1. 1 (of 22) FIN 468: Intermediate Corporate Finance Topic 3–Capital Budgeting Larry Schrenk, Instructor

2. Topics Review of Decision Rules Incremental Cash Flow Analysis Model to Value the Net Cash Flows Investments of Unequal Lives

3. Decision Rules

4. Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR)

5. Criteria for Decision Rules Recognize the time value of money Incorporate all relevant free cash flows Minimize arbitrary assumptions Minimize need for uncertain data Minimize excessive calculation complexity Minimize problems

6. Data For simplicity, we shall use the following cash flows for many of our examples (r = 10%): 01234 -1,000300200400700

7. Payback Period EXAMPLE: 3 Year Payback Period Calculation  300 + 200 + 400 = 900 < 1,000 Result: $900.00 < $1,000.00 Bad Project 01234 -1,000300200400700

8. Discounted Payback Period EXAMPLE (r = 10%): 3 Year Discounted Payback Period Calculation: Result: $738.54 < $1,000.00 Bad Project 01234 -1,000300200400700

9. Net Present Value (NPV) EXAMPLE (r = 10%): NPV Calculation: Result: $216.65 > 0 Good Project 01234 -1,000300200400700

10. Internal Rate of Return (IRR) EXAMPLE (r = 10%): IRR Calculation: Result: 18.1% > 10% Good Project 01234 -1,000300200400700

11. Modified Internal Rate of Return EXAMPLE (r = 10%): Find the MIRR that makes the present value of all cash outflows equal to the present value of the terminal value. Result: 15.53% > 10% Good Project 01234 -1,000300200400700

12. Summary of the Five Rules Ineffective Rules:  Payback Period: Payback period cash flow > investment  Discounted Payback Period: Discounted payback period cash flow > investment Effective Rules  NPV: NPV > 0  IRR: IRR > r  MIRR: MIRR > r

13. Some Additional Issues

14. Comparing NPV, IRR, PI and MIRR Using Decision Rules to Compare or Select among Projects Sign Changes in the Cash Flows and Multiple IRR’s

15. Capital Budgeting 15 (of 22)

16. Topics Two General Principles Factors in Cash Flow Analysis  Fixed versus Variable Costs  Depreciation  Working Capital  Taxes  Interest Payments and Financing Costs  Sunk Costs  Opportunity Costs  Externalities

17. Two General Principles Principle One: Use Increments.  The Incremental Approach to Cash Flow Analysis Principle Two: Use Real Cash Flows.  Real versus Accounting Cash Flows

18. The Incremental Approach The Incremental Approach to Cash Flow Analysis  Incremental: How real cash flows change  Alternate: Averages

19. Comparison Example New Project Costs CostBeforeAfterAverageIncrement Furniture$10,000$12,000 Software $9,000 Insurance $4,000 $6,000

20. Comparison Example Average Approach CostBeforeAfterAverageIncrement Furniture$10,000$12,000 $4,000 Software $9,000 $3,000 Insurance $4,000 $6,000 $2,000

21. Comparison Example Incremental Approach  change in costs, i.e., the increment, associated with the new project: CostBeforeAfterAverageIncrement Furniture$10,000$12,000 $4,000 $2,000 Software $9,000 $3,000 $0 Insurance $4,000 $6,000 $2,000

22. Comparison Example Conclusion: Use the increment CostBeforeAfterAverageIncrement Furniture$10,000$12,000 $4,000 $2,000 Software $9,000 $3,000 $0 Insurance $4,000 $6,000 $2,000

23. Real versus Accounting Values Real: Actual transfers of value at this time; Market values  Money, assets, etc. Accrual Accounting  May not be market values Goodwill, depreciation  May not be current ‘accrued’, ‘payable’ NOTE: Possible ambiguity… Real versus Accounting Real versus Nominal

24. Real versus Accounting Example Payment of $6,000 for insurance over the next three years. AccountingReal

25. Real versus Accounting Example Accrual Accounting Cash Flow  ‘Matching’  Profit AccountingReal $2,000

26. Real versus Accounting Example Real Cash Flow AccountingReal $2,000$6,000 $2,000$0 $2,000$0

27. Real versus Accounting Cash Flows A Complication Non-real cash flow has an effect on a real cash flow.  Incorporate the effect, but not non-real cash flow itself.  Depreciation

28. Factors in Cash Flow Analysis

29. Depreciation Working Capital Taxes Interest Payments and Financing Costs Sunk Costs Opportunity Costs Externalities

30. Depreciation

31. Depreciation not real cash flow! Effects on real cash flow, i.e., taxes  If a firm had no taxable income, then we could ignore depreciation. Incorporate  the tax effect of depreciation  not the depreciation itself.

32. Classes of Expenditures Costs: ‘expensed’  In theory, the value is exhausted during that one period  E.g. Stationary, production materials, etc. Deductible Investments: Over time.  In theory, the value is exhausted over multiple periods.  E.g. Factory equipment, computers, etc. Non-Deductible Investments: Never  In theory, the value is never exhausted  E.g. Land

33. Depreciation Different methods (‘schedules’) and over different lengths of time.

34. MARCS Example Schedule Capital investment $1,000,000 Yearly depreciation is: 123456 $200,000$320,000$192,000$115,200 $57,600 123456 20%32%19.2%11.52% 5.76%

35. For More Depreciation Details… If you actually want to know more…  To dip in your toe: http://www.irs.gov/businesses/small/article/0,,id=137026,00.html  Not for the faint of heart: Publication 946 (2005), How To Depreciate Property http://www.irs.gov/publications/p946/index.html

36. Depreciation Calculation 1. Begin with gross income/EBDIT. 2. Subtract the depreciation to get taxable income/EBIT. 3. Subtract the taxes based on this taxable income to get net income. 4. Add depreciation back to net income to get operating cash flow.

37. Depreciation Example▪ Gross Income/EBDIT$200,000 Less:Depreciation $50,000 Taxable Income/EBIT$150,000 Less:Taxes(  C = 35%) $52,500 Net Income $97,500 Plus:Depreciation $50,000 Real Cash Flow$147,500 ▪

38. Working Capital

39. Metaphorically, the grease that keeps the machine of business going! Production takes place over time.  Materials paid for long before product sold  Money must be available for suppliers, employees, etc.  This investment is ‘working capital’.

40. Working Capital All working capital eventually returned  Working capital as a ‘loan’ to the project  But ‘cost’ to tying up value in working capital Calculations  Increase in working capital → negative CF  Decrease in working capital → positive CF

41. Working Capital Example Initial working capital required $10,000 Working capital must be10% of sales: * Remember that at the end of the project all remaining working capital is recovered―$9,000 = $4,000 released plus $5,000 remaining. Period01234 Sales$0$130,000$150,000$90,000$50,000 WC$10,000$13,000$15,000$9,000$5,000  WC ($10,000)($3,000)($2,000)$6,000$9,000*

42. Taxes, Interest Payments, Sink Costs, etc.

43. Taxes The corporate tax rate is  C. Marginal Tax Rate Negative Earnings Issue

44. Interest/Financing Payments Not included in cash flows Accounted for in the discount rate ‘Double counting’ Contrast income statement

45. Sunk Costs Past expenditures  No value to project  No value as salvage Irrelevant to project the.  Ignore sunk costs Psychological Problem  Behavioral finance

46. Opportunity Costs What you give up Technically: next most valuable use for the asset  The value from selling or renting,  The value for another project,  Nothing,  Etc.

47. Opportunity Costs Using Unoccupied Factory Space  Could be rented out for $10,000/year. Opportunity cost = $10,000/year.  Otherwise unused. Opportunity cost = $0/year. Include all opportunity costs.

48. Externalities Project not independent of the firm. Externalities  Possible interactions with other parts of firm  Positive: Synergies  Negative: Cannibalization Incremental principle  Externality costs must be applied to the new project,

49. Steps in Estimating Cash Flows▪ Get input parameters. Determine investment. Determine operating cash flow. Determine working capital needs. Incorporate after tax salvage value Find annual, net project cash flows. Apply decision criteria. ▪

50. Example: Data Production  Units/year  Costs Fixed = $50,000 (real) Variable = $150.00/unit (nominal) Revenue  Initial Price = $300.00/unit (nominal)  Increase in Price = 2%/year 12345 50,000100,00080,00060,00020,000

51. Example: Data Capital Spending  Investment = $20,000,000 (nominal)  Set Up Costs = $500,000 (nominal, non-depreciable) Opportunity Cost  Factory Capacity = $5,000,000 (nominal) Project Feasibility Study = $2,000,000 (nominal) Salvage Value = $2,000,000 (nominal)

52. Example: Data Nominal Discount Rate = 15% Inflation Rate = 5% Working Capital  Initial = $250,000 (Nominal)  Thereafter = 8% (of sales) Corporate Tax Rate = 38%

53. Example: 1-Input Parameters 1) Parameters Tax Rate38% Fixed Cost$50,000 Variable Cost$150 Initial Price$300 Price Growth2% Salvage Value$2,000,000 Working Capital Rate12% Inflation Rate5% Nominal Discount Rate15% Year0123456 Units sold 50,000100,00080,00060,00020,000 MACRS Depreciation 20.00%32.00%19.20%11.52% 5.76%

54.  Total Investment = $25,500,000  Set-up and opportunity costs are not depreciable.  Opportunity cost is ‘returned’ at project end. Example: 2-Capital Spending 2) Investment012345 Investment($20,000,000) Set Up Costs($500,000) Factory (Opportunity Cost)($5,000,000) $5,000,000 Equals: Capital Spending($25,500,000) $5,000,000

55. Example: 3-Operating CF Year 1 3) Operating Cash FlowCalculation1 Sales revenue= units x price = 50,000 x $300 = $15,000,000 Less: variable costs= units x variable cost = 50,000 x $150 = ($7,500,000) Less: fixed costs = fixed cost =($50,000) Equals: EBDIT = revenue – variable cost – fixed cost =$7,450,000 Less: depreciation= investment x MARCS = $20,000,000 x 20% =($4,000,000) Equals: EBIT= EBDIT – depreciation =$3,450,000 Minus: taxes = tax rate x EBIT = 38% x $3,450,000 =($1,311,000) Equals: net income = EBIT – Taxes =$2,139,000 Plus: depreciation ”$4,000,000 Equals: operating cash flow= net income + depreciation = $6,139,000

56. Example: 3-Operating CF Year 2-5 Changes in Sales Revenue  Production changes  Price increases at 2% per year Changes in Depreciation  Follows MARCS 12345 $300$306$312$318$325

57. Example: 3-Operating CF Year 2-5 Changes in Variable Costs  Production changes Changes in Fixed Cost  Fixed cost are stated in real terms, so inflation needs to be taken into account: 12345 50,00050,000(1.05)50,000(1.05) 2 50,000(1.05) 3 50,000(1.05) 4 ($50,000)($52,500)($55,125)($57,881)($60,775)

58. Example: 3-Operating CF Year 2-5 3) Operating Cash Flow 0 12345 Sales revenue $15,000,000$30,600,000$24,969,600$19,101,744$6,494,593 Less: variable costs ($7,500,000)($15,000,000)($12,000,000)($9,000,000)($3,000,000) Less: fixed costs ($50,000)($52,500)($55,125)($57,881)($60,775) Equals: EBDIT $7,450,000$15,547,500$12,914,475$10,043,863$3,433,818 Less: depreciation ($4,000,000)($6,400,000)($3,840,000)($2,304,000) Equals: EBIT $3,450,000$9,147,500$9,074,475$7,739,863$1,129,818 Minus: taxes ($1,311,000)($3,476,050)($3,448,301)($2,941,148)($429,331) Equals: net income $2,139,000$5,671,450$5,626,175$4,798,715$700,487 Plus: depreciation $4,000,000$6,400,000$3,840,000$2,304,000 Equals: operating cash flow $6,139,000$12,071,450$9,466,175$7,102,715$3,004,487

59.  Initial Working Capital = ($250,000)  Change in Working Capital = -(New WC Requirement – Old WC Requirement) Year 1: -($1,200,000 - $250,000) = ($950,000) Year 3: -($1,997,568 - $2,448,000) = $450,532  In final year all working capital is returned. Example: 4-Working Capital 4) Working Capital012345 NWC requirement$250,000$1,200,000$2,448,000$1,997,568$1,528,140 Liquidation of WC $1,528,140 Change in WC($250,000)($950,000)($1,248,000)$450,432$469,428$1,528,140

60. Example: 5-Salvage Value  Remaining Book Value $20,000,000 x 5.76% = $1,152,000  Undepreciated Salvage Value $2,000,000 - $1,152,000 = $848,000  Tax on Undepreciated Salvage Value $848,000 x 38% = $322,240  After Tax Salvage Value $2,000,000 - $322,240 = $1,677,760 Salvage value$2,000,000 Minus: tax on salvage value($322,240) Equals: after tax salvage value$1,677,760

61. Example: 6-Net Project Cash Flows  Annual, net project cash flows are sum of operating cash flows, changes in working capital, salvage value and change in capital spending. 6) Net Project Cash Flows012345 Operating cash flow$0$6,139,000$12,071,450$9,466,175$7,102,715$3,004,487 change in NWC($250,000)($950,000)($1,248,000)$450,432$469,428$1,528,140 after tax salvage value$0 $1,677,760 change capital spend($25,500,000)$0 $5,000,000 Project Cash Flows:($25,750,000)$5,189,000$10,823,450$9,916,607$7,572,143$11,210,386

62. Example: 7-Decision Criteria 7) Decision Criteria Net Present Value$3,369,528 Internal Rate of Return19.98%

63. Complete Example You cannot read this–but you can paste it into a word document and expand it!

64. Other Methods for Computing OCF Bottom-Up Approach  Works only when there is no interest expense  OCF = NI + depreciation Top-Down Approach  OCF = Sales – Costs – Taxes  Don’t subtract non-cash deductions Tax Shield Approach  OCF = (Sales – Costs)(1 – T) + (Depreciation * T) NOTE: Cautions about ‘Formulae’ Approach

65. Investments of Unequal Lives

66. Air cleaner is mandated by law. Two choices: Assuming a 10% discount rate, which one should we choose? ModelCadillac CleanerCheapskate Cleaner Price $4,000$1,000 Annual Cost$100$500 Life10 years5 years

67. Investments of Unequal Lives Replacement Chain  Repeat projects until they begin and end at the same time.  Compute NPV for the “repeated projects.” The Equivalent Annual Cost Method

68. Replacement Chain Approach The Cadillac cleaner time line of cash flows: -$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100 0 1 2 3 4 5 6 7 8 9 10 -$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500 0 1 2 3 4 5 6 7 8 9 10 The Cheapskate cleaner time line of cash flows over ten years:

69. Equivalent Annual Cost (EAC) Greater Applicability The EAC is the value of the level payment annuity that has the same PV as our original set of cash flows. EAC like Average Annual Cost to Operate

70. Equivalent Annual Cost (EAC) Cadillac Air Cleaner 1) Find PV of Annual Cost P/Y = 1; N = 10; I/Y = 10; PMT = -100; FV = 0 → PV = $614.47 2) Add Price $4,000.00 + 614.47 = $4,614.47 3) Find EAC P/Y = 1; N = 10; I/Y = 10; PMT = - 4,614.47; FV = 0 → PMT = $750.98 = EAC Problem: Cheapskate Air Cleaner flows.