Topic 4 Capital Budgeting - Part 1

What is capital budgeting?

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.
Very important to firms future.

Methods of Project Evaluation

1. Non-discounted cash flow methods

- payback period - accounting rate of return 2. Discounted cash flow methods - internal rate of return - net present value

Payback Period
The amount of time required for an investment to generate cash flows to recover its initial cost. An investment is acceptable if its calculated payback is less than some prescribed number of years.

Payback Period Illustrated

Initial outlay -$1 000

Year
1 2 3

Cash flow $200 400 600 Accumulated Cash flow $200 600 1 200

Year
1 2 3

Payback period = 2.67 years

Example
Year Project A Project B Project C
Decision:

0 -50 -50 -50

1 1 49 0

2 49 0 0

3 0 1 500

Payback 2 years 3 years 3 years

Choose project A But clearly wrong!

Advantages of Payback Period

No need for detailed analysis. Simple to calculate and understand. Adjusts for uncertainty of later cash flows. Biased towards liquidity.

Disadvantages of Payback Period

Time value of money and risk ignored. Ad hoc determination of acceptable payback period. Ignores cash flows beyond the cut-off date. Biased against long-term projects.

Accounting Rate of Return (ARR)

Measure of an investments profitability.

average net profit ARR average book value

A project is accepted if ARR > target average return.

ARR Example
Year 1 Sales Expenses Gross profit Depreciation Earnings before taxes Taxes (25%) Net profit $440 220 220 80 140 35 $105 2 $240 120 120 80 40 10 $30 3 $160 80 80 80 0 0 $0

Assume initial investment = $240

ARR Example (continued)

$105 $30 $0 Average net profit 3 $45 Average book value Initial investment Salvage value 2 $240 $0 2 $120 Average net profit ARR Average book value $45 $120 37.5%

Disadvantages of ARR
The measure is not a true reflection of return.
Time value of money is ignored. Ad hoc determination of target average return. Uses profit and book value instead of cash flow and market value.

Advantages of ARR
Easy to calculate and understand. Considers all profits of the project.

Net Present Value (NPV)

Net present value is the difference between an investments market value (in todays dollars) and its cost (also in todays dollars).

Net present value is a measure of how much value (in dollars) is created by undertaking this investment.

Steps
1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine r = discount rate for the project.

4.
5.

Find NPV
Accept if NPV > 0

NPV Illustrated
0 Initial outlay Revenues Expenses Cash flow 1 2 Revenues Expenses

($1 100) $1 100.00 +454.55

$1 000 500 $ 500

Cash flow

$2 000 1 000 $1 000

$500

1.10

+826.45
+$181.00 NPV

$1 000 2 (1.10)

NPV
An investment should be accepted if the NPV is positive and rejected if it is negative. Estimation of the future cash flows and the discount rate are important in the calculation of the NPV.

Internal Rate of Return (IRR)

The discount rate which makes the Present value of the Projects Future Cash flows equal to the cost of the Project. A project is accepted if its IRR is > the required rate of return. Generally found by trial and error.

Internal Rate of Return: IRR

0 CF0 Cost

1 CF1

2 CF2 Inflows

3 CF3

IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

IRR Example
Initial outlay = -$200

Year
1 2 3

Cash flow
$ 50 100 150

Find the IRR such that NPV = 0 50 0 = -200 + (1+IRR) +

1

100 + (1+IRR) +
2

150 + (1+IRR) 3

50 200 = (1+IRR)
1

100 (1+IRR)
2

150 (1+IRR)
3

IRR Example (continued)

Trial and Error Discount rates NPV
0% 5% $100 68

10% 15%
20%

41 18
-2

IRR is just under 20% -- about 19.44%

Rationale for the IRR Method

If IRR > r, then the projects rate of return is greater than its cost-- some return is left over to boost shareholders returns. Example: r = 10%, IRR = 15%. Profitable.

IRR Acceptance Criteria

If IRR > r, accept project. If IRR < r, reject project.

Problems with IRR

Does not take into account the size of the project More than one negative cash flow multiple rates of return. If project is not independent i.e. mutually exclusive investments IRR can provide incorrect decision.

Multiple Rates of Return

Assume you are considering a project for which the cash flows are as follows:
Year
0 1 2 3 4

Cash flows
-$252 1 431 -3 035 2 850 -1 000

Multiple Rates of Return

Whats the IRR? Find the rate at which the computed NPV = 0: at 25.00%: at 33.33%: at 42.86%: at 66.67%: NPV = NPV = NPV = NPV = 0 0 0 0

Two questions: 1. Whats going on here? 2. How many IRRs can there be?

Multiple Rates of Return

NPV $0.06 $0.04 IRR = 25%

$0.02

$0.00

($0.02)

IRR = 33.33%

IRR = 66.67% IRR = 42.86%

($0.04)

($0.06)

($0.08) 0.2 0.28 0.36 0.44 0.52 0.6 0.68

Discount rate

How is a projects IRR related to a bonds YTM?

If a 9% Coupon 10 year $1000 bond sells for $1,134.20 what is the YTM (cost of debt, interest rate in the market place)

0 YTM = ?

2 ...

10

-1,134.2

90
YTM = 7.08%

90

1,090

If an investment project costs $1,134.20 and generates cash inflows of $90 for the next 9 years and $1090 at end of year 10, what is the IRR? Answer: 7.08%

IRR and YTM are the same thing. A bonds YTM is the IRR if you invest in the bond.
0 IRR = ? 1 2 ... 10

-1,134.2

90
IRR = 7.08%

90

1,090

What is the difference between independent and mutually exclusive projects?

Projects are:

Independent, if the cash flows of one are unaffected by the acceptance of the other.
Mutually Exclusive, if the acceptance of one project results in the rejection of another project.

NPV and IRR always lead to the same accept/reject decision for independent projects:

NPV ($)

IRR > r and NPV > 0 Accept.

r > IRR and NPV < 0. Reject.

r (%) IRR

IRR, NPV and Mutually Exclusive Projects

Net present value 160 140 120 100 80 60 40 20 0 20 40 60 80 100 0 2% 6% 10% 14% IRR 18% IRR 22% 26% Discount rate 0 Project A: Project B: $350 $250 1 50 125 Year 2 100 100 3 150 75 4 200 50

Crossover Point

IRR vs NPV
IRR selects project if r = 4% if r = 6% if r = 12% if r = 15% B B B B NPV selects project A A B B

Reinvestment Rate Assumptions

NPV assumes reinvest at r (opportunity cost of capital). IRR assumes reinvest at IRR. Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

Which methods do companies use?

USA study by Ryan
Always or often used (>=75%) Net Present Value (NPV) Internal rate of return (IRR) Payback Discounted Payback Profitability Index Accounting rate of return Australian study Freeman & Modified internal rate by of return (MIRR) Economic Value Added (EVA) 85% 77% 53% 38% 21% 15% Hobbes9% 31%

NPV IRR DCF Profitability Index Payback Accounting return on Investment (AROI) Other

75% 72% 23% 44% 33% 49%

When calculating NPVs consider:

Include all incremental cash flows.
In undertaking a Project Evaluation need to consider what difference it makes to the total cash flows of the firm whether the firm does or does not undertake the project under consideration. What to do about ? sunk costs opportunity costs side effects

Ignore Sunk Costs Sunk costs are unavoidable (incurred in the past) cash outflows, no longer relevant to influencing whether a project should be undertaken Example $10,000 payment to be made to a marketing company for assessing the market for a project which costs $125,000, and yields net cash flows of $75,000 for 2 years when the discount rate is 10%. Should the project be taken on? Project NPV if: (incorrectly) include marketing costs: -135+75/(1.1)1+75/(1.1)2 = -4.8 => reject (correctly) exclude marketing costs: -125+75/(1.1)1+75/(1.1)2 = 5.2 => accept

Include Opportunity Costs

If project uses resources which could be put to some other use (ie. has an opportunity cost), then $ value of alternative use must be included as cash outflow
Example A company owns machinery which has been leased out generating income of $3m per year. The machinery will now be used in a project which yields $20m for 2 years and costs $30m (opportunity cost of capital is 10%). Should the project be taken on? Project NPV if: (incorrectly) ignore foregone lease income as a cash outflow: -30+20/(1.1)1+20/(1.1)2 = 4.7m => accept (correctly) include foregone lease income as cash outflow: -30+17/(1.1)1+17/(1.1)2 = -0.5m => reject

Include Side Effects

Include positive or negative cash flows which result to other aspects of the business as a result of taking on the current business
Example: Company sells 200 sedans a year which each net $30,000.It is considering a new sports car which for 2 years will net $40,000 and cost $10,000,000 to set up. Demand will shift from the sedan to the sports car. (discount rate is 10%) Project NPV if: (incorrectly) exclude side effect (ie. lost revenue on sedan): -10+8/(1.1)1+8/(1.1)2 =$3.9m => accept (correctly) include side effect (ie. lost revenue on sedan): -10 + 2/(1.1)1 + 2/(1.1)2 =$-6.5m =>reject

Consistency Inflation
If cash flows are nominal cash flows, ie the effect of inflation has not been removed, then the discount rate has to be a nominal discount rate. If the cash flows are real, ie the effect of inflation has been removed the discount rate has to be a real discount rate. If the analysis is done correctly it should not matter whether it is done in real or nominal terms

Tax
If the cash flows are after tax cash flows the discount rate has to be an after tax discount rate. If the cash flows are before tax cash flows the discount rate has to be a before tax discount rate. If the analysis is done properly it should not matter whether it is done in pre tax or after tax cash flows

 Working capital requirements:

investment in long term assets generally requires support of current assets initial outflow in current assets necessary to support investment represents cash outflow . This is assumed to be returned as a cash inflow at the end of the project's life current assets are financed in part by current liabilities, thus net working capital is the cash flow considered

What about Financing Costs?

The costs of financing can be taken account of in either the cash flows or the discount rate. In our analysis we will be taking account of the financing costs in the discount rate /required rate of return so therefore it is important it is not also taken into account in the cash flows or else there would be double counting. The required rate of return is the return that the firm has to earn on the project in order to satisfy the providers of financial capital to the project

Net Cash Flows Vs Accounting Entries

Net Cash Flows and Accounting Profit Are Not Equivalent Accounting entries: allow for subjectivity and manipulation due to accounting system's inherent problems Net cash flows: timing and magnitude of cash flows are of importance cash pays expenses; cash can be invested

Taxation
3 major impacts:

represents a cash outlay

depreciation tax deduction provides a tax shield Capital gains( losses) increases ( decreases) amount of tax paid

Disposal of assets gain/loss on disposal of assets

If the salvage value > book value, a profit/gain is made on disposal. This profit/gain is subject to tax. If the salvage value < book value, the ensuing loss on disposal is a tax deduction.

Capital gains
dont confuse these with gain/loss on disposal of assets Capital gains made on the sale of assets such as rental property are subject to taxation. Capital losses are not a tax deduction but can be offset against future capital gains.

Investment Allowance
Incentive to encourage investment - cash inflow Example: investment allowance of 18% i.e. 18% of the cost of an investment is an allowable deduction when assessing income tax payable, initial outlay $1000, tax rate 40%
$ $

Revenue less investment allowance Taxable income less tax (0.4)

500 (180) 320 (128)

500

500 (200)

The tax bill is reduced by $200 - $128 = $72.00 or Tax Benefit or Tax saving = 0.18 * 1000 * 0.40 = $ 72.00