Principles of Corporate Finance Session 17 & 18 Unit III: Capital Budgeting And its Practices

Introduction Capital Budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities. It seeks to identify investments that will enhance a firm’s competitive advantage and increase shareholder wealth. The typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. Poor capital budgeting decisions can ultimately result in company bankruptcy.

Key Motives for Capital Investments

Examples Replacing worn out or obsolete assets improving business efficiency acquiring assets for expansion into new products or markets acquiring another business complying with legal requirements satisfying work-force demands environmental requirements

The Capital Budgeting Process Step 1: Identify Investment Opportunities - How are projects initiated? - How much is available to spend? Step 2: Project Development - Preliminary project review - Technically feasible? - Compatible with corporate strategy? Step 3: Evaluation and Selection - What are the costs and benefits? - What is the project’s return? - What are the risks involved? Step 4: Post Acquisition Control - Is the project within budget? - What lessons can be drawn? Our Focus

Independent versus Mutually Exclusive Investments Mutually Exclusive Projects are investments that compete in some way for a company’s resources. A firm can select one or another but not both. Independent Projects, on the other hand, do not compete with the firm’s resources. A company can select one, or the other, or both -- so long as they meet minimum profitability thresholds.

Relevant Cash Flows Incremental cash flows –only cash flows associated with the investment –effects on the firms other investments (both positive and negative) must also be considered For example, if a day-care center decides to open another facility, the impact of customers who decide to move from one facility to the new facility must be considered.

Relevant Cash Flows Incremental cash flows –only cash flows associated with the investment –effects on the firms other investments (both positive and negative) must also be considered Note that cash outlays already made (sunk costs) are irrelevant to the decision process. However, opportunity costs, which are cash flows that could be realized from the best alternative use of the asset, are relevant.

Examples of relevant cash flows: –cash inflows, outflows, and opportunity costs –changes in working capital –installation, removal and training costs –terminal values –depreciation –sunk costs –existing asset affects Relevant Cash Flows

Categories of Cash Flows: –Initial Cash Flows are cash flows resulting initially from the project. These are typically net negative outflows. –Operating Cash Flows are the cash flows generated by the project during its operation. These cash flows typically net positive cash flows. –Terminal Cash Flows result from the disposition of the project. These are typically positive net cash flows. Relevant Cash Flows

Example Operating Cash Flow Calculation Existing Hoist

Example Operating Cash Flow Calculation

Example Terminal Cash Flow Calculation

Example Terminal Cash Flow Calculation

Example Incremental Cash Flow Summary

Principles of Corporate Finance Session 19 & 20 Unit III: Capital Budgeting And its Practices

Project Evaluation: Alternative Methods Payback Period (PBP) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI) Payback Period (PBP) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI)

Proposed Project Data Julie Miller 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.

Independent Project IndependentIndependent – A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.

Payback Period (PBP) PBP PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow –40 K 10 K 12 K 15 K 10 K 7 K

(c) 10 K 22 K 37 K 47 K 54 K Payback Solution (#1) PBP 3.3 Years PBP = a + ( b – c ) / d = 3 + (40 – 37) / 10 = 3 + (3) / 10 = 3.3 Years –40 K 10 K 12 K 15 K 10 K 7 K Cumulative Inflows (a) (-b) (d)

Payback Solution (#2) PBP 3.3 Years PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. PBP 3.3 Years PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. Cumulative Cash Flows –40 K 10 K 12 K 15 K 10 K 7 K –40 K –30 K –18 K –3 K 7 K 14 K

PBP Acceptance Criterion Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.] The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type. Should this project be accepted?

PBP Strengths and Weaknesses Strengths: Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows Strengths: Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows Weaknesses: Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective

Principles of Corporate Finance Session 20 Unit III: Capital Budgeting And its Practices

Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. CF 1 CF 2 CF n (1+k) 1 (1+k) 2 (1+k) n ICO - ICO NPV =

Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. $10,000 $7,000 NPV Solution $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 = +

NPV Solution NPV $40,000 NPV = $10,000(PVIF 13%,1 ) + $12,000(PVIF 13%,2 ) + $15,000(PVIF 13%,3 ) + $10,000(PVIF 13%,4 ) + $ 7,000(PVIF 13%,5 ) – $40,000 NPV $40,000 NPV = $10,000(0.885) + $12,000(0.783) + $15,000(0.693) + $10,000(0.613) + $ 7,000(0.543) – $40,000 NPV $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 – $40,000 $1,428 =- $1,428

NPV Acceptance Criterion Reject NPV0 No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted?

NPV Strengths and Weaknesses Strengths: Cash flows assumed to be reinvested at the hurdle rate. Accounts for TVM. Considers all cash flows. Strengths: Cash flows assumed to be reinvested at the hurdle rate. Accounts for TVM. Considers all cash flows. Weaknesses: May not include managerial options embedded in the project. See Chapter 14.

Net Present Value Profile Discount Rate (%) IRR Sum of CF’sPlot NPV for each discount rate. Three of these points are easy now! Net Present Value $000s

Profitability Index (PI) 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 n (1+k) 1 (1+k) 2 (1+k) n ICOPI = NPVICO PI = 1 + [ NPV / ICO ] > Method #2: Method #1:

PI Acceptance Criterion PI Reject PI1.00 No! The PI is less than This means that the project is not profitable. [Reject as PI < 1.00 ] PI PI = $38,572 / $40,000 =.9643 (Method #1, previous slide) Should this project be accepted?

PI Strengths and Weaknesses Strengths: Strengths: Same as NPV Allows comparison of different scale projects Strengths: Strengths: Same as NPV Allows comparison of different scale projects Weaknesses: Same as NPV Provides only relative profitability Potential Ranking Problems

Principles of Corporate Finance Session 23 Unit III: Capital Budgeting And its Practices

Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. CF 1 CF 2 CF n (1 + IRR) 1 (1 + IRR) 2 (1 + IRR) n ICO =

$15,000 $10,000 $7,000 IRR Solution $10,000 $12,000 (1+IRR) 1 (1+IRR) 2 Find the interest rate (IRR) that causes the discounted cash flows to equal $40, $40,000 = (1+IRR) 3 (1+IRR) 4 (1+IRR) 5

IRR Solution (Try 10%) $40,000 $40,000 = $10,000(PVIF 10%,1 ) + $12,000(PVIF 10%,2 ) + $15,000(PVIF 10%,3 ) + $10,000(PVIF 10%,4 ) + $ 7,000(PVIF 10%,5 ) $40,000 $40,000 = $10,000(0.909) + $12,000(0.826) + $15,000(0.751) + $10,000(0.683) + $ 7,000(0.621) $40,000 $41,444[Rate is too low!!] $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 =$41,444[Rate is too low!!]

IRR Solution (Try 15%) $40,000 $40,000 = $10,000(PVIF 15%,1 ) + $12,000(PVIF 15%,2 ) + $15,000(PVIF 15%,3 ) + $10,000(PVIF 15%,4 ) + $ 7,000(PVIF 15%,5 ) $40,000 $40,000 = $10,000(0.870) + $12,000(0.756) + $15,000(0.658) + $10,000(0.572) + $ 7,000(0.497) $40,000 $36,841[Rate is too high!!] $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 =$36,841[Rate is too high!!]

0.10$41, IRR$40,000 $4, $36,841 X$1, $4,603 IRR Solution (Interpolate) $1,444 X =

0.10$41, IRR$40,000 $4, $36,841 X$1, $4,603 IRR Solution (Interpolate) $1,444 X =

0.10$41, IRR$40,000 $4, $36,841 ($1,444)(0.05) $4,603 IRR Solution (Interpolate) $1,444 X X =X = IRR = = or 11.57%

IRR Acceptance Criterion No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR < Hurdle Rate ] The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted?

IRR Strengths and Weaknesses Strengths: Strengths: Accounts for TVM Considers all cash flows Less subjectivity Strengths: Strengths: Accounts for TVM Considers all cash flows Less subjectivity Weaknesses: Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs

Evaluation Summary Basket Wonders Independent Project