Berlin, Fußzeile1 Professor Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Capital Budgeting (Chapter 8)

Berlin, 18th of June, 2007Fußzeile2 The Capital Budgeting Decision Process The capital budgeting process involves three basic steps: Generating long-term investment proposals; Reviewing, analyzing, and selecting from the proposals that have been granted, and Implementing and monitoring the proposals that have been selected. Managers should separate investment and financing decisions.

Berlin, 18th of June, 2007Fußzeile3 Capital Budgeting Decision Techniques Payback period: most commonly used Accounting rate of return (ARR): focuses on project’s impact on accounting profits Net present value (NPV): best technique theoretically; difficult to calculate realistically Internal rate of return (IRR): widely used with strong intuitive appeal, theoretically inappropriate. Profitability index (PI): related to NPV

Berlin, 18th of June, 2007Fußzeile4 A Capital Budgeting Process Should: Account for the time value of money; Account for risk; Focus on cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders’ wealth.

Berlin, 18th of June, 2007Fußzeile5 Accounting Rate Of Return (ARR) Can be computed from available accounting data ARR uses accounting numbers, not cash flows; no time value of money. Average profits after taxes Average annual operating cash inflows Average annual depreciation =- Need only profits after taxes and depreciation Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.

Berlin, 18th of June, 2007Fußzeile6 Payback Period The payback period is the amount of time required for the firm to recover its initial investment. If the project’s payback period is less than the maximum acceptable payback period, accept the project. If the project’s payback period is greater than the maximum acceptable payback period, reject the project. Management determines maximum acceptable payback period.

Berlin, 18th of June, 2007Fußzeile7 Net Present Value The present value of a project’s cash inflows and outflows Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk. Accept projects if NPV > 0.

Berlin, Fußzeile8 Global Wireless  Global Wireless is a worldwide provider of wireless telephony devices.  Global Wireless evaluating major expansion of its wireless network in two different regions: Western Europe expansion A smaller investment in Southeast U.S. to establish a toehold $175Year 5 inflow $160Year 4 inflow $130Year 3 inflow $80Year 2 inflow $35Year 1 inflow -$250Initial outlay $32Year 5 inflow $30Year 4 inflow $25Year 3 inflow $22Year 2 inflow $18Year 1 inflow -$50Initial outlay Western Europe ($ millions)Southeast U.S. ($ millions)

Berlin, 18th of June, 2007Fußzeile9 Calculating NPVs for Global Wireless Projects  Assuming Global Wireless uses 18% discount rate, NPVs are: Western Europe project: NPV = $75.3 million Southeast U.S. project: NPV = $25.7 million Should Global Wireless invest in one project or both?

Berlin, 18th of June, 2007Fußzeile10 Pros and Cons of Using NPV as Decision Rule Key benefits of using NPV as decision rule: Focuses on cash flows, not accounting earnings Makes appropriate adjustment for time value of money Can properly account for risk differences between projects Though best measure, NPV has some drawbacks: Lacks the intuitive appeal of payback, and Doesn’t capture managerial flexibility (option value) well. NPV is the “gold standard” of investment decision rules.

Berlin, 18th of June, 2007Fußzeile11 Internal Rate of Return IRR found by computer/calculator or manually by trial and error. Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project: The IRR decision rule is: If IRR is greater than the cost of capital, accept the project. If IRR is less than the cost of capital, reject the project.

Berlin, 18th of June, 2007Fußzeile12 Calculating IRRs for Global Wireless Projects Western Europe project: IRR (r WE ) = 27.8%Southeast U.S. project: IRR (r SE ) = 36.7% Global Wireless will accept all projects with at least 18% IRR.

Berlin, 18th of June, 2007Fußzeile13 Calculating IRRs for Global Wireless Projects 27.91%

Berlin, 18th of June, 2007Fußzeile14 Advantages and Disadvantages of IRR Advantages of IRR: Properly adjusts for time value of money (???) Uses cash flows rather than earnings Accounts for all cash flows Project IRR is a number with intuitive appeal Disadvantages of IRR “Mathematical problems”: multiple IRRs, no real solutions Scale problem Timing problem

Berlin, 18th of June, 2007Fußzeile15 Multiple IRRs NPV ($) NPV<0 NPV>0 Discount rate NPV<0 With multiple IRRs, which do we compare with the cost of capital to accept/reject the project? IRR When project cash flows have multiple sign changes, there can be multiple IRRs.

Berlin, 18th of June, 2007Fußzeile16 No Real Solution Sometimes projects do not have a real IRR solution. Modify Global Wireless’s Western Europe project to include a large negative outflow (-$355 million) in year 6. There is no real number that will make NPV= so no real IRR. Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!

Berlin, 18th of June, 2007Fußzeile17 Conflicts Between NPV and IRR NPV and IRR do not always agree when ranking competing projects. $25.7 mn36.7%Southeast U.S. $75.3 mn27.8%Western Europe NPV (18%)IRRProject Southeast U.S. project has higher IRR, but doesn’t increase shareholders’ wealth as much as Western Europe project. The scale problem:

Berlin, 18th of June, 2007Fußzeile18 The Timing Problem The NPV of the long-term project is more sensitive to the discount rate than the NPV of the short-term project is. Discount rate Short- term project Long- term project 17% 15% NPV 13% IRR = 15% IRR = 17% Long-term project has higher NPV if the cost of capital is less than 13%. Short-term project has higher NPV if the cost of capital is greater than 13%.

Berlin, 18th of June, 2007Fußzeile19 Profitability Index Decision rule: Accept project with PI > 1.0, equal to NPV > 0 Both projects’ PI > 1.0, so both acceptable if independent. 1.5$50 million$75.7 millionSoutheast U.S. 1.3$250 million$325.3 millionWestern Europe PIInitial OutlayPV of CF (yrs1-5)Project Calculated by dividing the PV of a project’s cash inflows by the PV of its outflows: Like IRR, PI suffers from the scale problem.

Some Extensions Berlin, 18th of June, 2007Fußzeile20 The Tax Paradoxon Tax payments affect the cash flows of a project in a negative way. On the other hand, a discount rate after tax will be smaller than a discount rate before tax. Under some circumstances fiscal policy – i.e. Tax rate policy – may determine the ranking of investments. Inflation We always have to make sure, that nominal cash flows must refer to nominal discount rates while real cash flows require real discoount rates. Exchange Rates If global financial markets are working well, the effect of different inflation rates will be perfectly substituted by a well functioning exchange rate mechanism.

The Tax Paradoxon Corporate tax will affect N.P.V.- calculation in numerous aspects: 1.Tax payments reduce the cash flow 2.Depreciation and interest on debt diminish the taxable income (don‘t confuse taxable income with cash flow 3.As the cash flow now reflects after tax figures, the concept of opportunity costs also has to be adjusted to after tax interest rates (r after tax = r before tax x (1 – t);{ t = tax rate }.

The Tax Paradoxon 0123 Investment Investment r = 10% s = 0% Two mutually exclusive investment proposals show the following cash flows over three years (without taxes): 0123NPV Inv ,090,9661,2751,33,38 Inv ,0909,1578,575,162,73

Discounted cash flows lead to following N.P.V.s. At 10% and no taxes, Investment 2 is clearly dominant. 0123N.P.V. Inv ,38 Inv ,73 - 1, ,000 +3,38 The Tax Paradoxon

At a given tax rate, the NPV is a continously decreasing function of the opportunity cost of capital NPV 2 > NPV 1

The Tax Paradoxon Considering a corporate tax rate of 40 %, the NPV result changes to: 0123NPV Investment Investment Depreciation-500 Tax payments Tax payments Cash flow after tax Cash flow after tax P.V. after tax ,3+605,2+671,7 + 22,2 P.V. after tax ,7+551,8+218,3 + 24,8

The Tax Paradoxon NPV after tax can also be calculated in a step-by-step mode, i.e. The project‘s NPV consists of the NPV of the cash flows and the NPV of the tax payments: 0123NPV Cash flow before tax Present values Tax payments Present values Tax shield (Depreciation x tax rate) Present values

The Tax Paradoxon At a given discount rate, the first cash flows NPV starts rising according to rising tax rates (Tax Paradox). A tax rate of approx. 50% would affect the ranking order.... !!! Tax rates NPV after tax (r before tax = 10%)

Inflation Effects / FX Rates Sometimes there is uncertainty about the question how to include inflationary effects. Basically nominal cash flows need to be discounted by nominal (inflated) discount rates, while cash flows which reflect the purchase power must be discounted using real rates. Following nominal cash flows do include a yearly inflation rate of 15%. The expected real rate is supposed to be 10%:

The use of nominal cash flows and real discount rates will not lead to a correct result. A first solution would be, to inflate the real discount rate: A second solution could mean, to deflate the nominal cash flows and use the real discount rate: Inflationary Effects

After inflating the real discount rate of 10% with an inflation rate of 15%, the nominal discount rate is at: Consequently, the N.P.V. will drop to 1,231 Mio €. Inflation Effects / FX Rates

Another way round, we could also transfer nominal cash flows into real figures: Consequently the N.P.V. Now remains the same. Inflation Effects / FX Rates

Two alternative ways to avoid a wrong way of calcu- lation: All figures reflect „real“ data, i.e. real (not in - or deflated) cash flows and real discount rates (expected grow of purchasing power): All figures reflect „nominal“ data, i.e. nominal (in- or deflated) cash flows and nominal discount rates (usually inflated interest rate): Inflation Effects / FX Rates

CFr bef. tax TcTc r after tax d local d foreign EXR 0 s.u.10%50%5%2%10%1000:1 In the view of the foreign country based subsidiary, the N.P.V. is at Mrd. Inflation Effects / FX Rates Cash Flows (FC) Depreciation (straight) Tax rate 50% Disc.rate(before tax) 10% Disc.rate(after tax) 5%

The NPV can also be calculated as the sum of the cash flows present values before taxes and the present value of the tax payments: Adjusted Present Value (A.P.V.) CFr bef. tax TcTc r after tax d local d foreign EXR 0 s.u.10%50%5%2%10%1000:1 Inflation Effects / FX Rates

Regarding the foreign inflation rate, the local N.P.V. drops to 546,467. Cash Flows increased but discount rate adjusted to 15,5% ( = 1,05*1,10 ). Inflationary Effects / Foreign Exchange Rates CFr bef. tax TcTc r after tax d home d foreign EXR 0 s.u.10%50%5%2%10%1000:1 Inflation Effects / FX Rates

Considering the different sources of NPV it becomes clear, that it is not the PV of the operational cash flow which has changed, but the PV of tax payments. In our example the smaller NPV is exclusively caused by higher tax payments. CFr bef. tax TcTc r after tax d local d foreign EXR 0 s.u.10%50%5%2%10%1000:1 Inflation Effects / FX Rates

Inflation alone, under certain circumstances, (completely passed on to customers and suppliers, no supply- or demand- shifts) does not change the valuation of an investment. A smaller NPV then will be exclusively caused by higher tax payments (taxation of pseudo-profits). Tax authorities profit from inflation. The investegated negative impact of inflation on the economical attractiveness of investment proposals could be avoided, if tax authorities would refrain from taxation of pseudo profits. In the simplest way inflationary effects could be cancelled out by depreciation on the basis of higher, inflated purchase costs. Inflation Effects / FX Rates

If purchasing costs are continously inflated and depreciation is calculated on the basis of increasing current costs (per year + 10%) : Inflation Effects / FX Rates

Tax deductible depreciation based on current market prices, would neutralize the negative effects of inflation on N.P.V. Inflation Effects / FX Rates

What will be the effect of inflated cash flows in foreign curren- cies, if the foreign cash flows are transferred at the end of each period ? If international interest rate differences are perfectly reflected by a perfectly (unregulated) working foreign exchange rate mechanism, future exchange rates (EXR) are to be calculated using the „Fisher Equation“: in example for t 1 : Inflation Effects / FX Rates

If an exchange rate mechanism is perfectly working, the profit- ability (in terms of NPV) of real investment projects are not af- fected. Lower Cash Flows – due to impaired exchange rates – are then perfectly substituted by lower discount rates. Inflation Effects / FX Rates