CHAPTER 10 & 11
The Basics of Capital Budgeting &
Cash Flow Estimation
Should we
build this
plant?
10-1
Capital Budgeting Overview




Project Classifications
Analysis Methods/Decision Rules
Comparison of NPV & IRR
Optimal Capital Budget
10-2
What is Capital Budgeting?

Long-term Strategic Decisions

Analysis of Future Cash Flows


Large Expenditures (Fixed Assets)
Basis for Future Growth
10-3
5 Steps to Capital Budgeting
1.
Estimate CFs (inflows & outflows)
2.
Assess riskiness of CFs
3.
Determine the Risk-adjusted Cost of Capital
4.
Find NPV and/or IRR (and other methods)
5.
Accept if NPV > 0 and/or IRR > WACC
10-4
Project Classifications

Replacement



Expansion





Maintenance
Cost Reduction
Existing Products or Markets
New Products or Markets
Safety or Environmental
R&D (Long-term)
Long-term Contracts (Specific Customers)
10-5
Major Capital Budgeting
Methods

Payback ( + Discounted Payback)

Discounted Cash Flow (DCF or NPV)

Internal Rate of Return (IRR)

Profitability Index (not used in practice)

Modified Internal Rate of Return (MIRR)
10-6
Independent vs Mutually
Exclusive Projects?


Independent projects – if the cash
flows of one are unaffected by the
acceptance of the other.
Mutually exclusive projects – if the
cash flows of one can be adversely
impacted by the acceptance of the
other.
10-7
Normal vs Nonnormal cash flow
streams?


Normal stream –Negative CF followed
by a series of positive CFs. 1 change
of sign
Nonnormal stream – Two or more
changes of sign Most common:
Negative CF followed by positive CFs,
then negative CF to terminate
 Nuclear Power, Toxic Waste
10-8
Payback Method


The number of years required to
recover a project’s cost, or “How long
does it take to get our money back?”
Calculated determining when the
cumulative cash flow for the project
turns positive.
10-9
Calculating Payback
Project L
CFt
Cumulative
PaybackL
Project S
CFt
Cumulative
PaybackS
0
1
2
2.4
3
-100
-100
10
-90
60
-30
100
0
80
== 2
0
1.6
1
-100
-100
== 1
30 / 80
+
70
-30
+
= 2.375 years
2
100 50
0 20
30 / 50
50
3
20
40
= 1.6 years
10-10
Strengths & Weaknesses of
Payback

Strengths



Provides an indication of a project’s risk and
liquidity.
Easy to calculate and understand.
Weaknesses

Ignores the time value of money


Discounted Payback Alternative
Ignores CFs occurring after the payback
10-11
Net Present Value (NPV)
Method

Sum of the PVs of ALL cash inflows and
outflows of a project:
NPV = ∑ CFt/(1 + r)t + CF0
OR
n
NPV
t 0
CFt
t
(1 r )
10-12
Project L’s NPV, r=10%
Year
0
1
2
3
CFt
-100
10
60
80
NPVL =
PV of CFt
-$100
9.09
49.59
60.11
$18.79
NPVS = $19.98
10-13
Rationale for NPV



NPV= PV of inflows – PV outflows (Cost)
= Net gain in Wealth
If projects are independent, accept if the
project NPV > 0
If projects are mutually exclusive, accept
projects with the highest positive NPV,
Accept S if mutually exclusive (NPVs >
NPVL) & both if independent
10-14
Internal Rate of Return (IRR)
Method

IRR is the discount rate that forces PV of
inflows equal to costs. NPV = 0:
0
t

CFt
t
IRR )
0 (1
n
IRRL = 18.13% and IRRS = 23.56%.
10-15
Project IRR vs Bond YTM



Same Concept
YTM on the bond would be the IRR
of the “bond” project
EXAMPLE: Assume a 10-year bond
with a 9% annual coupon sells for
$1,134.20.

Solve for IRR = YTM = 7.08%
10-16
Rationale for IRR


If IRR > WACC, the Project’s return
is greater than its costs.
There is “excess” Return left over to
boost stockholders’ returns.
10-17
IRR Acceptance Criteria




If IRR > r, accept project.
If IRR < r, reject project.
If projects are independent, accept
both projects, as IRR > r = 10%
If projects are mutually exclusive,
accept S, because IRRs > IRRL.
10-18
NPV Profiles

A graphical representation of project NPVs at
various different costs of capital.
r
0
5
10
15
20
NPVL
$50
33
19
7
(4)
NPVS
$40
29
20
12
5
10-19
Drawing NPV profiles
NPV 60
($)
.
40 .
50
30
.
.
20
Crossover Point = 8.7%
.
10
IRRL = 18.1%
L
..
0
5
-10
10
15
S
.
.
20
.
IRRS = 23.6%
Discount Rate (%)
23.6
10-20
Main Reasons why NPV & IRR
Decisions may Conflict

Reinvestment Rate Assumptions are
different


Size (scale) differences – the smaller project frees
up funds at t = 0 for investment. The higher the
opportunity cost, the more valuable these funds,
so high r favors small projects
Timing differences – the project with faster
payback provides more CF in early years for
reinvestment. If r is high, early CF good, NPVS >
NPVL.
10-21
Reinvestment Rate Assumptions


NPV method assumes CFs are reinvested at
r, the opportunity cost of capital.
IRR method assumes CFs are reinvested at
IRR.


Assuming CFs are reinvested at the opportunity
cost of capital is more realistic, so NPV method is
the best.
NPV method should be used to choose between
mutually exclusive projects.
10-22
Profitability Index (PI)

PI is the Ratio of the PV of the Cash
Inflows to the PV of Investment
PI = [ [CFinflowt/(1+r)t]] ÷ CFinvest0

PIL = $158.1/$100 = 1.581

PIs = $159.7/$100 = 1.597
10-23
Optimal Capital Budget


Theory says to accept all positive NPV
projects.
Two problems can occur when there is
not enough internally generated cash to
fund all positive NPV projects:
 An increasing Marginal Cost of Capital.
 Capital Rationing
10-24
Increasing Marginal Cost of
Capital


Externally raised capital can have large
flotation costs, which increase the cost
of capital.
Investors often perceive large capital
budgets as being risky, which drives up
the cost of capital.
10-25
Capital Rationing


Capital rationing occurs when a
company chooses not to fund all
positive NPV projects.
The company typically sets an upper
limit on the total amount of capital
expenditures that it will make in the
upcoming year.
10-26
Cash Flow Estimation


Estimating Relevant Cash Flows
Adjusting for Inflation
10-27
Relevant Project Cash Flows

2 Cardinal Rules



Cash Flows Included



Use Cash Flows NOT Accounting Income
Use Incremental After-tax Cash Flows
Opportunity Costs
Externalities
Cash Flows NOT Included


Finance Costs
Sunk Costs
10-28
Example Project

Initial Investment






Depreciable Investment ($240,000)
Changes in Working Capital ($20,000)
Operations (no inflation)
 New sales: 100,000 units/year @ $2/unit
 Variable cost: 60% of sales
Life of the project
 Economic life: 4 years
 Depreciable life: MACRS 3-year class
 Salvage value: $25,000
Tax rate: 40%
WACC: 10%
10-29
Determining Project Value

Estimate relevant Cash Flows
0
1
2
3
4
Initial
Invest
OCF1
OCF2
OCF3
NCF0
NCF1
NCF2
NCF3
OCF4
+
Terminal
CFs
NCF4
10-30
Investment Cash Flows

Initial Investments (Depreciable Cost)
Equipment
Ship/Installation
Net Investment CF0

$200,000
40,000
$240,000
Change in Working Capital



Inventories
Acct/Payables
Net Δ NOWC
$25,000 (Asset)
$5,000 (Liability)
$20,000
10-31
Annual Depreciation Expense
Year
1
2
3
4
Rate
0.33
0.45
0.15
0.07
1.00
x
x
x
x
x
Basis
$240
240
240
240
Depr
$ 79
108
36
17
$240
Due to the MACRS ½-year convention, a
3-year asset is depreciated over 4 years.
10-32
Annual Operating Cash Flows
Revenues
- Op. Costs (60%)
- Depr Expense
Oper. Income (EBIT)
- Tax (40%)
Oper. Income (AT)
+ Depr Expense
Operating CF
1
2
3
4
200 200 200 200
-120 -120 -120 -120
-79 -108 -36 -17
1 -28
44 63
-11
18 25
1 -17
26 38
79
80
108
91
36
62
17
55
10-33
Terminal Cash Flow
Recovery of NOWC
Salvage value
Tax on SV (40%)
Terminal CF
$20,000
25,000
-10,000
$35,000
10-34
Estimated Project CFs (No
Inflation)
0
1
-260
80
CCF -260
-180

2
3
91
62
+Terminal CF →
-89
-27
4
55
35
90
63
IRR & NPV at WACC = 10%.



NPV = -$4.01 million
IRR = 9.28%
Payback = 3.30 yrs
10-35
What if the expected Annual
Inflation is 5%. Is NPV biased?

Yes, inflation included in the discount
rate (WACC)

Inflation NOT included in CFs

CFs should be adjusted for Inflation
10-36
Operating CFs, Inflation = 5%
Revenues
Op. Costs (60%)
- Depr Expense
- Oper. Income (BT)
- Tax (40%)
Oper. Income (AT)
+ Depr Expense
Operating CF
1
2
3
4
210 220 232 243
-126 -132 -139 -146
-79 -108 -36 -17
5 -20
57
80
2
-8
23
32
3 -12
34
48
79 108
36
17
82
96
70
65
10-37
Estimated Project CFs
adjusted for Inflation
0
1
2
-260
82
96

3
70
Terminal CF →
4
65
35
100
IRR & NPV at WACC = 10%.



NPV = $14.78 million.
IRR = 12.56%.
Payback = 3.12 yrs
10-38