Lecture 7 - Capital Budgeting: Decision Criteria

2 What is Capital Budgeting? Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to a firm’s future. The Ideal Evaluation Method should: a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project. Determine r = WACC for project.

3 What is the difference between independent and mutually exclusive projects? Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

= CF t Cumulative Payback L 2+30/80 = years Payback Period - The number of years required to recover a project’s cost Payback for Franchise Long (Long: Most CFs in out years) 4

Franchise Short (Short: CFs come quickly) CF t Cumulative Payback S /50 = 1.6 years = 5

Another Example Ms. Hoa is is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000. 6

7 PBP PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. Note : K = 1000s PBP PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. Note : K = 1000s K 10 K 12 K 15 K 10 K 7 K Payback period

8 (c) 10 K 22 K 37 K 47 K 54 K PBP 3.3 Years PBP = a + ( b - c ) / d = 3 + ( ) / 10 = 3 + (3) / 10 = 3.3 Years K 10 K 12 K 15 K 10 K 7 K Cumulative Inflows (a) (-b) (d) A Payback solution

Strengths of Payback: 1.Provides an indication of a project’s risk and liquidity. 2.Easy to calculate and understand. Weaknesses of Payback: 1.Ignores the Time Value of Money. 2.Ignores CFs occurring after the payback period. 9

CF t Cumulative Discounted payback /60.11 = 2.7 yrs Discounted Payback: Uses discounted rather than raw CFs. PVCF t % = Recover invest. + cap. costs in 2.7 yrs. 10

11 NPV:Sum of the PVs of inflows and outflows. Cost often is CF 0 and is negative. Notice difference in t Net Present Value (NPV) Method

What is Franchise Long’s NPV? % Project L: = NPV L NPV S = $

Basket Wonders has determined that the appropriate discount rate (r) for this project is 13%. $10,000 $7,000 $10,000 $12,000 $15,000 (1.13) 1 (1.13) 2 (1.13) $40,000 - $40,000 (1.13) 4 (1.13) 5 NPV NPV = + Basket Wonders Example NPV$40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000 $1,428 = - $1,428 13

Rationale for the NPV Method NPV= PV inflows – Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value. 14 U sing NPV method, which franchise(s) should be accepted? If Franchise S and L are mutually exclusive, accept S because NPV s > NPV L. If S & L are independent, accept both; NPV > 0.

Internal Rate of Return: IRR 0123 CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. 15

NPV: Enter r, solve for NPV. IRR: Enter NPV = 0, solve for IRR. 16

What’s Franchise Long’s IRR? 10 (70s)80 (20s)60 (50s) 0123 IRR = ? PV 3 PV 2 PV 1 0 = NPV IRR L = 18.13%.IRR S = 23.56%. 17

Rationale for the IRR Method If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns. Example:WACC = 10%, IRR = 15%. Profitable. 18

19 Decisions on Projects S and L per IRR If S and L are independent, accept both. IRRs > r = 10%. If S and L are mutually exclusive, accept S because IRR S > IRR L.

We can construct NPV profiles We find NPV L and NPV S at different discount rates: r NPV L NPV S (4) 20

NPV ($) Discount Rate (%) IRR L = 18.1% IRR S = 23.6% Crossover Point = 8.7% r NPV L (4) NPV S S L 21

NPV and IRR always lead to the same accept/reject decision for independent projects: r > IRR and NPV < 0. Reject. NPV ($) r (%) IRR IRR > r and NPV > 0 Accept. 22

Mutually Exclusive Projects r 8.7 r NPV % IRR S IRR L L S r NPV S, IRR S > IRR L CONFLICT r > 8.7: NPV S > NPV L, IRR S > IRR L NO CONFLICT 23

Two Reasons NPV Profiles Cross 1. Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects. 2.Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPV S > NPV L. Reinvestment Rate Assumptions NPV assumes reinvest at r (opportunity cost of capital). IRR assumes reinvest at IRR. Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects. 24

Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR? Yes, MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC. 25

MIRR = 16.5% % MIRR for Franchise L (r = 10%) % TV inflows PV outflows MIRR L = 16.5% $100 = $158.1 (1+MIRR L ) 3 26

Why use MIRR versus IRR? MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR. 27

Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine. 28

Inflow (+) or Outflow (-) in Year NNN N N N

Pavilion Project: NPV and IRR? 5,000-5, r = 10% -800 NPV = IRR = ERROR. Why? 30

We got IRR = ERROR because there are 2 IRRs. Nonnormal CFs--two sign changes. Here’s a picture: NPV Profile IRR 2 = 400% IRR 1 = 25% r NPV 31

Logic of Multiple IRRs 1.At very low discount rates, the PV of CF 2 is large & negative, so NPV < 0. 2.At very high discount rates, the PV of both CF 1 and CF 2 are low, so CF 0 dominates and again NPV < 0. 3.In between, the discount rate hits CF 2 harder than CF 1, so NPV > 0. 4.Result: 2 IRRs. 32

When there are nonnormal CFs and more than one IRR, use MIRR: ,0005,000,000-5,000,000 PV 10% = -4,932, TV 10% = 5,500, MIRR = 5.6% Should We Accept Project P? 33

34 Accept Project P? NO. Reject because MIRR = 5.6% < r = 10%. Also, if MIRR < r, NPV will be negative: NPV = -$386,777.

PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. CF 1 CF 2 CF t (1+r) 1 (1+r) 2 (1+r) t ICO PI = Profitability Index (PI) 35 It measures the “bang for the buck.” Profitability Index Acceptance Criterion Reject if PI1.00 Reject if PI < 1.00 ]

01234 Project S: (100) Project L: (100) S and L are mutually exclusive and will be repeated. r = 10%. 36

NPV L > NPV S. But is L better? S L CF ,000 CF 1 60,000 33,500 NJNJ 24 I10 NPV4,1326, Note that Project S could be repeated after 2 years to generate additional profits.

Replacement Chain Approach Franchise S with Replication: NPV = $7, Franchise S: (100) (100) (100) (40) 60 All values in thousands 38

Compare to Franchise L, where NPV = $6, ,132 3,415 7,547 4,132 10% Or, use NPVs: 39

NPV S = $3,415 < NPV L = $6,190. Now choose L. NPV S = $3,415 < NPV L = $6,190. Now choose L Franchise S: (100) 60 (105) (45) 60 Suppose cost to repeat S in two years rises to $105,

41 Economic Life versus Physical Life Consider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage value. Should you always operate for the full physical life? See next slide for cash flows.

Economic Life versus Physical Life (Continued) YearCFSalvage Value 0($5000)$ ,1003,100 22,000 31,

CFs Under Each Alternative (000s) No termination(5) Terminate 2 years(5) Terminate 1 year(5) NPVs under Alternative Lives (Cost of capital = 10%) NPV(3)= -$123. NPV(2)= $215. NPV(1)= -$273. The project is acceptable only if operated for 2 years. A project’s engineering life does not always equal its economic life.

44 Choosing the Optimal Capital Budget Finance theory says to accept all positive NPV projects. Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects: An increasing marginal cost of capital. Capital rationing

45 Increasing Marginal Cost of Capital Externally raised capital can have large flotation costs, which increase the cost of capital. Investors often perceive large capital budgets as being risky, which drives up the cost of capital. If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.

46 Capital Rationing Capital rationing occurs when a company chooses not to fund all positive NPV projects. The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year. Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital. Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing. Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted. Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.

47 Increasing Marginal Cost of Capital Externally raised capital can have large flotation costs, which increase the cost of capital. Investors often perceive large capital budgets as being risky, which drives up the cost of capital. If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.

48 Find the PV of the foreign CF’s denominated in the foreign currency and discounted by the foreign country’s cost of capital Convert the PV of the CF’s to the home country’s currency multiplying by the spot exchange rate Subtract the parent company’s initial cost from the Present values of net cash flows to get the NPV International Capital Budgeting Amount and Timing of Foreign CF’s will depend on Differential tax rates Legal and political constraints on CF Government subsidized loans