CHAPTER 10 The Basics of Capital Budgeting Should we build this plant?

What is capital budgeting? Investment decision: Analysis of potential cost-benefit of fixed assets. Replacement decision: Analysis of cost-benefit of the new machine in comparison to the old machine. Project launching: Complete cost-benefit analysis of the project taking under the whole life of the project under consideration .

Challenges of capital budgeting To forecast the long term cash flows. To assess the riskiness of the future cash flow. To select the right cost of capital To select the right method of capital budgeting

Difference between independent and mutually exclusive projects Independent projects – if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.

Methods of capital budgeting Accounting Technique: Accounting Rate of Return Financial Techniques: 1. Payback Period 2. Discounted payback period 3. Net Present Value (NPV) Method 4. Internal Rate of Return (IRR) 5. Profitability Index (PI)

Problem defined Both project L and project S are $100 projects. The investments have zero salvage value at the end of the 3 year project. Revenue and expenses (including depreciation) are as following. Tax rate is 30%. Cost of capital is 10%. Evaluate the potentiality of the projects.    Project L  Project S Year 1 Year 2 Year 3 Revenue 50 194 132 103 104 57 Expenses 83 113 123 80 90

AAR Vs. Cash Flow Project L Project S Year 1 Year 2 Year 3 Revenue 50   Project L  Project S Year 1 Year 2 Year 3 Revenue 50 194 132 103 104 57 Expenses (Incl. depreciation) 83 113 123 80 90 Taxable income -33 81 9 53 24 Tax (30%) -10 3 16 7 Net income -23 6 37 17 Cash Flow (Net Inc+ Dep.) 10 40 70 Average Net Income (-23+57+6)/3= 13.3  (37+17-23)/3=10.3  Average Investment (100+0)/2= 50 (100+0)/2=50  AAR 13.3/50=26.6%  10.3/50=20.5%

What is the payback period? The number of years required to recover a project’s cost, or “How long does it take to get our money back?” It is not related to profitability as it defines the time period needed to get the original investment back. A project would only make profit after the expiry of the payback period.

1. Payback Period: Project L Year Cash Flow (CFt) Cumulative CF -100 1 10 -90 2 90 3 40 Payback Period of Project L=2 years

Payback Period: Project S Year CFt Cumulative Cash flow -100 1 70 -30 2 50 20 3 40 Project S=1 year+30/50 year=1.6 years

Decision Project L has the payback period of 2 years and project S has a payback period of 1.6 years. So project S is better than project L. Project S should be accepted.

Strengths and weaknesses of Payback Period An investor is primarily concerned of the protection of original investment rather than profit, and PBP aims to give such an idea. Easy to calculate and understand. Weaknesses Ignores the time value of money. Ignores CFs occurring after the payback period. No yardstick to compare with

2. Discounted Payback Period Project L Suppose, cost of capital is 10% Year Cash flow Discounted CF at 10% Cumulative CF -100 1 10 9.09 -90.9 2 90 74.38 -16.53 3 40 30.1 13.5 Discounted Payback Period Project L=2+16.53/30.1=2.55 years

2. Discounted Payback Period Project S Year Cash flow Discounted CF at 10% Cumulative CF -100 1 70 63.64 -36.36 2 50 41.32 4.96 3 20 15.03 19.98 Discounted Payback Period Project S=1+36.36/41.32=1.67 years

Decision based on Discounted Payback Period Project L has a Discounted Payback Period of 2.55 years and Project S has a Discounted Payback Period of 1.67 years. So, project S is the better project.

3. Net Present Value (NPV) Sum of the Present Values of all cash inflows and outflows of a project:

NPV of Project L Suppose, the cost of capital is 10% Year CFt PV of CFt 0 -100 -$100 1 10 9.09 =(10/1.1) 2 90 74.38 =(90/(1.1)2) 3 40 30.1 =(40/(1.1)3) NPVL = 13.5

NPV of Project S Year CFt PV of CFt 0 -100 -$100 1 70 63.64 2 50 41.32 0 -100 -$100 1 70 63.64 2 50 41.32 3 20 15.02 NPVs = $19.98

Decision making in NPV method If projects are independent, accept the project if the NPV is positive. Reject the project if NPV is negative. If projects are mutually exclusive, accept projects with the highest positive NPV. In this example, we would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent.

4. Internal Rate of Return (IRR) IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

Short-cut method of IRR Interpolation method for IRR L1:Lower discount rate L2: Higher discount rate NPV1: NPV of lower discount rate NPV2: NPV of higher discount rate IRR=L1+ [NPV1/(NPV1-NPV2)] *(L2-L1)

IRR of project L (under the short-cut method) To use the short-cut method of IRR we need to know the NPVs at two different discount rates. We know, NPV of the project L was $13.52 when the discount rate is 10%. If the discount rate was 15% then the NPV comes down to $3.05. So, The IRR so calculated is close to the true IRR of 16.6%

IRR of Project S For project S, at 10% discount rate the NPV was $19.98. At 20% discount rate it arrives at $4.63. Using the short cut method: IRRS= 10%+[(20%-10%)*(19.98/(19.98-4.63)] = 23% The true IRR however was 23.57%

Rational for the IRR method If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns.

IRR Acceptance Criteria If IRR > k, accept project. If IRR < k, reject project. If projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept S, because IRRs > IRRL.

5. Profitability Index (PI)

Evaluation of the 2 projects Techniques Project L Project S Comment Accounting Return 26.6% 20.5% Payback Period 2 years 1.6 years Discounted Pay Back 2.55 1.67 Net Present Value 13.5 19.98 IRR (ke=10%) 16.5% 23% Profitability Index 1.14 1.2

Comments Although Accounting Return of project L is better than that of project S, but all other techniques show superiority of project S over project L. Project S has lower Payback Period and Discounted Payback period. Its NPV is positive and higher than Project L, its IRR is higher than the cost of capital and higher than project L, and Profitability Index is greater than one and higher than project L. So, project S should be accepted if the projects are mutually exclusive. If the projects are independent, project L would also be accepted (along with project S) since NPV is positive, IRR is greater than the cost of capital, and Profitability Index is greater than one.

Problem 2: NPV vs. IRR: Project V & Project H Year Cash Flow V Cash Flow H -1200 1 1000 100 2 500 600 3 50 1050 NPV 160 176 IRR 20.7% 16.2%

Conflicting result: NPV vs. IRR Project H Project V 176 160 Discount Rate 10% 16% 21%

Comments: NPV vs. IRR Given the cost of capital of 10%, project H has higher NPV than Project V. If we take NPV as the decision criteria then Project H should be accepted. On the other hand, if we take IRR as the decision criteria, then project V should be accepted. If we are very confident of the cost of capital of 10% (or any rate below the rate at cross over point), then project H is better. If we are not sure of the cost of capital, and there is possibility of increasing the cost of capital, then project V is better. Of course, if there a possibility that cost capital can be higher than 21%, then no project should be accepted.

Tips of Capital Budgeting Incremental Cash flow: The change in a firm’s net cash flow attributable to an investment project. This must be taken under consideration. For example, Consider TQC Co. at present without the project A; versus, TQC Co. with the project A. If cost increases in the second case then the increasing amount is the cost of the project A. If cost decreases in the second case then that is the benefit of project A. Sunk Cost: A cash outlay that has already been incurred and can not be recovered regardless whether the project is accepted or not. Like the cost of feasibility study. This must not be taken under consideration.

Tips of Capital Budgeting (Contd.) Opportunity cost: The return of the best alternative foregone must be taken under consideration even if it does not have an impact on cash flow. Example, rental value of the land owned by the firm should be a cost even though the firm does not pay that. Externalities: The effect accepting a project will have on the cash flows of other project. Example, opening a new branch may cause a loss of sale of an existing branch. That loss must be considered as the cost of the new branch.

Tips of Capital Budgeting (Contd.) Terminal Cash Flow: The value of the project or any part of it that would arrive at the end of the project must be considered as a cash inflow in its after tax form. Example, net salvage value, net working capital, etc.

Problem 3: Net salvage value Example: (a) The price of machine is $1000. The machine has a life of 10 years. The life of the project is 4 years. It is estimated that the machine would be sold at $900 at the end of the project. Find the net salvage value. (b) The building requires an investment of $200. It has a life of 20 years. The selling price of the building at the end of the 4 year project is $100. Find the salvage value.

Calculation of Net Salvage Value Machine Building Annual Depreciation (cost/Life) 1000/10=100 200/20=10 Depreciation for 4 years 100*4=400 10*4=40 Book value (Cost-Depr) 1000-400=600 200-40=160 Market value 900 100 Profit (Loss) 900-600=300 100-160=(60) Tax effect (120) 24 Net salvage value 900-120=780 100+24=124

Problem 3: A fast food shop has a 4 year life that needs the investment in machine of $1000 and building of $200. Annual sales $300 and the cost is 40% of sales. The feasibility study needed $500 and the rental value of the land (owned by the firm) is $20 per year. Cost of capital is 8% and the corporate tax rate is 40%.

Solution of Problem 3 Source Year 0 Year 1 Year 2 Year 3 Year 4 Investment (1200) Sales 300 Cost (120) Land Rent (20) Depreciation (110) EBIT 50

Solution (Contd.) EBIT 50 Tax 40% (20) Net income 30 Source Year 0 Year 1 Year 2 Year 3 Year 4 EBIT 50 Tax 40% (20) Net income 30 Add back Depreciation 110 Net salvage value 904 Cash Flow (1200) 140 1044

Solution (Contd.) Source Year 0 Year1 Year2 Year3 Year4 Cash Flow (1200) 140 1044 Present Value of Cash Flow 129.6 120.0 111.1 767.4 NPV=-$71.8 Since the NPV is negative, so do not accept the project.

Other methods of capital budgeting Payback Period=3.75 years Discounted Payback= The project does not have a discounted payback period in the project life with 8% cost of equity. IRR=6.03% (Trial & Error method) IRR (Shortcut method) =5%+(8%-5%)/(40.456/40.456+71.83) =6.06% Comment: NPV is negative, IRR is less than ke, DPBP is negative, PBP is inconclusive. So, do not accept the project.

Problem 3a: Sensitivity Analysis A market promotion firm assures that sales of the firm could be doubled every year provided that firm takes care of market expansion. The firm would charge 20% as the sales commission. What would be the effects in capital budgeting?

The statement of cost-benefit Source Year 0 Year 1 Year 2 Year 3 Year 4 Investment (1200) Sales 600 Cost (240) Land Rent (20) Sales Commission (120) Depreciation (110) EBIT 110

Calculation of Cash-Flow Source Year 0 Year 1 Year 2 Year 3 Year 4 EBIT 110 Tax 40% (44) Net income 66 Add back Depreciation Net salvage value 904 Cash Flow (1200) 176 1080

Calculation of NPV & IRR Source Year 0 Year1 Year2 Year3 Year 4 Cash Flow (1200) 176 1080 Present Value of Cash Flow 163 150.9 139.7 793.8 NPV=$47.4 IRR=9.3% The NPV is positive and IRR ke, so accept the project. The offer of the marketing firm should be accepted.

Problem 4 A Gulshan based fast food shop contemplates to introduce a branch at Kamal Ataturk Road. The firm has expended Tk.2 million for the feasibility of the project, and found the project feasible. The initial investment requires Tk.50 million in machineries, Tk.30 million for building and Tk.10 million for permanent working capital. There would be a cost of installation of machineries to an extent of Tk.10 million. The working capital would be required through out the whole life of the 4 year project and expected to be fully recovered at the end. The machine would have a 10 year life and the building would have a 15 year life. It is expected that both the machine and the building would be sold at Tk.25 million each at the end of the project. It has been known that the project would not require any investment for land as the land is already owned by the firm (cost price Tk.50 million) and presently brings a rent of Tk.2 million per year.

Problem 4 (Contd.) The annual sales from the project would be Tk.100 million in the next year and it is expected to increase annually by 10%. The fixed cost is estimated Tk.25 million per year and the variable cost is estimated 25% of the sales for the first 2 years and 30% for the last 2 years. The fixed cost of the project includes the salaries for engineers that can be used for the Gulshan branch saving the branch to an amount of Tk.5 million per year. The marketing department of the firm says that there should be a billboard investment of Tk.1 million per year through out the project to maintain the sales. The Gulshan branch says the sale of the branch would be affected by an extent of Tk.20 million for the first year and Tk.10 million for the second year in consequence of the introduction of the new branch. The corporate tax rate is 40%. Due to the growing nature of fast food shop in and around the location of the project, the cost of equity is estimated to be as high as 20%. You have to evaluate the profitability of the project and comment on that.

Solution: Problem 4 Sources Year 0 Year 1 Year 2 Year 3 Year 4 Total Investment -100   Sales Revenue 100 110 121 133.1 Fixed Costs -25 Variable Costs -27.5 -36.3 -39.9 Depreciation -7 Land -2 Bill board expenses -1 Loss of existing sales -20 -10 Cost saving of engineers 5 Taxable income  -100 25 42.5 54.7 63.17

Solution: Problem 4 (Contd.) 1 2 3 4 Total Taxable income   25 42.5 54.7 63.17 Tax -10 -17 -21.9 -25.3 Net Income 15 25.5 32.8 37.9 Add back depreciation 7 Net Working capital 10 Net salvage value 50.8 Net cash flow -100 22 32.5 39.8 105.7 PV (Cash Flow) Ke=20% 18.3 22.6 23.0 51.0 14.9 PV (Cash Flow) i=25% 17.6 20.8 20.4 43.3 2.1 IRR (Short cut method) 25.80% Since NPV is positive and IRR > ke So the project should be accepted. NPV (Ke=20%) Tk.14.9m

Notes of solution of Problem 4 1. Tk.2 million expended for feasibility is the sunk cost and so excluded.     2. Calculation of Net Salvage Value: Machineries Building Cost Price   50 30   Annual Depreciation   5 2   Accumulated Depreciation   20 8    Book Value at the end of the project 30 22    Market Value   25 25   Profit (loss)   -5 3   Tax Effect (40%)   2 -1.2    Net Salvage Value   27 23.8 3. Total Investment Machineries 50 Building 30 Installation 10 Permanent Working Capital 10 Total 100