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