INSTRUCTORS: ANTHONY ESSEL-ANDERSON & EBENEZER SIMPSON INTRODUCTION TO FINANCE Jan. 11, Prepared by A. Essel-Anderson

THE CAPITAL BUDGETING PROCESS ESTIMATING CASH FLOWS CAPITAL BUDGETING TECHNIQUES Lectures 8 and 9 Capital Budgeting

1. THE CAPITAL BUDGETING PROCESS 2. GENERATING INVESTMENT PROJECT PROPOSALS 3. ESTIMATING PROJECT “AFTER-TAX INCREMENTAL OPERATING CASH FLOWS Capital Budgeting Process and Estimation of Cash Flows 11/6/ Compiled by A. Essel-Anderson

Objectives Students should be able to: Define capital budgeting and identify the steps involved in the capital budgeting process. Explain the procedure used to generate long-term project proposal within a firm. Justify why cash, not income, flows are the most relevant to capital budgeting decision. Define the terms sunk cost and opportunity cost and explain why sunk costs must be ignored, whereas opportunity costs must be included, in capital budgeting analysis. Explain how tax and depreciation affect capital budgeting cash flows. Determine initial, interim, and terminal period “after-tax, incremental, operating cash flows” associated with a capital investment project. 11/6/ Compiled by A. Essel-Anderson

The Capital Budgeting Process Generating investment project proposals that are consistent with overall corporate strategic objectives Estimating “after-tax incremental operating cash flows for investment projects Evaluating project incremental cash flows Selecting projects based on a value-maximizing acceptance criterion Re-evaluating implemented investment projects continually and performing post-audits for completed projects 11/6/ Compiled by A. Essel-Anderson

Generating Investment Project Proposals Several reasons may call for an investment project. New products or expansion of existing product line Replacement of equipment or building Research and development Exploration Investment project may be proposed for – The proposed project must be compatible with corporate strategy. 11/6/ Compiled by A. Essel-Anderson

Estimating Project “After-tax Incremental Cash Flows” Cash is invested in the project at the initial stage and so cash is expected from the project in the future. Cash flows is preferred to income flows because cash (but not income) can be reinvested or paid out to stakeholders in the form of interest and dividends. The accuracy of the estimated future cash flows is paramount to capital budgeting decisions. Inaccurate cash flow projections could lead to wrong judgments and uninformed decisions. 11/6/ Compiled by A. Essel-Anderson

Cash Flow Checklist 11/6/2008 Compiled by A. Essel-Anderson 8 Only cash flows are included (i.e. exclude non-cash items)Only operating flows are included (i.e. exclude financing flows)Cash flows are stated after-taxOnly incremental flows are includedSunk costs are ignoredOpportunity costs are includedRelated changes in working capital are includedEffect of inflation is considered

Calculating the Incremental Cash Flows 11/6/2008 Compiled by A. Essel-Anderson 9 Depending on timing, incremental cash flows can be grouped under the following categories : Initial cash outflowInterim incremental net cash flows Terminal year incremental net cash flows

Initial Cash Outflow 11/6/2008 Compiled by A. Essel-Anderson 10 Costs of new assets; Capitalized expenditures such as shipping expenses, installation costs etc; Changes in net working capital; and Sale proceeds from the disposition of any assets replaced, and tax adjustments. The initial net cash investment which includes:

Calculation of Initial Cash Outflow 11/6/2008 Compiled by A. Essel-Anderson 11 (a) Purchase cost of new assets(b)+Capitalized expenditures(c)+ (-)Increase (decrease) in “net” working capital(d)-Net proceeds from sale of old assets(e)+ (-)Taxes (tax savings) due to the sale of old assets(f)=Initial cash outflow

Interim Incremental Net Cash Flows 11/6/2008 Compiled by A. Essel-Anderson 12

Calculating Interim Incremental Net Cash Flows 11/6/2008 Compiled by A. Essel-Anderson 13 (a)Net increase (decrease) in operating revenue less (plus) net increase (decrease) in operating expenses excluding depreciation (b)- (+) Net increase (decrease) in tax depreciation charges(c)=Net change in income before taxes(d)- (+)Net increase (decrease) in taxes(e)=Net change in income after taxes(f)+ (-)Net increase (decrease) in tax depreciation charges(g)=Incremental net cash flow for the period

Terminal Year Incremental Net Cash Flow 11/6/2008 Compiled by A. Essel-Anderson 14 Final-years net operating cash flows Wind-up cash flows such as The salvage value of any assets sold or disposed Taxes (tax saving) related to asset sale or disposal, and Any project-termination-related change in working capital The final period’s net cash flow which is made up of the following:

Project Evaluation Techniques Non- discounted Cash Flow Techniques Discounted Cash Flow Techniques Average Accounting Return Payback Period Discounted Payback Net Present Value Internal Rate of Return Profitability Index 11/6/2008 Compiled by A. Essel-Anderson 15

Average Accounting Return (AAR) Average income attributable to the investment divided by the investment’s average book value Average Accounting ReturnComputation of AAR A proposed investment is accepted if its AAR is greater than a targeted AAR A proposed investment is rejected if its AAR is less than a targeted AAR AAR Acceptance Rule 11/6/2008 Compiled by A. Essel-Anderson 16

Average Accounting Return Easy to calculate and simple to understand Needed information is not difficult to gather or generate Strengths Since it ignores time value of money, the AAR computed is not a true rate of return Benchmark cutoff rate is arbitrary Analysis is based on accounting values and not cash flows Weaknesses 11/6/2008 Compiled by A. Essel-Anderson 17

Payback Period Method The length of time required for an investment to generate cumulative cash flows sufficient to recover the initial cash outflow Payback Period A proposed investment is accepted if its computed payback period is less than a predetermined maximum acceptable period A proposed investment is rejected if its computed payback period is greater than a predetermined maximum acceptable period Payback Period Acceptance Rule 11/6/2008 Compiled by A. Essel-Anderson 18

Computation of Payback Period In a case where the same amount of net cash flow is expected from the investment during each period, payback can be computed using the following formula: In a case where the amount of net cash flow from the investment is not expected to be equal during each period, payback can be computed using the following formula: 11/6/2008 Compiled by A. Essel-Anderson 19

Payback Period cont. Simple It is biased towards investments with shorter payback periods and so it is biased towards liquidity It adjust for extra riskiness of later cash flows by ignoring cash flows expected later after payback period which are likely to be more uncertain Strengths It ignores time value of money and so could lead to choice of projects that are actually worth less than their costs Does not consider cash flows occurring after the payback period Biased towards short-term projects Requires arbitrary cut-off point Weaknesses 11/6/2008 Compiled by A. Essel-Anderson 20

Discounted Payback Period The length of time required for a project’s discounted cash flows to equal its initial cash outflow Discounted Payback Period A proposed investment is acceptable if its discounted payback period is less than a predetermined maximum acceptable period A proposed investment is rejected if its discounted payback period is greater than a predetermined maximum acceptable period Discounted Payback Acceptance Rule 11/6/2008 Compiled by A. Essel-Anderson 21

Computation of Discounted Payback Period In a case where the same amount of net cash flow is expected from the investment during each period, payback can be computed using the following formula: In a case where the amount of net cash flow from the investment is not expected to be equal during each period, payback can be computed using the following formula: 11/6/2008 Compiled by A. Essel-Anderson 22

Net Present Value (NPV) The different between present value of future cash flows from a project and the initial cash outflow NPV = (PV of future NCF) – (Initial Cash Outflow) Net Present Value An investment proposal is accepted if its NPV is positive An investment proposal is rejected if its NPV is negative NPV Acceptance Rule 11/6/2008 Compiled by A. Essel-Anderson 23

Internal Rate of Return The discount rate that makes the NPV of an investment equal to zero Internal Rate of Return A proposed investment is accepted if its IRR is greater than the required return for that investment A proposed investment is rejected if its IRR is less than the required return for that investment IRR Acceptance Rule 11/6/2008 Compiled by A. Essel-Anderson 24

Computation of IRR Select two discount rates, iL and iH Where i L is a discount rate that is less than the IRR and so will yield a positive NPV and i H is a discount rate that is greater than the IRR and so will yield a negative NPV Find the investment’s NPV using iL and its NPV using iH The IRR can be estimated using the following formula: 11/6/2008 Compiled by A. Essel-Anderson 25

Use of IRR - Suitable Conditions For IRR to give results identical to that of NPV the following two conditions must hold: Cash flows from the investment must be conventional – that is the first NCF (initial cash outflow) is negative and NCF that follow are all positive The investment must be independent – that is the decision to accept or reject the proposed investment does not affect the decision to accept or reject another investment 11/6/2008 Compiled by A. Essel-Anderson 26

Problems of IRR The reinvestment rate assumption Nonconventional cash flows and multiple rates of return Mutually exclusive investments 11/6/2008 Compiled by A. Essel-Anderson 27

Use of Modified Internal Rate of Return (MIRR) MIRR eliminates the assumption that the firm would be able to earn the IRR for each period it reinvest cash inflows. A formula for MIRR is the following: 11/6/2008 Compiled by A. Essel-Anderson 28

Use of Cross Over Rates The discount rate that makes the NPV’s of two projects equal It is the IRR for the extra investment needed to move from one project to another [i.e. IRR (B-A) or IRR (A-B) ] Crossover Rate In situation where one of the projects has a greater NPV than the other but the one with the lesser NPV has a greater IRR, the crossover rate can be used to decide. If Crossover rate > IRR, accept the project with higher NPV If Crossover rate < IRR, accept project with higher IRR Use of Crossover Rate 11/6/2008 Compiled by A. Essel-Anderson 29

Mutually Exclusive Investment Problem YearInvestment A (GH¢)Investment B (GH¢) 0(400)(500) Required return 15%: NPV A = GH¢29.11 NPV B = GH¢35.35 Using 18% and 25% IRR A = 20.69% IRR B = 20.58% 11/6/2008 Compiled by A. Essel-Anderson 30

Mutually Exclusive Investment Problem cont. Year Investment A (GH¢) Investment B (GH¢) Investment (B – A) GH¢ 0(400)(500)(100) Required return =15%: NPV A = GH¢29.11 NPV B = GH¢35.35 NPV (B-A) = GH¢6.24 Using 18% and 25% IRR A = 20.69% IRR B = 20.58% IRR (B-A) = 20.11% 11/6/2008 Compiled by A. Essel-Anderson 31

Which Investment Should be Accepted? The IRR for (B-A) which is the crossover rate is 20.11%. Decision Rule If Crossover rate > IRR, accept the project with higher NPV If Crossover rate < IRR, accept project with higher IRR Should we accept A or B? Since the crossover rate is less than the IRR of either A or B, we have to accept the project with higher IRR. So Investment A should be accepted 11/6/2008 Compiled by A. Essel-Anderson 32

Profitability Index (PI) Also known as benefit-cost ratio. It is the PV of an investment’s future cash flows divided by the initial cash outflow. Meaning of PIPI Formula 11/6/2008 Compiled by A. Essel-Anderson 33

PI Acceptance Rule If a project’s NPV is positive then the PV of future cash flows from the project is more than the initial cash outflow and so its PI will be greater than 1. If a project’s NPV is negative then the PV of future cash flows from the project is less than the initial cash outflow and so its PI will be less than 1. A project with positive NPV has PI>1 and a project with negative NPV has PI<1. Relationship between NPV and PI Accept investment if its PI>1 but reject investment if its PI<1. Acceptance Rule 11/6/2008 Compiled by A. Essel-Anderson 34

Strengths & Weakness of PI Related to NPV and so usually yields identical results Easy to understand and interpret Strength May lead to incorrect decisions when comparing mutually exclusive projects Weakness 11/6/2008 Compiled by A. Essel-Anderson 35

Sources Chapter 12 & 13 of Fundamentals of Financial Management (12 Ed) by Van Horne and Wachowicz Chapters 9 & 10 of Fundamentals of Corporate Finance (5 Ed) by Ross, Westerfield and Jordan Student Accountant (April 2008) 11/6/2008 Compiled by A. Essel-Anderson 36