Capital Budgeting - Analysis of Cashflows

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Capital Budgeting
- Analysis of Cashflows
MFIN 6664
Capital Budgeting
• evaluate potential projects with an evaluation methodology
such as net present value (NPV) or internal rate of return (IRR)
CFN
CF1
CF2
NPV  InitialInvestment


2
1  r  1  r 
1  r N
• CFt is the expected cashflow in period t
• r is the discount rate,
or required return,
or opportunity cost of capital,
or hurdle rate
Capital Budgeting
• To calculate IRR:
CFN
CF1
CF2
0  Investment 


2
(1  IRR) (1  IRR)
(1  IRR) N
• solve for IRR, the discount rate that gives NPV=0
• Both NPV and IRR are extremely common methods
for project evaluation in the real world
Cashflows
• To evaluate projects, need estimates of the cashflows
(CFts) expected
• First step is often development of pro forma income
statements for the project
• Even though we will adjust the accounting numbers in
the end, it is common to do this because:
• Common for financial info to be presented in
accounting format
• Many people are used to thinking terms of
accounting numbers
• You want to see what effect the project may have
on the accounting net income for the firm (i.e “How
will our numbers look if we take this project?”)
Simple Income Statement
Revenue
- Operating expenses
EBITDA
- Depreciation
EBIT
- Interest expense
Taxable Income (EBT)
- Tax
Net Income
• Estimating the top lines of the pro forma income
statement is extremely important
• Estimates of revenues and operating expenses
• Must be done via your knowledge of the business
• No “financial model” to do this
• May be based on past experience with this type of
project, or knowledge of the business and industry
• After that, must also estimate interest, depreciation, tax
rate to get down to net income
Cashflows
• Does net income represent the cashflow for the year
from the project?
• NO.
• There are various non-cash items in the income
statement that must be accounted for
• Capital expenditures are cashflow that must be paid by
firm, but do not show up on income statement
• Also, in capital budgeting it is typical for interest not to be
included as a cashflow
• The cost of debt is usually accounted for in the
discount rate used
• The operating cashflow to the project is often
represented as the Free Cash Flow to the Firm (FCFF)
Free Cash Flow to the Firm
FCFF = Net Income
+ Depreciation
- Capital Expenditures
- Change in non-cash Working
Capital
+ Interest (1 – tax rate)
Free Cash Flow to the Firm
• By combining the net income and interest parts, can also
write FCFF as:
FCFF = EBIT (1-tax rate)
+ Depreciation
- Capital Expenditures
- Change in non-cash Working
Capital
• The FCFF represents the estimated cashflow that will be
generated each period by the project
• Cashflow available to be paid out to investors (both
debtholders and shareholders)
• It is the cashflow to the firm overall (equity + debt)
• Part of FCFF will go to pay interest/principal on
debt and the residual belongs to the shareholders
Cashflows
• Other adjustments may be necessary to get the final
cashflow for analysis purposes
• All incremental cashflows must be included (and all nonincremental cashflows must be excluded)
• For example:
• Sunk costs should be ignored
• All effects on other parts of the firm should be
included
• Opportunity costs should be included
• After adjustment for any other effects, the FCFF can then
be used to estimate NPV (or IRR)
Example
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Firm thinking of launching new product
Initial cost = $2 million for new equipment
Estimated sales in first year = $3 million
Sales expected to increase by 5% per year
Fixed costs of production will be $1.5 million/year
Estimated that variable costs will be 40% of sales
Assume depreciation on new equipment will be simple straight line over 10
years
• i.e. ignore CCA rules in example
• Depreciation will be $200,000 per year
Accounts receivable will be 10% of sales each year
Accounts payable will be 15% of costs (fixed+variable) each year
Inventory will equal 5% of sales each year
IN 8 years, production will be shut down, all accounts payable/receivable
paid or collected, inventory sold, and equipment sold for $400,000
Firm’s tax rate is 35%
The firm requires a return of 12% on this project.
Calculate NPV and IRR
SEE SPREADSHEET FOR SOLUTION
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