Topic02 1capital Budgeting

F d t l f C it l B d ti
MBA 540 Financial Management

Fundamentals of Capital Budgeting
1. Investment Decision Rules
2. Capital Budgeting for Single Project 2. Capital Budgeting for Single Project
1 Investment Decision Rules 1. Investment Decision Rules
(1) For Single Project (1) For Single Project
(2) For Mutually Exclusive Projects
(3) For Multiple Projects
2
NPV Rule
We accept the project if the its NPV is positive.
We reject the project if the its NPV is negative.
3
IRR Rule
IRR is the interest rate that makes the projects
NPV zero.
We accept the project if its IRR exceeds r, the cost
of capital.
We reject the project if its IRR is less than r the We reject the project if its IRR is less than r, the
cost of capital.
In general, the IRR rule works for a stand-alone
4
In general, the IRR rule works for a stand alone
project if all of the projects negative cash flows
precede its positive cash flows.
Payback Period Rule
The payback period is amount of time it takes to
recover or pay back the initial investment.
We accept the project if its payback period is less
than a pre-specified length of time.
We reject the project if its payback period is more We reject the project if its payback period is more
than a pre-specified length of time.
5
NPVrule IRRrule Paybackperiodrule
Calculation NPVisthesumofall IRRisther that: Paybackperiodisthe
t
PVs: timet that:
R l If NPV 0 t it If IRR t it If t T t it
N
i
i
i
r
C
NPV
0
) 1 (
0
) 1 (
0

i
i
i
IRR
C
0
0

t
i
i
C
Rule IfNPV>0,acceptit.
IfNPV<0,rejectit.
IfIRR>r,acceptit.
IfIRR<r,rejectit.
(risgiven.)
Ift <T,acceptit.
Ift >T,rejectit.
(Tisprespecified.)
Application Always use NPV rule When negative cash flows When the T is short Application AlwaysuseNPVrule. Whennegativecashflows
precedepositivecash
flows.(downwardslope)
WhentheTisshort.
Pitfalls Delayedinvestments r is ignored.
6
y
MultipleIRRs
NonexistentIRR
r isignored.
CashflowsafterT are
ignored.
Adhocdecision.(T)
(2) For Mutually Exclusive Projects (2) For Mutually Exclusive Projects
The NPV rule
We should select the project with the highest,
positive NPV.
It is possible that all projects have negative NPVs.
Then, we should reject them all.
7
(2) For Mutually Exclusive Projects (2) For Mutually Exclusive Projects
IRR rule?
Can we extend the IRR rule to the case of mutually
exclusive projects by choosing the project with the
highest IRR greater than the cost of capital? highest IRR greater than the cost of capital?
No. It is wrong to choose the project with highest
IRR.
The IRR rule (including the Incremental IRR rule) is NOT
suitable for mutually exclusive projects.
8
(3) For Multiple Projects (3) For Multiple Projects
We take as many positive-NPV projects as we
lti l j t ithi th can among multiple projects within the resource
constraints.
s constraint resource : subject to
) ( max Total NPV
9
(3) For Multiple Projects (3) For Multiple Projects
Profitability Index
Use the profitability index to identify the optimal
combination of projects to undertake.
S 1 C l l h j fi bili i d Step 1: Calculate each projects profitability index.
Value Created NPV
Profitability Index
Resource Consumed Resource Consumed

Step 2: Rank order the projects by profitability index.
Step 3: Count how many projects we can take within the
Resource Consumed Resource Consumed
10
Step 3: Count how many projects we can take within the
resource constraint.
2 Capital Budgeting For Single Project 2. Capital Budgeting For Single Project
(1) Capital Budgeting (1) Capital Budgeting
(2) Step 1: Forecasting Earnings
(3) Step 2: Determining Free Cash Flows
(4) Step 3: Calculating NPV (4) Step 3: Calculating NPV
(5) Further Adjustments to Free Cash Flow
11
In the basic investment decision rule
di i ( NPR IRR b k i d) discussions (e.g. NPR, IRR, payback period),
we assume that the cash flows (C
i
), and the cost
of capital (r) are known of capital (r) are known.
In practice, we must estimate the cash flows
related to the project in order to calculate NPV related to the project in order to calculate NPV
(or IRR, pay back period, etc.). This practical
analysis is called Capital Budgeting.
12
y p g g
Capital budgeting is the process used by firms
t l lt ti i t t j t d to analyze alternative investment projects and
decide which ones to accept.
13
Procedures
Forecast the projects future consequences for the
firm.
l f f Examples of future consequences: revenues, costs, etc.
Although earnings are not cash flows, as a practical
matter, our analysis starts with forecasting earnings. y g g
Determine the effect on the firms cash flows.
Calculate the NPV of the project for investment
14
C cu e e N V o e p ojec o ves e
decision making.
Procedures:
Oneinvestmentproject p j
Forestingearnings
Wewilluseone
Calculatingcashflows
example,the
HomeNet project,
toillustratethe
procedures
CalculatingprojectNPV
Investment decision
procedures.
15
Investmentdecision
(2) Step 1: Forecasting Earnings (2) Step 1: Forecasting Earnings
Revenues and costs estimates
We assume that the revenues and costs related to
the project have been estimated through the
feasibility study feasibility study.
The data should be collected from different departments of
the firm.
For example, the sales dept.; the manufacturing dept.; the
R&D dept.; the marketing dept.
16
Example: HomeNet project
From sales or marketing:
Annual sales: 100,000 units
Product life: 4 years
U it i $260 (N t d t th t il i ) Unit price: $260 (Note: do not use the retail price.)
So, annual sales revenue = $26,000,000.
17
From R&D and manufacturing: hardware production:
Engineering and design costs: $5,000,000.
Production plan: outsourcing.
U it d ti t $110 Unit production cost: $110.
So, annual production cost = $11,000,000.
18
From R&D and manufacturing: software development:
R&D period: 1 year.
Labor cost: $10,000,000 (= 50 engineers * $200,000)
N i t t $7 500 000 New equipment cost: $7,500,000.
So, the total life of the project is 5 years (= 4 + 1); and we
need to calculate the depreciation of the new equipment.
19
From marketing:
Annual marketing and support cost: $2,800,000.
20
Direct incremental earnings forecast
Incremental earnings
The amount by which the firms earnings are expected to
change as a result of the investment decision change as a result of the investment decision.
We use the income statement to forecast the direct
incremental earnings.
And we ignore the financing costs in calculation.
21
We first construct the income statement:
Year 0 1 2 3 4 5
1) Revenue
2)COGS
3)Grossprofit=1 2
4)Selling,generaladministrative
5)R&D
6)Depreciation
22
) p
7)EBIT=3 4 5 6
8)Incometax(T=40%)
9)Unleverednetincome =7 8
We fill out the table step by step: sales (#17)
Year 0 1 2 3 4 5
1) Revenue $0 $26,000 $26,000 $26,000 $26,000 $0
2)COGS
3) G fi 1 2 3)Grossprofit=1 2
5)R&D
6)Depreciation
23
7)EBIT=3 4 5 6
8)Incometax(T=40%)
We fill out the table step by step: hardware (#18)
Year 0 1 2 3 4 5
1) Revenue $0 $26,000 $26,000 $26,000 $26,000 $0
2)COGS $0 $11,000 $11,000 $11,000 $11,000 $0
3) G fi 1 2 $0 $15 000 $15 000 $15 000 $15 000 $0 3)Grossprofit=1 2 $0 $15,000 $15,000 $15,000 $15,000 $0
5)R&D $5,000 $0 $0 $0 $0 $0
6)Depreciation
24
7)EBIT=3 4 5 6
8)Incometax(T=40%)
We fill out the table step by step: software (#19)
Year 0 1 2 3 4 5
1) Revenue $0 $26,000 $26,000 $26,000 $26,000 $0
2)COGS $0 $11,000 $11,000 $11,000 $11,000 $0
3) G fit 1 2 $0 $15 000 $15 000 $15 000 $15 000 $0 3)Grossprofit=1 2 $0 $15,000 $15,000 $15,000 $15,000 $0
5)R&D $15,000 $0 $0 $0 $0 $0
6)Depreciation $0 $1,500 $1,500 $1,500 $1,500 $1,500
R&D=
10M+5M
Equipment:
25
7)EBIT=3 4 5 6
8)Incometax(T=40%)
Equipment:
straightline
depreciation
We fill out the table step by step: marketing/support (#20)
Year 0 1 2 3 4 5
1) Revenue $0 $26,000 $26,000 $26,000 $26,000 $0
2)COGS $0 $11,000 $11,000 $11,000 $11,000 $0
3)Grossprofit=1 2 $0 $15,000 $15,000 $15,000 $15,000 $0
4)Selling,generaladministrative $0 $2,800 $2,800 $2,800 $2,800 $0
5)R&D $15,000 $0 $0 $0 $0 $0
6)Depreciation $0 $1,500 $1,500 $1,500 $1,500 $1,500
26
6) epreciation $0 $ ,500 $ ,500 $ ,500 $ ,500 $ ,500
7)EBIT=3 4 5 6 $15,000 $10,700 $10,700 $10,700 $10,700 $1,500
8)Incometax(T=40%)
We fill out the table step by step: net income
Year 0 1 2 3 4 5
1) Revenue $0 $26,000 $26,000 $26,000 $26,000 $0
2)COGS $0 $11,000 $11,000 $11,000 $11,000 $0
3) G fi 1 2 $0 $15 000 $15 000 $15 000 $15 000 $0
Thenegative
incometax
meansthetax
hi ld f th 3)Grossprofit=1 2 $0 $15,000 $15,000 $15,000 $15,000 $0
5)R&D $15,000 $0 $0 $0 $0 $0
6)Depreciation $0 $1,500 $1,500 $1,500 $1,500 $1,500
shieldforthe
company.
Evenifthe
projectwerethe
onlyonethe
27
7)EBIT=3 4 5 6 $15,000 $10,700 $10,700 $10,700 $10,700 $1,500
8)Incometax(T=40%) $6,000 $4,280 $4,280 $4,280 $4,280 $600
9)Unleverednetincome =7 8 $9,000 $6,420 $6,420 $6,420 $6,420 $900
firmhad,could
westillconsider
thetaxshield?
Yes.
Discussion
Unlevered net income: Generally, we do not include
interest payment in capital budgeting study interest payment in capital budgeting study.
Tax rate: It should be the marginal corporate tax rate,
which is the tax rate on an incremental pre-tax income.
R&D costs: in our example, no intangible assets (e.g.
patent) are generated, so we ignore amortization.
I t i l i i t b
28
Inventory: in our example, we ignore inventory because
of outsourcing and simplification.
Indirect effects on incremental earnings
We have just discussed the DIRECT incremental
earnings, by using the (project) income statement.
However that is only the DIRECT effects not all However, that is only the DIRECT effects, not all
about the projects effects.
We must also consider the INDRIRECT effects of
the project by studying the changes between
earnings with or without the project.
29
Without this project, we may take another project.
Taking this project may affect our current products.
Indirect effect 1: Opportunity costs
We must remember that it is NOT FREE using one
resource that the company already owns resource that the company already owns.
Reason: That resource could provide value to the company
in another project.
The opportunity cost of using one resource is the value
that resource could have provided in its best alternative
use.
30
Space will be required for the HomeNet project. The
equipment can be housed in an existing space. The
opportunity cost of not using the space in an alternative way
(e g renting it out) must be considered (e.g., renting it out) must be considered.
Suppose we know that the warehouse space would have
otherwise rented out for $200,000 per year during years 1-4.
This $200 000 annual rental income is one opportunity: a
31
This $200,000 annual rental income is one opportunity: a
foregone rent, and the incremental earnings will be reduced.
Example: HomeNet project with opportunity costs
The selling
Year 0 1 2 3 4 5
1) Revenue $0 $26,000 $26,000 $26,000 $26,000 $0
2)COGS $0 $11,000 $11,000 $11,000 $11,000 $0
Theselling,
generaland
admin.is
increasedby
$200Kbecauseof
h h
3)Grossprofit=1 2 $0 $15,000 $15,000 $15,000 $15,000 $0
5)R&D $15,000 $0 $0 $0 $0 $0
6)Depreciation $0 $1,500 $1,500 $1,500 $1,500 $1,500
thewarehouse
opportunitycost
Theunlevered
netincomeis
reducedby
32
6) epreciation $0 $ ,500 $ ,500 $ ,500 $ ,500 $ ,500
7)EBIT=3 4 5 6 $15,000 $10,500 $10,500 $10,500 $10,500 $1,500
8)Incometax(T=40%) $6,000 $4,200 $4,200 $4,200 $4,200 $600
y
$120K=200(1T)
comparedwith
theresulton
slide#27.
Indirect effect 2: Project externalities
The project may also affect the profits of other business of
the firm the firm.
Cannibalization is when sales of a new product displaces
sales of an existing product.
For example, the new iPad2 will definitely affect the sales
of the 1st generation iPad.
33
Suppose about 25% of sales come from customers who
would have purchased an existing Linksys wireless router
(wholesales price $100 per unit & COGS $60 per unit) if
HomeNet were NOT available HomeNet were NOT available.
This means that existing Linksys router sales will be
reduced, as a consequence of the HomeNet project.
34
So, we must include this reduced sales when we calculate
HomeNets incremental earnings.
Example: HomeNet project with cannibalization
Year 0 1 2 3 4 5
1) Revenue $0 $23,500 $23,500 $23,500 $23,500 $0
2)COGS $0 $9,500 $9,500 $9,500 $9,500 $0
$ $ $ $ $ $
Revenue:
reducedby
$2,500K =
3)Grossprofit=1 2 $0 $14,000 $14,000 $14,000 $14,000 $0
5)R&D $15,000 $0 $0 $0 $0 $0
6)Depreciation $0 $1,500 $1,500 $1,500 $1,500 $1,500
$2,500K
25%*$100*100K
COGS:reduced
by$1,500K=
25%*$60*100K.
S fit
35
7)EBIT=3 4 5 6 $15,000 $9,500 $9,500 $9,500 $9,500 $1,500
8)Incometax(T=40%) $6,000 $3,800 $3,800 $3,800 $3,800 $600
So,grossprofit
isreducedby
$1,000K.
Ignoring sunk costs
Sunk costs are costs that have been paid regardless of the
decision whether or not the investment is undertaken decision whether or not the investment is undertaken.
Sunk costs should not be included in the incremental
earnings analysis.
How to distinguish between the sunk cost and the
opportunity cost?
Opportunity costs Sunk costs
36
Opportunitycosts Sunkcosts
Ifwetaketheproject nothappen happen
Ifwedonottaketheproject happen happen
Real-world complexities
The HomeNet project is a simple example in
calculating the projects incremental earnings.
In practice, the estimates of revenues and costs
could be much more complicated.
Sales will change from year to year Sales will change from year to year.
The average selling price will vary over time.
The average cost per unit will change over time.
37
The average cost per unit will change over time.
Earningsandcostsinformation
Oneinvestmentproject
Foresting earnings Direct incremental earnings
(Incomestatement)
Forestingearnings
Directincrementalearnings
(Indirecteffects:opportunity
costs,externalities)
Incrementalearningsforecast
38
Investmentdecision
(3) Step 2: Determining Free Cash Flows (3) Step 2: Determining Free Cash Flows
What is free cash flow?
It is the incremental effect of an investment project
on a firms available cash.
We need the free cash flow (FCF) for project NPV.
The FCF calculation starts with the incremental
earnings earnings.
Recall how the Cash Flow Statement is constructed. It will
help us in FCF calculation.
39
FCF calculation
Adding back the depreciation
The depreciation is not a real cash expense. For FCF, we
need to add it back to the incremental earnings need to add it back to the incremental earnings.
Year 0 1 2 3 4 5
9)Unleverednetincome=7 8 $9,000 $5,700 $5,700 $5,700 $5,700 $900
10)Plus:depreciation(6) $0 $1,500 $1,500 $1,500 $1,500 $1,500
40
FCF calculation
Deducting the PP&E cost
The PP&E cost should be deducted in the action year.
The $7.5M equipment cost happens at the beginning of the
1st year. y
Year 0 1 2 3 4 5
41
11)Less:investmentinPP&E $7,500 $0 $0 $0 $0 $0
FCF calculation
Deducting change in net working capital (NWC)
Most projects require the firm to invest in net working
capital (NWC) capital (NWC).
NWC formula:
Payables s) Receivable Inventory (Cash
s Liabilitie Current Assets Current

NWC
Cash: the non-invested cash
Change in NWC (NWC)
42
g ( )
1

t t t
NWC NWC NWC
FCF calculation
Cash: We assume no incremental cash.
Inventory: outsourced => zero inventory.
Receivables: 15% of sales = $23,500*15% (Yr. 1 4) ( )
Payables: 15% of COGS = $9,500*15% (Yr. 1 4)
Year 0 1 2 3 4 5
Cash $0 $0 $0 $0 $0 $0
43
Cash $0 $0 $0 $0 $0 $0
Inventory $0 $0 $0 $0 $0 $0
Receivable=Revenue*15% $0 $3,525 $3,525 $3,525 $3,525 $0
Payable=COGS*15% $0 $1,425 $1,425 $1,425 $1,425 $0
FCF calculation
NWC = Cash + Inventory + Receivables Payables
Year 0 1 2 3 4 5
Cash $0 $0 $0 $0 $0 $0
Inventory $0 $0 $0 $0 $0 $0
Receivable=Revenue*15% $0 $3,525 $3,525 $3,525 $3,525 $0
Payable=COGS*15% $0 $1,425 $1,425 $1,425 $1,425 $0
NWC $0 $2 100 $2 100 $2 100 $2 100 $0
44
NWC $0 $2,100 $2,100 $2,100 $2,100 $0
noNWC needNWC needNWC needNWC needNWC noNWC
NWC $0 $2,100 $0 $0 $0 $2,100
FCF calculation
Year 0 1 2 3 4 5
9) Unlevered net income = 7 8 $9 000 $5 700 $5 700 $5 700 $5 700 $900 9)Unleverednetincome=7 8 $9,000 $5,700 $5,700 $5,700 $5,700 $900
12)Less:NWC $0 $2,100 $0 $0 $0 $2100
45
13)FreeCashFlow=9+10 11 12
FCF calculation: HomeNet project
Year 0 1 2 3 4 5
1) Revenue $0 $23,500 $23,500 $23,500 $23,500 $0
2)COGS $0 $9,500 $9,500 $9,500 $9,500 $0
3) Gross profit = 1 2 $0 $14 000 $14 000 $14 000 $14 000 $0 3)Grossprofit 1 2 $0 $14,000 $14,000 $14,000 $14,000 $0
5)R&D $15,000 $0 $0 $0 $0 $0
6)Depreciation $0 $1,500 $1,500 $1,500 $1,500 $1,500
7)EBIT=3 4 5 6 $15,000 $9,500 $9,500 $9,500 $9,500 $1,500
8)Incometax(T=40%) $6,000 $3,800 $3,800 $3,800 $3,800 $600
46
) p ( ) $ $ , $ , $ , $ , $ ,
12)Less:NWC $0 $2,100 $0 $0 $0 $2100
13)FreeCashFlow=9+10 11 12 $16,500 $5,100 $7,200 $7,200 $7,200 $2700
One investment project Oneinvestmentproject
Forestingearnings
+ depreciation;
PP&Einvestment;
NWC.
47
Investmentdecision
In Step 2, we calculate the FCF, which is the
C i NPV l l ti C
i
in NPV calculation.
NPV formula

N
i
i
i
project
r
FCF
NPV
0
) 1 (
FCF
i
: the free cash flow in each year from Step 2.
N: the whole life of the project.
i 0
) (
r: the cost of capital, which is the expected return
that we could earn on the best alternative
i t t ith i il i k d t it
48
investment with similar risk and maturity.
NPV rule (for single project)
If the projects NPV is positive, we accept it.
If the projects NPV is negative, we reject it.
49
FCFs from Step 2:
Year 0 1 2 3 4 5
h l $ $ $ $ $ $
NPV (given r = 12%)
FreeCashFlow $16,500 $5,100 $7,200 $7,200 $7,200 $2700
FCF
NPV
N
i
$
%) 12 1 (
2700
%) 12 1 (
7200
%) 12 1 (
7200
%) 12 1 (
7200
%) 12 1 (
5100
%) 12 1 (
16500
) 1 (
5 4 3 2 1 0
0
k

r
NPV
i
i
project
50
Conclusion: accept the project.
0 207 , 5 $ k
One investment project Oneinvestmentproject
Forestingearnings
N
i
i
project
FCF
NPV
NPV>0,taketheproject;
NPV<0,rejecttheproject

i
i
project
r
0
) 1 (
51
Investmentdecision
(5) Further Adjustments to Free Cash Flow (5) Further Adjustments to Free Cash Flow
In practice, we need to consider a number of
th t i h ti ti th FCF cases that may arise when estimating the FCF.
Other non-cash items: e.g. amortization
Timing of cash flows: cash flows may spread
throughout the year, e.g. monthly, quarterly, etc.
Li id i l l i l d d i FCF Liquidation or salvage value: included in FCF
Terminal or continuation value: for indefinite life
52
Tax carryfowards: tax loss can carry forward or
backward.
Review Review
This chapter is very close to the real world This chapter is very close to the real world
practice.
No calculation questions from this chapter in
quizzes.
You have practices in Case 1.
Capital budgeting p g g
What is it?
Procedures
53
Procedures
Review Review
Single project analysis Single project analysis
Incremental earnings forecast
Oneinvestmentproject
Forestingearnings
Free cash flow calculation
NPV calculation
g g
Investment decision-making
Further adjustments to free cash
Further adjustments to free cash
flow
Investmentdecision
54

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MBA 540 Financial Management

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