Capital budgeting

CAPITAL BUDGETING

CAPITAL BUDGETING

Investors require stock price appreciation.

To increase stock price, companies must become more profitable in order to increase the value of the firm’s stock.

Accordingly, [Financial] managers must make certain that new investments will increase the value of the firm.

CAPITAL BUDGETING

A. Motives for Capital Investment

1. Renewal: Modernize, Overhaul, Retrofit

2. Replacement: Replace worn out equipment

3. Expansion: Adding physical capacity

4. Other: A variety of corporate objectives.

Primary Objective: Increase value of firm!

CAPITAL BUDGETING

B. How Projects Are Evaluated;

1. Companies have a variety of opportunities: investment opportunity set.

2. Data is collected on each attractive opportunity.

3. Companies select the best opportunities.

4. Fund as many investments as they have capital to invest. Diversify investments in order to diversify risks.

5. Periodically reevaluate decisions in order to make decisions relative to continuance or abandonment (analysis).

CAPITAL BUDGETING

C. Learning Objectives

1. Learn relevant decision rules.

2. Learn basic analytical methodology

D. Business Objectives

1. Minimize the probability of losses

2. Recall that many new products / ventures fail and failures are expensive.

3. We want to make the most informed decision.

CAPITAL BUDGETING

E. The Data Inputs; What Information Is Necessary?

1. Type of project; new investment or replacement?

2. Expected economic life of the project (in years).

3. Initial outlay of cash required to finance project.

4. Identifying timing and magnitude of future cash flows.

5. Are projects;

Mutually exclusive? i.e. we can choose A or B

Independent? i.e., we can choose A and B

CAPITAL BUDGETING

F. The Hurdle Rate1. Capital investments subject to one important

constraint: • Investment must earn a rate of return greater than the

cost of capital (WACC).

2. The hurdle rate is the market derived weighted average of investor required rates of return on company’s stocks and bonds.

CAPITAL INVESTMENT DECISION RULES

A. Payback Period

1. How long will it take to recover the initial outlay from After-Tax Cash Flows (ATCF)?

2. Many smaller companies are asked for this information by banks before getting loans.

3. Problem: Ignores the time value of money.

CAPITAL INVESTMENT DECISION RULES

B. Net Present Value: NPV >> 0

* Note my use of the much greater than symbol (>>) rather than the text’s (). If I am going to put capital at risk - I don’t want to just

breakeven!

C. Internal Rate of Return: IRR > ka

1. IRR is the discount rate which makes NPV = zero.

2. The assumed reinvestment rate for cash flows.

3. If NPV greater than zero, then IRR is greater than ka.

CAPITAL INVESTMENT DECISION RULES

D. NPV Profile1. To create a profile, calculate net present value at

different discount rates.

2. The rate for a zero NPV is the IRR for the project.

E. Problem of Multiple IRR1. When signs change more than once.

2. Cartesian Rule of Signs; number if solutions.

CAPITAL INVESTMENT DECISION RULES

F. Modified Internal Rate of Return The NPV and IRR models assume that ATCF are

reinvested at the WACC or the IRR, respectively.

A problem with the IRR is that it may be unattainable over the long run.

The MIRR is that rate which takes the terminal value (TV) of the reinvested cash flows and computes the discount rate that makes the TV equal to the initial outlay. See text for MIRR model example.

FIVE STEP CAPITAL BUDGETING PROCESS

A. Proposal Generation: Schedule the Investment Opportunity Set.

B. Analysis: Evaluate Each Opportunity. C. Decision Making: Select best of the

Opportunity Set.D. Implementation: Assure Project

Development Compliance E. Control: Performance Assessment

ANCILLARY CONSIDERATIONS IN CAPITAL BUDGETING

B. Fisher's Separation Theorem (1930)An extension of the Fisher Separation theorem suggests that we separate the investment decision from the financing decision. The implication is that investment projects should be considered independently of the financing decision. This is a convenient fiction.Not so obvious, we must consider where our capital is coming from and the impact it will have on the capital structure of the firm.

CAPITAL BUDGETING MODEL

The “Macro” Model; details of changes in cost structure (VC and FC)*Chg In Sales Revenue (S)

minus Chg In Variable Costs (Direct Labor, Materials) (VC)minus Chg In Fixed Costs (Sell., General, Admin. Expenses) (FC)

Chg in Earnings Before Depreciation & Taxes (EBDT)minus Chg In Depreciation (Plus New, Minus Old ) (DEPR)

Chg In Earnings Before Taxes (EBT)minus Chg In Taxes T * (EBT)

Chg in Earnings After Taxes (EAT)Plus Chg In Depreciation (DEPR)

Chg In After-Tax Cash Flow ATCF {= (1 - T) EBT + DEPR}

* This model ignores the effect of debt financing. See Lecture Notes.