Chapter 6: Capital Budgeting: The Basics Objective Explain Capital Budgeting Develop Criteria Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley

Chapter 6 Contents 1 The Nature of Project Analysis 2 Where do Investment Ideas come from? 3 The NPV Investment Rule 4 Estimating a Project’s Cash Flows 5 Cost of Capital 6 Sensitivity Analysis 7 Analyzing Cost-Reducing Projects 8 Projects with Different Lives 9 Ranking Mutually Exclusive Projects 10 Inflation & Capital Budgeting

Objectives To show how to use discounted cash flow analysis to make decisions such as: Whether to enter a new line of business Whether to invest in equipment to reduce costs

Introduction Recall the objective of a firm Maximization of the market value of shareholders’ equity The theory of how to do this was provided in the prior two chapters Compute the net present value of the project’s expected cash flows, and undertake only those with positive NPV

6.1 The Nature of Project Analysis Basic unit of analysis the individual investment project

Procedural Outline Form ideas on how to increase shareholders’ equity Plan how to implement the ideas Gather information on timing and magnitude of costs and benefits Apply NPV criterion

Generating a forecast Information is often biased towards its provider’s goal (agency problem) There are many ways to implement a goal Some information is not fully quantifiable Impact on shareholder wealth difficult to evaluate when cash flows are risky

The Nature of Project Analysis We will postpone discussion of risky cash flows to avoid the complex issue of how they affect shareholder wealth The criterion used find the present value of all future cash flows, and subtract the initial investment to obtain the net present value (NPV)

6.2 Where do Investment Ideas Come From? monitor existing & potential customers needs monitor existing & potential technological capacity of the firm monitor the competition’s marketing, investment, patents, and technical recruiting monitor production & distribution functions for revenue enhancement / cost savings reward employees for innovative ideas

6.3 Net Present Value Rule A project’s net present value is the amount by which the project is expected to increase the wealth of the firm’s current shareholders As a criterion Invest in proposed projects with positive NPV

Illustration The following tables show the computation of NPV To show the affect of the discount rate, three tables are shown based on different rates

DCF Payback Do Project

Don’t Do Project

Internal Rate of Return Indifferent

Common Error It is a common mistake to start the investment in year 1 rather than year 0 (when this was not intended) Now is time 0 Like a child, a project is not one-year old until a year has passed

Summary The discount rate in the first scenario it was assumed to be 10%, and the resulting NPV was $20 In the second scenario it was assumed to be 15%, and the NPV was -$69 In the third scenario, the discount rate that resulted in a zero NPV was found

6.4 Depreciation and Cash Flows It is important to remember that when making financial decisions only timed cash flows are used depreciation is an expense, but is not a cash expense, and must be excluded the tax benefit of depreciation, however, is a cash flow, and must be included

Working Capital & Cash Flows Some cash flows do not occur on the income statement, but involve timing working capital additions and reductions are cash flows at the end of a project, the sum of the nominal changes in working capital is zero

Accruals & Deferrals Take extra care if you are provided with net income information by an accountant the flows forming net income may include accruals deferrals these are typically small, and may some-times be ignored

Incremental Cash Flows Only the incremental cash flows should form part of an investment decision Evaluate the projected cash flows, by (category and) timing, both with and without the project, and find the difference This difference is a collection of timed cash flows, and this is what affects the wealth of the shareholders

Illustration: Cannibalism A proposed project will generate $10,000 in revenue, but will causes another product line to lose $3,000 in revenues The incremental cash flow is only $7,000

Illustration: Prior Expenses R&D expenses are $10,000 to-date for your project, and you plan to spend another $20,000, making $30,000 in all The $10,000 is a sunk cost. The decision whether to undertake the project will not change this expenditure Only the $20,000 is an incremental cost, and the $10,000 should be excluded

Sunk Costs Shareholders are interested in the timing and magnitude of cash flows From an investor’s vantage, a project gives rise to an alternative cash flow If (alternative cash flows) - (original cash flows) is valuable to shareholders, do project A sunk cost has no impact on future cash flows: it is irrelevant to shareholders

Illustration: Underutilized Resources A project uses an existing (non-cancelable) leased warehouse with a remaining life of 20 years, and total annual rent of $100,000 The warehouse is projected to remain 50% utilized, unless your project is undertaken The lease prohibits sub-leasing The current project is making a loss Your project will use 25% of the warehouse What should the project be charged?

Proposed Solution 1 The original project currently using the warehouse is making a loss: “Charge the full $100,000 /year so the company can recover the very real warehousing costs.”

Proposed Solution 2 Half the warehouse is available: “The project should be charged the full $50,000 /year if it needs to use it. A portion of the warehousing costs will not be charged-out otherwise.”

Proposed Solution 3 The project should be charged for its share of the used space: “Charge $33,333 /year.”

Proposed Solution 4 The project is going to use only 25% of the space. “Charge $25,000 /year.”

Proposed Solution 5 The charge should be proportioned according to revenues generated by each project--that is fair, isn’t it? “The old project’s revenues = $9,000,000, and the new project has projected revenues = $1,000,000, so the charge is 10%, or $10,000/year.”

Proposed Solution 6 There is a suitable new (smaller) warehouse available on the market for $27,000 /year. “Charge the project the market rate of the space, $27,000.”

Proposed Solution 7 The original lease was entered into when warehouse space was cheap, but now space is twice what it was: “The market value of the leased warehouse is now $200,000, and the project should take its proper share of that amount.”

Proposed Solution 8 This is a new project, so give it a sporting chance: “The project should be charged nothing.”

Warehouse Illustration The solution in this case is proposed solution # 8, (but for another reason): The project should be charged nothing The warehouse expenditure will occur whether the project is done or not. It is therefore not an incremental cash flow With different facts (alternative usage or lease re-negotiation) the answer would be different

6.5 The Cost of Capital When determining the cost of capital the risk of the project is, in general, different from the risk of existing projects only the market-related risk is relevant only the risk from a project’s cash flows is relevant (not that of financing instruments)

Computing the Average Cost of Capital of a Corporation Determine the return to security holders of each class of security issued Determine the market value of each class of the company’s securities, and compute the weight of each After adjusting for tax, compute the weighted sum of returns

Average Cost of Capital: Example with 3-Securities Let ke be the return on equity kd be the return on debt kp be the return on preferred Ve be the market value of issued equity Vd be the Market value of issued bonds Vp be the market value of issued preferred t be the tax rate

Average Cost of Capital: Example with 3-Securities k = ke * Ve + kp * Vp + kd * Vd* (1 - t) The average cost of capital is also the cost of capital for each of the firms business divisions weighted according to their market value

6.6 Sensitivity Analysis Using Spreadsheets Will the project still be economical if some of the underlying variables are inaccurate? Spreadsheets are an excellent tool for exploring the influence of estimation errors on financial decisions

Base Case The following is an embedded Excel worksheet for the cash flow of a firm It is generally a good practice to divide the worksheet into two segments, one containing only data, and the other containing only formulae This practice increases flexibility & reduces the chance of error It is also a good practice to name variables using Insert:Name:Create in Excel

A Modified Scenario In this case the cash is piling up (Watch out for IRS penalties in this case!) The assumption is now made that sales units grow by +2%, unit prices by -3%, and fixed costs by +8% (No, Victor: Fixed costs may vary with time. Yes, Valerie: Fixed costs do not vary with sales.) Assume a dividend of $1,000,000/year

Additional Scenarios The following graphs are variations of from the basic model constructed by changing one variable at a time:

Was 15%

Was 40%

Was 0%

Was 75%

Was $3,100,000

Consequences Notice that the reduced long-term viability of the product, together with the dividend for demands, will cause: a cash flow crisis early in year 5, negative accounting profits in year 6, and a serious negative operating cash flow in year 8 when the tax benefits of depreciation are finally consumed.

Graphs Graphs are a useful supplement to spreadsheets as they may illustrate behavior of the model to continuing changes in a selected independent variable The following graphs explore a model

Table 6.4 Project Sensitivity to Sales Volume

Spreadsheet Planning Conclusions: Spreadsheets permit management to explore perturbations caused by randomness in the model’s inputs This should lead to management correctly prioritizing time to the variables of the model Management will recognize dangers sooner, and will create contingency plans to avoid their worst consequences

6.7 Break-Even and Indifference Points Break-even point is number of sales resulting in a NPV = 0 IRR is discount rate resulting in NPV = 0 Price B/E is unit price resulting in NPV= 0 Payback period is the project life resulting in NPV = 0

6.8 Projects with Different Lives When do you replace a sales car? As a car ages its resale price decreases the annual repair bills increase sales people become discontented people who live in their cars demand reliability customers are influenced by sales people’s cars a nice car is part of their unofficial remuneration

Data Collection A car uses about the same amount of oil, gasoline, cleaning, tire usage, et cetera, no matter how old it is This data need not be collected, because we are interested only in incremental cash flows assume that the degree of tires wear is compensated by a credit on sale

Data Collection In order to simplify this example, it will be assumed that all cash flows are in real terms Assumed that the required rate of return on cars is a real 10% (Excited already?)

Data Collection Sales people use the Bdella Sedan. The market prices for new and used Bdellas is given on the next slide The expected annual maintenance charges by year are also given Intangible losses have been listed

Car Replacement First compute the NPV of purchasing in year 0, and selling in year 1, purchasing in year 0, and selling in year 2, … purchasing in year 0, and selling in year 10 These figures are shown in col. PV_Proj

Interpretation We see that the incremental cost of replacing the car every year is $3810, replacing it every two years is $7,619… You are not yet tempted to select “replace every year” because this option does not provide a Bdella Sedan after the 1st year, while replace after 2-years does

Additional Analysis The analysis so far does not provide for a replacement car. The simplest way to do this is to replace each project with an identical project forever We have the perpetuity equation for this

Additional Analysis Take the two year problem as an example The NPV is discounted to year 0, the 1st replacement NPV is discounted to year 2, the 2nd to year 4, … for ever This is a perpetuity due, with interest (1.05)2 - 1 = 10.25%

Conclusion Replacing the car every year is the best scenario, but, watch out for an agency problem. Without the intangibles the answer is to keep the car as long as possible The Bdella Sedan is like a Volvo on Geritol: it doesn't know when to die

6.9 Ranking Mutually Exclusive Projects Using the NPV method, you are unlikely to encounter any serious problems Some managers, particularly those with an engineering background, prefer to use the IRR method The IRR method may be made to give the correct answer, but this requires considerable skill. Avoid it (unless your boss engineer)

6.10 Inflation and Capital Budgeting When computing NPV Use the nominal cost of capital to discount nominal cash flows (Nominal cash flows are rarely constant) Use the real cost of capital to discount real cash flows