Copyright© 2007 Cameron School of Business UNIVERSITY OF NORTH CAROLINA WILMINGTON FIN 335, Chapter 8 and Capital Budgeting Edward Graham Professor of Finance Department of Economics and Finance

Copyright© 2007 Continuing your Introduction to Finance Recalling the Broad Introduction to Finance I.The Three Primary Duties of the Financial Manager II.Capital Budgeting and Financial Decision-making: The Capital Budgeting Decision-making Criteria

Copyright© 2007 An Introduction to Finance What is finance? Finance is the study of the art and the science of money management; it is based on the Latin root finis, meaning the end. In managing ours or our firm’s money, we consider historical outcomes or “endings,” and we propose future results as a function of decisions made today. Those outcomes or results are typically portrayed using financial statements.

Copyright© 2007 I.The Three Primary Duties of the Financial Manager Whether managing monies for the home, or for the firm, our duties are met with decisions framed by the same general principles. These principles instruct us in making three main types of decisions as we perform those three primary duties: The capital budgeting decision The capital structure decision The working capital decision

Copyright© 2007 The Capital Budgeting Decision With the capital budgeting decision, the financial manager decides where best to deploy monies long-term. The purchase of a new delivery truck or a new warehouse is a capital budgeting decision; the payment of a utility bill is not. With the making of this decision, we consider three features of the cash flows deriving from the decision: The size of the cash flows The timing of the cash flows The risk of the cash flows We review a couple examples of capital budgeting decisions.

Copyright© 2007 The Capital Structure Decision With the capital structure decision, the financial manager decides from where best to acquire monies long-term. The purchase of that new delivery truck with cash or with a loan from GMAC or Ford Motor Credit is a capital structure decision; the use of long-term borrowing to fund a franchise purchase is another. Perhaps most importantly, the decision to fund a firm’s growth with equity - such as with funds invested by the firm’s founders, angel investors, venture capitalists or public stock offerings – or debt, is a critical capital structure choice. Two features of this choice bear mentioning: The risk of the debt The loss of control and reduced potential cash flows to the founders with an equity or stock sale We expand our review with a few capital structure decisions.

Copyright© 2007 The Working Capital Decision With the working capital decision, current assets and current liabilities become the focus of the financial manager. Such items as cash balances, accounts receivable, inventory levels and short-term accruals (such as prepaid rent or utilities) are included among the short-term assets that comprise one component of working capital. Also with the working capital decision, we concern ourselves with short-term obligations such as accounts payable to vendors, and other debt that is expected to be paid off within one year. Net working capital is a meaningful outcome of the working capital decision-making matrix. Net working capital is merely the difference between current assets and current liabilities.

Copyright© 2007 II.The Capital Budgeting Choice: Capital Budgeting Decision-making Criteria Recall the definition of a capital budgeting choice; we are deploying firm resources long-term towards the maximization of shareholder wealth. How do we know when we are doing that? We use your text and four new tools to assist us: The Net Present Value or NPV rule in Section 8.1 The Payback rule in Section 8.2 The Internal Rate of Return or IRR rule in Section 8.4 The Profitability Index in Section 8.5

Copyright© 2007 Capital Budgeting Decision-making A great summary of the four “new tools’ is given in Table 8.6 of your text (p.244) As well, problems in your BA II Plus Review Sheet on pages 28 and 29 of your course packet will assist you. Those problems introduce us to the ideas below. First, the NPV rule (pages ) The NPV = PV (Inflows) – PV (Outflows or Cost) We accept “deals” where the NPV > 0, and We reject deals where the NPV < 0. We illustrate all these new rules by example

Copyright© 2007 Capital Budgeting Decision-making We are considering a new gym and health plan for our employees. We have conducted a study and affirmed that the new gym and plan will save us $35,000 per year, in reduced absenteeism and turnover, and will cost us $200,000 to put into place. Should we make this investment? We “know” that 8 times 35,000 is more than 200,0000, but is it “enough” more? That is where the NPV criteria assists. If a reasonable time value of money (or cost of capital, as we will learn in later lessons) for this investment is 8%, we can treat the 35,000 per year as an annuity, and discover it has a PV of $201,132. Our NPV becomes $1,132. That is greater than zero, so we “accept” this deal. But, what if our time value of money (or required return, in this case) is greater than 8%? Or the cash flows are irregular? Then what?

Copyright© 2007 Capital Budgeting Decision-making So, what if our time value of money (or required return, in this case) is greater than 8%? Or the cash flows are irregular? Then what? Our calculators assist us. We can easily compute “new” PV’s with differing required returns or I/Y’s. But, with irregular cash flows, and with all subsequent capital budgeting choices, we use a different set of applications. We use the cash flow or CF keys. Thusly: Observe the calculator application for cash flows. Remember always to begin cash flow analyses by hitting 2 nd, CLR WORK after you hit the CF key.

Copyright© 2007 Capital Budgeting Decision-making The NPV rule anticipates the IRR rule in Section 8.4 of your text. We accept deals where the IRR > required return. The IRR is that discount rate that forces the NPV to zero. With equal-sized cash flows or annuities, the IRR is simply the I/Y. With irregular cash flows, we must use the CF keys to “discover” the IRR. We “know” the IRR in the first example with even $35,000 annual cash flows for 8 years is over 8%, as our NPV > 0. If the IRR > Required Return, then the NPV must be > 0. A graphical illustration, as on page 236 of your text, illustrates this premise. Using the CF keys, IRR = 8.149% in the first example, as also I/Y = 8.149%. With irregular cash flows, the IRR changes, but with a changing required return, the IRR is unchanged. The IRR is not impacted by the required return!

Copyright© 2007 Capital Budgeting Decision-making We examine the relationship between NPV and IRR with another set of prospective cash flows. Suppose a project will cost us $165,000 and throw off cash flows of $63,120 the first year, $70,800 the second and $91,080 the third. What is its IRR, and what is its NPV at a discount rate of 16%? The graph below portrays the NPV/IRR dynamic. The IRR occurs, of course, where the NPV = 0.

Copyright© 2007 Capital Budgeting Decision-making Advantages and disadvantages of the NPV and IRR rules are given in your text and condensed in Table 8.6. For the NPV rule, its greatest drawback is its complexity. For the IRR rule, it is elegant, and widely used, but with mutually exclusive projects, it can be misleading. An example? Suppose you are choosing between two new delivery trucks. The first costs $10,000 and provides cash flows of $7,000 the first year, and $5,000 each of the second and third years, yielding an IRR of 34.68%. A second newer truck costs $20,000 and generates cash flows of $12,000 the first year, $10,000 the second and $8,000 the third. This represents an IRR of 25.34% But, do we choose the first truck? Think about it…..

Copyright© 2007 Capital Budgeting Decision-making Recall the mutually exclusive decision of buying one used truck or one newer one. The old truck generated an IRR of 34.68%, the new one an IRR of 25.34%. But, if our cost of capital or required return is 10%, our NPV is $4,252 for the older truck, and $5,184 for the newer one. Confirm the IRR and NPV calculations. We choose the newer one, maximizing our wealth (and share price, indirectly) though it generates the lower IRR. That is a disadvantage of the IRR rule, it breaks down with those mutually exclusive buddies. With mutually exclusive projects, use the NPV rule. And, if the signs of your cash flows change more than once – if the cash flows are “unconventional,” you cannot dependably use the IRR rule, either. Multiple IRR’s are possible, depending on the number of “sign changes’ attaching to a given deal.

Copyright© 2007 Capital Budgeting Decision-making The third rule we review is the payback rule in Section 8.2 pages , where a deal is accepted if the payback < some required payback period. With an annuity, the payback period (PP) is simply equal to the cost of a project divided by the annual flows; using our original set of “simpler” cash flows: PP = Cost/Annual flows = 200,000/35,000 = 5.7 years Assuming our maximum allowable period for payback is 6 years, we would accept this project. Were our maximum allowable period something less than 5.7 years (or years to be more exact!), than we would reject the project. Unequal cash flows are handled as with the example in class.

Copyright© 2007 Capital Budgeting Decision-making The final rule we consider is the profitability index (PI) from page 242. The PI is simply a metric contrasting the present value of a project’s cash flows with its costs. PI = PV (Inflows)/PV (Outflows) The PI is larger the greater a project’s IRR. For the original set of cash flows, at a discount rate of 8%, the PV of the health plan’s cash flows (the numerator of the PI function above) was just over $201,000. (Cost plus the NPV). The cost or denominator was $200,000. The PI is around ($201,132/$200,000) The PI reveals a project’s “bang for the buck.” If we cannot do all positive NPV deals, we rank them by PI, and invest in them ‘til we are out of money. That maximizes the total possible NPV out of a given pot of invest-able capital. The four new rules are used in concert, by the firm and its financial managers, to optimize the results of the capital budgeting decision-making process.