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

2 Chapter 6 Contents 1 The Nature of Project Analysis1 The Nature of Project Analysis 2 Where do Investment Ideas come from?2 Where do Investment Ideas come from? 3 The NPV Investment Rule3 The NPV Investment Rule 4 Estimating a Project’s Cash Flows4 Estimating a Project’s Cash Flows 5 Cost of Capital5 Cost of Capital 6 Sensitivity Analysis6 Sensitivity Analysis 7 Analyzing Cost-Reducing Projects 8 Projects with Different Lives 9 Ranking Mutually Exclusive Projects 10 Inflation & Capital Budgeting

3 Objectives To show how to use discounted cash flow analysis to make decisions such as: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

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

5 6.3 Net Present Value Rule A project’s net present value isA 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 criterionAs a criterion –Invest in proposed projects with positive NPV

6 NPV of a Project Discount10% YearFlowPVCum_PV NPV20 Do Project DCF Payback

7 NPV of a Project Discount15% YearFlowPVCum_PV NPV-69 Don’t Do Project

8 NPV of a Project Discount11.04% YearFlowPVCum_PV NPV0 Indifferent Internal Rate of Return

9 Summary The discount rateThe 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

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11 More on Internal Rate of Return Assume you made an investment of $100 which gives you $130 at the end of one year. Assume that the Discount Rate = 10%Assume you made an investment of $100 which gives you $130 at the end of one year. Assume that the Discount Rate = 10% NPV = /(1.1) = $ NPV = /(1.1) = $ IRR is that rate at which NPV = /(1+?) = 0IRR is that rate at which NPV = /(1+?) = 0

Estimation of Cash Flows It is important to remember that when making financial decisions only timed incremental after-tax cash flows are usedIt is important to remember that when making financial decisions only timed incremental after-tax 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

13 Working Capital & Cash Flows Some cash flows do not occur on the income statement, but involve timingSome cash flows do not occur on the income statement, but involve timing –working capital additions and reductions are cash flows

14 An Example Rev. = $20, Cash Exp. = $18.1Rev. = $20, Cash Exp. = $18.1 Dep. = $0.4, Taxable Income = $1.5Dep. = $0.4, Taxable Income = $1.5 Taxes = $0.6, Net Income = $0.9Taxes = $0.6, Net Income = $0.9 Annual Cash Flow = Net Income plus Dep. = $0.9 + $0.4 = $1.3Annual Cash Flow = Net Income plus Dep. = $0.9 + $0.4 = $1.3

15 Example Continued - Initial Investment = - $2.8Initial Investment = - $2.8 Working Capital Increase at time zero = -$2.2Working Capital Increase at time zero = -$2.2 Working Capital decrease at the end of seven years = $2.2Working Capital decrease at the end of seven years = $2.2

16 Example Continued - Year 0 1 2……. 6 7 Year 0 1 2……. 6 7 Cash Flows $1.3 $1.3 $1.3 $1.3Cash Flows $1.3 $1.3 $1.3 $1.3 Inv. -$2.8Inv. -$2.8 W. Cap. -$2.2 $2.2W. Cap. -$2.2 $2.2 Total -$5.0 $1.3 $1.3 $1.3 $3.5Total -$5.0 $1.3 $1.3 $1.3 $3.5

17 The Incremental Nature of Cash Flows Only the incremental cash flows should form part of an investment decisionOnly the incremental cash flows should form part of an investment decision –Evaluate the timed after-tax cash flows of the total firm with and without the project, and find the difference –This difference is a collection of timed incremental after-tax cash flows, and this is what affects the wealth of the shareholders

18 Incremental Cash Flow Illustration: Pay for Cannibalism A proposed project will generate $10,000 in revenue, but will causes another product line to lose $3,000 in revenuesA 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 $7,000The incremental cash flow is only $7,000

19 Incremental Cash Flow Illustration: Ignore Prior Expenses or Sunk Costs R&D expenses are $10,000 to-date for your project, and you are considering spending another $20,000R&D expenses are $10,000 to-date for your project, and you are considering spending another $20,000 –The $10,000 is a sunk cost. The decision about spending another $20,000 will not change this expenditure –Only the $20,000 is an incremental cost, and the $10,000 should be ignored

20 Incremental Cash Flow Illustration: Do not Ignore Opportunity Costs A company owns a warehouse which the company could rent for for $100,000 a year, unless….A company owns a warehouse which the company could rent for for $100,000 a year, unless…. the warehouse is used by a new project undertaken by the firm.the warehouse is used by a new project undertaken by the firm. Since $100,000 is the opportunity cost, it must be charged to the new projectSince $100,000 is the opportunity cost, it must be charged to the new project

The Discount Rate When determining the discount rateWhen determining the discount rate –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)

22 Computing the Weighted Average Cost of Capital (WACC) of a Corporation Determine the cost of capital to security holders of each class of security issuedDetermine the cost of capital 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 eachDetermine 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 costs of capitalAfter adjusting for tax, compute the weighted sum of costs of capital

23 Weighted Average Cost of Capital: Example with two Securities LetLet k e be the cost of equityk e be the cost of equity k d be the cost of debtk d be the cost of debt V e be the market value of issued equityV e be the market value of issued equity V d be the Market value of issued bondsV d be the Market value of issued bonds t be the tax ratet be the tax rate

24 Weighted Average Cost of Capital: Example with two Securities k = k e * V e + k d * V d * (1 - t)k = k e * V e + k d * V d * (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 valueThe average cost of capital is also the cost of capital for each of the firms business divisions weighted according to their market value

25 Table 6.4 Project Sensitivity to Sales Volume

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Analyzing Cost Reducing Projects Example based on Table 6.6 on page 178 in the text bookExample based on Table 6.6 on page 178 in the text book

Projects with Different Lives Annualized Capital Cost is the annual cash payment that has a present value equal to initial outlayAnnualized Capital Cost is the annual cash payment that has a present value equal to initial outlay The project with the lower annualized capital cost should be undertakenThe project with the lower annualized capital cost should be undertaken Example on page in the text bookExample on page in the text book When do you replace a sales car?When do you replace a sales car? –As a car ages its resale price decreasesits resale price decreases the annual repair bills increasethe annual repair bills increase sales people become discontentedsales 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

Ranking Mutually Exclusive Projects Using the NPV method, you are unlikely to encounter any serious problemsUsing 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 can give a wrong answer

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