1 FINANCE 7311 CAPITAL BUDETING

2 Outline 4 Projects 4 Investment Criteria 4 NPV v. IRR 4 Sources of NPV 4 Project Cash Flow Checklist

3 Projects A project is any potential real investment opportunity Distinguish real from financial Mutually Exclusive - can do only one Independent - decision about one does not affect decision w/r/t the others Replacement - special case

4 Investment Criteria Investment criteria are the rules by which we decide whether or not to accept a particular project; consider the following :

5 Accounting Rate of Return ARR = Avg. Income / Avg. Investment Uses Income rather than Cash Flow Ignores Time Value of Money

6 Payback Years needed to recover initial investment To Find: Calculate where cumulative cash flows become positive Project A:2 1/6 years Project B:2 6/7 years

7 Problems with Payback Ignores Time Value of Money Can use Discounted Payback; Why? Ignores CF’s after payback To see: Assume Project B’s cash flow in year 4 is 1,000,000; how does this affect payback

8 Net Present Value This rule is always consistent with maximizing the value of the firm Economically, take all projects for which benefits > costs (in PV dollars) Mathematically, sum the present values of all the cash flows

9 Net Present Value

10 NPV example

11 Internal Rate of Return (IRR) IRR - That rate which causes NPV to = 0.

12 IRR Independent Projects - select all projects for which IRR > Cost of Capital Mutually Exclusive - select project with highest IRR Use ‘well-designed’ spreadsheet

13 Comparison of NPV & IRR Business people are accustomed to thinking in rates of return, so does it matter which of NPV or IRR we use? Independent - the two rules are equivalent NPV > 0 IRR > Cost of Capital

14 Comparison of NPV & IRR Mutually Exclusive Projects - can get different answers NPV Profile for Example Reinvestment Assumption

15 NPV v. IRR Example Project 1:(100,000)125,000 Project 2: 1,000 2,000 NPV IRR Project 113,636 25% Project %

16 NPV v. IRR, cont. IRR ==> Do Project 2 NPV ==> Do Project 1 Problem: Reinvestment Assumption What are you going to do with the other $99,000?

17 Profitability Index PV Cash Inflows / PV Cash Outflows Independent: Choose all with PI > 1 Mutually Exclusive: Choose highest PI Project 1:1.136 Project 2:1.818 May be useful for capital rationing

18 Other Real Options Option to Expand Option to Abandon Strategic Options Excluding biases NPV down Decision Tree: Capital Budgeting should be dynamic, not static

19 Source of NPV Market Opportunities - ‘deviations from equilibrium’ 4 Economies of Scale 4 Cost Advantages 4 Product differentiation 4 Distribution Advantage 4 Regulatory Protection

20 Relevant Cash Flows We can always write: EBIT + Depreciation - Taxes (t x EBIT) = Operating Cash Flow - ∆ NWC - Capital Spending = FCF

21 Cash Flows 1. Focus on Cash Flows; not accounting #’s Depreciation Not a cash flow Affects Cash Flow through depreciation Capital spending Capitalized for accounting purposes Cash outflow for finance purposes

22 Project Cash Flows 2 Focus on Incremental Cash Flows “What is different if project is accepted?” Ý Sunk Costs - those costs which have been incurred and are not affected by project decision Ý Opportunity Cost - highest value use of an asset if not used in project

23 Project CF’s, cont. 3 Externalities - less obvious costs/benefits which should be included in analysis 4 Change in NWC - often a cash outflow initially and cash inflow at end 5 Cash flows should be after tax ∆Rev/Exp x (1-t) Depreciation x t 6 Do not include interest as a cash flow

24 Project CF’s, cont. l Replacement problem - should you keep an existing asset, or replace it with a new one 4 ∆ in Cash Flows 4 Net of tax proceeds from disposal of existing asset