2. 8-2 Capital Budgeting Analysis of potential projects Long-term decisions Large expenditures Difficult/impossible to reverse Determines firm’s strategic direction Keep in mind: VALUE CREATION

3. 8-3 Required Replacement Expansion Diversification Capital Investment Process IdentificationEvaluationSelection Implementation and follow-up Riskier & Difficult Type of Investment

4. 8-4 Net Present Value How much value is created from undertaking an investment? Step 1: Estimate the expected future cash flows. Step 2: Estimate the required return for projects of this risk level. (Also called opportunity cost). Step 3: Find the present value of the cash flows and subtract the initial investment to arrive at the Net Present Value.

5. 8-5 Net Present Value Sum of the PVs of all cash flows Initial cost often is CF 0 and is an outflow. NPV = ∑ n t = 0 CF t (1 + R) t NPV = ∑ n t = 1 CF t (1 + R) t - CF 0 NOTE: t=0

6. 8-6 NPV – Decision Rule If NPV is positive, accept the project NPV > 0 means: –Project is expected to add value to the firm –Will increase the wealth of the owners NPV is a direct measure of how well this project will meet the goal of increasing shareholder wealth.

7. 8-7 Sample Project Data You are looking at a new project and have estimated the following cash flows, net income and book value data: –Year 0:CF = -165,000 –Year 1:CF = 63,120 NI = 13,620 –Year 2:CF = 70,800 NI = 3,300 –Year 3:CF = 91,080 NI = 29,100 –Average book value = $72,000 Your required return for assets of this risk is 12%. This project will be the example for all problem exhibits in this chapter.

8. 8-8 Computing NPV for the Project Using the formula: NPV = -165,000/(1.12) 0 + 63,120/(1.12) 1 + 70,800/(1.12) 2 + 91,080/(1.12) 3 = 12,627.41

9. 8-9 DisplayYou Enter C00165000 C0163120 F01 1 C0270800 F021 C0391080 F031 I12 NPV 12,627.41 Cash Flows: CF0= -165000 CF1= 63120 CF2= 70800 CF3= 91080 Computing NPV for the Project Using the TI BAII+ CF Worksheet

10. 8-10 Calculating NPVs with Excel NPV function: =NPV(rate,CF01:CFnn) –First parameter = required return entered as a decimal (5% =.05) –Second parameter = range of cash flows beginning with year 1 After computing NPV, subtract the initial investment (CF0)

11. 8-11 Net Present Value Sum of the PVs of all cash flows. << CALCULATOR << EXCEL

12. 8-12 Rationale for the NPV Method NPV = PV inflows – Cost NPV=0 → Project’s inflows are “exactly sufficient to repay the invested capital and provide the required rate of return” NPV = net gain in shareholder wealth Rule: Accept project if NPV > 0

13. 8-13 NPV Method –Meets all desirable criteria Considers all CFs Considers TVM Adjusts for risk Can rank mutually exclusive projects –Directly related to increase in V F –Dominant method; always prevails

14. 8-14 Payback Period How long does it take to recover the initial cost of a project? Computation –Estimate the cash flows –Subtract the future cash flows from the initial cost until initial investment is recovered –A “break-even” type measure Decision Rule – Accept if the payback period is less than some preset limit

15. 8-15 Computing Payback for the Project Do we accept or reject the project?

16. 8-16 Advantages and Disadvantages of Payback Advantages –Easy to understand –Adjusts for uncertainty of later cash flows –Biased towards liquidity Disadvantages –Ignores the time value of money –Requires an arbitrary cutoff point –Ignores cash flows beyond the cutoff date –Biased against long- term projects, such as research and development, and new projects ASKS THE WRONG QUESTION !

17. 8-17 Internal Rate of Return Most important alternative to NPV Widely used in practice Intuitively appealing Based entirely on the estimated cash flows Independent of interest rates

18. 8-18 IRR Definition and Decision Rule Definition: –IRR = discount rate that makes the NPV = 0 Decision Rule: –Accept the project if the IRR is greater than the required return

19. 8-19 NPV vs. IRR IRR: Enter NPV = 0, solve for IRR. NPV: Enter r, solve for NPV

20. 8-20 Computing IRR For The Project Without a financial calculator or Excel, this becomes a trial-and-error process. Calculator –Enter the cash flows as for NPV –Press IRR and then CPT –IRR = 16.13% > 12% required return Do we accept or reject the project?

21. 8-21 DisplayYou Enter C00165000 C0163120 F01 1 C0270800 F021 C0391080 F031 IRR 16.1322 Cash Flows: CF0= -165000 CF1= 63120 CF2= 70800 CF3= 91080 Computing IRR for the Project Using the TI BAII+ CF Worksheet

22. 8-22 Calculating IRR with Excel Start with the cash flows as you did to solve for NPV Use the IRR function –Enter the range of cash flows, beginning with the initial cash flow (Cash flow 0) –You can enter a guess, but it is not necessary –The default format is a whole percent

23. 8-23 Calculating IRR with Excel

24. 8-24 NPV Profile For The Project IRR = 16.13%

25. 8-25 IRR - Advantages Preferred by executives –Intuitively appealing –Easy to communicate the value of a project If the IRR is high enough, may not need to estimate a required return Considers all cash flows Considers time value of money

26. 8-26 IRR - Disadvantages Can produce multiple answers Cannot rank mutually exclusive projects Reinvestment assumption flawed

27. 8-27 Summary of Decisions for the Project Net Present Value Payback Period ??? Internal Rate of Return

28. 8-28 NPV vs. IRR NPV and IRR will generally give the same decision Exceptions –Non-conventional cash flows Cash flow sign changes more than once –Mutually exclusive projects Initial investments are substantially different Timing of cash flows is substantially different Will not reliably rank projects

29. 8-29 IRR & Non-Conventional Cash Flows “Non-conventional” –Cash flows change sign more than once –Most common: Initial cost (negative CF) A stream of positive CFs Negative cash flow to close project. For example, nuclear power plant or strip mine. –More than one IRR …. –Which one do you use to make your decision?

30. 8-30 Multiple IRRs Descartes Rule of Signs Polynomial of degree n → n roots –When you solve for IRR you are solving for the root of an equation –1 real root per sign change –Rest = imaginary (i 2 = -1)

31. 8-31 Non-Conventional Cash Flows Suppose an investment will cost $90,000 initially and will generate the following cash flows: –Year 1: 132,000 –Year 2: 100,000 –Year 3: -150,000 The required return is 15%. Should we accept or reject the project?

32. 8-32 Non-Conventional Cash Flows Summary of Decision Rules NPV > 0 at 15% required return, so you should Accept IRR =10.11% (using a financial calculator), which would tell you to Reject Recognize the non-conventional cash flows and look at the NPV profile

33. 8-33 NPV Profile IRR = 10.11% and 42.66% When you cross the x-axis more than once, there will be more than one return that solves the equation

34. 8-34 Independent versus Mutually Exclusive Projects Independent –The cash flows of one project are unaffected by the acceptance of the other. Mutually Exclusive –The acceptance of one project precludes accepting the other.

35. 8-35 Reinvestment Rate Assumption IRR assumes reinvestment at IRR NPV assumes reinvestment at the firm’s weighted average cost of capital (opportunity cost of capital) –More realistic –NPV method is best NPV should be used to choose between mutually exclusive projects

36. 8-36 Example of Mutually Exclusive Projects PeriodProject AProject B 0-500-400 1325 2 200 IRR19.43%22.17% NPV64.0560.74 The required return for both projects is 10%. Which project should you accept and why?

37. 8-37 NPV Profiles IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8%

38. 8-38 Two Reasons NPV Profiles Cross Size (scale) differences. –Smaller project frees up funds sooner for investment. –The higher the opportunity cost, the more valuable these funds, so high discount rate favors small projects. Timing differences. –Project with faster payback provides more CF in early years for reinvestment. –If discount rate is high, early CF especially good

39. 8-39 Conflicts Between NPV and IRR NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, always use NPV IRR is unreliable in the following situations: –Non-conventional cash flows –Mutually exclusive projects

40. 8-40 Profitability Index Measures the benefit per unit cost, based on the time value of money –A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value Can be very useful in situations of capital rationing Decision Rule: If PI > 1.0  Accept

41. 8-41 Profitability Index For conventional CF Projects: PV(Cash Inflows) Absolute Value of Initial Investment

42. 8-42 Advantages and Disadvantages of Profitability Index Advantages –Closely related to NPV, generally leading to identical decisions Considers all CFs Considers TVM –Easy to understand and communicate –Useful in capital rationing Disadvantages –May lead to incorrect decisions in comparisons of mutually exclusive investments (can conflict with NPV)

43. 8-43 Profitability Index Example of Conflict with NPV

44. 8-44 Capital Budgeting In Practice Consider all investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is a commonly used secondary investment criteria All provide valuable information

45. 8-45 Summary Calculate ALL -- each has value MethodWhat it measures Metric NPV  $ increase in VF $$ Payback  Liquidity Years IRR  E(R), risk % PI  If rationed Ratio

46. 9-46 Evaluating Projects Steps in Evaluation: –Determine the relevant cash flows for a proposed investment –Analyze the project’s projected cash flows –Calculate and interpret estimated NPV

47. 9-47 Relevant Cash Flows Include only cash flows that will only occur if the project is accepted Incremental cash flows The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

48. 9-48 Re levant Cash Flows: Incremental Cash Flow for a Project Corporate cash flow with the project Minus Corporate cash flow without the project

49. 9-49 Relevant Cash Flows “Sunk” Costs ………………………… N Opportunity Costs …………………... Y Side Effects/Erosion……..…………… Y Net Working Capital………………….. Y Financing Costs….………..…………. N Tax Effects ………………………..….. Y

50. 9-50 Pro Forma Statements and Cash Flow Pro Forma Financial Statements –Projects future operations Operating Cash Flow: OCF = EBIT + Depr – Taxes OCF = NI + Depr if no interest expense Cash Flow From Assets: CFFA = OCF – NCS –ΔNWC NCS = Net capital spending

51. 9-51 Shark Attractant Project Estimated sales50,000 cans Sales Price per can$4.00 Cost per can$2.50 Estimated life3 years Fixed costs$12,000/year Initial equipment cost$90,000 –100% depreciated over 3 year life Investment in NWC$20,000 Tax rate34% Cost of capital20%

52. 9-52 Pro Forma Income Statement Table 9.1 Sales (50,000 units at $4.00/unit)$200,00 0 Variable Costs ($2.50/unit)125,000 Gross profit$ 75,000 Fixed costs12,000 Depreciation ($90,000 / 3)30,000 EBIT$ 33,000 Taxes (34%)11,220 Net Income$ 21,780

53. 9-53 Projected Capital Requirements Table 9.2 Year 0123 NWC$20,000 Net Fixed Assets 90,000 60,000 30,000 0 Total Investment $110,000$80,000$50,000$20,000 NFA declines by the amount of depreciation each year Investment = book or accounting value, not market value

54. 9-54 Projected Total Cash Flows Table 9.5 Year 0123 OCF$51,780  NWC -$20,00020,000 Capital Spending -$90,000 CFFA-$110,00$51,780 $71,780 Note:Investment in NWC is recovered in final year Equipment cost is a cash outflow in year 0

55. 9-55 Shark Attractant Project OCF = EBIT + Depreciation – Taxes OCF = Net Income + Depreciation (if no interest)

56. 9-56 DisplayYou Enter ‘ ' C00110000 S!# C0151780 !# F01 2 !# C0271780 !# F021 !#( I20 !# NPV % 10647.69 ) % 25.76 Cash Flows: CF0= -110000 CF1= 51780 CF2= 51780 CF3= 71780 Computing NPV for the Project Using the TI BAII+ CF Worksheet

57. 9-57 Making The Decision Should we accept or reject the project?

58. 9-58 The Tax Shield Approach to OCF OCF = (Sales – costs)(1 – T) + Deprec*T OCF=(200,000-137,000) x 66% + (30,000 x.34) OCF = 51,780 Particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield –i.e., choosing between two different machines

59. 9-59 Changes in NWC GAAP requirements: –Sales recorded when made, not when cash is received Cash in = Sales - ΔAR –Cost of goods sold recorded when the corresponding sales are made, whether suppliers paid yet or not Cash out = COGS - ΔAP Buy inventory/materials to support sales before any cash collected

60. 9-60 Depreciation & Capital Budgeting Use the schedule required by the IRS for tax purposes Depreciation = non-cash expense –Only relevant due to tax affects Depreciation tax shield = DT –D = depreciation expense –T = marginal tax rate

61. 9-61 Computing Depreciation Straight-line depreciation D = (Initial cost – salvage) / number of years Straight Line  Salvage Value MACRS Depreciate  0 Recovery Period = Class Life 1/2 Year Convention Multiply percentage in table by the initial cost

62. 9-62 After-Tax Salvage If the salvage value is different from the book value of the asset, then there is a tax effect Book value = initial cost – accumulated depreciation After-tax salvage = salvage – T(salvage – book value)

63. 9-63 Tax Effect on Salvage Net Salvage Cash Flow = SP - (SP-BV)(T) Where: SP = Selling Price BV = Book Value T = Corporate tax rate

64. 9-64 Example: Depreciation and After-tax Salvage Car purchased for $12,000 5-year property Marginal tax rate = 34%.

65. 9-65 Salvage Value & Tax Effects Net Salvage Cash Flow = SP - (SP-BV)(T) If sold at EOY 5 for $3,000: NSCF = 3,000 - (3000 - 691.20)(.34) = $2,215.01 = $3,000 – 784.99 = $2,215.01 If sold at EOY 2 for $4,000: NSCF = 4,000 - (4000 - 5,760)(.34) = $4,598.40 = $4,000 – (-598.40) = $4,598.40

66. 9-66 Evaluating NPV Estimates NPV estimates are only estimates Forecasting risk: –Sensitivity of NPV to changes in cash flow estimates The more sensitive, the greater the forecasting risk Sources of value Be able to articulate why this project creates value

67. 9-67 Scenario Analysis Examines several possible situations: –Worst case –Base case or most likely case –Best case Provides a range of possible outcomes

68. 9-68 Scenario Analysis Example Note: “Lower” ≠ Worst “Upper” ≠ Best

69. 9-69 Scenario Analysis Example

70. 9-70 Problems with Scenario Analysis Considers only a few possible out- comes Assumes perfectly correlated inputs –All “bad” values occur together and all “good” values occur together Focuses on stand-alone risk, although subjective adjustments can be made

71. 9-71 Sensitivity Analysis Shows how changes in an input variable affect NPV or IRR Each variable is fixed except one – Change one variable to see the effect on NPV or IRR Answers “what if” questions

72. 9-72 Sensitivity Analysis: Unit Sales

73. 9-73 Sensitivity Analysis: Fixed Costs

74. 9-74 Sensitivity Analysis: Strengths –Provides indication of stand-alone risk. –Identifies dangerous variables. –Gives some breakeven information. Weaknesses –Does not reflect diversification. –Says nothing about the likelihood of change in a variable, –Ignores relationships among variables.

75. 9-75 Disadvantages of Sensitivity and Scenario Analysis Neither provides a decision rule. –No indication whether a project’s expected return is sufficient to compensate for its risk. Ignores diversification. –Measures only stand-alone risk, which may not be the most relevant risk in capital budgeting.

76. 9-76 Managerial Options Contingency planning Option to expand –Expansion of existing product line –New products –New geographic markets Option to abandon –Contraction –Temporary suspension Option to wait Strategic options

77. 9-77 Capital Rationing Capital rationing occurs when a firm or division has limited resources –Soft rationing – the limited resources are temporary, often self-imposed –Hard rationing – capital will never be available for this project The profitability index is a useful tool when faced with soft rationing