capital budgeting (handout)

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Kalle [email protected]

8th October, 2013

Corporate finance(TER2407)

Topics today

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Introduction to capital budgeting

Capital budgeting techniques

Rules for finding incremental cash flows

Sample project evaluation (in a seminar)

Next time (in 2 weeks): risk and return, portfolio theory, CAPM, APT.

Well return to budgeting in 3 weeks.

Introduction

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Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.

Long term assets may take up large proportion of total balance sheet and cannot be reversed at low cost

Principles of capital budgeting have been adapted to many other corporate decisions

Principles of capital budgeting are directly related to the maximisation of shareholder value.

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Capital budgetingWeighted average cost of capital (WACC) hurdle rate

1st Topic: Capital budgeting

Long term investment evaluation (capital expenditure) assumes that the proceeds from an investment are spread over longer time horizon.

The capital budgeting process involves the following basic steps:

I. Generating long-term investment proposals;

II. Gathering the information to forecast cash flows for each project and then evaluating the project's profitability;

III. Planning the Capital Budget;

IV. Monitoring and Post-auditing.

Managers should separate investment and financing decisions.

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Types of projects

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1. Replacement projects

2. Expansion projects

3. New products and services

4. Regulatory, safety, and environmental projects

5. Other projects

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Capital Budgeting Decision Techniques

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Accounting rate of return (ARR and ROI): focuses on projects impact on accounting profits

Payback period (PB): commonly used for small scale projects

Net present value (NPV): best technique theoretically; difficult to calculate realistically

Internal rate of return (IRR): widely used with strong intuitive appeal

Profitability index (PI): related to NPV, can be used to rank (prioritise) different projects

Modified internal rate of return (MIRR): similar (and perhaps superior) to IRR but a bit more difficult to calculate

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Account for the time value of money;

Account for risk;

Focus on (incremental) cash flow;

Rank competing projects appropriately, and

Lead to investment decisions that maximize shareholders wealth.

A Capital Budgeting Process Should:

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Example: Global Wireless

I use an example from Smart, Meggison and GitmanCorporate Finance.

Global Wireless is a worldwide provider of wireless telephony devices.

Global Wireless is contemplating a major expansion of its wireless network in two different regions:

Western Europe expansion

A smaller investment in Southeast U.S. to establish a toehold

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Global Wireless

Initial Outlay -$250

Year 1 inflow $35

Year 2 inflow $80

Year 3 inflow $130

Year 4 inflow $160

Year 5 inflow $175

Initial Outlay -$50

Year 1 inflow $18

Year 2 inflow $22

Year 3 inflow $25

Year 4 inflow $30

Year 5 inflow $32

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Can be computed from available accounting data

ARR uses accounting numbers, not cash flows; no time value of money.

Average profitsafter taxes

Average annual operating cash inflows

Average annualdepreciation

=

Need only profits after taxes and depreciation.

Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.

Accounting Rate Of Return (ARR)

vestmentAverage inr taxesofits afteAverage prARR =

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The payback period is the amount of time required for the firm to recover its initial investment.

If the projects payback period is less than the maximum acceptable payback period, accept the project.

If the projects payback period is greater than the maximum acceptable payback period, reject the project.

Management determines (sometimes arbitrarily) the maximum acceptable payback period.

Payback Period

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Managements cutoff is 2.75 years.

Western Europe project: initial outflow of -$250M

But cash inflows over first 3 years is only $245 million.

Global Wireless will reject the project (3>2.75).

Southeast U.S. project: initial outflow of -$50M

Cash inflows over first 2 years cumulate to $40 million.

Project recovers initial outflow after 2.40 years.

Total inflow in year 3 is $25 million. So, the project generates $10 million in year 3 in 0.40 years ($10 million $25 million).

Global Wireless will accept the project (2.4

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NPV: The sum of the present values of a projects cash inflows and outflows.

Discounting cash flows accounts for the time value of money.

Choosing the appropriate discount rate accounts for risk.

NN

r

CFr

CFr

CFr

CFCFNPV )(...)()()( +++++++++= 1111 33

221

0

Accept projects if NPV > 0.

Net Present Value (NPV)

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NN

r

CFr

CFr

CFr

CFCFNPV )(...)()()( +++++++++= 1111 33

221

0

A key input in NPV analysis is the discount rate.

r represents the minimum return that the project must earn to satisfy investors.

r varies with the risk of the firm and /or the risk of the project.

Net Present Value (NPV)

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Assuming Global Wireless uses 18% discount rate, NPVs are:

5432 )18.1(175

)18.1(160

)18.1(130

)18.1(80

)18.1(352503.75$ +++++==EuropeWesternNPV

Western Europe project: NPV = $75.3 million

5432.. )18.1(32

)18.1(30

)18.1(25

)18.1(22

)18.1(18507.25$ +++++==SUSoutheastNPV

Southeast U.S. project: NPV = $25.7 million

Should Global Wireless invest in one project or both?

NPV Analysis for Global Wireless

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The NPV Rule and Shareholder Wealth

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Key benefits of using NPV as decision rule:

Focuses on cash flows, not accounting earnings

Makes appropriate adjustment for time value of money

Can properly account for risk differences between projects

Though best measure, NPV has some drawbacks:

Lacks the intuitive appeal of payback, and

Doesnt capture managerial flexibility (real option value) well.

NPV is the gold standard of investment decision rules.

Pros and Cons of NPV

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NN

r

CFr

CFr

CFr

CFCFNPV )(....)()()( +++++++++== 11110 33

221

0

IRR: the discount rate that results in a zero NPV for a project.

The IRR decision rule for an investing project is:

If IRR is greater than the cost of capital, accept the project.

If IRR is less than the cost of capital, reject the project.

Internal Rate of Return (IRR)

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NPV Profile and Shareholder Wealth

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Western Europe project: IRR (rWE) = 27.8%

5432 )1(175

)1(160

)1(130

)1(80

)1(352500

WEWEWEWEWE rrrrr ++

++

++

++

++=

Southeast U.S. project: IRR (rSE) = 36.7%

5432 )1(32

)1(30

)1(25

)1(22

)1(18500

SESESESESE rrrrr ++

++

++

++

++=

Global Wireless will accept all projects with at least 18% IRR.

IRR Analysis for Global Wireless

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Advantages of IRR:

Properly adjusts for time value of money

Uses cash flows rather than earnings

Accounts for all cash flows

Project IRR is a number with intuitive appeal

Disadvantages of IRR:

Mathematical problems: multiple IRRs, no real solutions

Scale problem

Timing problem * re-investment rate problem (see MIRR)

Pros and Cons of IRR

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25Which IRR do we use?

IRR

IRR

When project cash flows have multiple sign changes, there can be multiple IRRs.

Multiple IRRs

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Sometimes projects do not have a real IRR solution.

Modify Global Wirelesss Western Europe project to include a large negative outflow (-$355 million) in year 6.

There is no real number that will make NPV=0, so no real IRR.

Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!

No Real Solution

Missing a real solution doesnt mean

that the project is necessarily bad.

Consider for instance the project:

Time 0 1 2

Cash Flow 100 300 250

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NPV and IRR do not always agree when ranking competing projects.

$25.7 mn36.7%Southeast U.S.

$75.3 mn27.8%Western Europe

NPV (18%)IRRProject

The Southeast U.S. project has a higher IRR, but doesnt increase shareholders wealth as much as the Western Europe project.

The scale problem:

Conflicts Between NPV and IRR:The Scale Problem

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Conflicts Between NPV and IRR:The Scale Problem

Why there is a conflict?

The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project.

Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive.

Another (simpler example): Assume that before the finance class starts two investment proposals are made to you:

A) invest 1 EUR and after a class you receive 2 EUR

B) invest 10 EUR and after a class you receive 12 EUR. The projects are mutually exclusive

Which one project would you choose?

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Conflicts Between NPV and IRR:The Timing Problem

The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.

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Conflicts Between NPV and IRR:The Timing Problem

Because of the differences in the timing of the two projects cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign.

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Decision rule: Accept project with PI > 1.0, equal to NPV > 00

221

)1(...)1()1(CF

r

CFr

CFr

CF

PIN

N

+++

++

+=

Both PI > 1.0, so both acceptable if independent.

1.5$50 million$75.7 millionSoutheast U.S.

1.3$250 million$325.3 millionWestern Europe

PIInitial OutlayPV of CF (yrs1-5)Project

Calculated by dividing the PV of a projects cash inflows by the PV of its initial cash outflows.

Like IRR, PI suffers from the scale problem.

Profitability Index

Capital Rationing

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Can a firm accept all investment projects with positive NPV?

Reasons why a company would not accept all projects:

Limited availability of skilled personnel to be involved with all the projects;

Financing may not be available for all projects. Companies are reluctant to issue new shares to finance new projects

because of the negative signal this action may convey to the market.

Capital Rationing

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Capital rationing: project combination that maximizes shareholder wealth subject to funding constraints

1. Rank the projects using Profitability Index (PI)

2. Select the investment with the highest PI

3. If funds are still available, select the second-highest PI, and so on, until the capital is exhausted.

The steps above ensure that managers select the combination of projects with the highest NPV.

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Capital Rationing and the Profitability Index

(12% required return)

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MIRR modified internal rate of return Addresses several shortcomings that IRR method has (e.g. the

reinvestment rate and multiple IRR problems, but has no cure to the scale problem)

MIRR is a discount rate that equates the future value of the project cash flows to the present value of investments.

Where COFt cash outflow at period t, CIFt cash inflow at period t, k reinvestment rate (pos cash flows) of financing rate (negative cash flows; could be different k-s), n project lifetime (years)

The MIRR for product development is 13,8% and marketing campaign 12,6% (well take a further look in seminar)

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Project evaluations in EXCEL

Check course home page for further examples.

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Capital budgeting is concerned with cash flow,not accounting profit.

To evaluate a capital investment, we must know:

1. Incremental cash outflows of the investment (marginal cost of investment), and

2. Incremental cash inflows of the investment (marginal benefit of investment).

3. The timing and magnitude of cash flows and accounting profits can differ dramatically.

Cash Flow Versus Accounting Profit

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Financing costs are captured in the process of discounting future cash flows.

Both interest expense from debt financing and dividend payments to equity investors should be

excluded.

Financing costs should be excluded when evaluating a projects cash flows.

Cash Flows: Financing Costs and Taxes

Only after-tax cash flows are relevant as only such cash flows can be potentially distributed to investors.

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Cash Flows: Noncash Expenses

Noncash expenses include depreciation, amortization, and depletion.

Accountants charge depreciation to spread a fixed assets costs over time to match its benefits.

Capital budgeting analysis focuses on cash inflows and outflows when they actually occur.

Non-cash expenses may (Estonia is a special case) affect cash flow through their impact on taxes: Compute after-tax net income and add depreciation back, o r

Ignore depreciation expense but add back its tax savings. (e.g. Depreciation tax shield)

Depreciation tax shield = tax rate (t) x Depreciation

In Estonia there is currently no tax shields (also including interest rate tax shield) - however, a realistic cash flow prognosis should take potential future dividends into account through potential tax costs

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Many capital investments require additions to working capital.

Example: additional investments into A/R, inventories.

The change in working capital can either be a positive or negative cash flow

An example

Operate booth from November 1 to January 31

Order $15,000 calendars on credit, delivery by Nov 1

Must pay suppliers $5,000/month, beginning Dec 1

Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10% in Jan

Always want to have $500 cash on hand

Working Capital Expenditures

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($5,000)($5,000)($5,000)$0Payments

($500)Net cash flow

$1,500

[10%]

$9,000

[60%]

$4,500

[30%]

$0Reduction in inventory

Jan 1 to Feb 1

Dec 1 to Jan 1

Nov 1 to Dec 1

Oct 1 to Nov 1

Payments and

inventory

($500) +$4,000 ($3,000)

(4,000)+500+500NAMonthly in WC

(3,000)1,0005000Net WC

5,00010,00015,0000Accts payable

01,50010,50015,0000Inventory

$0$500$500$500$0Cash

Feb 1Jan 1Dec 1Nov 1Oct 1

0

0

+3,000

Working Capital for Calendar Sales Booth

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Incremental cash flows versus sunk costs:

Capital budgeting analysis should include only incremental costs.

Simple example: assume that your company undertook a market research and the costs were 200.000$. The market research was successful and as a result, a more thorough project evaluation is to be undertaken. Should the costs of marketing research be included into the cash flow budget or not? Why or why not?

Incremental Cash Flow

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Cash flows from alternative investment opportunities, forgone when one investment is undertaken.

NPV of a project could fall substantially if opportunity costs are recognized!

Some time ago You were thinking of attending the MA (MBA) program. Indeed you calculated the incremental costs and

benefits from attending business school. What are the opportunity costs here?

Opportunity Costs

Excess Capacity and opportunity cost

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Excess capacity is not a free asset as traditionally regarded by managers.

Company has excess capacity in a distribution centre warehouse.

In two years, the firm will invest $2,000,000 to expand the warehouse.

The firm could lease the excess space for $125,000 per year (at the beginning of each year) for the next two years or decide NOT to lease and invest today

Expansion plans should begin immediately in this case to hold inventory for new stores coming on line in a few months.

Incremental cost: investing $2,000,000 at present vs. two years from today

Incremental cash inflow: $125,000 (at the beginning of the year)

Excess Capacity

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NPV of leasing excess capacity (assume 10% discount rate):

471,108$1.1

000,000,210.1000,125000,000,2000,125 2 =++=NPV

01.1

000,000,210.1

000,000,2 2 =++=XXNPV

- X = $181,818 (at the beginning of the year)

- Leasing the excess capacity for a price above $181,818 would increase shareholders wealth.

NPV negative: reject leasing excess capacity at $125,000 per year.

The firm could compute the value of the lease that would allow break even.

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Cannibalization

Cannibalization refers to the loss of sales of an existing product when a new product is introducedand should be included as an incremental (negative) cash flow.

Cannibalization is a substitution effect.

However there could be some exceptions to this rule. One should take into account the effect of potential competition.

The Human Face of Capital Budgeting

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Managers must be aware of optimistic bias in the assumptions made by project supporters.

Companies should have control measures in place to remove bias:

Investment analysis should be done by a group independent of individual or group proposing the project.

Project analysts must have a sense of what is reasonable when forecasting a projects profit margin and its growth potential.

Storytelling: The best analysts not only provide numbers to highlight a good investment, but also can explain why the investment makes sense.

Reading

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The topics of todays lecture are covered in BMA (10th ed)

Ch 5 (The net present value and other investment criteria)

Ch 6 ( Making investment decisions with the net present value rule)

Or CFT (Ch 2 - Capital budgeting),

You may also consult any other suitable book and respective chapters from suggested reading list (for instance Smart,S., Megginson, W. Gitman, L. Corporate Finance)