Capital Budgeting. Finance 100

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1 Capital Budgeting Finance 100 Prof. Michael R. Roberts 1 Topic Overview How should capital be allocated?» Do I invest / launch a product / buy a building / scrap / outsource...» Should I acquire / sell / accept offer for company or division?» How should the capital budgeting process be organized? Which choices should I make?» make or buy» which distribution channel» should I test market a product 2 1 1

2 Discounted Cash Flows (DCF) A Tool for Rational Decision Making What can be an object of capital budgeting procedures?» There must be a choice - choose a base case and an alternative. (Do nothing/status quo) Identify incremental cash flows from project» Treat as incremental cash flows to shareholder (marginal impact) Calculate the value of the project.» Taking into account timing and risk (t and r e )» Aggregate cash flows into one single number Show that doing all and only projects which have positive net present value maximizes the value of the firm. 3 Estimating Relevant Cash Flows The relevant cash flows for evaluating a new investment project are the incremental cash flows contributed by the project. Incremental = Firm s CFs - Firm s CFs Cash Flows with Project without Project Only Incremental Cash Flows are Relevant. But consider,» Side effects of the project» Investment in working capital.» Forget about sunk costs.» Include all opportunity costs» Allocated overhead expenses.» Impact on taxes (depreciation & expense)» Separate investment from financing decisions» Cash flow uncertainty, use expected values 4 2 2

3 Estimating Cash Flows Example A new machine costs $60,000» installation costs of $2,000.» generates revenues of $155,000 and» expenses of $100,000 annually.» depreciated to its estimated salvage value of $6,000 over its seven year life. What are the relevant cash flows? 5 Compute Cash Flows Year Revenues 155, ,000 Expenses -100, ,000 Depreciation -8, ,000 Taxable Income 47, ,000 Tax 15, ,980 Compute Net Cash Flows Compute Tax Cash Flows Year Revenues 155, , ,000 Expenses -100, , ,000 Tax -15, ,980-15,980 Cost of Machine -62,000 Salvage 6,000 Net Cash Flow -62,000 39, ,020 45,

4 Net Present Value & the Weighted Average Cost of Capital (WACC) You have incremental cash flows: CF 0, CF 1, CF 2,..., CF T NPV in year 0 is present values of all incremental cash flows: CF1 CF2 CFT NPV = CF T (1 + r) (1 + r) (1 + r) T CFt = t= 0 t ( 1+ r) where r is the WACC 7 The Weighted Average Cost of Capital (WACC) Method Assume that the firm maintains a constant debt-equity ratio and that the WACC remains constant over time WACC incorporates tax savings from debt we can compute levered value of an investment by discounting cash flows using the WACC E D rwacc = re + rd (1 τ c) E + D E + D V CF CF CF = L rwacc (1 + rwacc ) (1 + rwacc ) 8 4 4

5 Using the WACC to Value a Project Example Assume Avco is considering introducing a new line of packaging, the RFX Series.» Expenses and Income: Upfront R&D & Marketing Expense: $6.67mil Upfront Capital Investment Expense: $24mil Product Life = 4 years (straight line-depreciation) Annual Sales = $60mil/year Manufacturing Costs = $25mil/year Operating Expenses = $9mil/year» Other Info.: No net working capital requirements for the project. Avco pays a corporate tax rate of 40%. 9 Expected Cash Flow from Avco s RFX Project Table shows the expected increment cash flows from the project

6 Avco s Balance Sheet and Cost of Capital Without the RFX Project Avco plans on maintaining a similar (net) debt-equity ratio in the future including any financing decisions» What is Avco s WACC? 11 Using the WACC to Value a Project (Cont.) What is the value of the project, including the tax shield from debt? What is the project NPV?

7 NPV Rule Synopsis Step 1: Determine the free cash flow of the investment Step 2: Compute the WACC Step 3: Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC» The WACC can be used throughout the firm as the companywide cost of capital for new investments that are: of comparable risk to the rest of the firm, and that will not alter the firm s debt-equity ratio. NPV Rule: If NPV > 0, accept; if NPV < 0, reject 13 What Does a Positive NPV Mean? Consider a project with the following cash flows: Time CF and a discount rate of 10% had an NPV of 10%. So what? This project profile implies an NPV of NPV = =

8 What Does a Positive NPV Mean? (Cont.) Suppose the only shareholder can borrow and lend at the same rate (i.e., perfect capital markets) Year Project Cash Flow Loan Cash Flow Interest Balance of account Payment to shareholder Positive NPV projects are arbitrage opportunities 15 What Does a Negative NPV Mean? Suppose you accept a negative NPV project: Year Project Cash Flow Loan Cash Flow Interest Balance of account Payment to shareholder Negative NPV means that you like to throw money away

9 Mutually Exclusive Projects Suppose you have several mutually exclusive projects A, B, C,...:» Choose the project with the highest NPV.» Equivalent to breaking decision into sequence of binary decisions:» Choice between A and B, compare winner of A vs B with C: 17 Comparing Projects with Different Lives Example Your firm must decide which of two machines it should use to produce its output. Machine A costs $100,000, has a useful life of 4 years, and generates after-tax cash flows of $40,000 per year. Machine B costs $65,000, has a useful life of 3 years, and generates after-tax cash flows of $35,000 per year. The machine is needed indefinitely and the discount rate is r p = 10%. Year Machine A Machine B = = = = =

10 Comparing Projects with Different Lives Example (Cont.) Step 1: Calculate the NPV for each project for one reinvestment cycle:» NPV A =?» NPV B =? 19 Comparing Projects with Different Lives Example (Cont.) Step 2: Convert the NPVs for each project into an equivalent annual annuity. Recall the annuity formula: N 1 ( 1+ i) i PV = a a = PV i 1 ( 1+ i) N Project A:? Project B:?

11 Sources of Positive NPV Where does positive NPV come from?» Competitive advantage for company from protection through: barriers to entry, specific resources, skills» NPV measures value creation! Use caution in applying» How much of your NPV comes from cash flows beyond 5 years (10 years)? Can you sustain your competitive advantage that long?» Do your forecasts anticipate competition? What margins, growth do you anticipate relative to your competitors? 21 Payback Rule An Alternative Rule Payback Period» Length of time required to recover the initial investment of the project.» If PP less then pre-determined cutoff, accept the project.» Consider 3 projects (Brealey & Myers): Cash Flows Payback NPV Project t=0 t=1 t=2 t=3 Period (Years) 10%) A -$2,000 $500 $500 $5,000 3 $2,624 B -$2,000 $500 $1,800 $0 2 -$58 C -$2,000 $1,800 $500 $0 2 $

12 Internal Rate of Return An Alternative Rule Internal rate of return (IRR).» Rate of return to project required to obtain an NPV = 0.» If IRR > opportunity cost of capital then accept project. Examples of Problems with IRR (Brealey & Myers)» Problem 1: Sign changes in the cash flows Cash Flows NPV Project t=0 t=1 t=2 t=3 IRR 10%) A $1,000 -$3,600 $4,320 -$1,728 20% -$ Internal Rate of Return An Alternative Rule (Cont.) Examples of Problems with IRR (Brealey & Myers)» Problem 2: Multiple IRR s Cash Flows NPV Project t=0 t=1 t=2 t=3 t=4 T=5 T=6 IRR 10%) A -$1,000 $800 $150 $150 $150 $150 -$150-50% or 15.2% $74.90» Problem 3: No Real IRR Cash Flows NPV Project t=0 t=1 t=2 IRR 10%) A $1,000 -$3,000 $2,500 No Real IRR $339» Further Problems: Deciding among projects, which cost of capital to compare with?

13 Summary NPV Rule has strong attractions:» based on cash flows - so does not depend on accounting conventions» fully reflects time value of money» takes into account riskiness of project» gives clear go/no go answer Advance Corp Fin:»APV

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