FINA2303 Topic 03 Capital Budgeting

8/18/2019 FINA2303 Topic 03 Capital Budgeting

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Topic 3: Investment Decision Rules

and Capital Budgeting


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Topic 3 Investment Decision Rules and Capital Budgeting M K Lai Page 2

Learning Outcomes

introduction to capital budgeting

investment decision rules

net present value (NPV) rule

payback rule internal rate of return (IRR) rule

choosing between projects with differences inscale

equivalent annual annuity (EAA) rule forevaluating projects with different lives

3 building blocks

payback period(soon is better)


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Learning Outcomes

capital budgeting decision

capital budgeting process incremental free cash flows

tax depreciation vs. accounting depreciation

(extra)

post audit or financial control

A positive incremental cash flow means that the

company's cash flow will increase with the acceptance

of the project.


4/134Topic 3 Investment Decision Rules and Capital Budgeting M K Lai Page 4

Introduction to Capital Budgeting

also known as project appraisal/analysis

investment decision from perspective of a firmwith focus on its mix of long-term assets

spending on long-term assets is known as capital

expenditures (CapEx) which are scare andvaluable resources of a firm

a firm is required to prepare a 3- to 5-year capital

budget on annual basis to project future capital

expenditures (long-term financial planning)



Introduction to Capital Budgeting

issues to consider in capital budgeting

type of project: a project is any decision thatresults in using scare resources of a business

independent/stand-alone projects: .

mutually exclusive projects: .

cash flows to consider: relevant cash flows

what discount rate or cost of capital to use:weighed average cost of capital (WACC) (topic

7)

it is evaluated on its own basis

choose one among all



Investment Decision Rules

with scarce and valuable capital for investment, a

firm has to find a consistent and reliable decision

rule for evaluating projects

net

present

value rulepayback

rule

internal

rate of

returnrule equivalent

annual

annuity rule



Net Present Value Rule

net present value (NPV): difference betweenpresent value of an investment’s benefits (cash

inflows) and present value of its costs (cashoutflows)

application of valuation principle

estimate cash flows by a project

estimate discount rate or cost of capital

(reflecting and ) calculate present value of cash flows

NPV = present value of benefits – present

value of costs (in terms of cash flows)

(cost-benefit analysis)

time value of money, risk of the project




decision rule

independent projects: .mutually exclusive projects: .

other issues

NPV profile: a graph of a project’s NPV over a

range of discount rates

internal rate of return (IRR): discount rate thatrenders NPV equal to zero (common mistake:

IRR is different from the IRR rule discussed

later)

undertake it if the NPV>0, +ve

choose the one with the highest NPV

given that it is > 0




difference between IRR and cost of capital isthe amount of estimation error without altering

original decision (sensitivity analysis - atechnique used in project risk analysis)

advantages

correspond directly to impact of the project onfirm’s value

direct application of valuation principle

disadvantages

rely on accurate estimate of discount rate

can be time-consuming to compute


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Example: NPV Rule

Consider a stand-alone project with the followingfuture cash flows in the coming three years and

the discount rate is 10%. Should a firm acceptthe project under the NPV rule?

01 2 3

-$1,000 $500 $400 $250

year

project.therejecttoisdecisionthe0,NPVAs

95.26$

000,1$%)101(

250$%)101(

400$%101

500$NPV32

<

−=

−+

++

++

=


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Example: NPV Profile

($120)

($80)

($40)

$0

$40

$80

$120

$160

$200

0% 2% 4% 6% 8% 10% 12% 14% 16%

NPV

discount rate

IRR = 8.27%

region of acceptance:NPV > 0 when r < IRR

region of rejection:

NPV IRR

amount of estimation error ifcost of capital = 10%

set NPV=0, IRR= the discount rate

still positive


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Payback Rule

payback period: the amount of time required for

an investment to generate cash flows sufficient to

recover its initial investment

assume that cash flows are received evenly over

a year so as to consider a fraction of a year in thecalculation

decision rule

independent projects: .


undertake it if the payback period is < cut-off

period

choose the one with the shortest paybackperiod given that


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Payback Rule

advantages

simple to compute

favors liquidity

disadvantages

no guidance as to correct payback cutoff ignore cash flows after cutoff completely

ignore time value of money

biased against long-term projects such asresearch and development or new projects

not necessarily consistent with maximizingshareholder wealth


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Example: Payback Rule

Suppose that there are two mutually exclusiveprojects A and B with following future cash flows.

Which project be accepted under the paybackperiod rule?

0 1 2 3

-$2,000 $1,000 $1,500

-$2,000 $500 $1,000 $10,000

A

B

year


15/134


Example: Payback Rule

assume that the firm receives the cash flowssmoothly over a year

A.projectaccepttoisdecisiontheperiod,paybackshorterthehasAprojectAs

years05.2000,10$

$1,000 -$500 -$2,0002payback(B)

years67.1500,1$

000,1$000,2$1)A(payback

=+=

=−

+=


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Discounted Payback Rule

discounted payback period: the amount of time

required for an investment to generate present

value of cash flows sufficient to recover its initial

investment

still subject to most disadvantages of paybackrule except considering time value of money

decision rule



(solved)management sets a discounted payback cut-off period


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Example: Discounted Payback Rule

Suppose that there are two mutually exclusiveprojects A and B with following future cash flows.

Which project be accepted under the paybackperiod rule?

0 1 2 3

-$2,000 $1,000 $1,500

-$2,000 $500 $1,000 $10,000

A

B

year


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Example: Discounted Payback Rule

timeline of present value of discounted cashflows is as follows:

0 1 2 3

-$2,000 $909.09 $1,239.67

-$2,000 $454.55 $826.45 $7,513.15

A

B

year


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Internal Rate of Return Rule

internal rate of return (IRR): discount rate that

makes NPV of a project zero

decision rule



notice: cut-off rate is usually set at cost of

capital

r>IRR

IRR higher

(or by management)


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in many cases, NPV rule and IRR rule give thesame conclusion

however, due to some disadvantages of IRR rule,they may have conflicting conclusions

advantage

related to the NPV rule and usually yield thesame decision

disadvantages hard to compute

delayed investment (can be misleading if

inflows come before outflows)

NPV: time value of money

difficult to know the risk of the project

risk is related to the cost of capital

risk increase, cost of capital increase

midterm: no calculation of IRR

e.g. down payment,


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multiple solutions lead to ambiguity (solution:

modified internal rate of return, MIRR – not

discussed)

incorrect decisions in comparing mutually

exclusive projects (ranking problem)difference in scale

difference in timing of cash flows (solution:

equivalent annual annuity, EAA)

Mutual Exclusive Projects

project year** not fair*


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Example: IRR Rule

Two mutually exclusive projects have thefollowing cash flow patterns. The cost of capital is

25%. Which project should be accepted under theIRR rule? Under the NPV rule?

0 1 2

-$200 $150 $150

-$200 $100 $200

A

B

year


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Example: IRR Rule

A.projectaccepttoisdecisiontheNPV(B),NPV(A)As

8$200$%)251(

200$

%251

100$)B(NPV

16$200$

%)251(

150$

%251

150$)A(NPV

A.projectaccepttoisdecisiontheIRR(B),IRR(A)As

%08.28)B(IRR;)]B(IRR1[

200$

)B(IRR1

100$200$

%87.31)A(IRR;)]A(IRR1[

150$

)A(IRR1

150$200$

2

2

2

2

>

=−+

++

=

=−

+

+

+

=

>

=+

++

=

=+

++

=


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Problem 1: Delayed Investment

Consider a project that you receive the paymentof $500,000 upfront in year 0. To get it done, you

have to incur costs of $150,000, $200,000 and$250,000 in years 1, 2 and 3 respectively. Giventhat the cost of capital is 6%, should the project

be accepted under the IRR rule?

0 1 2

$500K -$125K -$150K

year

-$175K

3

Cash inflow first!!!!!!


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project.rejecttoisdecisionthe0,NPVAs

K41.29$

K500$%)61(

K250$

%)61(

K200$

%61

K150$NPV

project.accepttoisdecisionthe,%6IRRAs

%90.8IRR )IRR1(

K250$

)IRR1(

K200$

IRR1

K150$K500$

32

32

<

−=

++

−+

−+

−=

>

=

+−

+−

+−=

still work for the NPV rule


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($100)

($80)

($60)

($40)

($20)

$0

$20

$40

$60

$80

0% 2% 4% 6% 8% 10% 12% 14% 16%

NPV

discount rate

IRR = 8.90%

region of acceptance:

NPV > 0 when r > IRR

region of rejection:NPV


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Problem 2: Multiple Solutions

Descartes’ rule of sign: whenever there is achange in sign in a polynomial, there is an

additional solution

Consider a project with the following cash flowpattern. The cost of capital is 12%.

0 1 2

-$75 $200 -$128

year


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project.accepttoisdecisionthe,0NPVAs

53.1$75$%)121(

128$

%121

200$NPV

project.rejecttoisdecisionthe12%,6.67%As

project.accepttoisdecisionthe,%1260%As

60%or%67.6IRR

)IRR1(

128$

IRR1

200$75$

2

2

>

=−

+

−

+

=

<

>

=

+−

+=


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($5)

($4)

($3)

($2)

($1)

$0

$1

$2

$3

$4

$5

0% 10% 20% 30% 40% 50% 60% 70% 80%

NPV

discount rate

IRR =

60%

cost of capital = 12%

IRR =

6.67%


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Problem 3: Differences in Scale

ranking of mutually exclusive projects can bedifferent between IRR and NPV due to difference

in scale (the size of initial investment) law of diminishing marginal return (what is it?)

Consider two mutually exclusive projects with thefollowing cash flow patterns both at a discountrate of 12%. Which project should be acceptedaccording to (1) the IRR rule; and (2) the NPV rule?

0 1 2 3

-$100 $45 $45

-$50 $23 $23

$45A

B

year

$23

keep all factors of production constant*


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24.5$50$%)121(

23$

%)121(

23$

%121

23$)B(NPV

08.8$100$%)121(

45$

%)121(

45$

%121

45$)A(NPV

B.projectaccepttoisdecisiontheIRR(B),IRR(A)As

%01.18)B(IRR;)]B(IRR1[

23$

)]B(IRR1[

23$

)B(IRR1

23$50$

%65.16)A(IRR;)]A(IRR1[

45$

)]A(IRR1[

45$

)A(IRR1

45$100$

32

32

32

32

>

=−+

++

++

=

=−+

++

++

=

<

=+

++

++

=

=+

++

++

=


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at a discount rate of 12%, NPV(A) of $8.08 >NPV(B) of $5.24 and the decision is to accept

project A IRR(B) of 18.01% > IRR(A) of 16.65% and the

decision is to accept project B

there is a conflict between the two investmentdecision rules and the problem lies on the factthat IRR does not reflect the project risk and

there is a difference in scale

cross-over rate: the discount rate makes the NPVof two mutually exclusive projects the same, e.g.15.28% in the example


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($10)

$0

$10

$20

$30

$40

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

A B

NPV

discount rate

IRR(A) =

16.65%

cost of capital

= 12%

IRR(B) =

18.01%

NPV A = $8.08NPV(B) = $5.24

cross-over rate

= 15.28%


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Problem 4: Timing in Cash Flows

ranking of mutually exclusive projects can bedifferent between IRR and NPV due to different

timing in cash flows Consider two mutually exclusive projects with the

following cash flow patterns both at a discount

rate of 20%. Which project should be acceptedaccording to (1) the IRR rule; and (2) the NPV rule?

0 1 2 3

-$60 $50 $50

-$60 $90 $30

$50A

B

year


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83.35$60$%)201(

30$

%201

90$)B(NPV

32.45$60$%)201(

50$

%)201(

50$

%201

50$)A(NPV

B.projectaccepttoisdecisiontheIRR(B),IRR(A)As

%08.78)B(IRR;)]B(IRR1[

30$

)B(IRR1

90$60$

%67.64)A(IRR;)]A(IRR1[

50$

)]A(IRR1[

50$

)A(IRR1

50$60$

2

32

2

32

>

=−+

++

=

=−+

++

++

=

<

=+

++

=

=+

++

++

=


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at a discount rate of 20%, NPV(A) of $45.32 >NPV(B) of $35.83 and the decision is to accept

project A

IRR(B) of 78.08% > IRR(A) of 64.67% and thedecision is to accept project B

there is a conflict between the two investmentdecision rules and the problem lies on the factthat IRR does not reflect the project risk and

there is a difference in timing of cash flows


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($20)

$0

$20

$40

$60

$80

$100

0% 20% 40% 60% 80% 100%

A B

NPV

discount rate

IRR(A) =

64.67%

cost of capital

= 20%

IRR(B) =

78.08%

NPV A = $45..32NPV(B) = $35.83

undertake A

undertake B


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Equivalent Annual Annuity Rule

equivalent annual annuity (EAA): level annual

cash flow that has same present value as cash

flows of a project

assume that project can be replicated

indefinitely and convert cash flows into anannual annuity

propose to deal with problem of differences in

timing of cash flows of mutually exclusiveprojects or projects with different lives

E i l A l A i R l


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decision rule


important considerations

required life: the life of a machine is more than

the years to use

replacement cost: a change in technology may

reduce the replacement cost in the future

higher Annuity

(machine life not equal to project life)

then use NPV*

E i l t A l A it R l


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0 1 2 N.....

-C0

year N-1N-2

C1 C2 CN-2 CN-1 CN

NPV

EAA EAA EAA EAA EAA

E l EAA R l


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Example: EAA Rule

Consider two machines A and B with unequaluseful lives and otherwise same capacity.

Machine A costs $9,000 and will last for 3 yearswhile machine B costs $8,000 and will last for 2years. The cost of capital is 6%.

0 1 2 3

-$9,000 $4,000 $4,000 $4,000

-$8,000 $5,000 $5,000

A

B

year

E l EAA R l


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Example: EAA Rule

AmachinebuytoisdecisiontheNPV(B),NPV(A)as

96.166,1$ %)61(

000,5$

%61

000,5$ -$8,000NPV(B)

$1,692.05

%)61(

000,4$

%)61(

000,4$

%61

000,4$000,9$)A(NPV

2

32

>

=

+

+

+

+=

=

++

++

++−=

however, the NPV rule is not applicable herebefore the two mutually exclusive projects have

different lives

E l EAA R l


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Example: EAA Rule

BmachinebuytoisdecisiontheEAA(A),EAA(B)as

50.636$)B(EAA

%)61(11*

%61*)B(EAA96.166,1$

02.633$)A(EAA%)61(

11*

%6

1*)A(EAA05.692,1$

2

3

>

=

+−=

=

+−=

both are perpetuity

Corporate Financial Planning


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project future operating performance and

financial position of a firm (pro forma financial

statements/pro formas), formulate the way in

which financial goals are to be achieved (cash

and capital budgets) and establish guidelines for

change and growth in the firm (financial plan)

short-term financial planning (working capital

management) long-term financial planning (capital budgeting,

capital structure and dividend policy)



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current financial

position and past

operating

performance

pro-formas, cash

and capital

budgets, financial

plans

assumptions

implementation of

financial plans

actual results

analysis

control

financial

statements and

market dataplanning

feedback

Capital Budgeting Process


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Capital Budgeting Process

investment proposals generated from internal

staff or external consultants

initial screening of proposals

capital budgeting exercise: investment decision

rules and preparation of capital budget analysis of projects under consideration

working capital requirements

selection, approval and authorization

implementation of projects

post audit and feedback

change in working capital

Capital Budgeting Process with NPV


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Rule

estimate

discount rate

project cash

flows

determine NPV

NPV>?reject project0

keep recordspost audits

sale forecasts

and budgets

pro-forma

financialstatements

feedback

Steps in Evaluating a Project with NPV


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Rule

talk to sales people to forecast sales of project

talk to production and operations departments to

estimate expenses of project

estimate effects of project on asset requirements(and sources of financing it)

prepare pro-forma financial statements of projectto forecast incremental revenue, incrementalcosts, marginal tax rates, etc. through financialmodeling

estimate incremental free cash flows and theirtiming

Steps in Evaluating a Project with NPV


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Rule

estimate discount rate based on risk of project

(to be discussed in Cost of Capital)

calculate NPV

make decision

Cash Flows and Timing of a Project


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Cash Flows and Timing of a Project

initial outlay

purchase

equipment

initial development

cost

increase in working

capital

ongoing cash flows

incremental

revenue

incremental costs

taxes

change in net

working capital

terminal cash flows

decrease in net

working capital

shutdown costs

sale of equipment

(net of taxes)

Fundamentals of Capital Budgeting


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before-tax basis vs. after-tax basis

The operations manager of a firm forecaststhe future cash flows of a project on a before-tax basis and estimates the before-tax

discount rate. He discounts the before-taxfuture cash flows at the before-tax discountrate to calculate the NPV of the project

because he claims that tax implications willaffect the cash flows and discount rate at thesame time and hence they offset each other.

Do you agree?



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consistency in taking into account inflation

A project manager estimates a stream of even

operating cash flows over time for a project

and uses market information to estimate thediscount rate and calculate the NPV of the

project. What is the problem?



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incremental basis

A company has entered into a tenancyagreement with a factory owner to lease afactory at a specified monthly rental payment.

Now it considers to undertake a new projectthat will occupy part of the space in the factory.Should the pro rata rental payment of the

factory be included in calculating the NPV ofthe project?



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relevant cash flows

A firm carried out a pilot test, which cost

$300,000, to see whether a new product

would be accepted by consumers in themarket. Based on the test results, the firm

now wants to decide whether to have mass

production of the new product. Should the testcost be included as a cash outflow in capital

budgeting?



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A company owns a piece of land with a marketvalue of $50 million. It would like to make use

of the land for a project. Should the marketvalue of the land be included as a cash outflowin capital budgeting?

A company carries out a project and itproduces a by-product from the project, e.g.wood dust from producing timber. Should the

revenue of the by-product be included as acash inflow in capital budgeting?



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A company launches a new product. Somecustomers switch from the old product to the

new one, which results in a decline of the saleof the old product by $500,000. Should theforegone sales of the old product be considered

as a cash outflow in capital budgeting?A company launches a new product. After

buying the new product, some customers also

purchase some other items (cross selling).Should the increase in sale of the other itemsbe considered as a cash flow in capital

budgeting?



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p g g

flexibility

A company has the flexibility of opening a new

store now or in the future. Is this flexibility likely

to increase, decrease or have no effect on the

NPV of the project of opening a new store?

A company has the flexibility of terminating a

project in the future given that its performance

is poor. Is this flexibility likely to increase,decrease or have no effect on the NPV of the

project?

After-Tax Basis


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revenue arising from a project is taxable and taxpayment is a cash outflow

expenses incurred in a project are usually taxdeductible and tax saving is a cash inflow

in other words, have to consider the after-tax

cash flows and discount them at the after-taxdiscount rate

if a firm uses different accounting methods in

preparing the financial statements (financialreporting –income before tax) and the tax return(tax reporting – taxable income), which is more

relevant in capital budgeting?

Consistency in Considering Inflation


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y g

in principle, inflation is not an issue as long as itis with consistent treatment

discount nominal cash flows at nominaldiscount rate

discount real cash flows at real discount rate

in practice, which is better?

Fisher equation

(1+nominal discount rate) = (1+real discountrate)*(1+expected inflation rate)

nominal cash flows = real cash

flows*(1+expected inflation rate)

Incremental Basis


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in capital budgeting, consider cash flows on anincremental basis, i.e. the difference between

with a project and without a project or anychanges in future cash flows as a consequence oftaking a project

if a cash flow occurs regardless whether a firmtakes a project or not, it is not incremental andhence should not affect its capital budgeting

decision a firm should only take into account incremental

cash flows

Incremental Basis


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standalone principle: the assumption thatevaluation of a project may be based on the

project’s incremental cash flows instead ofcalculating the future cash flows with and withoutthe project

consider project as a “mini-firm” and preparepro forma financial statements on project

estimate the incremental cash flows throughthe pro forma financial statements

Incremental Basis


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similarly, by comparing two mutually exclusiveprojects A and B, consider the difference in the

cash flows between the two projects, known asthe “incremental project” (project A – project B)assuming that both projects have positive NPV

incremental NPV = NPV of project A – NPV ofproject B

if incremental NPV > 0, accept project A

if incremental NPV < 0, accept project B

Incremental Free Cash Flows


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concerned about cash flows rather than netincome

determine incremental free cash flow (to thefirm) from incremental earnings in capital

budgeting

free cash flows (to the firm) = - capitalexpenditures + operating cash flows - changein net working capital

Steps in Estimating Incremental Free

Cash Flows


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Cash Flows

estimate capital expenditures and salvage value

estimate incremental revenue and incremental

cost of project determine income tax expense

forecast incremental earnings

estimate change in net working capital

prepare pro forma financial statements

covert incremental earnings to incremental cashflows

calculate NPV of project and make decision on

project

Capital Expenditures vs. Operating

Expenses


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Expenses

capital expenditures: upfront costs of the

investment in property, plant and equipment

recorded as fixed assets at cost and

depreciated over several financial years as

depreciation expenses

operating expenses: costs of running the normal

operations of a firm

recorded as a cost in the financial year of

incurring it

Estimating Capital Expenditures


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capital expenditures: costs of buying new long-term assets, including shipping and installation

costs (cash outflow in year 0) estimate the initial investment in property, plant

and equipment

capital expenditures as cash outflows, whichdo not affect net income

depreciation expenses as non-cash items

which reduce net income, but not cash flows

difference between net income and cash flows

(quick reminder: why different?)



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salvage value is also known as scrap value,

residual value or disposal value

selling proceeds from disposal of long-term asset

(cash inflow at project end) gain/loss from disposal of asset = salvage

value – book value of long-term asset where

book value is estimated through thedepreciation method used for tax reporting (is

this a cash item?)



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but Inland Revenue raises tax implicationabout it (is this a cash item?)

tax payment on gain from disposal of asset:cash outflow

tax saving on loss from disposal of asset:

cash inflow incremental cash flows from disposal of long-

term fixed assets = salvage value – (salvage

value – book value)*marginal tax rate

Example: Estimating Capital

Expenditures


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Expenditures

a company intends to buy a machine at a cost of

$1,000,000 for a project

the machine is to be fully depreciated evenly on

straight-line depreciation method over 5 years fortax reporting

the salvage value of the machine in year 5 is$50,000


Expenditures


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year

beginning net

book value of

machine

depreciation

expense

ending net

book value

of machine

effect on

income

before tax

effect on cash

flows

0 $1,000,000 $0 -$1,000,000

1 $1,000,000 $200,000 $800,000 -$200,000 $0

2 $800,000 $200,000 $600,000 -$200,000 $0

3 $600,000 $200,000 $400,000 -$200,000 $0

4 $400,000 $200,000 $200,000 -$200,000 $0

5 $200,000 $200,000 $0 -$200,000 $33,000

Expenditures

difference between

income and cash flows

incremental cash

flow from disposal

of machine


Expenditures


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Expenditures

salvage value in year 5 = $50,000

book value of machine in year 5 = $0

gain from disposal of machine = $50,000 - $0 -$50,000

tax payment on gain from disposal of machine =($50,000-$0)*34% = $17,000

if marginal tax rate is 34%, incremental cash flowfrom disposal of machine = $50,000 - ($50,000-$0)*34% = $33,000

Depreciation Method for Tax Reporting


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so far, assume straight line depreciation method

is used for tax reporting

may be different from the depreciation method

used for financial reporting

accelerated depreciation: recognize higherdepreciation expenses in early years and lower in

later years

Inland Revenue is likely to adopt an accelerateddepreciation method for tax reporting (why?)

Depreciation Method in US


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actual tax depreciation method allowed by the

Inland Revenue Service in US is called modified

accelerated cost recovery system (MACRS) whichallows for accelerated depreciation of property

under different classifications

MACRS


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only for

half a year

depreciation

rate on eachyear

Example: MACRS


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Suppose a machine costs $12,000 and belongsto the 5-year class in MACRS.

year MACRS %depreciati

on

beginning

book value

ending

book value

1 20.00% $2,400 $12,000 $9,6002 32.00% $3,840 $9,600 $5,760

3 19.20% $2,304 $5,760 $3,456

4 11.52% $1,382 $3,456 $2,0745 11.52% $1,382 $2,074 $691

6 5.76% $691 $691 $0

total 100.00% $12,000

book

value in

IRSrecords

Depreciation Method in Hong Kong


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initial allowance (depreciation): 60% in year 1

annual allowance (depreciation): 10%, 20% or30% class on remaining balance from year 1onwards

Example: Depreciation Method in Hong

Kong


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Suppose a machine costs $12,000 and belongsto the 30% class in Hong Kong.

year beginningbook value

initialallowance

annualallowance

totalallowance

endingbook value

1 $12,000 $7,200 $1,440 $8,640 $3,360

2 $3,360 $1,008 $1,008 $2,352

3 $2,352 $706 $706 $1,646

4 $1,646 $494 $494 $1,152

5 $1,152 $346 $346 $807

6 $807 $242 $242 $5657 $565 $169 $169 $395

8 $395 $119 $119 $277

9 $277 $83 $83 $194

10 $194 $58 $58 $136

Estimating Incremental Revenue and

Incremental Cost


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talk to sales and marketing people to estimateincremental revenue

talk to production and operations people toestimate incremental costs

estimate revenue and costs on incremental basis


Incremental Cost


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issues to notice

product life cycle: initial low sales (start-up),

accelerating sales (growth), level sales(maturity) and declining sales (decline)

prices and costs increase with inflation and

decline with technological advancement competition tends to drive profit margins down

over time

EBIT = incremental revenue – incremental costs -depreciation


Incremental Cost


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sales revenue

time

start-up growth declinematurity

Example: Estimating Incremental

Revenue and Incremental Cost


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after examining the issue of the $1,000,000machine in the previous example, the financial

manager has talked to the people from differentdepartments and he forecasts the followingestimates:

year 0 1 2 3 4 5

incremental revenue $525,000 $525,000 $525,000 $525,000 $525,000

incremental cost -$75,000 -$175,000 -$175,000 -$175,000 -$175,000 -$175,000

depreciation -$200,000 -$200,000 -$200,000 -$200,000 -$200,000

EBIT -$75,000 $150,000 $150,000 $150,000 $150,000 $150,000

Determining Income Tax Expense


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marginal tax rate: the tax rate a firm will pay onan incremental dollar of pretax income

effective tax rate: the tax rate calculated asincome tax expense divided by pretax income

statutory tax rate: the tax rate announced by the

government which is the appropriate tax rate?

income tax expense = EBIT * tax rate

Example: Determining Income Tax

Expense


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if the company in the previous example faces amarginal tax rate of 34%, the financial manager

estimates the following:

year 0 1 2 3 4 5



depreciation -$200,000 -$200,000 -$200,000 -$200,000 -$200,000

EBIT -$75,000 $150,000 $150,000 $150,000 $150,000 $150,000

income tax @34% -$25,500 $51,000 $51,000 $51,000 $51,000 $51,000

what does a negative

income tax mean?

Taxes and Negative EBIT


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if EBIT is negative in a year, are taxes still relevant?

if the company earns taxable income elsewhere

in that year, the negative EBIT from the projectcan reduce the overall taxable income andhence the tax payment for the year

if the company does not generate any taxableincome in that year or the taxable income isless than the negative EBIT, all or part of the

negative EBIT (taxable loss) can be carriedbackward to past years (tax rebate) or forwardto the coming years within a specified limit

Example: Taxes and Negative EBIT


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A company plans to launch a new product. Theheavy advertising expenses associated with the

new product will result in an operating loss of$10 million next year for the product. Thecompany expects to earn a taxable income of

$500 million from operations other than the newproduct. The tax rate is 34%. What will be the taxpayment without the project? With the project?

Example: Taxes and Negative EBIT


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tax payment without project = $500 million*34% = $170 million

tax payment with project = ($500--$10million)*34% = $166.6 million

difference in tax payment of $3.4 million is anincremental cash inflow and hence relevant in

capital budgeting

Forecasting Incremental Earnings


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incremental earnings

= (incremental revenue – incremental cost –

depreciation) * (1 – tax rate)= incremental EBIT * (1 – tax rate)

Example: Forecasting Incremental

Earnings


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as in the previous example, the financialmanager estimates the following:

year 0 1 2 3 4 5



depreciation -$200,000 -$200,000 -$200,000 -$200,000 -$200,000

EBIT -$75,000 $150,000 $150,000 $150,000 $150,000 $150,000

income tax @34% -$25,500 $51,000 $51,000 $51,000 $51,000 $51,000

incremental earnings -$49,500 $99,000 $99,000 $99,000 $99,000 $99,000

Estimating Change in Net Working

Capital


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broad definition: NWC = current assets – current

liabilities

narrow definition: NWC = current assets(excluding cash that can generate a market rate

of return, e.g. cash equivalents) – current

liabilities (excluding short-term financing

liabilities)

change in NWC in year t = NWCt – NWCt-1 increase in NWC is a cash outflow (why?)

decrease in NWC is a cash inflow (why?)

Estimating Change in Net Working

Capital


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cash outflow at beginning of project (increase in

NWC in year 0) and cash inflow at project end

(decrease in NWC at project end) but with inflation, NWC changes every year and

change in NWC occurs every year until project

end (why?)

Example: Estimating Change in Net

Working Capital


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as in previous example, the financial estimatesthe net working capital level associated with the

project as follows:year 0 1 2 3 4 5

NWC $200,000 $200,000 $200,000 $200,000 $200,000 $0

change in NWC -$200,000 $0 $0 $0 $0 $200,000

inflation rate is 10%

year 0 1 2 3 4 5

NWC $200,000 $220,000 $242,000 $266,200 $292,820 $0change in NWC -$200,000 -$20,000 -$22,000 -$24,200 -$26,620 $292,820

Preparing Pro Forma Financial

Statements


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treat project as “mini-firm” and prepare pro

forma financial statements for project

pro forma financial statements or pro formas:

describe a company that is not based on actual

data but rather depicts a firm’s financials under a

given set of assumptions

Example: Preparing Pro Forma Financial

Statements


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in the previous example, the financial managerprepares the following financial statements:

year 0 1 2 3 4 5

Revenue $0 $525,000 $525,000 $525,000 $525,000 $525,000

COGS $0 -$100,000 -$100,000 -$100,000 -$100,000 -$100,000

Gross profit $0 $425,000 $425,000 $425,000 $425,000 $425,000

Selling, general and

administrative expense -$75,000 -$75,000 -$75,000 -$75,000 -$75,000 -$75,000

Depreciation $0 -$200,000 -$200,000 -$200,000 -$200,000 -$200,000

EBIT -$75,000 $150,000 $150,000 $150,000 $150,000 $150,000

Income tax @34% -$25,500 $51,000 $51,000 $51,000 $51,000 $51,000

Net Income -$49,500 $99,000 $99,000 $99,000 $99,000 $99,000

year 0 1 2 3 4 5

Net working capital $200,000 $200,000 $200,000 $200,000 $200,000 $0

Fixed assets $1,000,000 $800,000 $600,000 $400,000 $200,000 $0

Equity $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $0

Income Statement

Statement of Financial Position

Estimating Incremental Free Cash Flows


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from pro forma financial statements andincremental earnings, estimate incremental free

cash flows and apply NPV rule to make decisionon project

FCFt = -CapExt + incremental operating cash

flows - ∆NWCtwhere FCFt = incremental free cash flows (to

the firm) at time t; CapEx = capital

expenditures at time t; ∆NWCt = change in networking capital at time t

not all cash flows occur at the same time

Estimating Incremental Free Cash Flows


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operating cash flows on incremental basis (addback depreciation to incremental earnings)

= (incremental revenue – incremental costs –depreciation)*(1-tax rate) + depreciation (top-down)

= (incremental revenue – incrementalcosts)*(1-tax rate) +deprecation*tax rate(depreciation tax shield)

= incremental EBIT*(1-tax rate) + depreciation(bottom-up) (notice: EBIT = revenue – costs –depreciation)

Example: Estimating Incremental Free

Cash Flows


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as in previous example, the financial managerestimates the incremental free cash flows :

year 0 1 2 3 4 5incremental revenue $525,000 $525,000 $525,000 $525,000 $525,000


depreciation -$200,000 -$200,000 -$200,000 -$200,000 -$200,000

EBIT -$75,000 $150,000 $150,000 $150,000 $150,000 $150,000

income tax @34% -$25,500 $51,000 $51,000 $51,000 $51,000 $51,000

incremental earnings -$49,500 $99,000 $99,000 $99,000 $99,000 $99,000

add: depreciation $0 $200,000 $200,000 $200,000 $200,000 $200,000

subtract: Capex and

disposal of machine

-$1,000,000 $0 $0 $0 $0 $33,000

subtract: change in

NWC -$200,000 $0 $0 $0 $0 $200,000

incremental free cash

flows -$1,249,500 $299,000 $299,000 $299,000 $299,000 $532,000

Summary of Incremental Free Cash

Flows


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initial investment: cash outflow in year 0

incremental operating cash flows: cash inflows

usually from year 1 until project end

add back depreciation as non-cash item

change in net working capital: cash outflow inyear 0 and cash inflow at project end

only change in NWC matters, not NWC itself

salvage value: cash flow from disposal of fixedassets

gain/loss from disposal is subject to tax effect


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Example: Calculating NPV and Make

Decision

i i l th fi i l g


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as in previous example, the financial managercalculate the NPV and decides to reject the

project as follows:

year 0 1 2 3 4 5

incremental free cash

flows -$1,249,500 $299,000 $299,000 $299,000 $299,000 $532,000

discounted cash flows

@12% -$1,249,500 $266,964 $238,361 $212,822 $190,020 $301,871

NPV -$39,461

Decision reject project

Overall Example

You are the finance manager of a company You


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You are the finance manager of a company. Youwant to analyze a proposal for a new product. You

have prepared the forecasts shown in thefollowing table so that you can prepare the pro-forma financial statements. The project requiresan initial investment of $12 million in equipment.The company uses the straight line depreciationmethod in preparing the financial statements.The estimated life of the equipment is 6 years

and the ending book value in year 6 is assumedto be zero.

Overall Example

The equipment can be dismantled and sold for


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The equipment can be dismantled and sold fornet proceeds estimated at $2 million in year 6.

This is your forecast of the equipment’s salvagevalue. In Hong Kong, there is an initial allowanceof 60% and the equipment belongs to thecategory of 30% annual allowance on theremaining balance.

The estimated discount rate for the project is20%.

Overall Example


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including the gain on selling

equipment = ($2,000-$0) = $2,000

year (HK$'000) 0 1 2 3 4 5 6

1. Initial investment of equipment 12,000

2. Accumulated depreciation 2,000 4,000 6,000 8,000 10,000 12,000

3. Year-end book value 12,000 10,000 8,000 6,000 4,000 2,000 04. Net working capital 550 1,289 3,261 4,890 3,583 2,002 0

5. Total book value (3+4) 12,550 11,289 11,261 10,890 7,583 4,002 0

6. Salvage value of equipment 2,000

7. Sales 523 12,887 32,610 48,901 35,834 19,717

8. Cost of goods sold 837 7,729 19,552 29,345 21,492 11,8309. Other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772

10. Depreciation 2,000 2,000 2,000 2,000 2,000 2,000

11. Income before tax (7-8-9-10) -4,000 -4,514 1,948 9,727 16,092 10,731 6,115

12. Tax at 16.5% -660 -745 321 1,605 2,655 1,771 1,009

13. Net income (11-12) -3,340 -3,769 1,627 8,122 13,437 8,960 5,106

Overall Example

The tax depreciation schedule is as follows:


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Topic 3 Investment Decision Rules and Capital Budgeting M K Lai Page 104Topic 05 Capital Budgeting M K Lai Page 104

The tax depreciation schedule is as follows:

year (HK$'000) 0 1 2 3 4 5 6

1. Initial investment of equipment 12,000

2. Initial allowance of 60% 7,200

3. Annual allowance of 30% 1,440 1,008 706 494 346 242

4. Total tax depreciation 8,640 1,008 706 494 346 242

5. Year-end tax book value 3,360 2,352 1,646 1,152 807 565

Overall Example

The tax schedule is as follows:


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The tax schedule is as follows:

year (HK$'000) 0 1 2 3 4 5 61. Sales 523 12,887 32,610 48,901 35,834 19,717

2. Cost of goods sold 837 7,729 19,552 29,345 21,492 11,830

3. Other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772

4. Tax depreciation 8,640 1,008 706 494 346 242

5. Gain on sale of equipment 1,435

6. Taxable income -4,000 -11,154 2,940 11,021 17,598 12,385 7,308

7. Tax at 16.5% -660 -1,840 485 1,819 2,904 2,044 1,206

Overall Example

Assume that the company takes advantage of all


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Assume that the company takes advantage of alltax savings.

Projected cash flow table

year (HK$'000) 0 1 2 3 4 5 6

1. Sales 523 12,887 32,610 48,901 35,834 19,717

2. Cost of goods sold 837 7,729 19,552 29,345 21,492 11,830

3. Other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772

4. Tax -660 -1,840 485 1,819 2,904 2,044 1,2065. Operating cash flow -3,340 -674 3,463 9,908 15,188 10,687 4,909

6. Change in NWC -550 -739 -1,972 -1,629 1,307 1,581 2,002

7. Capital spending -12,000 2,000

8. Total net cash flow -15,890 -1,413 1,491 8,279 16,495 12,268 8,911

9. Discounted cash flow at 20% -15,890 -1,177 1,035 4,791 7,955 4,930 2,98410 NPV 4,629

As NPV > 0, accept the project.

Special Effects on Incremental Free

Cash Flows

opportunity cost


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opportunity cost

incidental/externality/spillover/side effects

sunk cost (ignored)

overhead cost allocation (be careful)

financing costs (excluded)

Opportunity Cost

opportunity cost: most valuable alternative


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opportunity cost: most valuable alternative(second best project) that is given up if aparticular project is accepted

cash outflow though it may not involve actual

cash payment

the project and its alternative can be considered

as mutually exclusive projects, i.e. if acceptingthe project, have to forego the alternative(remember the “incremental” basis)

Opportunity Cost

in order to accept the project, a firm has to make


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in order to accept the project, a firm has to makesure that the present value of all cash flowsarising from the project exceed that of thealternative – otherwise, it adds more value to thefirm by accepting the alternative – hence the (netpresent) value of the alternative becomes arelevant cash outflow

Incidental/Externality/Spillover/

Side Effect

externality: relevant cash flows incidental on the


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externality: relevant cash flows incidental on the

project

negative effects lead to cash outflowserosion or cannibalization: cash flows of

new product come from those of old

products

environment: meeting environmental

standards

Incidental/Externality/Spillover/

Side Effect

positive effects lead to cash inflows


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positive effects lead to cash inflows

by-products: sale of side products

cross-selling: sale of new product triggerssale of old products.

increased traffic: more customers attracteven more customers

real options: the right to make a particular

business decisionthe value of a real option is usually non-

negative (why?)

Real Options in Capital Budgeting

add positive value to NPV of project


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p p j

option to delay commitment: the right to time

a particular investment option to expand: the right to start with limited

production and expand only if the product is

successful option to abandon: the right for an investor to

cease investing in a project (drop it when it is

not successful)

Sunk Cost

sunk cost: a cost that has already been incurred


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yand cannot be recovered

irrelevant for making the current decision

past research and development expenditures

past marketing or pilot test

fixed overhead expenses

Overhead Cost Allocation

a firm should be careful to distinguish between


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gaccounting overhead cost allocation andincremental overhead cost allocation

only incremental overhead cost allocation is arelevant cash outflow

for example a firm has rented a warehouse for storage

now, it launches a new project which requires

the use of some storage space in thewarehouse and it has to hire new workers totake care of the logistics of the new products

Overhead Cost Allocation

in accounting, part of the rental expense may


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be allocated to the new project, but it is notincremental and hence irrelevant

however, the wages to the newly hired workersare relevant cash outflows in capital budgeting

because they are incremental

Financing Cost

financing costs like dividend payments, stock


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g p y

repurchase, interest payments, principal

repayment are not included in capital budgetingand hence irrelevant

especially be careful about interest expenses that

are included in calculating the net income in theincome statement

exclude interest expenses and their tax saving, i.e.

we consider the EBIT as the operating cash flows

Financing Cost

separation of investment and financing decisions


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only consider cash flows from assets in

investment decision, i.e. uses of funds cash flow implication from financing decision

(e.g. interest expenses), i.e. sources of funds

unlevered net income: net income that does notinclude interest expenses associated with debt

in capital budgeting, estimate unlevered net

income of a project and determine its cashflows

Post Audit

also known as financial control, an often ignored


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but actually important step

compare actual results with the estimates infinancial planning

positive or negative deviations?

why deviations? human errors and/oruncontrollable external factors

who is responsible?

any remedial actions

feedback to next round of capital budgetingexercise

Post Audit

uses of post audit


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1.

2.

3.

4.

Post Audit

assumptionsfinancial


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current financial

position and pastoperating

performance

pro-formas, cash

and capitalbudgets, financial

plans

p

implementation of

financial plans

actual results

analysis

control

statements and

market data planning

feedback

Conclusion

generate the idea of a project


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be careful about assumptions in pro formafinancial statements of the project

project incremental free cash flows of the project

use NPV rule in making decision on the project

carry out post audit

Challenging Questions

1. How is the NPV rule related to the goal ofi i i g h h ld lth?


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maximizing shareholder wealth?

2. Why does the NPV decision not depend on theinvestor’s preferences?

3. How can you interpret the difference between

the cost of capital and the internal rate of return(IRR) under the NPV rule?

4. Explain why choosing the option with the highest

NPV is not always correct when the options havedifferent lives. What additional issues shouldyou keep in mind when choosing among

projects with different lives?


5. Which of the investment criteria in capital


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budgeting does not take into account the project

risk, NPV, IRR, payback period, discountedpayback period and equivalent annual annuity?

6. What are the differences between incremental

earnings and incremental free cash flows incapital budgeting?

7. Which of the following statements describes a

situation that is not considered as appropriate

when applying the net present value rule in

capital budgeting?


A. A financial manager estimates the before-

h fl f j d di


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tax cash flows of a project and discounts

them at the before-tax discount rate. B. In considering two mutually exclusive

projects, a financial manager subtracts the

cash flows of one project from those ofanother project. Based on the net present

value of this net cash flow stream, he makes

a decision to choose between these two

projects.


C. A financial manager includes the

d i ti t hi ld l t h


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depreciation tax shield as a relevant cash

inflow in a project. D. When calculating the corporate income

tax paid to the government in a capital

budgeting exercise, a financial manager usesthe accounting methods used in preparing

the financial statements.


8. A company is considering whether to undertake a

j t I th j t th i i d t


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project. In the project, the company is required to

make use of an idle machine which has noalternative use at all. In the tax records, the net

book value of the machine is $100,000. In the

financial statements, the net book value of themachine is $250,000. Which of the following

statements is correct with respect to the machine?


A. There is no relevant cash flow associatedwith the use of the machine in this project


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with the use of the machine in this project.

B. There is a relevant cash outflow of$100,000 with the use of the machine in thisproject because it is the opportunity cost.

C. There is a relevant cash outflow of$150,000 with the use of the machine in thisproject because it is the opportunity cost.

D. There is a relevant cash outflow of$250,000 with the use of the machine in thisproject because it is the opportunity cost.


9. A company is carrying out a capital budgeting

exercise on an incremental project of project X


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exercise on an incremental project of project X

minus project Y. Which of the following items isconsidered as a cash outflow for this

incremental project?

A. Project X will recognize an annualdepreciation expense of $200,000 for tax

reporting.


B. In project X, it is estimated that some old

customers will switch from the old products


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customers will switch from the old products

to the new products and there will be a dropin the annual sales revenue of the old

products by $400,000.

C. There is an increase in net working capitalof $450,000 at the beginning of project Y.

D. There will be a tax saving on disposal of a

machine of $150,000 at the end of project Y.


10.“The board of directors of a company decides to

assign a particular senior manager in the


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assign a particular senior manager in the

operations department to lead a new project ofimproving the operational efficiency of the

company. In the capital budgeting exercise, the

board agrees that they should allocate thesalary of the senior manager as a cash outflow

to the project. The rationale is that the manager

is now 100% devoted to the project. Without theproject, he can be assigned elsewhere and this

is an opportunity cost.” Do you agree?


11. In order to fill the rush orders from customers, a

manufacturing company usually asks the workers


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manufacturing company usually asks the workers

to work overtime, but the overtime pay is usually

1.1 times the normal pay on an hourly basis. With

a capital project, the company expects that there

will be a lot of rush orders from customers. Inorder to give more incentives to the workers to

work overtime for the project, the company

decides to raise the overtime hourly wage rate to1.15 times the normal hourly wage rate. Which of

the following statements is correct with respect to

the overtime pay for the project?


A. The original overtime pay of 1.1 times the

normal pay for the project is relevant because it is


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normal pay for the project is relevant because it is

an incremental cash outflow.

B. The original overtime pay of 1.1 times the

normal pay for the project is irrelevant because it

is a sunk cost. C. The additional overtime pay of 0.05 (1.15 – 1.1)

times the normal pay for the project is irrelevant

because it is a sunk cost. D. The additional overtime pay of 0.05 (1.15 – 1.1)

times the normal pay for the project is relevant

because it is an incremental cash outflow.


12.In the capital budgeting exercise on a project,

the chief financial officer of a company finds


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the chief financial officer of a company finds

that the company has the flexibility to give upthe project before the end of its life in the future.

Which of the following statements is correct in

respect of this flexibility to abandon?


A. The flexibility may add negative value to thenet present value of the project because it


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p p jrenders the initial investment of the project

worthless in the future. B. The flexibility may add negative value to the

net present value of the project because of the

increased uncertainty. C. The flexibility may add positive value to the

net present value of the project because it is

an opportunity cost. D. The flexibility may add positive value to the

net present value of the project because it is a

strategic option.

FINA2303 Topic 03 Capital Budgeting

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