1. Chapter 17 Capital Budgeting Analysis © 2011 John Wiley and Sons

2. 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. 3 Chapter Outcomes, continued n Explain how relevant cash flows are determined for capital budgeting decision purposes. n Discuss how a project’s risk can be incorporated into capital budgeting analysis.

4. 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 –Relate to firm’s mission n Mutually exclusive versus independent

5. 5 Identifying Potential Capital Budget Projects n Time value concepts tell us: Value = present value of expected cash flows n Separating out the initial up-front cost, we have: Net Present Value = Present value of expected cash flows – cost of project

6. 6 Identifying Potential Capital Budget Projects n Net Present Value = Present value of expected cash flows – cost of project n If NPV >0 the project adds value to the firm. n Where do firms find attractive capital budgeting projects with potentially positive NPVs?

7. 7 Identifying Potential Capital Budget Projects n Planning tools: n MOGS: Mission, Objectives, Goals, Strategies n SWOT: (Internal to firm):Strengths, Weaknesses (External to firm): Opportunites, Threats

8. 8 Capital Budgeting Process n Identification n Development n Selection n Implementation n Follow-up

9. 9 Data Needs n Economic and Political Data n Financial Data n Non-Financial Data

10. 10 Oil/Gas Company Projects Ranking of items from most to least important on capital spending: 1. Natural gas price forecast 2. Crude oil price forecast 3. Natural gas demand forecast 4. Crude oil demand forecast 5. Availability and cost of capital 6. Regulatory requirements on projects 7. Tax considerations

11. 11 Forecasts n Note the multiple uses of the word “forecast” in the previous list n Managers must make educated guesses about the future to estimate future cash flows

12. 12 Capital Budgeting Techniques n Net Present Value n NPV = Present value of all cash flows minus cost of project n Inputs: cash in/outflows, required rate of return or “cost of capital”

13. 13 Cash Flow Data YEARPROJECT APROJECT B 0 (today) -20,000-25,000 15,800 4,000 25,800 4,000 35,800 8,000 45,80010,000 55,80010,000

14. 14 NPV of Project A CASH10% PRESENT YRFLOW xPVIF = VALUE 0 –$20,0001.000 –$20,000 1 5,8000.9095,272 2 5,8000.8264,791 3 5,8000.7514,356 4 5,8000.6833,961 5 5,8000.6213,602 Net Present Value =$ 1,982

15. 15

16. 16 NPV of Project B CASH10% PRESENT YRFLOW xPVIF = VALUE 0 -$25,0001.000 -$25,000 1 4,0000.9093,636 2 4,0000.8263,304 3 8,0000.7516,008 4 10,0000.6836,830 5 10,0000.6216,210 Net Present Value = $ 988

17. 17 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

18. 18 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

19. 19 NPV Profile

20. 20 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

21. 21

22. 22 What Does the IRR Measure? IRR measures the return earned on funds that remain internally invested in the project

23. 23 (1)(2)(3) (4) (5)(6) Year Beginning Cash 10% ReturnReductionEnding InvestmentInflow on thein theValue of Value(savings) InvestedInvestedInvested Funds FundsFunds (2) x 0.10 (3) - (4)(2) - (5) 1 $5,000.00 $2,010.57 $500.00$1,510.57$3,489.43 2 3,489.432,010.57 348.94 1,661.63 1,827.80 3 1,827.802,010.57 182.78 1,827.79 0.01 * * Value is not 0.00 due to rounding.

24. 24 NPV vs. IRR n They will always agree on whether to accept or reject a project n So if projects are independent: either method is acceptable n Problem: they may rank projects differently n What to do if projects are mutually exclusive and the rankings conflict? n Answer: use NPV as it measures the change in shareholder wealth occurring because of the project.

25. 25 NPV vs. IRR n Another issue with IRR: a project may have more than one IRR! n Can occur if project has alternative positive and negative cash flows. n Most likely to occur if project requires substantial renovations or maintenance during its life or if end- of-life shut-down costs are high.

26. 26 Modified Internal Rate of Return n MIRR developed to solve some of the issues associated with IRR. n MIRR will agree with NPV on the accept/reject decision n MIRR gives a single answer—there is only one MIRR n MIRR agrees with NPV rankings when the initial investments are of comparable size.

27. 27 Modified Internal Rate of Return: Three step process 1. Find the present value of all cash outflows 2. Find the future value of all cash inflows at the end of the project’s life at year n. This lump sum is called the terminal value. 3. MIRR is the discount rate which equates the present value of the outflows and the future value of the inflows: FV at year n = PV (1 + MIRR) n

28. 28 MIRR for Project A 1. Present value of outflows = 20,000 (no additional calculation needed) 2. Find FV as of year 5 for cash inflows from years 1-5: 5800 (1.10) 4 = 8491.78 5800 (1.10) 3 = 7719.80 5800 (1.10) 2 = 7018.00 5800 (1.10) 1 = 6380.00 5800 (1.10) 0 = 5800.00 Terminal value (sum of FV) = 35,409.58

29. 29 MIRR for Project A n PV of outflows: 20,000 n Terminal value (sum of FV of inflows) = 35,409.58 n Step 3: FV = PV(1 + MIRR) n = $35,409.58= $20,000(1 + MIRR) 5 n Solving, we find the MIRR is 12.10 percent n Accept project as MIRR>10% required return

30. 30 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

31. 31 Project A and B Project A’s profitability ratio: PI = $21,982/$20,000 = 1.099 Project B’s profitability ratio: PI = $25,988/$25,000 = 1.040

32. 32 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 always means that: IRR>minimum required return and that the: PI > 1

33. 33 Reject Decision, too n If one indicates we should reject the project, they will all indicate “reject” n NPV < 0 always means that the IRR < minimum required return and that the PI < 1

34. 34 Conflicts Between NPV, IRR, MIRR, Profitability Index n May occur as different rankings may occur if projects are mutually exclusive. Most likely when projects have: n Different cash flow patterns –Projects with larger and earlier cash flows may have higher IRR rankings than those with larger later cash flows

35. 35 Conflicts Between NPV, IRR, MIRR, Profitability Index n Different time horizons –Project Long and Project Short require $100 investment –Short: returns $200 in 2 years IRR = 41.42% and NPV (at 10% required return) = $65.29. –Long: returns $2,000 in 20 years IRR =16.16% NPV (at 10% required return) = $197.29.

36. 36 Conflicts Between NPV, IRR, MIRR, Profitability Index n Different Sizes –Projects with smaller initial investments may have higher IRR and higher PI and smaller NPV than projects with larger initial investments. Initial PV of Cash Profitability Project Outlay Cash Flows NPV Index Small $100 $150 $50 1.5 Large 1,000 1,100 $100 1.1

37. 37 Conflicts Between NPV, IRR, MIRR, Profitability Index n Four discounted cash flow methods: n NPV, IRR, MIRR, profitability index n Goal in capital budgeting is to select projects that will help maximize shareholder wealth. n NPV is the best as it measures the absolute dollar change in shareholder wealth. n The others are relative measures of project attractiveness.

38. 38 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

39. 39 Project A Payback Example Investment: $20,000 Cash Cumulative Dollars YRFlow Cash flow Needed 1 5,800 5,800 14,200 2 5,800 11,600 8,400 3 5,800 17,400 2,600 4 5,800 Fraction of year: 2,600/5,800 = 0.45 Payback = 3.45 years

40. 40 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

41. 41 What Managers Use n 75% of CFOs used NPV, IRR or both to evaluate projects n IRR is most popular n Over half still use payback as a secondary or supplementary method of analysis

42. 42 Why Are IRR and Payback Used So Much? n Safety margin –IRR gives managers an intuitive feel for a project’s “safety margin”—amount by which cash flows can be incorrect and the project can still increase shareholder wealth. n Project Size n Managerial flexibility and options

43. 43 Estimating Project Cash Flows n Important concepts : n Stand-alone principle n Incremental after-tax cash flows from the base case n Cannibalization or enhancement effects n Opportunity costs

44. 44 Ignore…. n Sunk costs n Financing costs

45. 45 Project Cash Flows Project sales (generally a cash inflow) - Project costs (generally a cash outflow) - Depreciation (a noncash expense) EBIT = EBT(earnings before interest and taxes, which also equals earnings before taxes as financing costs are ignored in cash flow analysis) - Taxes (a cash outflow) Net income

46. 46 Firm versus Project Statement of Cash Flows The Firm's Cash Flow Statement A Project's Cash Flow Statement Cash Flow from OperationsCash Flow from Operations Net Income Net Income +Depreciation +Depreciation +current asset/liability sources +current asset/liability sources -current asset/liability uses -current asset/liability uses Cash Flow from Investment ActivitiesCash Flow from Investment Activities -change in gross fixed assets-Funds invested in the project -change in investments Cash Flow from Financing ActivitiesCash Flow from Financing Activities -Dividends paid Not applicable +net new bond issues +net new stock issues

47. 47 Project Cash Flows Cash flows from operations: Net income + depreciation – change in net working capital Cash flows from investment activities: change in gross fixed assets Cash flows from financing activities: ignore Recall, as the cash account is always zero, that the change in NWC does not include the cash account

48. 48 Operating Cash Flow n OCF = Net Income + Depreciation – ΔNWC n From the project’s income statement, this is the same as: n (Sales-Costs-Depreciation) – Taxes + Depreciation – ΔNWC n If the firm’s tax rate is t then n Taxes = t(pre-tax income) = t(Sales-Costs- Depreciation) so operating cash flow is:

49. 49 Operating Cash Flow n OCF = n Sales-Costs-Depreciation – t(Sales-Costs- Depreciation) + Depreciation – ΔNWC n Simplifying, we have a general formula for estimating operating cash flow: n OCF = (Sales-Costs-Depreciation)(1– t) + Depreciation – ΔNWC

50. 50 Why do we subtract the change in NWC ( ΔNWC) ? n Recall NWC = Current Assets (excluding the cash account) minus Current Liabilities n If NWC rises: either CA has risen, CL has fallen, or both n Example: Cash is used to pay AP; cash flows out of the firm and NWC (CA-CL) rises n A use of cash leads to an increase of NWC; to measure operating cash flow, this amount is subtracted.

51. 51 Why do we subtract the change in NWC ( ΔNWC) ? n If NWC falls: either CA has fallen, CL has risen, or both. n Example: Cash comes into the firm if a customer pays their AR. AR falls, CA falls, and NWC falls n A source of cash leads to a decrease of NWC; when we subtract this negative change in NWC it becomes a positive addition to OCF.

52. 52 The Depreciation Tax Shield With DeprecWithout Deprec Expense Expense Sales $1000$1000 -Costs -300 -300 -Deprec -100 0 EBT $600 $700 -Taxes (40%) 240 280 Net Income $360 $420 OCF=Net Income + Depreciation $460 $420 Difference is $40—which equals tax rate x depreciation (04.0) ($100) = $40

53. 53 Reality: Keeping Managers Honest n Pet projects can be accepted into the capital budget by inflating cash flow estimates so their NPV is positive n Possible solutions: –Review spending in implementation stage; additional requests for funds needed in case of overruns –Compare forecasted cash flows with actuals –Record names of those issuing forecasts

54. 54 Risk-related Considerations n Expected return/risk tradeoff n Higher (lower) than average risk projects should have a higher (lower) than average discount rate

55. 55 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)

56. 56 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

57. 57 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%

58. 58 Web Links www.benjerry.com www.wendys.com www.wellsfargo.com www.merck.com www.dell.com www.ebay.com www.salvagesale.com

59. 59 Learning Extension 17: Estimating Project Cash Flows

60. 60 Up-front or “time zero” investment Investment = cost + transportation, delivery, and installation charges

61. 61 Project Stages and Cash Flow Estimation n Initial Outlay –Engineering estimates (designs, modifications) –Current market prices of new items –Bid prices from possible supplies or construction firms –Will be reduced if new project is replacing old equipment/building that can be sold

62. 62 Project Stages and Cash Flow Estimation n Cash Flows During the Project’s Life n For each period of time during the project’s life, use the general equation: n OCF = (Sales-Costs-Depreciation)(1– t) + Depreciation – ΔNWC n Estimating the inputs: marketing studies, production cost estimates, suppliers

63. 63 Project Stages and Cash Flow Estimation n Salvage Value and NWC Recovery –After-tax salvage value = Asset selling price – t (selling price – book value) –Project’s NWC may be assumed to be liquidated (converted to cash) and returned to the firm as a cash flow

64. 64 Project Stages and Cash Flow Estimation n Salvage value example. Asset purchased for $100; depreciation of $10/year. Sold in year 7. Book value will be $30. Tax rate is 25%. n After-tax salvage value if selling price is $50: $50 –.25 ($50-30) = $45 n After-tax salvage value if selling price is $30: $30 –.25 ($30-30) = $30 n After-tax salvage value if selling price is $10: $10 –.25 ($10-30) = $15

65. 65 Project Stages and Cash Flow Estimation n If project is expected to continue indefinitely: n Estimate operating cash flows for several years and then estimate its “going concern value” using the constant dividend (cash flow) growth model: Dividend time t+1 Value time t = ----------------------- r - g

66. 66 Example: Revenue-Expanding Project n Initial outlay: t = 0 Depreciable Outlays ‑ $4.5 Expensed Cash Outlays, after tax ‑ 0.4 ‑‑‑‑‑‑‑ ‑ $4.9

67. 67 Annual Project Income Statement years 1-5 Sales $3.000 -Costs -0.635 -Depreciation -0.900 EBT $1.465 -Taxes (40%) -0.586 Net income $0.879

68. 68 OCF estimates tax rate = 40% Year 1Year 2-4Year 5 Saless$3.000$3.000$3.000 -Cost -$0.635-$0.635 -$0.635 -Depreciation -$0.900-$0.900 -$0.900 SUM $1.465$1.465$1.465 x (1-t)$0.879$0.879$0.879 +Depreciation$0.900$0.900$0.900 -change NWC-$0.100$0.000$0.100 Operating CF$1.679$1.779$1.879

69. 69 Salvage Value n Market value in year 5 of project assets: $1 million n They will be fully depreciated at that time. n After-tax salvage value = Asset selling price – t (selling price – book value) n = $1 million – (0.40)($1 million-0) n = $0.600 million

70. 70 Cash Flow Summary Initial Operating Salvage Total Year Outlay Cash Flows ValueIncremental Cash Flows 0 $-4.9$ 0.000$ 0.0$-4.90 1 0.0 1.679 0.0 1.679 2 0.0 1.779 0.0 1.779 3 0.0 1.779 0.0 1.779 4 0.0 1.779 0.0 1.779 5 0.0 1.879 0.6 2.479 At 10%, NPV = $2.20 million

71. 71 Other Examples n Cost-saving project n Setting a minimum bid price on a project so NPV=0 n Tables, data in textbook