1. 1 Chapter 6: Capital Budgeting: The Basics Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley Objective Explain Capital Budgeting Develop Criteria

2. 2 Chapter 6 Contents 1 The Nature of Project Analysis1 The Nature of Project Analysis 2 Where do Investment Ideas come from?2 Where do Investment Ideas come from? 3 The NPV Investment Rule3 The NPV Investment Rule 4 Estimating a Project’s Cash Flows4 Estimating a Project’s Cash Flows 5 Cost of Capital5 Cost of Capital 6 Sensitivity Analysis6 Sensitivity Analysis 7 Analyzing Cost-Reducing Projects 8 Projects with Different Lives 9 Ranking Mutually Exclusive Projects 10 Inflation & Capital Budgeting

3. 3 Objectives To show how to use discounted cash flow analysis to make decisions such as:To show how to use discounted cash flow analysis to make decisions such as: –Whether to enter a new line of business –Whether to invest in equipment to reduce costs

4. 4 Introduction Recall the objective of a firmRecall the objective of a firm –Maximization of the market value of shareholders’ equity The theory of how to do this was provided in the prior two chaptersThe theory of how to do this was provided in the prior two chapters –Compute the net present value of the project’s expected cash flows, and undertake only those with positive NPV

5. 5 6.1 The Nature of Project Analysis Basic unit of analysisBasic unit of analysis –the individual investment project

6. 6 Procedural Outline Form ideas on how to increase shareholders’ equityForm ideas on how to increase shareholders’ equity Plan how to implement the ideasPlan how to implement the ideas Gather information on timing and magnitude of costs and benefitsGather information on timing and magnitude of costs and benefits Apply NPV criterionApply NPV criterion

7. 7 Generating a forecast Information is often biased towards its provider’s goal (agency problem)Information is often biased towards its provider’s goal (agency problem) There are many ways to implement a goalThere are many ways to implement a goal Some information is not fully quantifiableSome information is not fully quantifiable Impact on shareholder wealth difficult to evaluate when cash flows are riskyImpact on shareholder wealth difficult to evaluate when cash flows are risky

8. 8 The Nature of Project Analysis We will postpone discussion of risky cash flows to avoid the complex issue of how they affect shareholder wealthWe will postpone discussion of risky cash flows to avoid the complex issue of how they affect shareholder wealth The criterion used The criterion used –find the present value of all future cash flows, and subtract the initial investment to obtain the net present value (NPV)

9. 9 6.2 Where do Investment Ideas Come From? –monitor existing & potential customers needs –monitor existing & potential technological capacity of the firm –monitor the competition’s marketing, investment, patents, and technical recruiting –monitor production & distribution functions for revenue enhancement / cost savings –reward employees for innovative ideas

10. 10 6.3 Net Present Value Rule A project’s net present value isA project’s net present value is –the amount by which the project is expected to increase the wealth of the firm’s current shareholders As a criterionAs a criterion –Invest in proposed projects with positive NPV

11. 11 Illustration The following tables show the computation of NPVThe following tables show the computation of NPV –To show the affect of the discount rate, three tables are shown based on different rates

12. 12 Do Project DCF Payback

13. 13 Don’t Do Project

14. 14 Indifferent Internal Rate of Return

15. 15 Common Error It is a common mistake to start the investment in year 1 rather than year 0 (when this was not intended)It is a common mistake to start the investment in year 1 rather than year 0 (when this was not intended) –Now is time 0 –Like a child, a project is not one-year old until a year has passed

16. 16 Summary The discount rateThe discount rate –in the first scenario it was assumed to be 10%, and the resulting NPV was $20 –In the second scenario it was assumed to be 15%, and the NPV was -$69 –In the third scenario, the discount rate that resulted in a zero NPV was found

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18. 18 6.4 Depreciation and Cash Flows It is important to remember that when making financial decisions only timed cash flows are usedIt 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

19. 19 Working Capital & Cash Flows Some cash flows do not occur on the income statement, but involve timingSome 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

20. 20 Accruals & Deferrals Take extra care if you are provided with net income information by an accountantTake extra care if you are provided with net income information by an accountant –the flows forming net income may include accrualsaccruals deferralsdeferrals –these are typically small, and may some- times be ignored

21. 21 Incremental Cash Flows Only the incremental cash flows should form part of an investment decisionOnly the incremental cash flows should form part of an investment decision –Evaluate the projected cash flows, by (category and) timing, both with and without the project, and find the difference –This difference is a collection of timed cash flows, and this is what affects the wealth of the shareholders

22. 22 Illustration: Cannibalism A proposed project will generate $10,000 in revenue, but will causes another product line to lose $3,000 in revenuesA proposed project will generate $10,000 in revenue, but will causes another product line to lose $3,000 in revenues The incremental cash flow is only $7,000The incremental cash flow is only $7,000

23. 23 Illustration: Prior Expenses R&D expenses are $10,000 to-date for your project, and you plan to spend another $20,000, making $30,000 in allR&D expenses are $10,000 to-date for your project, and you plan to spend another $20,000, making $30,000 in all –The $10,000 is a sunk cost. The decision whether to undertake the project will not change this expenditure –Only the $20,000 is an incremental cost, and the $10,000 should be excluded

24. 24 Sunk Costs Shareholders are interested in the timing and magnitude of cash flowsShareholders are interested in the timing and magnitude of cash flows –From an investor’s vantage, a project gives rise to an alternative cash flow –If (alternative cash flows) - (original cash flows) is valuable to shareholders, do project –A sunk cost has no impact on future cash flows: it is irrelevant to shareholders

25. 25 Illustration: Underutilized Resources A project uses an existing (non-cancelable) leased warehouse with a remaining life of 20 years, and total annual rent of $100,000A project uses an existing (non-cancelable) leased warehouse with a remaining life of 20 years, and total annual rent of $100,000 The warehouse is projected to remain 50% utilized, unless your project is undertakenThe warehouse is projected to remain 50% utilized, unless your project is undertaken The lease prohibits sub-leasingThe lease prohibits sub-leasing The current project is making a lossThe current project is making a loss Your project will use 25% of the warehouseYour project will use 25% of the warehouse What should the project be charged?What should the project be charged?

26. 26 Proposed Solution 1 The original project currently using the warehouse is making a loss:The original project currently using the warehouse is making a loss: –“Charge the full $100,000 /year so the company can recover the very real warehousing costs.”

27. 27 Proposed Solution 2 Half the warehouse is available:Half the warehouse is available: –“The project should be charged the full $50,000 /year if it needs to use it. A portion of the warehousing costs will not be charged-out otherwise.”

28. 28 Proposed Solution 3 The project should be charged for its share of the used space:The project should be charged for its share of the used space: –“Charge $33,333 /year.”

29. 29 Proposed Solution 4 The project is going to use only 25% of the space.The project is going to use only 25% of the space. –“Charge $25,000 /year.”

30. 30 Proposed Solution 5 The charge should be proportioned according to revenues generated by each project--that is fair, isn’t it?The charge should be proportioned according to revenues generated by each project--that is fair, isn’t it? –“The old project’s revenues = $9,000,000, and the new project has projected revenues = $1,000,000, so the charge is 10%, or $10,000/year.”

31. 31 Proposed Solution 6 There is a suitable new (smaller) warehouse available on the market for $27,000 /year.There is a suitable new (smaller) warehouse available on the market for $27,000 /year. –“Charge the project the market rate of the space, $27,000.”

32. 32 Proposed Solution 7 The original lease was entered into when warehouse space was cheap, but now space is twice what it was:The original lease was entered into when warehouse space was cheap, but now space is twice what it was: –“The market value of the leased warehouse is now $200,000, and the project should take its proper share of that amount.”

33. 33 Proposed Solution 8 This is a new project, so give it a sporting chance:This is a new project, so give it a sporting chance: –“The project should be charged nothing.”

34. 34 Warehouse Illustration The solution in this case is proposed solution # 8, (but for another reason): The project should be charged nothingThe solution in this case is proposed solution # 8, (but for another reason): The project should be charged nothing –The warehouse expenditure will occur whether the project is done or not. It is therefore not an incremental cash flow –With different facts (alternative usage or lease re-negotiation) the answer would be different

35. 35 6.5 The Cost of Capital When determining the cost of capitalWhen determining the cost of capital –the risk of the project is, in general, different from the risk of existing projects –only the market-related risk is relevant –only the risk from a project’s cash flows is relevant (not that of financing instruments)

36. 36 Computing the Average Cost of Capital of a Corporation Determine the return to security holders of each class of security issuedDetermine the return to security holders of each class of security issued Determine the market value of each class of the company’s securities, and compute the weight of eachDetermine the market value of each class of the company’s securities, and compute the weight of each After adjusting for tax, compute the weighted sum of returnsAfter adjusting for tax, compute the weighted sum of returns

37. 37 Average Cost of Capital: Example with 3-Securities LetLet k e be the return on equityk e be the return on equity k d be the return on debtk d be the return on debt k p be the return on preferredk p be the return on preferred V e be the market value of issued equityV e be the market value of issued equity V d be the Market value of issued bondsV d be the Market value of issued bonds V p be the market value of issued preferredV p be the market value of issued preferred t be the tax ratet be the tax rate

38. 38 Average Cost of Capital: Example with 3-Securities k = k e * V e + k p * V p + k d * V d * (1 - t)k = k e * V e + k p * V p + k d * V d * (1 - t) The average cost of capital is also the cost of capital for each of the firms business divisions weighted according to their market valueThe average cost of capital is also the cost of capital for each of the firms business divisions weighted according to their market value

39. 39 6.6 Sensitivity Analysis Using Spreadsheets Will the project still be economical if some of the underlying variables are inaccurate?Will the project still be economical if some of the underlying variables are inaccurate? –Spreadsheets are an excellent tool for exploring the influence of estimation errors on financial decisions

40. 40 Base Case Base Case The following is an embedded Excel worksheet for the cash flow of a firmThe following is an embedded Excel worksheet for the cash flow of a firm –It is generally a good practice to divide the worksheet into two segments, one containing only data, and the other containing only formulae –This practice increases flexibility & reduces the chance of error –It is also a good practice to name variables using Insert:Name:Create in Excel

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42. 42 A Modified Scenario –In this case the cash is piling up (Watch out for IRS penalties in this case!) –The assumption is now made that sales units grow by +2%, unit prices by -3%, and fixed costs by +8% (No, Victor: Fixed costs may vary with time. Yes, Valerie: Fixed costs do not vary with sales.) –Assume a dividend of $1,000,000/year

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44. 44 Additional Scenarios The following graphs are variations of from the basic model constructed by changing one variable at a time:The following graphs are variations of from the basic model constructed by changing one variable at a time:

45. 45 Was 15%

46. 46 Was 40%

47. 47 Was 0%

48. 48 Was 75%

49. 49 Was $3,100,000

50. 50 Consequences –Notice that the reduced long-term viability of the product, together with the dividend for demands, will cause: –a cash flow crisis early in year 5, –negative accounting profits in year 6, –and a serious negative operating cash flow in year 8 when the tax benefits of depreciation are finally consumed.

51. 51 Graphs –Graphs are a useful supplement to spreadsheets as they may illustrate behavior of the model to continuing changes in a selected independent variable –The following graphs explore a model

52. 52 Table 6.4 Project Sensitivity to Sales Volume

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56. 56 Spreadsheet Planning Conclusions: Spreadsheets permit management to explore perturbations caused by randomness in the model’s inputsSpreadsheets permit management to explore perturbations caused by randomness in the model’s inputs –This should lead to management correctly prioritizing time to the variables of the model –Management will recognize dangers sooner, and will create contingency plans to avoid their worst consequences

57. 57 6.7 Break-Even and Indifference Points Break-even point is number of sales resulting in a NPV = 0Break-even point is number of sales resulting in a NPV = 0 IRR is discount rate resulting in NPV = 0IRR is discount rate resulting in NPV = 0 Price B/E is unit price resulting in NPV= 0Price B/E is unit price resulting in NPV= 0 Payback period is the project life resulting in NPV = 0Payback period is the project life resulting in NPV = 0

58. 58 6.8 Projects with Different Lives When do you replace a sales car?When do you replace a sales car? –As a car ages its resale price decreasesits resale price decreases the annual repair bills increasethe annual repair bills increase sales people become discontentedsales people become discontented –people who live in their cars demand reliability –customers are influenced by sales people’s cars –a nice car is part of their unofficial remuneration

59. 59 Data Collection A car uses about the same amount of oil, gasoline, cleaning, tire usage, et cetera, no matter how old it isA car uses about the same amount of oil, gasoline, cleaning, tire usage, et cetera, no matter how old it is –This data need not be collected, because we are interested only in incremental cash flows assume that the degree of tires wear is compensated by a credit on saleassume that the degree of tires wear is compensated by a credit on sale

60. 60 Data Collection In order to simplify this example, it will be assumed that all cash flows are in real termsIn order to simplify this example, it will be assumed that all cash flows are in real terms Assumed that the required rate of return on cars is a real 10% (Excited already?)Assumed that the required rate of return on cars is a real 10% (Excited already?)

61. 61 Data Collection Sales people use the Bdella Sedan.Sales people use the Bdella Sedan. The market prices for new and used Bdellas is given on the next slideThe market prices for new and used Bdellas is given on the next slide The expected annual maintenance charges by year are also givenThe expected annual maintenance charges by year are also given Intangible losses have been listedIntangible losses have been listed

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63. 63 Car Replacement First compute the NPV ofFirst compute the NPV of –purchasing in year 0, and selling in year 1, –purchasing in year 0, and selling in year 2, –… –purchasing in year 0, and selling in year 10 These figures are shown in col. PV_ProjThese figures are shown in col. PV_Proj

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65. 65 Interpretation We see that the incremental cost of replacing the car every year is $3810, replacing it every two years is $7,619…We see that the incremental cost of replacing the car every year is $3810, replacing it every two years is $7,619… You are not yet tempted to select “replace every year” because this option does not provide a Bdella Sedan after the 1st year, while replace after 2-years doesYou are not yet tempted to select “replace every year” because this option does not provide a Bdella Sedan after the 1st year, while replace after 2-years does

66. 66 Additional Analysis The analysis so far does not provide for a replacement car.The analysis so far does not provide for a replacement car. The simplest way to do this is to replace each project with an identical project foreverThe simplest way to do this is to replace each project with an identical project forever We have the perpetuity equation for thisWe have the perpetuity equation for this

67. 67 Additional Analysis Take the two year problem as an exampleTake the two year problem as an example The NPV is discounted to year 0, the 1st replacement NPV is discounted to year 2, the 2nd to year 4, … for everThe NPV is discounted to year 0, the 1st replacement NPV is discounted to year 2, the 2nd to year 4, … for ever This is a perpetuity due, with interest (1.05) 2 - 1 = 10.25%This is a perpetuity due, with interest (1.05) 2 - 1 = 10.25%

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69. 69 Conclusion Replacing the car every year is the best scenario, but, watch out for an agency problem. Without the intangibles the answer is to keep the car as long as possibleReplacing the car every year is the best scenario, but, watch out for an agency problem. Without the intangibles the answer is to keep the car as long as possible The Bdella Sedan is like a Volvo on Geritol: it doesn't know when to dieThe Bdella Sedan is like a Volvo on Geritol: it doesn't know when to die

70. 70 6.9 Ranking Mutually Exclusive Projects Using the NPV method, you are unlikely to encounter any serious problemsUsing the NPV method, you are unlikely to encounter any serious problems –Some managers, particularly those with an engineering background, prefer to use the IRR method The IRR method may be made to give the correct answer, but this requires considerable skill. Avoid it (unless your boss engineer)The IRR method may be made to give the correct answer, but this requires considerable skill. Avoid it (unless your boss engineer)

71. 71 6.10 Inflation and Capital Budgeting When computing NPVWhen computing NPV –Use the nominal cost of capital to discount nominal cash flows (Nominal cash flows are rarely constant)(Nominal cash flows are rarely constant) –Use the real cost of capital to discount real cash flows