CHAPTER 10 & 11 The Basics of Capital Budgeting & Cash Flow Estimation

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1 CHAPTER 10 & 11 The Basics of Capital Budgeting & Cash Flow Estimation Should we build this plant? 10-1

2 Capital Budgeting Overview Project Classifications Analysis Methods/Decision Rules Comparison of NPV & IRR Optimal Capital Budget 10-2

3 What is Capital Budgeting? Long-term Strategic Decisions Analysis of Future Cash Flows Large Expenditures (Fixed Assets) Basis for Future Growth 10-3

4 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

5 Project Classifications Replacement Maintenance Cost Reduction Expansion Existing Products or Markets New Products or Markets Safety or Environmental R&D (Long-term) Long-term Contracts (Specific Customers) 10-5

6 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

7 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

8 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

9 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

10 Calculating Payback Project L CF t Cumulative Payback L = / 80 = years Project S CF t Cumulative Payback S = / 50 = 1.6 years 10-10

11 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

12 Net Present Value (NPV) Method Sum of the PVs of ALL cash inflows and outflows of a project: NPV = CF t /(1 + r) t + CF 0 OR NPV t n 0 CFt (1 r ) t 10-12

13 Project L s NPV, r=10% Year CF t PV of CF t $ NPV L = $18.79 NPV S = $

14 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 (NPV s > NPV L ) & both if independent 10-14

15 Internal Rate of Return (IRR) Method IRR is the discount rate that forces PV of inflows equal to costs. NPV = 0: 0 t n 0 ( 1 CFt IRR ) t IRR L = 18.13% and IRR S = 23.56%

16 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, Solve for IRR = YTM = 7.08% 10-16

17 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

18 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 IRR s > IRR L

19 NPV Profiles A graphical representation of project NPVs at various different costs of capital. r NPV L NPV S 0 $50 $ (4)

20 Drawing NPV profiles NPV ($) Crossover Point = 8.7% L. S IRR L = 18.1% IRR S = 23.6% Discount Rate (%) 10-20

21 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, NPV S > NPV L

22 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

23 Profitability Index (PI) PI is the Ratio of the PV of the Cash Inflows to the PV of Investment PI = [ [CFinflow t /(1+r) t ]] CFinvest 0 PI L = $158.1/$100 = PI s = $159.7/$100 =

24 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

25 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

26 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

27 Cash Flow Estimation Estimating Relevant Cash Flows Adjusting for Inflation 10-27

28 Relevant Project Cash Flows 2 Cardinal Rules Use Cash Flows NOT Accounting Income Use Incremental After-tax Cash Flows Cash Flows Included Opportunity Costs Externalities Cash Flows NOT Included Finance Costs Sunk Costs 10-28

29 Example Project Initial Investment Depreciable Investment ($240,000) Changes in Working Capital ($20,000) Operations (no inflation) New sales: 100,000 $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

30 Determining Project Value Estimate relevant Cash Flows Initial OCF 1 OCF 2 OCF 3 OCF 4 Invest + Terminal CFs NCF 0 NCF 1 NCF 2 NCF 3 NCF

31 Investment Cash Flows Initial Investments (Depreciable Cost) Equipment $200,000 Ship/Installation 40,000 Net Investment CF 0 $240,000 Change in Working Capital Inventories $25,000 (Asset) Acct/Payables $5,000 (Liability) Net Δ NOWC $20,

32 Annual Depreciation Expense Year Rate x Basis Depr x $240 $ x x x $240 Due to the MACRS ½-year convention, a 3-year asset is depreciated over 4 years

33 Annual Operating Cash Flows Revenues Op. Costs (60%) Depr Expense Oper. Income (EBIT) Tax (40%) Oper. Income (AT) Depr Expense Operating CF

34 Terminal Cash Flow Recovery of NOWC $20,000 Salvage value 25,000 Tax on SV (40%) -10,000 Terminal CF $35,

35 Estimated Project CFs (No Inflation) Terminal CF CCF IRR & NPV at WACC = 10%. NPV = -$4.01 million IRR = 9.28% Payback = 3.30 yrs 10-35

36 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

37 Operating CFs, Inflation = 5% Revenues Op. Costs (60%) Depr Expense Oper. Income (BT) Tax (40%) Oper. Income (AT) Depr Expense Operating CF

38 Estimated Project CFs adjusted for Inflation Terminal CF IRR & NPV at WACC = 10%. NPV = $14.78 million. IRR = 12.56%. Payback = 3.12 yrs 10-38

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