Agenda Capital Budgeting Decision Frameworks

Capital Budgeting Process Goal of management is to maximize value Companies continually invests in a portfolio of projects In theory all projects that create value should be approved In reality, a company may not invest in all projects estimated to create value Capital budgeting is the process to assess: if an investment will create value for the investors Expected project return > cost of capital If constrained, how to prioritize across investments. Capital constraints Non-Capital constraints Estimation Bias Describe process to create a budget ZBB process What would you like to see in approving a project

Capital Budgeting Process Compliance with new Federal regulation New Product Upgrade the Factory Capital Budgeting Process Marketing Program Approved Projects Open new Sales office Leadership Training ‘Big Data’ Software New Feature for existing product

The Capital Budgeting Decision Process The capital budgeting process involves a few basic steps: Identifying potential investments Ensure potential investments are linked to strategic direction Types of Projects: Safety, Replacement, Contraction, Expansion (products or markets), Mergers Reviewing, analyzing, and selecting from the proposals that have been generated Strategic Alignment Does the project create value? Implementing and monitoring the proposals that have been selected Analyzing involves valuing the project -> same principles as valuing a security or business

A capital budgeting process should… Be easy to apply and explain Focus on cash flow Account for the time value of money Account for project risk Lead to investment decisions that maximize shareholders’ wealth

Investment Decision Frameworks Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Profitability Index Payback Discounted Payback All frameworks will require a financial forecast Most require size of cash flows, timing of cash flows and risk. Typical profile: investment in development, marketing, capital and inventory revenue ramp and then transition down costs to support and then reclaim of some investment Does the profile make economic sense? Create value

What Companies Do Globally 7

Project Analysis General Framework What are the cash flows associated with the project Understand the strategy and operational assumptions related to the project Forecast the pro forma financials Income statement and balance sheet Percent of sales approach as starting point Utilize ratios & competitive positioning to guide assumptions Free Cash flow = CF from Operations - Investment in WC – Investment in LT Assets Only new, incremental cash flows should be included Assess riskiness of cash flows: Discount Rate WACC: Cost of Equity (CAPM) and Cost of Debt (after tax yield) Market based costs and Target or Market weights Risk based on the project cash flows, not necessarily that of the company Apply decision criteria (NPV, IRR, payback) NPV generally the best method Test the decision and the critical assumptions What are the key inputs that have the most uncertainty? What causes the decision to change? Utilize Scenarios, Sensitivity, Breakeven to focus on key assumptions Recommendation with key risks identified and suggestions to mitigate

Capital Budgeting Decision Frameworks Net Present Value Present Value of all future cash flows Discount rate based on risk of project Acceptance Criteria: NPV > $0 NPV Amount = amount of value creation IRR / MIRR Discount rate that results in NPV = 0 Cash flow forecast same as NPV analysis Acceptance Criteria: IRR > Cost of Capital Profitability Index Present Value of Cash Inflow divided by Present Value of Cash Outflow Cash flow forecast same as NPV analysis Acceptance Criteria: PI > 1.0 Payback Numbers of time periods required to recoup the investment Cash flow forecast same as NPV analysis Acceptance Criteria: Arbitrary

NPV Profile Project NPV NPV > $0 +$ IRR > Discount Rate $0 -$ NPV > $0 IRR > Discount Rate IRR of Project Discount Rate NPV < $0 IRR < Discount Rate

NPV versus IRR NPV and IRR will generally give the same decision. Exceptions: Mutually exclusive projects Scale is substantially different Timing of cash flows is substantially different Non-conventional cash flows – cash flow signs change more than once Modified IRR can help with the non conventional cash flows and re-investment rate assumptions Profiles of non traditional CFs Reinvest rate assumptions: NPV= cost of capital IRR= IRR MIRR, define the reinvestment rate MIRR

Example Company is considering investing in a new product requiring $35M in R&D and $125M in capital equipment. Total available market (TAM) size is 400M units / year. Company expects to address 15% of TAM and initially capture 2% market share. Product price is $70 / unit COGS is 40% of price Sales and Marketing expense is estimated at 10% of revenue. General and administrative is 5% of revenue Working capital is forecast as: A/R at 10% of sales, Inventory at 15% of sales, A/P at 8% of sales Depreciation based on 3 year MACRS Tax rate is 35% Product life is approx 4 years. Equipment will have a $10M salvage value Cost of capital = 10% Should the company invest in the new product?

Which Cash Flows -> Incremental Cash Flows Cash flows matter—not accounting earnings. Incremental cash flows matter. Sunk costs do not matter. Don’t forget start-up and salvage value cash flows Opportunity costs matter. Externalities like cannibalism and erosion matter. Inflation matters. Taxes matter: we want incremental after-tax cash flows.

Depreciation Many countries allow firms to use one depreciation method for tax purposes and another for reporting purposes. Accelerated depreciation methods such as the modified accelerated cost recovery system (MACRS) increase the present value of an investment’s tax benefits. Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life. Which method would you expect companies to use when they file their taxes, and which would they use when preparing public financial statements? For capital budgeting analysis, it is the depreciation method for tax purposes that matters. 14

Assignments for Next Class Investment Decisions and Risk Analysis Chapter 11

Summary – Investment Decision Frameworks Net present value Difference between market value and cost Accept the project if the NPV is positive Has no serious problems Preferred decision criterion Internal rate of return Discount rate that makes NPV = 0 Take the project if the IRR is greater than the required return Same decision as NPV with conventional cash flows IRR is unreliable with non-conventional cash flows or mutually exclusive projects MIRR can address the non-conventional cash flow issue Profitability Index Benefit-cost ratio Take investment if PI > 1 Cannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital rationing Payback Time required to recoup the initial investment Does not account for timing, risk or cash flows beyond payback period Payback decision criteria is arbitrary NPV is preferred Benefits of other methods -> provide insight on margin of safety A B NPV $10M $10.5M IRR 30% 12% Investment $5M $60M

Example A company has two potential projects to invest in: Each has a cost of capital of 10% What would you recommend?

Net Present Value Minimum Acceptance Criteria: Accept if NPV > 0 Net Present Value (NPV) = Total PV of cash inflows – PV of costs Minimum Acceptance Criteria: Accept if NPV > 0 A key input in NPV analysis is the discount rate. r represents the minimum return that the project must earn to satisfy investors. r varies with the risk of the firm and/or the risk of the project.

Internal Rate of Return Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project. IRR found by computer/calculator or manually by trial and error 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. Similar to a YTM calculation Significance of IRR / NPV=0 ?

Pros and Cons of Using NPV as Decision Rule NPV is the “gold standard” of investment decision rules. NPV is the present value of cash inflows less present value of cash outflows How much the project contributes to shareholder wealth 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 Doesn’t capture managerial flexibility (option value) well 20

Pros and Cons of Payback Method Advantages of payback method: Computational simplicity Easy to understand Focus on cash flow Disadvantages of payback method: Does not account properly for time value of money Does not account properly for risk Cutoff period is arbitrary Does not lead to value-maximizing decisions

The Profitability Index (PI) Present Value of Future Cash Flows Initial Investment Minimum Acceptance Criteria: Accept if PI > 1 Ranking Criteria: Select alternative with highest PI Advantages: Easy to understand and communicate Correct decision when evaluating independent projects Disadvantages: Problems with mutually exclusive investments