Capital Budgeting: Tools and Techniques On Corporate Finance and Corporate Government Sector Maria Ella T. Betos MAE 630: Managerial Economics

Discussion Proper:  Overview and Process of Capital Budgeting Decisions  Projected Cashflows – Cost of Investment Computation  Payback Period and Discounted Payback Period  Accounting Rate of Return  Profitability Index – Benefit-Cost Analysis  Net Present Value  Internal Rate of Return  Sample Problems and Cases

Overview of Capital Budgeting, its Decisions and Process  Capital Budgeting – process of identifying, evaluating, and implementing a firm’s investment opportunities  The process of making long-term planning decisions for investments (Investment Decisions – Selection decisions concerning projects and Replacement Decision)  The profitability of a firm is affected to the greatest extent by the success of its management in making capital budget investment decisions  A fixed-asset decision will be sound only if it produces a stream of future cash inflows that earns the firm an acceptable rate of return on its invested capital.

Overview of Capital Budgeting, its Decisions and Process  Capital budgeting decisions involve mutually exclusive or independent projects.  Mutually exclusive projects - two or more machines that perform the same function may be available from competing suppliers, possibly at different costs and with different expected cash benefits  Independent projects - Project not in direct competition with one another - They are to be evaluated based on their expected effect on shareholder wealth

Overview of Capital Budgeting, its Decisions and Process Capital Budgeting Processes:  Identification stage – involves finding potential capital investment opportunities and identifying whether a project involves a replacement decision and/or revenue expansion  Development stage – requires estimating relevant cash inflows and outflows  Selection stage – involves applying the appropriate capital budgeting techniques to help make a final accept or reject decision  Implementation stage – projects that are accepted must be executed in a timely fashion  Follow-up – a stage in the capital budgeting process during which managers track, review, or audit a project’s results.

Major Categories of Cash Flows  Initial cash outflow -- the initial net cash investment.  Operating cash flows -- those net cash flows occurring after the initial cash investment but not including the final period’s cash flow. Projected Cash Flows Computation

Initial Cash Outflow a) Cost of “new” assets b)+ Capitalized expenditures c)+ (-) Increased (decreased) NWC d)- Net proceeds from sale of “old” asset(s) if replacement e)+ (-) Taxes (savings) due to the sale of “old” asset(s) if replacement f)= Initial cash outflow

Operating Cash Flows a) Operating Revenue b)(- )Operating Expense c)(-) Increase in net working capital d)(-) Depreciation e) = Taxable Income f)(-) Income Taxes g)(=) Net Income h)(+) Depreciation i)(=) Operating Cash Flow

Example for Initial Cash Outflow Computation Basket Wonders (BW) is considering the purchase of a new basket weaving machine. The machine will cost $50,000 plus $20,000 for shipping and installation and has 3-year useful life. NWC will rise by $5,000. Management forecasts indicates that revenues will increase by $110,000 for each of the next 4 years and will then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends. Operating costs will rise by $70,000 for each of the next four years. BW is in the 40% tax bracket.

Initial Cash Outflow a) $50,000 b)+ 20,000 c)+ 5,000 d)- 0 (not a replacement) e)+ (-) 0 (not a replacement) f)= $75,000* * Note that we have calculated this value as a “positive” because it is a cash OUTFLOW (negative).

We plan on purchasing a new assembly machine for $25,000.. It will cost $2,000 to have the new machine installed and we expect a $ 1,000 net increase in working capital. By making the investment, we will reduce our annual operating costs by $ 7,000 and we expect to save $ 500 a year in maintenance. The new machine will require $ 750 each year for technical support. We will depreciate the machine over 5 years under the straight-line method of depreciation with an expected salvage value of $ 5,000. The effective tax rate is 35%. Example for Operating Cash flow

Operating Cash Flows a)Annual Savings in Operating Costs $ 7,000 b)Annual Savings in Maintenance 500 c)Annual Costs for Technical Support (750) d)Annual Depreciation (4,000) * e)Revenues $ 2,750 35% (962) g)Net Project Income 1,788 h)Add Back Depreciation 4,000 i)Operating Cash Flow $ 5,788 * $ 25,000 - $ 5,000 / 5 years = $ 4,000

 It refers to the length of time the firm can recover its initial investment in a project.  The management will choose the projects whose paybacks are less than a management-specific period.  Payback period is computed by dividing the initial investment by the cash inflows in the case of annuity; for a mixed stream, the yearly cash inflows must be accumulated until the initial investment is covered. Payback Period

PAYBACK PERIOD = INITIAL INVESTMENT ANNUAL CASH INFLOW Payback Period

EXAMPLE : Calculate the firm’s payback period assuming their initial investments and operating cash inflows are as follows: Payback Period Initial Investment Year Php150, 000 Project X Cash Inflows 1Php40,

PAYBACK PERIOD FOR Project X PP = Initial Investment Cash Inflows = 150,000 40,000 = 3.75 years of 3 years and 270 days Payback Period

EXAMPLE : Calculate the firm’s payback period assuming their initial investments and operating cash inflows are as follows: Payback Period Initial Investment Year Php200, 000 Project Y Cash Inflows 1Php40,000 2Php45,000 3Php50,000 4Php55,000 5Php60,000

PAYBACK PERIOD FOR Project Y Payback Period Initial Investment Year Cost of Investment Net Annual Cash Flow Cumulative Net Cash Flow 0Php200,000 1Php40,000 2Php45,000Php85,000 3Php50,000Php135,000 4Php55,000Php190,000 5Php60,000Php250,000

PAYBACK PERIOD FOR Project Y 190,000 (cash inflows for 4 years) + 10,000/60,000 X 360 = 60 days PBP = 4 years and 60 days Payback Period

 Payback Period does not consider time value of money when providing an answer whereas with Discounted Payback Period we get to see the real value of cash inflows when they are measured in today's amount of money as these are discounted at an interest rate called the Discount Rate  Discounted Payback Period is computed as follows: Discounted Payback Period Discounted PP = year before recovery + Unrecovered cost at the start of the year Initial cash flows during the year

EXAMPLE :  For example, assume a machine purchased for $5000 yields cash inflows of $5000, $4000, and $4000. The cost of capital is 10%. Discounted Payback Period YearCash Inflows PV Factor at 10% PV of Cash Inflow 1Php5, Php4,545 2Php4, Php3,304 3Php4, Php3,004

SOLUTION:  The payback period (without discounting the future cash flows) is exactly 1 year. However, the discounted payback period is a little over 1 year because the first year discounted cash flow of $4545 is not enough to cover the initial investment of $5000.  The discounted payback period is 1.14 years (1 year + ($ $4545)/$3304 = 1 year +.14 year). Discounted Payback Period

 Accounting Rate of Return calculates the return, generated from net income of the proposed capital investment  This doesn’t take into account the time value of money  If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Accounting Rate of Return

 The ARR is computed as follows:  DECISION CRITERIA: ARR > COI= ACCEPT THE PROJECT ARR < COI = REJECT THE PROJECT Accounting Rate of Return ARR = Annual Cash Inflows - Depreciation Average Investment

 EXAMPLE: Let's say you're looking at equipment costing $7,500 that is expected to return roughly Php2,000 per year for five years. After five years you'll sell the equipment for Php500. The depreciation would be (Php7,500 - $500) ÷ 5, or Php1,400. Accounting Rate of Return ARR = Php2,000 – 1400 = 8% Php7,500

 Also known as benefit-cost ratio, desirability index  It expresses the present value of cash benefits as to an amount per peso of investment in a project  It is also used as a measure of ranking projects in descending order of desirability  The formula is as follows: Profitability Index Profitability Index = Present Value of Net Cash Flows Initial Investment

 DECISION RULE: The higher the profitability index, the more desirable the project. Projects with index of less than 1 are rejected. Thus: If PI > 1; ACCEPT If PI < 1; REJECT Profitability Index

 ILLUSTRATION Company XYZ has Php 200,000 funds available for investment. It is considering the following projects: Profitability Index AB PV of annual Cash inflows Php244,000Php130,000 Less Investment Required Php200,000Php100,000 Net PVPhp44,000Php30,000

 COMPUTATION Project A: Php 244,000 / 200,000 = 1.22 Project B: 130,000 / 100,000 = 1.30  DECISION – The company should invest in Project B since it has higher profitability index than Project A Profitability Index

 Net Present Value (NPV) is a sophisticated capital budgeting technique because it gives explicit consideration to the time value of money.  It is computed as: NPV = PV of Cash Inflows – Initial Investment NPV= ∑CF t – CF 0 (1+r) t Net Present Value

 The Decision Criteria If the NPV is greater than 0, accept the project If the NPV is less than 0, reject the project  If the NPV is greater than 0, the firm will earn a return greater than its cost of capital. Such action should enhance the market value of the firm and therefore the wealth of its owners. Net Present Value

 ILLUSTRATION: Marga Company, a medium sized metal fabricator is currently contemplating two projects. Project A requires an initial investment of 42,000 and Project B an initial investment of 45,000. The projected relevant operating cash inflows for the two projects are as follows: Net Present Value

Project AProject B Initial Investment Php42,000Php45,000 YearOperating Cash Inflows (PV Factor at 10%) 1Php14,000Php28,000 2Php14,000Php12,000 3Php14,000Php10,000 4Php14,000Php10,000 5Php14,000Php10,000 Net Present Value

Project AProject B Total Cash Inflows Php70, 000 PV of Inflows at 10% Php14,000 x = Php53, 071 (Php28,000 x 0.909)+ (Php12,000 x 0.826)+ (Php10,000 x 0.751)+ (Php10,000 x 0.683)+ (Php10,000 x 0.621) = Php55,924 Initial Investment Php42,000Php45,000 Net Present Value Php11,071Php10,924 Net Present Value

 The calculations results in net present value for projects A and B of 11,071 and 10,924, respectively.  Both projects are acceptable because the net present value of each is greater than 0. If the projects were being ranked, however, project A would be considered superior to B, because it has a higher net present value than that of B. Net Present Value

 The internal rate of return method differs from the Net Present Value method in that it finds the interest yield of the potential investment  Sometimes known as the Economic Rate of Return  The internal rate of return is the discount rate that makes the net present value of all cash flows from a particular project equal to zero Internal Rate of Return

 FORMULA: Internal Rate of Return IRR= Lower Rate + NPV at lower rate x (Higher rate – Lower rate) NPV at lower rate – NPV at higher rate Initial Cost of Investment = CF1 + CF2 + CF3 + CFn (1+irr) 1 (1+irr) 2 (1+irr) 3 (1+irr) n PV factor at the number of periods at IRR = Initial Cost of Investment Equal Cash Inflows

 EXAMPLE: A company is considering to purchase an equipment at a cost of Php244,371. Net annual cash flows for this equipment is estimated to be Php100, 000 for three years. To determine for the IRR, look for the PV factor first: *the factor of is the PV factor of annuity of 1 at 11% Internal Rate of Return PV factor at the number of periods at IRR = Php244,371 = Php100,000

 EXAMPLE: Ella Company, is currently contemplating on a project. Project A requires an initial investment of Php52,000. The projected relevant operating cash inflows for the term of five years is equal to Php What is the internal rate of return? Internal Rate of Return

 Using the rate of 10%, the PV factor of annuity of 1 is ; whereas using the rate of 11%, the PV factor of annuity of 1 is  The NPV at 10% is equal to Php1, while the NPV at 11% is (Php257.44). To interpolate for the IRR: Internal Rate of Return RateNPV 11%(Php257.44) IRR0 10%Php1,071

Internal Rate of Return  SOLUTION: IRR= Lower Rate + NPV at lower rate x (Higher rate – Lower rate) NPV at lower rate – NPV at higher rate IRR= 10% + 1, x (11% – 10%) (1, – (257.44)) IRR= 10% + 1, x 1%=10% % x 1 = 10.81%

 Official Development Assistance - Assistance being provided or granted by a foreign government/multilateral agency, which is usually a developed country, to another nation, which is categorized as a developing country. Corporate Finance and Corporate Government Sector

 KEY TERMS: Profitability – ability to gain Sustainability – ability to stand on the long term Serviceability – ability to “service” the benefits to the end-users Corporate Finance and Corporate Government Sector