1 Capital Budgeting Capital budgeting - A process of evaluating and planning expenditure on assets that will provide future cash flow(s).

2 Payback period The number of years required to recover a project’s cost, or how long does it take to recover the investment? Pros: Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Cons: Ignores the TVM. Ignores CFs occurring after the payback period.

3 Net Present Value Sum of the PVs of inflows and outflows CF t Period t Cash Flow, positive for inflows, negative for outflows. r discount rate

4 NPV= PV Inflows – PV Outflows (Cost) = Net gain in wealth. Accept project if NPV > 0 Reject project if NPV < 0 Choose between mutually exclusive projects on basis of higher NPV. Adds most value. NPV Decision rule.

5 IRR:Internal rate of Return IRR is the discount rate that forces PV inflows = PC outflow. This is the same as forcing NPV = 0. IRR is the rate that solve the equation.

6 IRR Decision Rule r Discount rate If IRR > r, accept project. If IRR < r, reject project. Consistent with NPV If IRR > r  NPV >0

7 NPV vs IRR 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.

8 NPV vs IRR For mutually exclusive projects, IRR does not consider project scale. Multiple outflow periods lead to multiple IRR.

9 Project Cash Flow Consider only incremental cash flows. Disregard sunken cost (sunken cost has no impact on future cash flows: it is irrelevant to shareholders) Opportunity cost of resources as project cost. Consider effect on other projects (externalities). Beware of inflation.

10 Depreciation and Cash Flows It is important to remember that when making financial decisions only timed 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

11 Proposed Project A Capital equipment initial cost $240,000, all depreciable. Economic life = 4 years Salvage value = 25,000 Depreciable using 3 year class MACRS. Sales: 100,000 $2. Variable cost = 60% of sales. Tax rate = 40%. Discount rate = 10%.

12 Proposed Project A

13 Working Capital & Cash Flows Some cash flows do not occur on the income statement, but involve timing –working capital additions and reductions are cash flows –at the end of a project, the sum of the nominal changes in working capital is zero

14 Proposed Project A.1 Working Capital – The difference between current assets and current liabilities. In capital budgeting Working capital is committed to the project and is fully recovered by the end of the project. Project requires $50,000 working capital in the initial year. The working capital is recovered when the project is terminated.

15 Proposed Project A.1

16 Inflation and Capital Budgeting Assume annual inflation (π ) rate affect all project cash flow. We can: –Use nominal rate to discount nominal cash flows –Use real rate to discount real cash flow.

17 Proposed Project A.2 Assume Project A faces inflation π = 5% Inflate cash flow by inflation rate (after period 1).

18 Proposed Project A.2

19 Sensitivity Analysis Will the project still be economical if some of the underlying variables are incorrect? –We can check the effect on the project of different variable and how sensitive is the project NPV to them –For Example: Sales Units Sales Price Variable Cost Life of the Project

20 Sensitivity Analysis Project A, with $10,000 sales increments. NPV Breakeven occurs at $187,985