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Capital Budgeting

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1. Introduction

Capital budgeting is the process of planning expenditures on assets (fixed assets) whose cash flows are expected to extend beyond one year. Managers analyze projects and decide which ones to include in the capital budget. The "capital" refers to long-term assets. The "budget" is a plan which details projected cash inflows and outflows during future period. The typical steps in the capital budgeting process: 1. Generating good investment ideas to consider. 2. Analyzing individual proposals - forecast cash flows, evaluate profitability, etc. 3. Planning the capital budget - how does the project fit within the company's overall strategies? What's the timeline and priority? 4. Monitoring and post-auditing - The post-audit is a follow-up of capital budgeting decisions. It is a key element of capital budgeting. By comparing actual results with predicted results and then determining why differences occurred, decision makers can: Improve forecasts, based on which you can make good capital budgeting decisions. Otherwise, you will have the GIGO (garbage in, garbage out) problem; Improve operations, thus making capital decisions well implemented.

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1. Introduction

Project classifications: Replacement projects. There are two types of replacement decisions. o Replacement decisions to maintain the business. The issue is two-fold: should you continue the existing operations? If yes, should you continue to use the same processes? Maintenance decisions are usually made without detailed analysis. o Replacement decisions to reduce costs. Cost reduction projects determine whether to replace serviceable but obsolete equipments. These decisions are discretionary, and a detailed analysis is usually required. The cash flows from the old asset must be considered in replacement decisions. Specifically, in a replacement project, the cash flows from selling old assets should be used to offset the initial investment outlay. Analysts also need to compare the revenue/cost/depreciation before and after the replacement to identify changes in these elements. Expansion projects. Expansion into new products, services or markets. These projects involve strategic decisions and explicit forecasts of future demand, and thus require detailed analysis. These projects are more complex than replacement projects. Regulatory, safety and environmental projects. These projects are mandatory investments, and are often non-revenue-producing. Others. Some projects need special considerations other than the traditional capital budgeting analysis, for example, a very risky research project in which cash flows cannot be reliably forecast.

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Capital budgeting decisions are based on incremental after-tax cash flows discounted at the opportunity cost of capita. Assumptions of capital budgeting are: Capital budgeting decisions must be made on cash flows, not accounting income. o Accounting profits only measures the return on the invested capital. Accounting income calculations reflect non-cash items and ignore the time value of money. They are important for some purposes, but for capital budgeting, cash flows are what are relevant. o Economic income is the investment's after-tax cash flow plus the change in the market value. Financing costs are ignored in computing economic income. Cash flow timing is critical because money is worth more the sooner you get it. Also, firms must have adequate cash flow to meet maturing obligations. The opportunity cost should be charged against a project. Remember that just because something is on hand does not mean it's free. See below for the definition of opportunity cost.

Expected future cash flows must be measured on an after-tax basis. The firm's wealth depends on its usable after-tax funds. Ignore how the project is financed. Interest payments should not be included in the estimated cash flows since the effects of debt financing are reflected in the cost of capital used to discount the cash flows. The existence of a project depends on business factors, not financing. Copyright www.educorporatebridge.com

A sunk cost is a cash outlay that has already been incurred and which cannot be recovered regardless of whether the project is accepted or rejected. Since sunk costs are not increment costs, they should not be included in the capital budgeting analysis. For example, a small bookstore is considering opening a coffee shop within its store, which will generate from selling coffee an annual net cash outflow of $10,000. That is, the coffee shop will always be losing money. In the previous year, the bookstore spent $5,000 to hire a consultant to perform an analysis. This $5,000 consulting fee is a sunk cost - whether the coffee shop is opened or not, the $5,000 is spent. Incremental cash flow is the net cash flow attributable to an investment project. It represents the change in the firm's total cash flow that occurs as a direct result of accepting the project. o Forget sunk costs. o Subtract opportunity costs. o Consider side effects on other parts of the firm: externalities and cannibalization. o Recognize the investment and recovery of net working capital.

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Opportunity cost is the return on the best alternative use of an asset or the highest return that will not be earned if funds are invested in a particular project. For example, to continue with the bookstore example, the space to be occupied by the coffee shop is an opportunity cost - it could be used to sell books and generate $5,000 annual net cash inflow. Externalities are the effects of a project on cash flows in other parts of the firm. Although they are difficult to quantity, they (which can be either positive or negative) should be considered. o Positive externalities create benefits for other parts of the firm. For example, the coffee shop may generate some additional customers for the bookstore who otherwise may not buy books there. Future cash flows generated by positive externalities occur if with the projects and do not occur if without the project, so they are incremental. o Negative externalities create costs for other parts of the firm. For example, if the bookstore is considering to open a branch two blocks away, some customers who buy books at the old store will switch to the new branch. The customers lost by the old store are a negative externality. The primary type of negative externalities is cannibalization, which occurs when the introduction of a new product causes sales of existing products to decline.

Future cash flows represented by negative externalities occur regardless of the projects, so they are nonincremental. Such cash flows represent a transfer from the existing projects to the new projects, and thus should be subtracted from the new projects' cash flows.

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A conventional cash flow pattern is one with an initial outflow followed by a series of inflow

In a non-conventional cash flow pattern, the initial outflow can be followed by inflows and/or outflows

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Independent versus mutually exclusive projects. Mutually exclusive are investments that compete in some way for a company's resources - a firm can select one or another but not both. Independent projects, on the other hand, do not compete with the firm's resources. A company can select one or the other or both, so long as minimum profitability thresholds are met. Project sequencing. How does one sequence multiple projects through time since investing in project B may depend on the result of investing in project A? Unlimited funds versus capital rationing. Capital rationing occurs when management places a constraint on the size of the firm's capital budget during a particular period. In such situations, capital is scarce and should be allocated to the best projects to maximize the firm's aggregate NPV. The firm's capital budget and cost of capital must be determined simultaneously to best allocate the firm's capital. On the other hand, a firm can raise the funds it wants for all profitable projects simply by paying the required rate of return.

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When a firm is embarking upon a project, it needs tools to assist in making the decision of whether to invest in the project or not. In order to demonstrate the use of these four methods, the cash flows presented below will be used.

Expected After Tax Net Cash Flows , CFt Year (t) 0 1 2 3 4 Project A ($1,000) 750 350 150 50 Project B ($1,000) 100 250 450 750

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This method discounts all cash flows (including both inflows and outflows) at the project's cost of capital and then sums those cash flows. The project is accepted if the NPV is positive. NPV = [CFt/(1 + k)t] Where CFt is the expected cash flow at period t, k is the projects where CFT is the expected cash flow at period t, k is the project's cost of capital and n is its life. Cash outflows are treated as negative cash flows since they represent expenditure that the company has to incur to fund the project. Cash inflows are treated as positive cash flows since they represent money being brought into the company. The NPV represents the amount of present-value cash flows that a project can generate after repaying the invested capital (project cost) and the required rate of return on that capital. An NPV of zero signifies that the project's cash flows are just sufficient to repay the invested capital and to provide the required rate of return on that capital. If a firm takes on project with a positive NPV, the position of the stockholders is improved. Decision rules 1. The higher the NPV, the better. 2. Reject if NPV is less than or equal to 0.

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NPV measures the dollar benefit of the project to shareholders. However, it does not measure the rate of return of the project, and thus cannot provide "safety margin" information. Safety margin refers to how much the project return could fall in percentage term before the invested capital is at risk.

Assuming the cost of capital for the firm is 10%, calculate each cash flow by dividing the cash flow by (1 + k)t where k is the cost of capital and t is the year number. Calculate the NPV for Project A and B above. NPV = CF0 + CF1 + CF2 + CF3 + CF4

Project A's NPV = -1,000 + 750/1.101 + 350/1.102 + 150/1.103 + 50/1.104 = -1,000 + 682 + 289 + 113 + 34 = $118 (rounded). Project B's NPV = -1,000 + 100/1.101 + 250/1.102 + 450/1.103 + 750/1.104 = -1,000 + 91 + 207 + 338 + 512 = $148 (rounded).

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Internal Rate of Return (IRR) It is the discount rate that forces a project's NPV to equal to zero. NPV = [CFt/(1 + IRR)t] Note this formula is simply the NPV formula solved for the particular discount rate that forces the NPV to equal zero. The IRR on a project is its expected rate of return. The NPV and IRR methods will usually lead to the same accept or reject decisions. Decision rules 1. The higher the IRR, the better. 2. Define the hurdle rate, which typically is the cost of capital. 3. Reject if IRR is less than or equal to the hurdle rate. IRR does provide "safety margin" information. Calculate Project A's and B's IRR. Project A: -1000 + 750/(1 + IRR)1 + 350/(1+IRR)2 + 150/(1+IRR)3 + 50/(1+IRR)4 = 0 Since it is difficult to determine the IRR by hand, the use of a financial calculator is needed to solve for IRR. The IRR for Project A is 18.32% and for Project B is 15.03%.

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Payback Period

It is the expected number of years required to recover the original investment. Payback occurs when the cumulative net cash flow equals 0. Decision rules 1. The shorter the payback period, the better. 2. A firm should establish a benchmark payback period. Reject if payback is greater than benchmark. PaybackA = 1 + (1000 - 750)/350 = 1.7 years. PaybackB = 3 + (1000 - 100 - 250 - 450)/750 = 3.27 years. Drawbacks It ignores cash flows beyond the payback period. Payback period is a type of "break even" analysis: it cares about how quickly you can make your money to recover the initial investment, not how much money you can make during the life of the project. It does not consider the time value of money. Therefore, the cost of capital is not reflected in the cash flows or calculations.

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It is similar to the regular payback method except that it discounts cash flows at the project's cost of capital. It considers the time value of money, but it ignores cash flows beyond the payback period. Again, assume the cost of capital for the firm is 10%: Discounted PaybackA = 2 + (1000 - 682 - 289)/113 = 2.26 years. Discounted PaybackB = 3 + (1000 - 91 - 207 - 338)/512 = 3.71 years.

The payback provides an indication of a project's risk and liquidity because it shows how long the invested capital will be tied up in a project and "at risk". The shorter the payback period, the greater the project's liquidity, the lower the risk, and the better the project. The payback is often used as one indicator of a project's risk.

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This is a very simply rate of return: AAR = Average net income / Average book value The only advantage is that it is very easy to calculate.

Drawbacks o It does not take into account the time value of money - the value of cash flows does not diminish with time as is the case with NPV and IRR. o ARR is based on numbers that include non-cash items.

Profitability Index (PI) This is an index used to evaluate proposals for which net present values have been determined. The profitability index is determined by dividing the present value of each proposal by its initial investment.

PI = PV of future cash flows / Initial investment = 1 + (NPV / Initial investment) The PI indicates the value you are receiving in exchange for one unit of currency invested. An index value greater than 1.0 is acceptable and the higher the number, the more financially attractive the proposal. A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment.

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4. NPV Profiles.

A NPV profile is a graph showing the relationship between a project's NPV and the firm's cost of capital. The point where a project's net present value profile crosses the horizontal axis indicates a project's internal rate of return.

Some observations: The IRR is the discount rate that sets the NPV to 0. The NPV profile declines as the discount rate increases. Project A has a higher NPV at low discount rates, while Project B has a higher NPV at high discount rates. The NPV profiles of Project A and B join at the crossover rate, at which the projects' NPVs are equal. The slope of Project A's NPV profile is steeper. This indicates that Project A's NPV is more sensitive to changes in the discount rates. Copyright www.educorporatebridge.com

The IRR formula is simply the NPV formula solved for the particular rate that sets the NPV to 0. The same equation is used for both methods. The NPV method assumes that cash flows will be reinvested at the firm's cost of capital, while the IRR method assumes reinvestment at the project's IRR. Reinvestment at the cost of capital is a better assumption in that it is closer to reality.

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For independent projects, the NPV and IRR methods make the same accept or reject decisions. Assuming that Project A and B are independent, consider their NPV profiles. The IRR criterion for accepting independent project is IRR > hurdle rate. That is, cost of capital must be less than (or to the left of) the IRR. Whenever cost of capital is less than the IRR, the project's NPV is positive. Recall that the decision rule for independent projects: accept if NPV > 0. Thus, both projects should be accepted based on the NPV method. However, for mutually exclusive projects, ranking conflicts can arise. Assuming that Project A and B are mutually exclusive, consider their NPV profiles. If the cost of capital > crossover rate, then NPVB > NPVA, and IRRB > IRRA. Thus, both methods lead to the selection of Project B. If the cost of capital <crossover rate, then NPVB <NPVA, and IRRB > IRRA. Thus, a conflict arises because now the NPV method will select Project A while the IRR method will choose B. Therefore, for mutually exclusive projects, the NPV and IRR methods lead to same decisions if the cost of capital > the crossover rate, and different decisions if the cost of capital the crossover rate.

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For mutually exclusive projects, NPV and IRR methods will lead to the same accept or reject decision when: Two projects are of equal size and have the same life. Two projects are of equal size but differ in lives. However the projects can generate conflicting results if the NPV profiles of two projects cross (and there is a crossover rate): As long as the cost of capital (k) is larger than the crossover rate, the two methods both lead to the same decision; A conflict exists if k is less than the crossover rate. Two conditions cause the NPV profiles to cross When project size (or scale) differences exist. The cost of one project is larger than that of the other When timing differences exist. The timing of cash flows from the two projects differs such that 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.

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The root cause of the conflict between NPV and IRR is the rate of return at which differential cash flows can be reinvested. Both the NPV and IRR methods assume that the firm will reinvest all early cash flows. The NPV method implicitly assumes that early cash flows can be reinvested at the cost of capital. The IRR assumes that the firm can reinvest at the IRR. Whenever a conflict exists, NPV method should be used. It can be demonstrated that the better assumption is the cost of capital for the reinvestment rate Multiple IRRs is the situation where a project has two or more IRRs. This problem is caused by nonConventional cash flows of a project. Conventional cash flows means that the initial cash outflows are followed by a series of cash inflows. Non-conventional cash flows means that a project calls for a larger cash outflow either sometime during or at the end of its life. Thus, the signs of the net cash flows flip-flop during the project's life. In fact, non-conventional cash flows can cause other problems such as negative IRR or an IRR, which leads to an incorrect accept or reject decision. However, a project can have only one NPV regardless of its cash flow patterns so the NPV method is preferable when evaluating projects with non-normal cash flows.

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The usefulness of various capital budgeting methods depends on the specific applications. Although financial textbooks often recommend of the use of NPV and IRR methods, other methods are also heavily used by corporations.

Capital budgeting is also relevant to external analysts to estimate the value of stock prices theoretically, if a company invests in positive NPV projects, the wealth of its shareholders should increase.

The integrity of a firm's capital budgeting processes can also be used to show how the management pursues its goal of shareholder wealth maximization.

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