities
If NWC rises: either CA has risen, CL has fallen, or both
Example: Cash is used to pay AP; cash flows out of the firm and NWC (CA-CL) rises
A use of cash leads to an increase of
NWC; to measure operating cash flow, this amount is subtracted.
50

Why do we subtract the change in NWC ( ΔNWC) ?
 If NWC falls: either CA has fallen, CL has risen, or both.
 Example: Cash comes into the firm if a customer pays their AR. AR falls, CA falls, and NWC falls
 A source of cash leads to a decrease of
NWC; when we subtract this negative change in NWC it becomes a positive addition to OCF.
51

Sales
With Deprec Without Deprec
Expense Expense
$1000 $1000
-Costs
-Deprec
-300
-100
EBT $600
-Taxes (40%) 240
-300
0
$700
280
Net Income $360
OCF=Net Income + Depreciation
$420
$460 $420
Difference is $40 —which equals tax rate x depreciation (04.0) ($100) = $40
52

Reality: Keeping Managers Honest
 Pet projects can be accepted into the capital budget by inflating cash flow estimates so their NPV is positive
 Possible solutions:
– Review spending in implementation stage; additional requests for funds needed in case of overruns
– Compare forecasted cash flows with actuals
– Record names of those issuing forecasts
53

 Expected return/risk tradeoff
 Higher (lower) than average risk projects should have a higher (lower) than average discount rate
54

 Required return on average risk project = firm’s cost of capital, or cost of financing
 For average risk projects, use this number as the discount rate (NPV,
PI) or the minimum required rate of return (IRR)
55

Adjust the project’s discount rate up or down from the firm’s cost of capital for projects of above-average or below-average risk
56

Below-average risk:
Discount rate = cost of capital –2%
Average risk:
Discount rate = cost of capital
Above-average risk:
Discount rate = cost of capital + 2%
High risk:
Discount rate = cost of capital + 5%
57

www.benjerry.com
www.wendys.com
www.wellsfargo.com
www.merck.com
www.dell.com
www.ebay.com
www.salvagesale.com
58

Learning Extension 17: Estimating Project
Cash Flows
59

Investment = cost + transportation, delivery, and installation charges
60

Project Stages and Cash Flow
Estimation
 Initial Outlay
– Engineering estimates (designs, modifications)
– Current market prices of new items
– Bid prices from possible supplies or construction firms
– Will be reduced if new project is replacing old equipment/building that can be sold
61

Project Stages and Cash Flow
Estimation

Cash Flows During the Project’s Life


For each period of time during the project’s life, use the general equation:
OCF = (Sales-Costs-Depreciation)(1 – t)
+ Depreciation – ΔNWC
 Estimating the inputs: marketing studies, production cost estimates, suppliers
62

Project Stages and Cash Flow
Estimation
 Salvage Value and NWC Recovery
– After-tax salvage value = Asset selling price – t (selling price – book value)
– Project’s NWC may be assumed to be liquidated (converted to cash) and returned to the firm as a cash flow
63

Project Stages and Cash Flow
Estimation




Salvage value example. Asset purchased for $100; depreciation of $10/year. Sold in year 7. Book value will be $30. Tax rate is
25%.
After-tax salvage value if selling price is
$50: $50 – .25 ($50-30) = $45
After-tax salvage value if selling price is
$30: $30 – .25 ($30-30) = $30
After-tax salvage value if selling price is
$10: $10 – .25 ($10-30) = $15
64

Project Stages and Cash Flow
Estimation


If project is expected to continue indefinitely:
Estimate operating cash flows for several years and then estimate its “going concern value” using the constant dividend (cash flow) growth model:
Dividend time t+1
Value time t
= ----------------------r - g
65

Example: Revenue-Expanding Project
 Initial outlay:
Depreciable Outlays
Expensed Cash Outlays, after tax t = 0
-$4.5
-0.4
-------
-$4.9
66

Annual Project Income Statement years 1-5
Sales
-Costs
$3.000
-0.635
-Depreciation -0.900
EBT $1.465
-Taxes (40%) -0.586
Net income $0.879
67

OCF estimates tax rate = 40%
Year 1 Year 2-4 Year 5
Saless
-Cost
$3.000
-$0.635
$3.000
$3.000
-$0.635 -$0.635
-Depreciation -$0.900
-$0.900 -$0.900
SUM x (1-t)
$1.465
$1.465
$0.879
$0.879
+Depreciation $0.900
$0.900
-change NWC -$0.100
$0.000
Operating CF $1.679
$1.779
$1.465
$0.879
$0.900
$0.100
$1.879
68

 Market value in year 5 of project assets:
$1 million
 They will be fully depreciated at that time.


After-tax salvage value = Asset selling price – t (selling price – book value)
= $1 million – (0.40)($1 million-0)
 = $0.600 million
69

Initial Operating Salvage Total
Year Outlay Cash Flows Value Incremental
Cash Flows
0 $-4.9 $ 0.000 $ 0.0
1 0.0
1.679 0.0
2 0.0
1.779
0.0
3 0.0
1.779
0.0
4 0.0
1.779
0.0
5 0.0
1.879
0.6
At 10%, NPV = $2.20 million
$-4.90
1.679
1.779
1.779
1.779
2.479
70

 Cost-saving project
 Setting a minimum bid price on a project so NPV=0
 Tables, data in textbook
71