1. Chapter 17 Capital Budgeting Analysis © 2000 John Wiley & Sons, Inc.

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 Describe the importance of determining the correct base case from which to estimate project cash flows. 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 n Mutually exclusive versus independent

5. 5 Capital Budgeting Process n Identification n Development n Selection n Implementation n Follow-up

6. 6 Data Needs n Economic and Political Data n Financial Data n Non-Financial Data

7. 7 Capital Budgeting Techniques n Net Present Value n NPV = Present value of all cash flows minus cost of project

8. 8 Cash Flow Data YEARPROJECT APROJECT B 15,800 4,000 25,800 4,000 35,800 8,000 45,80010,000 55,80010,000

9. 9 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

10. 10 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

11. 11 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

12. 12 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

13. 13 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

14. 14 What Does the IRR Measure? IRR measures the return earned on funds that remain internally invested in the project

15. 15 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

16. 16 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  IRR>minimum required return  PI > 1

17. 17 Reject Decision, too n If one indicates we should reject the project, they will all indicate “reject” n NPV < 0  IRR < minimum required return  PI < 1

18. 18 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

19. 19 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

20. 20 Estimating Project Cash Flows n Important : n Stand-alone principle n Incremental after-tax cash flows from the base case n Cannibalization or enhancement effects n Opportunity costs

21. 21 Ignore…. n Sunk costs n Financing costs

22. 22 Up-front or “time zero” investment Investment = cost + transportation, delivery, and installation charges

23. 23 Cash-Based Income Statement Cash revenues$12,000 Cash operating expenses –5,600 Cash earnings before depreciation 6,400 Depreciation –4,000 Cash earnings before taxes 2,400 Income taxes (25%) –600 Cash earnings after taxes$ 1,800

24. 24 Periodic after-tax cash flows n Cash revenues - cash expenses - tax = $12,000 - 5,600 - 600 = $5,800 n Cash earnings after tax+Depreciation = $1,800 + 4,000 = $5,800 n (Cash revenues-cash expenses) (1-T) + T (Depreciation expense) = ($12,000-5,600)(1-.25) + (.25)($4,000) = $5,800

25. 25 Risk-related Considerations n Expected return/risk tradeoff n Higher (lower) than average risk projects should have a higher (lower) than average discount rate

26. 26 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)

27. 27 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

28. 28 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%

29. 29 Learning Extension 17A: Strategic Analysis and Cash Flow Estimation Strategic analysis, marketing analysis, and financial analysis should agree on the accept/reject decision of a project

30. 30 Common Problem Areas n Determining the correct base case n Overvaluing a strategy n Define project boundaries at the corporate level

31. 31 Depreciation and Project Cash Flows n Straight-line depreciation n MACRS--accelerated depreciation

32. 32 Depreciation Classes 3-year class 5-year class 7-year class 10-year class 27.5-year class 31.5-year class Designated tools and equipment used in research Cars, trucks, and some office equipment such as computers and copiers Other office equipment and industrial machinery Other long-lived equipment Residential real estate Commercial and industrial real estate

33. 33 Some MACRS Percentages Asset class Year3-year5-year7-year 133.33%20.00%14.29% 244.4532.0024.49 314.8219.2017.49 4 7.4011.5212.49 511.52 8.93 6 5.76 8.93 7 8.93 8 4.45

34. 34 An example first year’s second year’s third year final year’s For an asset in the three-year class that originally cost $50,000, the first year’s depreciation is $50,000 x 0.3333 = $16,665; the second year’s depreciation is $50,000 x 0.4445 = $22,225; for the third year, depreciation will be $50,000 x 0.1482 = $7,410; the final year’s depreciation expense will be $50,000 x 0.0740 = $3,700.