The Basics of Capital Budgeting
nProject classifications
nRole of financial analysis
nCash flow estimation
nBreakeven and profitability measures
nThe post audit
What is capital budgeting?
nAnalysis of potential additions to a
business’ fixed assets.
nSuch decisions:
lTypically are long-term in nature.
lOften involve large expenditures.
lUsually define strategic direction.
nThus, such decisions are very
important to a business’ future.
Project Classifications
nFor analysis purposes, projects are
classified according to purpose
and size. For example,
lMandatory replacement
lExpansion of existing services
lExpansion into new services
? How are such classifications
used?
Role of Financial Analysis
nFor investor-owned firms, financial
analysis identifies those projects that
are expected to contribute to
shareholder wealth.
nFor not-for-profit businesses,
financial analysis identifies a
project’s expected effect on the
business’ financial condition.
? Why is this important?
Overview of Capital Budgeting
Financial Analysis
1. Estimate the capital outlay.
2. Forecast the cash inflows:
lOperating flows
lTerminal flows
3. Assess the project’s riskiness.
4. Estimate the cost of capital.
5. Measure the financial impact.
Key Concepts in Cash Flow Estimation
nIncremental cash flows:
Inc. CF = CF(w/ project) - CF(w/o project).
nCash flow versus accounting income
nCash flow timing
nProject life
Key Concepts (Cont.)
nSunk costs
nOpportunity costs:
lFor capital
lFor other resources
nEffects on other business lines
nShipping and related costs
Key Concepts (Cont.)
nWorking capital effects:
lCurrent assets
lCurrent liabilities
nInflation effects
nStrategic value
Cash Flow Estimation Example
nAssume Northwest Healthcare, a notfor-profit hospital, is evaluating a
new piece of diagnostic equipment
nCost:
l$200,000 purchase price
l$40,000 shipping and installation
nExpected life = 4 years.
nSalvage value = $140,000.
Cash Flow Estimation Example (Cont.)
nUtilization = 5,000 scans/year.
nCharge = $80 per scan.
nVariable cost = $40 per scan.
nFixed costs = $100,000.
nCorporate cost of capital = 10%.
Time Line Setup
0
1
2
3
4
Initial
Costs
(CF0)
OCF1
OCF2
OCF3
OCF4
NCF 0
NCF 1
+
Terminal
CF
NCF 2
NCF 3
NCF 4
Investment at t = 0 (000s)
Equipment
Installation & Shipping
$200
40
Net investment outlay
$240
Operating cash flows (000s)
1
2
3
4
Revenues
$400 $400 $400 $400
Total VC
200
200
200 200
Fixed costs
100
100 100 100
Depreciation
25
25
25
25
BT op. inc. $ 75 $ 75 $ 75 $ 75
Taxes
----AT op. inc. $ 75 $ 75 $ 75 $ 75
Depreciation
25
25
25
25
Net op. CF
$100 $100 $100 $100
?How were the above values developed?
Should the CFs on the previous
slide have included interest expense
or dividends?
No. Financial costs are accounted
for by discounting the net cash flows
at the 10% corporate cost of capital.
Thus, deducting interest or
dividends from the estimated cash
flows would be “double counting”
financing (capital) costs.
Terminal cash flows at t = 4 (000s)
Salvage value
Tax on SV
Net terminal CF
$140
0
$140
?How are salvage value taxes determined
for investor-owned firms?
Suppose $5,000 had been spent last
year to improve the space for the new
diagnostic equipment. Should this
cost be included in the analysis?
No. This is a sunk cost. The money
has already been spent, so project
acceptance would have no effect on
that flow. Cash flows in the analysis
must be incremental to the project.
Suppose the space could be leased
out for $12,000 a year. Would this
affect the project’s cash flows?
Yes. Accepting the project means
that Northwest Healthcare is
foregoing a $12,000 cash inflow. This
is an opportunity cost that should be
charged to the project.
If the new equipment would decrease
patient utilization of existing services,
would this affect the analysis?
nYes. The effect on other CFs within the
business is an “externality.”
nThe net CF loss each year on other
services would be a cost to this project.
nExternalities can be either positive or
negative.
Net cash flows (000s)
0
1
2
3
4
-240
100
100
100
100
140
240
If this were a replacement rather than a
new (expansion) project, would the
analysis change?
nThe relevant operating CFs would be
the difference between the CFs on
the new and old equipment.
nAlso, selling the old equipment would
produce an immediate cash inflow,
but the salvage value at the end of its
original life is foregone.
Breakeven Analysis
nThere are many different approaches
to breakeven in project analysis:
lTime breakeven
lInput variable breakeven
• Utilization
• Charge
nWe will focus on payback (or payback
period), a measure of time breakeven.
What is the project’s payback?
0
1
2
3
4
-240
100
100
100
240
60
300
Cumulative CFs:
-240
-140
-40
Payback = 2 + 40 / 100 = 2.4 years.
Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.
Weaknesses of Payback:
1. Ignores time value.
2. Ignores all CFs occurring after the
payback period.
Profitability Analysis
nProfitability analysis focuses on a
project’s return.
nAs with any investment, returns can
be measured either in dollar terms or
in rate of return (percentage) terms.
lNet present value (NPV) measures a
project’s dollar return.
lInternal rate of return (IRR) measures a
project’s rate of return.
Net Present Value (NPV)
nNPV is merely the sum of the present
values of the project’s net cash flows.
nThe discount rate used is called the
project cost of capital . If we assume
that the illustrative project has
average risk, its project cost of
capital is the corporate cost of
capital , 10%.
What is the project’s NPV?
0
10%
1
-240.00
100
90.91
82.64
75.13
163.93
172.61 = NPV
2
3
4
100
100
240
Financial Calculator Solution
Enter in CFj registers:
-240
CF0
100
CF1
100
CF2
100
CF3
240
CF4
Then:
I = 10
And solve for:
NPV = 172.61
Interpretation of the NPV
nNPV is the dollar contribution of the
project to the equity value of the
business.
nA positive NPV signifies that the
project will enhance the financial
condition of the business.
nThe greater the NPV, the more
attractive the project financially.
? What is the meaning of a NPV of $0?
Internal Rate of Return (IRR)
nIRR measures a project’s percentage
(rate of) return.
nIt is the discount rate that forces the
PV of the inflows to equal the cost of
the project. In other words, it is the
discount rate that forces the project’s
NPV to equal $0.
nIRR is the project’s expected rate of
return.
What is the project’s IRR?
0
IRR = ?
1
-240.00
100
?
?
?
?
0.00 = NPV
2
3
4
100
100
240
What is the project’s IRR? (Cont.)
0
1
IRR = 35.4%
-240.00
100
73.84
54.53
40.27
71.36
0.00 = NPV
2
3
4
100
100
240
Therefore, IRR = 35.4%.
Calculator Solution
Enter in CFj registers:
-240
CF0
And solve for:
100
CF1
IRR = 35.4%
100
CF2
100
CF3
240
CF4
Interpretation of the IRR
nIf a project’s IRR is greater than its
cost of capital, then there is an “excess”
return that contributes to the equity
value of the business.
nIn our example, IRR = 35.4% and the
project cost of capital is 10%, so the
project is expected to enhance
Northwest’s financial condition.
? What is meant by IRR = 0%? IRR = 10%?
Comparison of NPV and IRR
NPV ($)
IRR > k
and NPV > 0.
Value is increased.
IRR
k > IRR
and NPV < 0.
Value is
decreased.
Cost of
Capital (%)
Here, k = project cost of capital.
Some Thoughts on Project Analysis
nThere are other breakeven and
profitability measures that can be used.
nComputers make it easy to calculate all
such measures.
nA thorough analysis will consider the
information in all measures.
nHowever, the key to effective project
analysis is the ability to forecast the
cash flows.
Capital Budgeting in NFP Businesses
nMeasures thus far have focused on
the financial impact of a project.
nPresumably, NFPs have important
goals besides financial ones. Other
considerations can be incorporated
into the analysis by using:
lThe net present social value (NPSV)
model.
lProject scoring.
Post Audit
nThe post audit is a formal process for
monitoring a project’s performance
over time.
nIt has several purposes:
lImprove forecasts
lDevelop historical risk data
lImprove operations
lReduce losses