E$cellence in Financial Mana e!

ent

Course 3: Capital Budgeting Analysis

Prepared by: Matt H. Evans, CPA, CMA, CFM

This course provides a concise overview of capital bud etin analysis. This course is reco!!ended for " hours of Continuin Professional Education. #n order to receive credit, you will need to pass a !ultiple choice e$a! which is ad!inistered over the internet at www.e$inf!.co!%trainin A co!panion toll free course can be accessed by dialin &'())'*(+',-+), option ., #/ )0".

The Overall Process

Chapter
Capital Expenditures
1henever we !a2e an e$penditure that enerates a cash flow benefit for !ore than one year, this is a capital e$penditure. E$a!ples include the purchase of new e3uip!ent, e$pansion of production facilities, buyin another co!pany, ac3uirin new technolo ies, launchin a research 4 develop!ent pro ra!, etc., etc., etc. Capital e$penditures often involve lar e cash outlays with !a5or i!plications on the future values of the co!pany. Additionally, once we co!!it to !a2in a capital e$penditure it is so!eti!es difficult to bac2'out. Therefore, we need to carefully analy6e and evaluate proposed capital e$penditures.

The Three Stages of Capital Budgeting Analysis

Capital 7ud etin Analysis is a process of evaluatin how we invest in capital assets8 i.e. assets that provide cash flow benefits for !ore than one year. 1e are tryin to answer the followin 3uestion: Will the future benefits of this project be large enough to justify the investment given the risk involved? #t has been said that how we spend our !oney today deter!ines what our value will be to!orrow. Therefore, we will focus !uch of our attention on present values so that we can understand how e$penditures today influence values in the future. A very popular approach to loo2in at present values of pro5ects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluatin a pro5ect. 1e will include three sta es within Capital 7ud etin Analysis: /ecision Analysis for 9nowled e 7uildin :ption Pricin to Establish Position /iscounted Cash Flow ;/CF< for !a2in the #nvest!ent /ecision 9E= P:#>T /o not force decisions to fit into /iscounted Cash Flows? =ou need to o throu h a three'sta e process: /ecision Analysis, :ption

Pricin , and /iscounted Cash Flow. This is one of the bi !ade in financial !ana e!ent.

est !ista2es

Three Stages of Capital Budgeting

Level of Uncertainty

&--A (-A *-A ,-A "-A -A

/ecision Analysis :ption Pricin /CF B..--

B&.--

B".-Investment Amount

Stage 1: ecision Analysis

/ecision'!a2in is increasin ly !ore co!ple$ today because of uncertainty. Additionally, !ost capital pro5ects will involve nu!erous variables and possible outco!es. For e$a!ple, esti!atin cash flows associated with a pro5ect involves wor2in capital re3uire!ents, pro5ect ris2, ta$ considerations, e$pected rates of inflation, and disposal values. 1e have to understand e$istin !ar2ets to forecast pro5ect revenues, assess co!petitive i!pacts of the pro5ect, and deter!ine the life cycle of the pro5ect. #f our capital pro5ect involves production, we have to understand operatin costs, additional overheads, capacity utili6ation, and start'up costs. Conse3uently, we can not !ana e capital pro5ects by si!ply loo2in at the nu!bers8 i.e. discounted cash flows. 1e !ust loo2 at the entire decision and assess all relevant variables and outco!es within an analytical hierarchy. #n financial !ana e!ent, we refer to this analytical hierarchy as the Multiple Attribute /ecision Model ;MA/M<. Multiple attributes are involved in capital pro5ects and each attribute in the decision needs to be wei hed differently. 1e will use an analytical hierarchy to structure the decision and derive the i!portance of attributes in relation to one another. 1e can thin2 of MA/M as a decision tree which brea2s down a co!ple$ decision into co!ponent parts. This decision tree approach offers several advanta es: 1e syste!atically consider both financial and non'financial criteria. @ud e!ents and assu!ptions are included within the decision based on e$pected values. 1e focus !ore of our attention on those parts of the decision that are i!portant.

1e include the opinions and ideas of others into the decision. Croup or tea! decision !a2in is usually !uch better than one person analy6in the decision. Therefore, our first real step in capital bud etin is to obtain 2nowled e about the pro5ect and or ani6e this 2nowled e into a decision tree. 1e can use software pro ra!s such as E$pert Choice or /ecision Pro to help us build a decision tree. Di!ple E$a!ple of a /ecision Tree:

Stage !: Option Pricing

The uncertainty about our pro5ect is first reduced by obtainin 2nowled e and wor2in the decision throu h a decision tree. The second sta e in this process is to consider all options or choices we have or should have for the pro5ect. Therefore, before we proceed to discounted cash flows we need to build a set of options into our pro5ect for !ana in une$pected chan es. #n financial !ana e!ent, consideration of options within capital bud etin is called contin ent clai!s analysis or option pricin . For e$a!ple, suppose you have a choice between two boiler units for your factory. 7oiler A uses oil and 7oiler 7 can use either oil or natural as. 7ased on traditional approaches to capital bud etin , the least costs boiler was selected for purchase, na!ely 7oiler A. However, if we consider option pricin 7oiler 7 !ay be the best choice because we have a choice or option on what fuel we can use. Duppose we e$pect risin oil prices in the ne$t five years. This will result in hi her operatin costs for 7oiler A, but 7oiler 7 can switch to a second fuel to better control operatin costs. Conse3uently, we want to assess the options of capital pro5ects. :ptions can ta2e !any for!s8 ability to delay, defer, postpone, alter, chan e, etc. These options ive us !ore opportunities for creatin value within capital pro5ects. 1e need to thin2 of capital pro5ects as a bundle of options. Three co!!on sources of options are: &. Ti!in :ptions: The ability to delay our invest!ent in the pro5ect. ". Abandon!ent :ptions: The ability to abandon or et out of a pro5ect that has one bad.

.. Crowth :ptions: The ability of a pro5ect to provide lon 'ter! rowth despite ne ative values. For e$a!ple, a new research pro ra! !ay appear ne ative, but it !i ht lead to new product innovations and !ar2et rowth. 1e need to consider the rowth options of pro5ects. :ption pricin is the additional value that we reco ni6e within a pro5ect because it has fle$ibilities over si!ilar pro5ects. These fle$ibilities help us !ana e capital pro5ects and therefore, failure to reco ni6e option values can result in an under'valuation of a pro5ect.

Stage 3: iscounted Cash "lo#s

Do we have co!pleted the first two sta es of capital bud etin analysis: ;&< 7uild and or ani6e 2nowled e within a decision tree and ;"< Eeco ni6e and build options within our capital pro5ects. 1e can now !a2e an invest!ent decision based on /iscounted Cash Flows or /CF. Fnli2e accountin , financial !ana e!ent is concerned with the values of assets today8 i.e. present values. Dince capital pro5ects provide benefits into the future and since we want to deter!ine the present value of the pro5ect, we will discount the future cash flows of a pro5ect to the present. /iscountin refers to ta2in a future a!ount and findin its value today. Future values differ fro! present values because of the ti!e value of !oney. Financial !ana e!ent reco ni6es the ti!e value of !oney because: &. Inflation reduces values over ti!e8 i.e. B &,--- today will have less value five years fro! now due to risin prices ;inflation<. ". Uncertainty in the future8 i.e. we thin2 we will receive B &,--- five years fro! now, but a lot can happen over the ne$t five years. .. Opportunity Costs of !oney8 B &,--- today is worth !ore to us than B &,--- five years fro! now because we can invest B &,--- today and earn a return. Present values are calculated by referrin to tables or we can use calculators and spreadsheets for discountin . The discount rate we will use is the opportunity costs of the invest!ent8 i.e. the rate of return we re3uire on any other pro5ect with si!ilar ris2s. E$hibit & G Present Halue of B &.--, year I n, rate I 2 =ear ;n< & " . 2 I &-A .+-+ .("* .)0& 2 I &&A .+-& .(&" .).& 2 I &"A .(+. .)+) .)&"

, 0

.*(. .*"&

.*0+ .0+.

.*.* .0*)

E$a!ple & G Calculate the Present Halue of Cash Flows =ou will receive B 0-- at the end of ne$t year. #f you could invest the B 0-today, you esti!ate that you could earn &"A. 1hat is the Present Halue of this future cash inflowJ B 0-- $ .(+. ;E$hibit &< I B ,,*.0-

#f we were to receive the sa!e cash flows year after year into the future, then we could use the present value tables for an annuity. E$hibit " G Present Halue of Annuity for B &.--, year I n, rate I 2 =ear ;n< & " . , 0 2 I &-A .+-+ &.).* ".,() ..&)..)+& 2 I &&A .+-& &.)&. ".,,, ..&-" ..*+* 2 I &"A .(+. &.*+".,-" ..-.) ..*-0

E$a!ple " G Calculate the Present Halue of Annuity Type Cash Flows =ou will receive B 0-- each year for the ne$t five years. =our opportunity costs for this invest!ent is &-A. 1hat is the present value of this invest!entJ B 0-- $ ..)+& ;E$hibit "< I B &,(+0.01e now understand discountin of cash flows ;/CF< and the three reasons why we discount future cash flows: #nflation, Fncertainty, and :pportunity Costs.

Calculating the iscounted Cash "lo#s of Pro&ects

#n capital bud etin analysis we want to deter!ine the after ta$ cash flows associated with capital pro5ects. 1e are concerned with all relevant chan es or differences to cash flows once we invest in the pro5ect.

'nderstanding ()elevancy(
:ne 3uestion that we !ust as2 in capital bud etin is what is relevant. Here are so!e e$a!ples of what is relevant to pro5ect cash flows: &. /epreciation: Capital assets are sub5ect to depreciation and we need to account for depreciation twice in our calculations of cash flows. 1e deduct depreciation once to calculate the ta$es we pay on pro5ect revenues and we add bac2 depreciation to arrive at cash flows because depreciation is a non'cash ite!. ". 1or2in Capital: Ma5or invest!ents !ay re3uire increases to wor2in capital. For e$a!ple, new production facilities often re3uire !ore inventories and hi her salaries payable. Therefore, we need to consider the net chan e in wor2in capital associated with our pro5ect. Chan es in net wor2in capital will so!eti!es reverse the!selves at the end of the pro5ect. .. :verhead: Many capital pro5ects can result in increases to allocated overheads, such as co!puter support services. However, the sub5ective nature of overhead allocations !ay not !a2e any difference at all. Therefore, you need to assess the i!pact of your capital pro5ect on overhead and deter!ine if these costs are relevant. ,. Financin Costs: #f we plan on financin a capital pro5ect, this will involve additional cash flows to investors. The best way to account for financin costs is to include the! within our discount rate. This eli!inates the possibility of double'countin the financin costs by deductin the! in our cash flows and discountin at our cost of capital which also includes our financin costs. 1e also need to i nore costs that are sun28 i.e. costs that will not chan e if

Chapter

we invest in the pro5ect. For e$a!ple, a new product line !ay re3uire so!e preli!inary !ar2etin research. This research is done re ardless of the pro5ect and thus, it is sun2. The concept of sun2 costs and relevant costs applies to all types of financin decisions.

E$a!ple . G Ma2e or 7uy /ecision =ou have the option to !anufacture your own parts or purchase the! fro! outside suppliers. #f we purchase the parts, it will cost B 0-.-- per part. :ur factory is operatin at )-A of capacity and our total costs to !anufacture parts is: /irect Materials /irect Kabor :verhead ' Hariable :verhead ' Fi$ed Total Costs B &0.-- % part B &+.-- % part B &,.-- % part B &".-- % part B *-.-- % part

Dince we are operatin at )-A capacity, we do not e$pect an increase in fi$ed overhead8 this is a sun2 cost. 1e would !anufacture the parts since it is B ".-- % part cheaper: Purchase B 0-.-- vs. Manufacture B ,(.-- ;B &0.-- L B &+.-- L B &,.--<

E$a!ple , G /iscontinue a Product =ou are considerin droppin product CM', fro! your product line because the #nco!e Dtate!ent for CM', shows the followin : Traditional Eelevant Dales Eevenues B &-,--B &-,--Cost of Coods Dold ' Hariable ; *,---< ; *,---< Cost of Coods Dold ' Fi$ed ; ",---< :peratin E$penses ' Hariable ; ",0--< ;",0--< :peratin E$penses ' Fi$ed ; *--< #nco!e ;Koss< B ; &,&--< B &,0-Conclusion: 1e should continue sellin #nco!e. CM', since it earns B &,0-- of

E$a!ple 0 G Accept a Dpecial :ffer A custo!er has offered you B &0.-- for 0,--- units of your product. =ou nor!ally sell your product for B "0.--. Dhould you accept this offerJ =ou currently produce and sell ,-,--- units with a !a$i!u! capacity of 0-,--- units. Total !anufacturin costs are B &(.-- per unit, consistin of B &".0- variable and B 0.0- fi$ed. Chan e in Eevenues B )0,--;0,--- $ B &0.--<

Chan e in E$penses ; *",0--< ;0,--- $ B &".0-< >et Chan e B &",0-Conclusion: =ou should accept the special offer since it results in B &",0-of additional inco!e. Do far, we have covered present values and relevancy within capital bud etin . 1e now can proceed to calculate the present value of relevant cash flows. :nce we have deter!ined the present value of cash flows, we will have a basis for co!parin our initial invest!ent. 7oth values ;future cash flows and initial invest!ent< will be e$pressed in current values. The net of these two a!ounts will tell us how !uch value we will create or destroy by investin in a pro5ect. E$a!ple * G Calculate Eelevant Cash Flows for Capital Pro5ect 1e plan on purchasin a new asse!bly !achine for B "0,---.. #t will cost B ",--- to have the new !achine installed and we e$pect a B &,--- net increase in wor2in capital. 7y !a2in the invest!ent, we will reduce our annual operatin costs by B ),--- and we e$pect to save B 0-- a year in !aintenance. The new !achine will re3uire B )0- each year for technical support. 1e will depreciate the !achine over 0 years under the strai ht'line !ethod of depreciation with an e$pected salva e value of B 0,---. The effective ta$ rate is .0A. Annual Davin s in :peratin Costs Annual Davin s in Maintenance Annual Costs for Technical Dupport Annual /epreciation Eevenues Ta$es O .0A >et Pro5ect #nco!e Add 7ac2 /epreciation ;noncash ite!< Relevant Pro ect Cash !lo" N B "0,--- ' B 0,--- % 0 years I B ,,--B ),--0-; )0-< ; ,,---< N B ",)0; +*"< &,)(( ,,--# $%&''

1e will receive B 0,)(( of cash flow each year by investin in this new asse!bly !achine. Dince we have a salva e value, we have a ter!inal cash flow associated with this pro5ect. E$a!ple ) G Calculate Ter!inal Cash Flow for Capital Pro5ect Esti!ated Dalva e A!ount in 0 =ears Kess Ta$es B 0,--;&,)0-<

Terminal Cash !lo"

# (%)$*

Calculating the Present -alue of Cash "lo#s

:ur ne$t step is to calculate present values of our two cash flow strea!s. 1e will use our cost of capital to discount the cash flows. 1e will assu!e that our cost of capital is &"A. 1e will use the present value tables in E$hibits & and " for findin the appropriate discount factor per the life of our cash strea!s and the &"A cost of capital. E$a!ple ( G Calculate Present Halue of Cash Flows Annual Pro5ect Cash Flows /iscount Factor per E$hibit " Present Halue of Annual Flows Ter!inal Cash Flow /iscount Factor per E$hibit & Present Halue of Ter!inal Flow Total Present +alue B 0,)(( $ ..*-0 ;&< B "-,(** B .,"0$ .0*) ;"< &,(,. # ))%&*,

;&<: 1e use the Annuity Table since we have the sa!e cash flows each year for the ne$t 0 years. #f we loo2 at E$hibit " for n I 0 years and &"A, we find ..*-0 ;"<: 1e need to discount the ter!inal cash flow received five years fro! now to the present by usin the Present Halue Table in E$hibit &.

Calculating .et /nvest0ent

>ow that we have the current value of B "",)-+ for our cash flows, we need to co!pare this to our invest!ent a!ount. :ur invest!ent is the total cash outlay we !ust !a2e today and it includes: All cash paid out to invest in the pro5ect and place it into service, such as installation, transportation, etc. >et proceeds fro! the disposal of any old e3uip!ent that will be replaced by the new e3uip!ent. Any ta$es paid and%or ta$ benefits received fro! !a2in the invest!ent.

E$a!ple + G Calculate >et #nvest!ent

Chapter

Eeferrin bac2 to E$a!ple *, we can calculate our >et #nvest!ent. 1e will also assu!e that an e$istin !achine can be sold for B *,---. Ac3uisition Costs #nstallation Costs #ncrease in 1or2in Capital Proceeds fro! Dale B *,--Kess Ta$es O .0A ;",&--< >et Proceeds fro! Dale -et Investment B "0,--",--&,--;.,+--< # ).%/**

Do we now have a current value for our cash flows of B "",)-+ and a total net invest!ent of B ",,&--. These a!ounts are derived by loo2in at three different types of cash flows: &. Eelevant cash flows durin the life of the pro5ect. ". Ter!inal cash flows at the end of the pro5ect. .. #nitial cash flows ;net invest!ent<.

Three Econo0ic Criteria for Evaluating Capital Pro&ects

1e have co!pleted our three !ain sta es of capital bud etin analysis, includin the calculation of discounted cash flows. The ne$t step is to apply so!e econo!ic criteria for evaluatin the pro5ect. 1e will use three criteria: >et Present Halue, Modified #nternal Eate of Eeturn, and /iscounted Paybac2 Period.

.et Present -alue

The first criterion we will use to evaluate capital pro5ects is >et Present Halue. >et Present Halue ;>PH< is the total net present value of the pro5ect. #t
12

represents the total value added or subtracted fro! the or ani6ation if we invest in this pro5ect. 1e can refer bac2 to our previous e$a!ple and calculate >et Present Halue. E$a!ple &- G Calculate >et Present Halue >et #nvest!ent :utflow ;E$a!ple +< Present Halue of #nflows ;E$a!ple (< -et Present +alue B ;",,&--< "",)-+ # 0/%(,/1

#f the >et Present Halue is positive, we should proceed and !a2e the invest!ent. #f the >et Present Halue is ne ative ;as is the case in E$a!ple &-<, then we would not !a2e the invest!ent.

3odified /nternal )ate of )eturn

7esides deter!inin the >et Present Halue of a pro5ect, we can calculate the rate of return earned by the pro5ect. This is called the #nternal Eate of Eeturn. #nternal Eate of Eeturn ;#EE< is one of the !ost popular econo!ic criteria for evaluatin capital pro5ects since !ana ers can identify with rates of return. #nternal Eate of Eeturn is calculatin by findin the discount rate whereby the >et #nvest!ent a!ount e3uals the total present value of all cash inflows8 i.e. >et Present Halue I -. #f we have e3ual cash inflows each year, we can solve for #EE easily.

E$a!ple && G Calculate #nternal Eate of Eeturn Eeferrin bac2 E$a!ple *, we would solve for #EE as follows: B 0,)(( $ discount factor I B ",,&-- or B ",,&-- % B 0,)(( I ,.&*,. #f we loo2 in the Present Halue Tables for n I 0 years, we want to find a present value factor nearest to ,.&*,. 7y referrin to published present value tables, we find the followin : At *A, n I 0 As Calculated At )A, n I 0 /ifference ,."&", ,.&*,.-,(, ,."&", ,.&--" .&&""

.-* L ;.-,(, % .&&""< $ ;.-) ' .-*< I .-*,.

11

Internal Rate of Return 2 34.(5

#f the #nternal Eate of Eeturn were hi her than our cost of capital, then we would accept this pro5ect. #n our e$a!ple, the #EE ;*.,.A< is less than our cost of capital ;&"A<. Therefore, we would not invest in this pro5ect. :ne of the proble!s with #EE is the so'called reinvest!ent rate assu!ption. #EE !a2es the assu!ption that every year you will be able to earn the #EE each ti!e you reinvest your cash inflows. This assu!ption can result in so!e !a5or distortions between >et Present Halue and #nternal Eate of Eeturn. 1e will correct this distortion by !odifyin our #EE calculation. E$a!ple &" G #EE /istortions fro! Eeinvest!ent Eate Assu!ption A summary of four simple projects with I Cash #nflows Pro5ect #nvest!ent =ear'& =ear'" A 7 C / B ",--",--",--",--B '-' &,0-",,0'-' B ,,0-","0&,--,,"&and !"#$ #EE 0-A 0-A 00A ,0A >PH B .,&.",(&",*,",+,-

#f we use #EE, we would select Pro5ect C, but if we o by >PH, we would select Pro5ect A.

#n order to eli!inate the reinvest!ent rate assu!ption, we will !odify the #nternal Eate of Eeturn so that the reinvest!ent rate is our cost of capital. This will ive us a !ore accurate #EE for our pro5ect. Fortunately, we can use spreadsheets li2e Microsoft E$cel to calculate Modified #nternal Eate of Eeturn. E$a!ple &. G Calculate Modified #EE Fsin Microsoft E$cel Eeferrin bac2 to E$a!ple *, we have the followin : B 0,)(( annual pro5ect cash inflows B ",,&-- net invest!ent a!ount &"A cost of capital The for!ula for calculatin Modified #EE in a Microsoft E$cel Dpreadheet is: OM#EE;A&:An, 2A, rA< A&:An is the cell ran e for enterin our data. 1e always enter the net invest!ent in the first cell and the cash inflows in each cell thereafter. 2A

1!

refers to our cost of capital and rA is the rate we believe we can earn when we reinvest cash inflows. #f we assu!e that we can earn our cost of capital on reinvested cash flows, then we would enter the followin fro! our e$a!ple: Cell A& A" A. A, A0 A* 7& #nput '",,&-0,)(( 0,)(( 0,)(( 0,)(( 0,)(( OM#EE;A&:A*, &"A, &"A< :utput

+A

The Modified #EE on our pro5ect is +A.

iscounted Pay4ac5 Period

The final econo!ic criteria we will use is the /iscounted Paybac2 Period. Paybac2 refers to the nu!ber of years it ta2es to recover our net invest!ent. #n our previous e$a!ple ;E$a!ple *<, we could use a si!ple paybac2 calculation as follows: B ",,&-- % B 0,)(( I ,." years However, this !ethod does not reco ni6e the ti!e value of !oney and as we previously indicated, we !ust consider the ti!e value of !oney because of inflation, uncertainty, and opportunity costs. Therefore, we will use the discounted cash flows to calculate the paybac2 period ;discounted paybac2 period<.

E$a!ple &, G Calculate /iscounted Paybac2 Period Eeferrin bac2 to E$a!ple *, we can calculate the discounted paybac2 period as follows: =ear & Cash Flow $ B 0,)(( P.H. Factor I P.H. Cash Flow Total to /ate .(+. B 0,&*+ B 0,&*+

13

" . , 0 0

0,)(( 0,)(( 0,)(( 0,)(( .,"0-

.)+) .)&" .*.* .0*) .0*)

,,*&. ,,&"& .,*(& .,"(" &,(,.

+,)(" &.,+-. &),0(, "-,(** "",)-+

Fnder the /iscounted Paybac2 Period, we would never receive a paybac2 on our pro5ect8 i.e. the total to date present cash flows never reached B ",,&-;net invest!ent<. #f we had relied on the re ular paybac2 calculation, we would falsely assu!e that this pro5ect does paybac2 in the fourth year. #n su!!ary, we use econo!ic criteria that have realistic econo!ic assu!ptions about capital invest!ents. Three econo!ic criteria that !eet this test are: >et Present Halue Modified #nternal Eate of Eeturn /iscounted Paybac2 Period

1$

Additional Considerations in Capital

$ Budgeting Analysis
1henever we analy6e a capital pro5ect, we !ust consider uni3ue factors. A discussion of all of these factors is beyond the scope of this course. However, three co!!on factors to consider are: Co!pensatin for different levels of ris2s between pro5ects. Eeco ni6in ris2s that are specific to forei n pro5ects. Ma2in ad5ust!ents to capital bud etin analysis by loo2in at the actual results.

Chapter

Ad&usting for )is5

1e previously learned that we can !ana e uncertainty by initiatin decision analysis and buildin options into our pro5ects. 1e now want to turn our attention to !ana in ris2s. #t is worth notin that uncertainty and ris2 are not the sa!e thin . Fncertainty is where you have no basis for a decision. Eis2 is where you do have a basis for a decision, but you have the possibility of several outco!es. The wider the variation of outco!es, the hi her the ris2. #n our previous e$a!ple ;E$a!ple *<, we used the cost of capital for discountin cash flows. :ur e$a!ple involved the replace!ent of e3uip!ent and carried a low level of ris2 since the e$pected outco!e was reasonably certain. Duppose we have a pro5ect involvin a new product line. 1ould we still use our cost of capital to discount these cash flowsJ The answer is no since this pro5ect could have a !uch wider variation in outco!es. 1e can ad5ust for hi her levels of ris2 by increasin the discount rate. A hi her discount rate reflects a hi her rate of return that we re3uire whenever we have hi her levels of ris2. Another way to ad5ust for ris2 is to understand the i!pact of ris2 on outco!es. Densitivity Analysis and Di!ulation can be used to !easure how chan es to a pro5ect affect the outco!e. Densitivity analysis is used to deter!ine the chan e in >et Present Halue iven a chan e in a specific variable, such as esti!ated pro5ect revenues. Di!ulation allows us to si!ulate the results of a pro5ect for a iven distribution of variables. 7oth sensitivity analysis and si!ulation re3uire a definition of all relevant variables associated with the pro5ect. #t should be noted that sensitivity analysis is !uch easier to

1%

i!ple!ent since sophisticated co!puter !odels are usually re3uired for si!ulation.

/nternational Pro&ects
Capital invest!ents in other countries can involve additional ris2s. 1henever we invest in a forei n pro5ect, we want to focus on the values that are added ;or subtracted< to the Parent Co!pany. This !a2es us consider all relevant ris2s of the pro5ect, such as e$chan e rate ris2, political ris2, hyper'inflation, etc. For e$a!ple, the discounted cash flows of the pro5ect are the discounted cash flows of the pro5ect to the forei n subsidiary converted to the currency of the ho!e country of the Parent Co!pany at the current e$chan e rate. This forces us to ta2e into account e$chan e rate ris2s and its i!pact to the Parent Co!pany.

Post Analysis
:ne of the !ost i!portant steps in capital bud etin analysis is to follow'up and co!pare your esti!ates to actual results. This post analysis or review can help identify bias and errors within the overall process. A for!al trac2in syste! of capital pro5ects also 2eeps everyone honest. For e$a!ple, if you were to announce to everyone that actual results will be trac2ed durin the life of the pro5ect, you !ay find that people who sub!it esti!ates will be !ore careful. The purpose of post analysis and trac2in is to collect infor!ation that will lead to i!prove!ents within the capital bud etin process.

Course Su00ary
The lon 'ter! invest!ents we !a2e today deter!ines the value we will have to!orrow. Therefore, capital bud etin analysis is critical to creatin value within financial !ana e!ent. And the only certainty within capital bud etin is uncertainty. Therefore, one of the bi est challen es in capital bud etin is to !ana e uncertainty. 1e deal with uncertainty throu h a three'sta e process: &. 7uild 2nowled e throu h decision analysis. ". Eeco ni6e and encoura e options within pro5ects. .. #nvest based on econo!ic criteria that have realistic econo!ic assu!ptions. :nce we have co!pleted the three'sta e process ;as outlined above<, we evaluate capital pro5ects usin a !i$ of econo!ic criteria that adheres to the principles of financial !ana e!ent. Three ood econo!ic criteria are >et Present Halue, Modified #nternal Eate of Eeturn, and /iscounted Paybac2.

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Additionally, we need to !ana e pro5ect ris2 differently than we would !ana e uncertainty. 1e have several tools to help us !ana e ris2s, such as increasin the discount rate. Finally, we want to i!ple!ent post analysis and trac2in of pro5ects after we have !ade the invest!ent. This helps eli!inate bias and errors in the capital bud etin process.

"inal Exa0
Delect the best answer for each 3uestion. E$a!s are raded and ad!inistered over the internet at www.e$inf!.co!%trainin . &. Capital bud etin analysis consists of three distinct sta es. The first sta e is: a. /iscounted Cash Flows b. Di!ulation c. /ecision Analysis d. >et Present Halue ". The ability to postpone, delay, alter or abandon a pro5ect adds value to the pro5ect. This value is referred to as: a. Eelevant cash flows b. Attribute value c. >et Present Halue d. :ption Pricin .. The ti!e value of !oney is i!portant for three reasons. These three reasons are: a. #nflation, uncertainty, and opportunity costs. b. Eelevancy, stability, and consistency. c. Pro5ect returns, costs, and ti!in . d. Pro5ect options, positions, and variables. ,. 1hich of the followin is relevant in deter!inin the cash flows of a pro5ectJ a. Dun2 costs b. /epreciation
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c. Paybac2 period d. >et Present Halue

0. =ou are about to invest B &0,--- into a pro5ect that will enerate B 0,0-- of cash flows each year for the ne$t . years. #f your cost of capital is &&A, then the present value of future cash flows is: ;refer to E$hibit " for present value tables< a. B ".,"&( b. B &.,,," c. B &&,*&" d. B &-,(-( *. Eeferrin bac2 to 3uestion 0, the >et Present Halue of the pro5ect is: a. B *,,&( b. B (,"&( c. B ;&,00(< d. B ;,,&+"< ). =ou are considerin investin in a new cotton'bailin !achine. The purchase price of new bailer is B &-,---. #t will cost B )0- to transport the bailer to your location. The old bailer will be sold for B ",--- and your ta$ rate is ,-A. The net invest!ent for this pro5ect is: a. B &&,+0b. B &-,)0c. B +,00d. B (,+0(. #n addition to usin >et Present Halue to evaluate a pro5ect, another ood econo!ic criteria that can be used is: a. Accountin Eate of Eeturn b. Modified #nternal Eate of Eeturn c. Di!ple Paybac2

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d. Eeturn on #nvest!ent

+. :ne !ethod for !ana in pro5ect ris2 is to use: a. Densitivity Analysis b. /iscounted Paybac2 c. >et #nvest!ent d. Pro5ect Turnover &-. An additional ris2 usually associated with an international pro5ect is: a. Pro5ect paybac2 b. /irect Kabor Chan es c. #nstallation Costs d. Forei n E$chan e Eate Eis2

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