Chapter 17 Capital Budgeting Analysis © 2000 John Wiley & Sons, Inc.

2 Chapter Outcomes n Explain how the capital budgeting process should be related to a firm’s mission and strategies. n Identify and describe the five steps in the capital budgeting process. n Identify and describe the methods or techniques used to make proper capital budgeting decisions.

3 Chapter Outcomes, continued n Explain how relevant cash flows are determined for capital budgeting decision purposes. n Describe the importance of determining the correct base case from which to estimate project cash flows. n Discuss how a project’s risk can be incorporated into capital budgeting analysis.

4 Capital Budgeting Projects n Seek investment opportunities to enhance a firm’s competitive advantage and increase shareholder wealth –Typically long-term projects –Should be evaluated by time value of money techniques –Large investment n Mutually exclusive versus independent

5 Capital Budgeting Process n Identification n Development n Selection n Implementation n Follow-up

6 Data Needs n Economic and Political Data n Financial Data n Non-Financial Data

7 Capital Budgeting Techniques n Net Present Value n NPV = Present value of all cash flows minus cost of project

8 Cash Flow Data YEARPROJECT APROJECT B 15,800 4,000 25,800 4,000 35,800 8,000 45,80010,000 55,80010,000

9 NPV of Project A CASH10% PRESENT YRFLOW xPVIF = VALUE 0 –$20, –$20, , , , , , , , , , ,602 Net Present Value =$ 1,982

10 NPV of Project B CASH10% PRESENT YRFLOW xPVIF = VALUE 0 -$25, $25, , , , , , , , , , ,210 Net Present Value = $ 988

11 What Does the NPV Represent? n NPV represents the dollar gain in shareholder wealth from undertaking the project n If NPV > 0, do the project as shareholder wealth rises n If NPV <0, do not undertake; it reduces shareholder wealth

12 Internal Rate of Return It is the discount rate that causes NPV to equal zero N NPV =  [CF t / (1 + IRR) t ] – Inv = 0 t = 1

13 Solution Methods n Compute the IRR by: –Trial and error –Financial calculator –Spreadsheet software n Accept the project if IRR > minimum required return on the project

14 What Does the IRR Measure? IRR measures the return earned on funds that remain internally invested in the project

15 Profitability Ratio (Benefit/Cost Ratio) n Profitability Index = Present value of cash flows/initial cost n Accept project if PI > 1.0 n Reject project if PI < 1.0 n Interpretation: Measures the present value of dollars received per dollar invested in the project

16 Relationships n NPV, IRR, PI will always agree on the Accept/Reject decision n If one indicates we should accept the project, they will all indicate “accept” n NPV > 0  IRR>minimum required return  PI > 1

17 Reject Decision, too n If one indicates we should reject the project, they will all indicate “reject” n NPV < 0  IRR < minimum required return  PI < 1

18 A popular, but flawed, measure... n Payback period = number of years until the cash flows from a project equal the project’s cost n Accept project is payback period is less than a maximum desired time period

19 Payback’s Drawbacks n Ignores time value of money n Any relationship between the payback, the decision rule, and shareholder wealth maximization is purely coincidental! n It ignores the cash flows beyond the payback period

20 Estimating Project Cash Flows n Important : n Stand-alone principle n Incremental after-tax cash flows from the base case n Cannibalization or enhancement effects n Opportunity costs

21 Ignore…. n Sunk costs n Financing costs

22 Up-front or “time zero” investment Investment = cost + transportation, delivery, and installation charges

23 Cash-Based Income Statement Cash revenues$12,000 Cash operating expenses –5,600 Cash earnings before depreciation 6,400 Depreciation –4,000 Cash earnings before taxes 2,400 Income taxes (25%) –600 Cash earnings after taxes$ 1,800

24 Periodic after-tax cash flows n Cash revenues - cash expenses - tax = $12, , = $5,800 n Cash earnings after tax+Depreciation = $1, ,000 = $5,800 n (Cash revenues-cash expenses) (1-T) + T (Depreciation expense) = ($12,000-5,600)(1-.25) + (.25)($4,000) = $5,800

25 Risk-related Considerations n Expected return/risk tradeoff n Higher (lower) than average risk projects should have a higher (lower) than average discount rate

26 Cost of Capital n Required return on average risk project = firm’s cost of capital, or cost of financing n For average risk projects, use this number as the discount rate (NPV, PI) or the minimum required rate of return (IRR)

27 Risk-adjusted Discount Rate Adjust the project’s discount rate up or down from the firm’s cost of capital for projects of above-average or below-average risk

28 An Example Below-average risk: Discount rate = cost of capital –2% Average risk: Discount rate = cost of capital Above-average risk: Discount rate = cost of capital + 2% High risk: Discount rate = cost of capital + 5%

29 Learning Extension 17A: Strategic Analysis and Cash Flow Estimation Strategic analysis, marketing analysis, and financial analysis should agree on the accept/reject decision of a project

30 Common Problem Areas n Determining the correct base case n Overvaluing a strategy n Define project boundaries at the corporate level

31 Depreciation and Project Cash Flows n Straight-line depreciation n MACRS--accelerated depreciation

32 Depreciation Classes 3-year class 5-year class 7-year class 10-year class 27.5-year class 31.5-year class Designated tools and equipment used in research Cars, trucks, and some office equipment such as computers and copiers Other office equipment and industrial machinery Other long-lived equipment Residential real estate Commercial and industrial real estate

33 Some MACRS Percentages Asset class Year3-year5-year7-year %20.00%14.29%

34 An example first year’s second year’s third year final year’s For an asset in the three-year class that originally cost $50,000, the first year’s depreciation is $50,000 x = $16,665; the second year’s depreciation is $50,000 x = $22,225; for the third year, depreciation will be $50,000 x = $7,410; the final year’s depreciation expense will be $50,000 x = $3,700.