Capital Budgeting S S S Kumar Corporate Finance 1 Course Administration Assessment Weigh tage Quizzes 25% Midterm Exam 30% End term Exam 35% Projects/Assignments/Submissions 10% Attendance policy Roll call Occupy the designated seats only Late attendance Closure of attendance 3 What is in this course? In a nutshell – decisions that a chief financial officer must make 4 What are those decisions? How to make good investment decisions? How to make good financing decisions? How to manage the firm’s cashflows while doing the first two. 5 6 Key Ideas Unless you enter the tiger's den, you cannot take the cubs 7 Key Ideas Money is like manure. You have to spread it around or it smells. 8 Key Ideas Free Lunch 9 Corporate objective Survive Avoid financial distress and bankruptcy Beat the competition Maximize sales or market share Minimize costs Maximize the profits Balance the needs of all stakeholders Maximize shareholders wealth 10 Ultimate Corporate Objective.. SWM 11 What is Capital budgeting? When a firm considers a new project, corporate acquisition, plant expansion or asset acquisition that will produce income over the course of many years…this is called capital budgeting. It is imperative that in the analysis of such projects that we consider the timing, riskiness and magnitude of the after‐tax cash flows that the project is expected to generate. Capital budgeting decisions can be the most complex decisions facing management. 12 Pl note that.. Capital budgeting a.k.a – Capex – Investments – Projects 13 Features of capex projects Large cashflows Affect LT profitability Costly to reverse Top management’s attention How are capex projects classified? Independent – Acceptance or rejection has no affect on other projects. Mutually Exclusive – Acceptance of one automatically rejects the others. Contingent – Acceptance of one project is dependent upon the selection of another. Expansion Revenue expansion New product Strategic Capex projects Replacement Cost reduction Modernization 16 Payback Non DCF A/C RoI Capex evaluation techniques NPV DCF IRR PI 17 A good capex evaluation technique Good evaluation technique should: • Takes into consideration TVM • Includes risk adjustment • Consistent with the SWM Payback This is a simple approach to capital budgeting that is designed to tell you how many years it will take to recover the initial investment. It is often used by financial managers as one of a set of investment screens, because it gives the manager an intuitive sense of the project’s risk. How is it computed? Decision Rule Accept if the payback period is less than some preset limit 19 Calculation of Payback 20 Payback calculation Year A 0 1 2 3 4 Payback B C -200 -200 -100 40 40 30 20 20 40 10 10 50 130 60 4 years 2.6 years Never 21 Pros and Cons • Ease of – Calculation – Comprehension – Communication • Ignores – TVM – CFs after payback period 22 Discounted payback Calculates the time it takes to recover the initial investment in current or discounted dollars. Incorporates time value of money by adding up the discounted cash inflows at time 0, using the appropriate hurdle or discount rate, and then measuring the payback period. It is still flawed in that cash flows after the payback are ignored. 23 Discounted Payback Initial cost = AT cash flow benefits = Useful life(years) = Cost of Capital = Year 0 1 2 3 4 5 6 Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit $1,00,000 $60,000 6 12% Cumulative After-tax incremental CF PV Factor Cash Flows -$1,00,000 1 -$1,00,000 60,000 0.892857 $53,571 60,000 0.797194 $47,832 60,000 60,000 60,000 60,000 Payback period = 1.97 years 24 Accounting Rate of Return/Investment • How is it computed? • ARR = avg. income / avg. investment • A project will cost Rs 50000 and produces a stream of earnings as shown in the table. Assuming 50% tax rate and SLM method of depreciation compute the project’s ARR. 25 ARR Contd.. EBDIT DEP EBIT TAX EBIT(1-t) OPENEING BV CLOSING BV 1 14000 10000 4000 2000 2000 50000 40000 2 16000 10000 6000 3000 3000 40000 30000 3 18000 10000 8000 4000 4000 30000 20000 4 20000 10000 10000 5000 5000 20000 10000 5 AVERAGE 22000 10000 12000 6000 6000 4000 10000 0 25000 ARR 16.00% Decision Rule Accept if the ARR is more than cutoff level Pros and Cons Uses Income rather than Cash Flow Ignores time value of money 26 Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? 27 Net Present Value contd… • This rule is always consistent with maximizing the value of the firm • Economically, take all projects for which benefits > costs (in PV rupees) • Mathematically, sum the present values of all the cash flows 28 Net Present Value contd… Decision rule If the NPV is positive, accept the project Example: Year 0 1 2 3 4 5 6 Initial cost = AT cash flow benefits = Useful life(years) = Cost of Capital = $100,000 $60,000 6 12.0% Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit After-tax incremental CF -$100,000 $60,000 $60,000 $60,000 $60,000 $60,000 $60,000 NPV = PV Factor Present Value 1 -$100,000 0.892857 $53,571 0.797194 $47,832 0.71178 $42,707 0.635518 $38,131 0.567427 $34,046 0.506631 $30,398 $146,684 29 NPV with Excel Discount Rate Future Cash flows Assumption that cash flows occur at the end of the period 30 NPV and Shareholder Wealth A project’s NPV is the net effect that undertaking a project is expected to have on the firm’s value A project with an NPV > (<) 0 should increase (decrease) firm value Since the firm desires to maximize shareholders wealth, it should select the project with the highest NPV Why +ive NPV projects lead to SWM? 31 NPV Example Initial cost = $100,000 $60,000 AT cash flow benefits = 6 Useful life(years) = 0.0% Cost of Capital = Year 0 1 2 3 4 5 6 Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit Discount Rate = 0.0% NPV = $260,000 After-tax incremen PV Present tal CF Factor Value -$100,000 1.000 -$100,000 $60,000 1.000 $60,000 $60,000 1.000 $60,000 $60,000 1.000 $60,000 $60,000 1.000 $60,000 $60,000 1.000 $60,000 $60,000 1.000 $60,000 NPV = $260,000 NPV Example Initial cost = $100,000 $60,000 AT cash flow benefits = 6 Useful life(years) = 10.0% Cost of Capital = Year 0 1 2 3 4 5 6 Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit Discount Rate = 0.0% 10.0% NPV = $260,000 $161,316 After-tax incremen PV Present tal CF Factor Value -$100,000 1.000 -$100,000 $60,000 0.909 $54,545 $60,000 0.826 $49,587 $60,000 0.751 $45,079 $60,000 0.683 $40,981 $60,000 0.621 $37,255 $60,000 0.564 $33,868 NPV = $161,316 NPV Example Initial cost = $100,000 $60,000 AT cash flow benefits = 6 Useful life(years) = 20.0% Cost of Capital = Year 0 1 2 3 4 5 6 After-tax incremen PV Present tal CF Factor Value -$100,000 1.000 -$100,000 $60,000 0.833 $50,000 $60,000 0.694 $41,667 $60,000 0.579 $34,722 $60,000 0.482 $28,935 $60,000 0.402 $24,113 $60,000 0.335 $20,094 NPV = $99,531 Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit Discount Rate = 0.0% 10.0% NPV = $260,000 $161,316 20.0% $99,531 NPV Example Initial cost = $100,000 AT cash flow benefits = $60,000 Useful life(years) = 6 Cost of Capital = 30.0% Year 0 1 2 3 4 5 6 After-tax incremen PV Present tal CF Factor Value -$100,000 1.000 -$100,000 $60,000 0.769 $46,154 $60,000 0.592 $35,503 $60,000 0.455 $27,310 $60,000 0.350 $21,008 $60,000 0.269 $16,160 $60,000 0.207 $12,431 NPV = $58,565 Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit Discount Rate = 0.0% 10.0% NPV = $260,000 $161,316 20.0% $99,531 30.0% $58,565 NPV Example Initial cost = $100,000 AT cash flow benefits = $60,000 Useful life(years) = 6 Cost of Capital = 40.0% Year 0 1 2 3 4 5 6 After-tax incremen PV Present tal CF Factor Value -$100,000 1.000 -$100,000 $60,000 0.714 $42,857 $60,000 0.510 $30,612 $60,000 0.364 $21,866 $60,000 0.260 $15,618 $60,000 0.186 $11,156 $60,000 0.133 $7,969 NPV = $30,078 Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit Discount Rate = 0.0% 10.0% NPV = $260,000 $161,316 20.0% $99,531 30.0% $58,565 40.0% $30,078 NPV Example Initial cost = $100,000 AT cash flow benefits = $60,000 Useful life(years) = 6 Cost of Capital = 50.0% Year 0 1 2 3 4 5 6 After-tax incremen PV Present tal CF Factor Value -$100,000 1.000 -$100,000 $60,000 0.667 $40,000 $60,000 0.444 $26,667 $60,000 0.296 $17,778 $60,000 0.198 $11,852 $60,000 0.132 $7,901 $60,000 0.088 $5,267 NPV = $9,465 Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit Discount Rate = 0.0% 10.0% NPV = $260,000 $161,316 20.0% $99,531 30.0% $58,565 40.0% $30,078 50.0% $9,465 NPV Example Initial cost = $100,000 AT cash flow benefits = $60,000 Useful life(years) = 6 Cost of Capital = 60.0% Year 0 1 2 3 4 5 6 After-tax incremen PV Present tal CF Factor Value -$100,000 1.000 -$100,000 $60,000 0.625 $37,500 $60,000 0.391 $23,438 $60,000 0.244 $14,648 $60,000 0.153 $9,155 $60,000 0.095 $5,722 $60,000 0.060 $3,576 NPV = -$5,960 Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit Discount Rate = 0.0% 10.0% NPV = $260,000 $161,316 20.0% $99,531 30.0% $58,565 40.0% $30,078 50.0% $9,465 60.0% -$5,960 NPV Example Initial cost = $100,000 AT cash flow benefits = $60,000 Useful life(years) = 6 Cost of Capital = 55.806% Year 0 1 2 3 4 5 6 IRR = After-tax incremen PV Present tal CF Factor Value -$100,000 1.000 -$100,000 $60,000 0.642 $38,510 $60,000 0.412 $24,716 $60,000 0.264 $15,864 $60,000 0.170 $10,182 $60,000 0.109 $6,535 $60,000 0.070 $4,194 NPV = $0 Cashflow Initial cost ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit ATCF operating benefit Discount Rate = 0.0% 10.0% NPV = $260,000 $161,316 55.8058% 20.0% $99,531 30.0% $58,565 40.0% $30,078 50.0% $9,465 55.8% $0 39 NPV to IRR Rule NPV $ IRR 0 Discount Rate 40 IRR Rule This is the most important alternative to NPV. It is often used in practice and is intuitively appealing. It is based entirely on the estimated cash flows and is independent of any external rates/returns. Definition IRR is the return that makes the NPV = 0 Decision Rule Accept the project if the IRR is greater than the required return 41 IRR definition 42 Finding IRR There is no general algebraic closed‐form formula that solves the IRR for a project with multiple cash flows. The IRR solution is the zero‐point of a higher‐order polynomial. With three or more cash flows, this is a mess or impossible. Manual iteration = intelligent trial‐and‐error. 43 More about IRR Many spreadsheets and calculator have trial‐and‐error methods built‐in. In Excel, this function is called IRR(). Intuitively, a project with a higher IRR is more profitable. Multiplying each cash flow by the same factor, positive or negative, will not change the IRR. (Look at the formula.) 44 More about IRR The IRR rule leads often (but not always) to the same answer as the NPV rule, and thus to the correct answer. This is also the reason why IRR has survived as a common method for capital budgeting. If you use IRR correctly and in the right circumstances, it can not only give you the right answer, but it can also often give you nice extra intuition about your project itself, separate from the capital markets. 45 Profitability Index Measures the benefit per unit cost, based on the time value of money A profitability index of 1.1 implies that for every Re. 1 of investment, we create an additional Re. 0.10 in value Used occasionally. Not as common as IRR. Acceptance Rule Invest if PI > 1. Reject if PI < 1. Often gives the same recommendation as NPV. 𝑃𝐼 𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 46 NPV and IRR ‐ dilemmas NPV and IRR give consistent results when the projects are not mutually exclusive and when IRR > k (cost of capital) Which one would you select? Project A year cash flow 0 (135,000) 1 60,000 2 60,000 3 60,000 required return = 12% IRR = 15.89%% NPV = 9,110= 1.07 Project B year cash flow 0 (30,000) 1 15,000 2 15,000 3 15,000 required return = 12% IRR = 23.38% NPV = 6,027 Pattern of cashflows The prevailing cost of capital is 10%. Now consider two exclusive projects which one should you take? Time M N 0 ‐500 ‐500 1 75 290 2 175 200 3 225 150 4 IRR NPV 300 16% ₹ 86.76 50 19% ₹ 75.77 Fisher’s intersection/crossover 200 150 NPVM = 56.24 = NPVM 100 IRRN = 19% 50 0 0.03 0.05 0.07 0.09 0.11 0.13 0.15 0.17 0.19 0.21 0.23 0.25 ‐50 12% IRRM = 16% ‐100 ‐150 M N 50 …. dilemmas NPV profiles of projects can cross when project size differences exist (the cost of one project is larger than that of the other) or When timing differences exist (most of the cash flows from one project come in the early years, while most of the cash flows from the other project come in the later years) ….dilemmas If the cost of capital is greater than this crossover rate, the two methods give same answer If the cost of capital less than crossover rate, two methods give separate answers A close look at IRR If C0 = $40, C1 = ‐$80, C2 = 104, what is the IRR? A close look at IRR contd.. If C0 = ‐$100, C1 = $360, C2 = ‐$431, C3 = +$171.60, is 10% the IRR? A close look at IRR contd.. If C0 = ‐$100, C1 = $360, C2 = ‐$431, C3 = +$171.60, is 20% the IRR? A close look at IRR contd… If C0 = ‐$100, C1 = $360, C2 = ‐$431, C3 = +$171.60, is 30% the IRR? A close look at IRR contd… Which is the correct IRR for the earlier project? Which answer will Excel give? Why do you get multiple IRRs? 0 ‐800,000 1 5,000,000 2 ‐5,000,000 Are these irrelevant and absurd IRRs a problem? A little but not greatly. – You are guaranteed one unique IRR if you have at first only up‐front cash flows that are investments (negative numbers), followed only by payback (positive cash flows) after the investment stage. – This cash flow pattern is the case for financial bonds. – This cash flow pattern is also usually the case for most normal corporate investment projects. Outside the classroom, most projects do not have both positive and negative cash flows that alternate many times. (But there are projects that require big overhauls/maintenance, where it can happen.) You must be aware of these issues, lest they bite you one day unexpectedly. Which one would you prefer? Project A Project B Indifferent. 1000 ‐1000 ‐1500 1500 IRR = 50% IRR = 50% In case of conflicts.. Year 0 1 2 3 4 5 6 IRR NPV @10% P -250 100 100 75 75 50 25 22% $76.29 Q -250 50 50 75 100 100 125 20% $94.08 Q~P 0 -50 -50 0 25 50 100 15% $17.79 MIRR The interest rate where the FV of a project’s inflows (TV) are discounted to equal the PV of a project’s outflows. Assumes cash inflows are reinvested at the project’s cost of capital (k). This slight difference, makes the MIRR more accurate than the IRR. Steps to find MIRR Find • Find the sum of the FVs of all inflow as at the end of the project. Find • Find PV of all outflows as at the beginning of the project. Find • Then find rate over the n years that equates the sum of FVs to the sum of the PVs. Compare • Decision rule same as IRR: Compare MIRR to cost of capital. MIRR Compute the MIRR for the following project 65 What do the practitioners use? Indian Practice Scene Source: S. Singh, P.K. Jain, S.S. Yadav (2012) “Capital budgeting decisions: Evidence from India” Journal of Advances in Management Research, 9 (1), pp. 96‐112 67 What do the practitioners use? PI 16.90% IRR 68.90% NPV ARR Payback 0.00% 67.60% 18.20% 68.90% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% Source: Batra and Verma (2017)