5-1 Capital Budgeting : Part I Capital Budgeting : Part I Investment Criteria Investment Criteria
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5-1
Capital Budgeting : Part ICapital Budgeting : Part I
Investment CriteriaInvestment Criteria
5-2
Investment Criteria
How should a firm make an investment decisionHow should a firm make an investment decisionWhat assets do we buy?What assets do we buy?What is the underlying goal?What is the underlying goal?What is the right decision criterion?What is the right decision criterion?
Capital BudgetingCapital Budgeting
Evaluate different decision rules Evaluate different decision rules tools! tools!Implement using the Super Project case studyImplement using the Super Project case study
5-3
Net Present ValueNet Present Value
NPV = –Initial Cost + Market ValueNPV = –Initial Cost + Market Value NPV = – Initial Cost + PV(Expected Future CF’s)NPV = – Initial Cost + PV(Expected Future CF’s)
wherewhere r reflects the risk of the project’s cash flowsreflects the risk of the project’s cash flows
Note that this is a generic formula, and we really use the tools from Note that this is a generic formula, and we really use the tools from time value of money (annuities, perpetuities, etc.) from before.time value of money (annuities, perpetuities, etc.) from before.
Net Present Value (NPV) Rule:Net Present Value (NPV) Rule: NPV > 0NPV > 0 Accept the project.Accept the project. NPV < 0 NPV < 0 Reject the project.Reject the project.
T
0=tt
tT
1=tt
t
r)+(1
CF =
r)+(1
CF +Cost - =NPV
5-4
More on the Appropriate More on the Appropriate Discount Rate, rDiscount Rate, r
Discount rate = opportunity cost of capitalDiscount rate = opportunity cost of capital Expected rate of return given up by investing in the projectExpected rate of return given up by investing in the project Reflects the risk of the cash flows from the projectReflects the risk of the cash flows from the project
Discount rate does Discount rate does notnot reflect the risk of the reflect the risk of the firm or the risk of the firm’s previous firm or the risk of the firm’s previous projects (remember: the past is irrelevant)projects (remember: the past is irrelevant)
5-5Using the NPV Rule
Your firm is considering whether to invest in a new product. The Your firm is considering whether to invest in a new product. The costs associated with introducing this new product and the costs associated with introducing this new product and the expected cash flows over the next four years are listed below. expected cash flows over the next four years are listed below. (Assume these cash flows are 100% likely). The appropriate (Assume these cash flows are 100% likely). The appropriate discount rate for these cash flows is 20% per year. Should the discount rate for these cash flows is 20% per year. Should the firm invest in this new product? firm invest in this new product?
Costs:Costs: ($ million)($ million)
Promotion and advertising 100
Production & related costs 400
Other 100
Total Cost 600
Initial Cost: $600 million and r = 20%
The cash flows ($million) over the next four years:
Year 1: $200; Year 2: $220; Year 3: $225; Year 4: $210
Should the firm proceed with the project?
5-6
Using NPV, concluded
Year
Cash Flow
Present Value
Factor
PV(Cash Flow)
0
(600.00)
1.00
(600.00)
1
$200.00
2
$220.00
3
$225.00
4
$210.00
NPV =
(1.20)1 166.67
(1.20)2 152.78
(1.20)3 130.21
(1.20)4 101.27
(49.07)
5-7
Payback Rule
Payback period = the length of time until Payback period = the length of time until the accumulated cash flows from the the accumulated cash flows from the investment are equal to or exceed the investment are equal to or exceed the original costoriginal cost
Payback rule: If the calculated payback Payback rule: If the calculated payback period is less than or equal to some pre-period is less than or equal to some pre-specified payback period, then accept the specified payback period, then accept the project. Otherwise reject it.project. Otherwise reject it.
5-8
Example: Payback
Example:Example: Consider the previous investment project. The Consider the previous investment project. The initial cost is $600 million. It has been decided that the initial cost is $600 million. It has been decided that the project should be accepted if the payback period is 3 years project should be accepted if the payback period is 3 years or less. Using the payback rule, should this project be or less. Using the payback rule, should this project be undertaken?undertaken?
Year
Cash Flow
Accumulated Cash Flow
1
$200.00
$200
2
220.00
3
225.00
4
210.00
$420
$645 > $600
$855
5-9
Analyzing the Payback Rule
Consider the following table. The payback period cutoff is two Consider the following table. The payback period cutoff is two years. Both projects cost $250. Which would you pick years. Both projects cost $250. Which would you pick using the payback rule? Why?using the payback rule? Why?
Year
Long
Short
1
$100.00
$200.00
2
100.00
100.00
3
100.00
0.00
4
100.00
0.00
Which project would you pick using the NPV rule? Assume Which project would you pick using the NPV rule? Assume the appropriate discount rate is 20%.the appropriate discount rate is 20%.
5-10Advantages and Disadvantages of the Advantages and Disadvantages of the Payback RulePayback Rule
AdvantagesAdvantages
DisadvantagesDisadvantages
Popular among many large companiesPopular among many large companiesCommonly used when the:Commonly used when the:
• capital investment is smallcapital investment is small• merits of the project are so obvious that merits of the project are so obvious that
more formal analysis is unnecessarymore formal analysis is unnecessary
5-11
The Discounted Payback RuleThe Discounted Payback Rule
Discounted Payback periodDiscounted Payback period: The length of time : The length of time until the accumulated until the accumulated discounteddiscounted cash flows cash flows from the investment equal or exceed the original from the investment equal or exceed the original cost. (We will assume that cash flows are cost. (We will assume that cash flows are generated continuously during a period)generated continuously during a period)
The Discounted Payback RuleThe Discounted Payback Rule: An investment is : An investment is accepted if its calculated discounted payback accepted if its calculated discounted payback period is less than or equal to some pre-specified period is less than or equal to some pre-specified number of years.number of years.
5-12
Example: Discounted Payback
Example: Consider the previous investment project analyzed with the NPV rule. The initial cost is $600 million. The discounted payback period cutoff is 3 years. The appropriate discount rate for these cash flows is 20%. Using the discounted payback rule, should the firm invest in the new product?
Year
Cash Flow
Present ValueFactor
Discounted
AccumulatedCash Flow
1
$200.00
2
$220.00
3
$225.00
4
$210.00
(1.20)1 166.67
(1.20)2 152.78 319.45
(1.20)3 130.21 449.66
(1.20)4 101.27 550.93
5-13AnalyzingAnalyzingthe Discounted Payback Rulethe Discounted Payback Rule
AdvantagesAdvantages DisadvantagesDisadvantages Bottom Line:Bottom Line:
Why Bother? You might Why Bother? You might as well compute the NPV! Will as well compute the NPV! Will
always work!always work!
5-14Internal Rate of Return (IRR) RuleInternal Rate of Return (IRR) Rule
IRR is that discount rate, IRR is that discount rate, r,r, that makes the NPV that makes the NPV equal to zero. In other words, it makes the equal to zero. In other words, it makes the
present value of future cash flows equal to the present value of future cash flows equal to the initial cost of the investment.initial cost of the investment.
T
0=tt
t
T
0=tt
t
IRR)+(1
CF0
r)+(1
CF = NPV
5-15
IRR RuleIRR Rule
Accept the project if the IRR is greater than Accept the project if the IRR is greater than the required rate of return (discount rate). the required rate of return (discount rate). Otherwise, reject the project.Otherwise, reject the project.
Calculating IRR: Like Yield-to-Maturity, IRR Calculating IRR: Like Yield-to-Maturity, IRR is difficult to calculate.is difficult to calculate. Need financial calculatorNeed financial calculator Trial and errorTrial and error Excel or Lotus SpreadsheetExcel or Lotus Spreadsheet Easy to first calculate NPV then use the answer to get a Easy to first calculate NPV then use the answer to get a
first good guess about the IRR!!!first good guess about the IRR!!!
5-16
IRR Illustrated
Initial outlay = -$200Initial outlay = -$200
Year Cash flowYear Cash flow
11 50 50
22 100100 33 150150
Find the IRR such that NPV = 0Find the IRR such that NPV = 0
5050 100 100 150150 0 0 = = -200 + + +-200 + + + (1+IRR)(1+IRR)11 (1+IRR) (1+IRR)2 2 (1+IRR)(1+IRR)33
5050 100 100 150150 200 200 = = + + + + (1+IRR)(1+IRR)11 (1+IRR) (1+IRR)22 (1+IRR) (1+IRR)33
5-17
IRR Illustrated
Trial and ErrorTrial and Error
Discount ratesDiscount rates NPVNPV
0%0% $100$100
5%5% 68 68
10%10% 41 41
15%15% 18 18
20%20% –2 –2
IRR is just under 20% -- about 19.44%IRR is just under 20% -- about 19.44%
5-18
Year Cash flow
0 – $200 1 50 2 100 3 150 4 0
Net Present Value Profile
Discount rate
2% 6% 10%
14% 18%
120
100
80
60
40
20
Net present value
0
– 20
– 40
22%
IRR
5-19
Comparison of IRR and NPV
IRR and NPV rules lead to identical decisions IRR and NPV rules lead to identical decisions IFIF
the following conditions are satisfied:the following conditions are satisfied: Conventional Cash FlowsConventional Cash Flows: The first cash flow (the initial : The first cash flow (the initial
investment) is negative and investment) is negative and allall the remaining cash flows the remaining cash flows are positiveare positive
Project is independentProject is independent: A project is independent if the : A project is independent if the decision to accept or reject the project does decision to accept or reject the project does notnot affect affect the decision to accept or reject any other project.the decision to accept or reject any other project.
When one or both of these conditions are not When one or both of these conditions are not met, problems with using the IRR rule can result!met, problems with using the IRR rule can result!
5-20
Unconventional Cash Flows
Unconventional Cash Flows: Cash flows come Cash flows come first and investment cost is paid later. In this first and investment cost is paid later. In this case, the cash flows are like those of a loan and case, the cash flows are like those of a loan and the IRR is like a borrowing rate. Thus, in this the IRR is like a borrowing rate. Thus, in this case a lower IRR is better than a higher IRR.case a lower IRR is better than a higher IRR.
Multiple rates of return problem: Multiple sign Multiple sign changes in the cash flows introduce the changes in the cash flows introduce the possibility that more than one discount rate possibility that more than one discount rate makes the NPV of an investment project zero.makes the NPV of an investment project zero.
5-21
Example: Unconventional Cash Flows
Example: A strip-mining project requires an initial Example: A strip-mining project requires an initial investment of $60. The cash flow in the first year is $155. investment of $60. The cash flow in the first year is $155. In the second year, the mine is depleted, but the firm has to In the second year, the mine is depleted, but the firm has to spend $100 to restore the land. spend $100 to restore the land.
$60 = 155/(1 + IRR) – 100/(1 + IRR)$60 = 155/(1 + IRR) – 100/(1 + IRR)22
Discount Rate (IRR)Discount Rate (IRR) NPVNPV
0.0%0.0% – $5.00 – $5.00
10.0010.00 – 1.74 – 1.74
20.0020.00 – 0.28 – 0.28
25.0025.00 0.00 0.00
30.0030.00 0.06 0.06
33.3333.33 0.00 0.00
40.0040.00 – 0.31 – 0.31
Generally, the number of possible IRRs is equal to the Generally, the number of possible IRRs is equal to the number of changes in the sign of the cash flows.number of changes in the sign of the cash flows.
5-22
Mutually Exclusive Projects
Mutually exclusive projectsMutually exclusive projects: If taking one project : If taking one project implies another project is not taken, the projects implies another project is not taken, the projects are mutually exclusive. The one with the highest are mutually exclusive. The one with the highest IRR may not be the one with the highest NPV.IRR may not be the one with the highest NPV.
Example: Project A has a cost of $500 and cash Example: Project A has a cost of $500 and cash flows of $325 for two periods, while project B has flows of $325 for two periods, while project B has a cost of $400 and cash flows of $325 and $200 a cost of $400 and cash flows of $325 and $200 respectively, in years 1 and 2.respectively, in years 1 and 2.
5-23
Mutually Exclusive Projects
Period Project A Project B
0 -500 -400
1 325 325
2 325 200
IRR
Project B appears better because of the higher return. However...Project B appears better because of the higher return. However...
19.43% 22.17%
5-24
Mutually Exclusive Projects
Discount RateDiscount Rate NPV(A)NPV(A) NPV(B)NPV(B)
0.0%0.0% $150.00$150.00 $125.00$125.00
5.005.00 104.32 104.32 100.00 100.00
10.0010.00 64.05 64.05 60.74 60.74
15.0015.00 28.36 28.36 33.84 33.84
20.0020.00 -3.47 -3.47 9.72 9.72
Which project is preferred depends on the discount rate. Which project is preferred depends on the discount rate.
Project A has a higher NPV at a 10% discount rateProject A has a higher NPV at a 10% discount rate
Project B has a higher NPV at a 15% discount rate.Project B has a higher NPV at a 15% discount rate.
5-25
Crossover Rate
Crossover RateCrossover Rate: The discount rate that makes the : The discount rate that makes the NPV of the two projects the same. NPV of the two projects the same.
Finding the Crossover RateFinding the Crossover Rate Use the NPV profilesUse the NPV profiles
Calculate the IRR based on the Calculate the IRR based on the incrementalincremental cash flows. cash flows.
If the incremental IRR is greater than the required rate of If the incremental IRR is greater than the required rate of return, take the larger project.return, take the larger project.
5-26
Mutually Exclusive Cash FlowsMutually Exclusive Cash Flows
Period Project A Project B Incremental(A - B)
0 -500 -400
1 325 325
2 325 200
IRR 19.43 22.17
Example: If project A has a cost of $500 and cash flows of $325 for two periods, while project B has a cost of $400 and cash flows of $325 and $200 respectively, the incremental cash flows are:
–$100
0
125
100=125/(1+IRR)2
IRR=11.8%
5-27
NPV Profiles of Mutually NPV Profiles of Mutually Exclusive ProjectsExclusive Projects
($50.00)
($30.00)
($10.00)
$10.00
$30.00$50.00
$70.00
$90.00
$110.00
$130.00
$150.00
0 5 10 15 20 25
Project A Project B
Crossover Rate = 11.8
IRRA=19.43
IRRB=22.17
5-28
Advantages and Disadvantages of IRRAdvantages and Disadvantages of IRR
AdvantagesAdvantages closely related to NPVclosely related to NPV easy to understand and communicateeasy to understand and communicate
DisadvantagesDisadvantages may result in multiple answersmay result in multiple answers may lead to incorrect decisionsmay lead to incorrect decisions not always easy to calculatenot always easy to calculate
Very Popular: People like to talk in terms of Very Popular: People like to talk in terms of returnsreturns 99% use IRR Rule instead of 85% using NPV rule99% use IRR Rule instead of 85% using NPV rule
5-29Capital Budgeting:
Determining the Relevant Cash Flows
Relevant cash flowsRelevant cash flows - the - the incremental cash incremental cash flowsflows associated with the decision to invest associated with the decision to invest in a project.in a project.
The The incremental cash flowsincremental cash flows for project for project evaluation consist of evaluation consist of any and all any and all changes in changes in the firm’s future cash flows that are a direct the firm’s future cash flows that are a direct consequence of taking the project.consequence of taking the project.
Difference between cash flows with project Difference between cash flows with project and cash flows withoutand cash flows without
5-30
Stand-Alone PrincipleStand-Alone Principle
Evaluation of a project on the basis of its Evaluation of a project on the basis of its incremental cash flowsincremental cash flows
Project = "Mini-firm”Project = "Mini-firm” has own assets and liabilities; revenues and costshas own assets and liabilities; revenues and costs
Allows us to evaluate the investment project Allows us to evaluate the investment project separately from other activities of the firmseparately from other activities of the firm
5-31Aspects of Incremental
Cash Flows
Sunk CostsSunk Costs
Opportunity CostsOpportunity Costs
Side Effects: ErosionSide Effects: Erosion
Net Working Capital Net Working Capital
Financing CostsFinancing Costs
All Cash Flows should be after-tax cash flows
5-32Sunk CostsSunk Costs
Heinz hires The Boston Consulting Group (BCG) Heinz hires The Boston Consulting Group (BCG) to evaluate whether a new product line should be to evaluate whether a new product line should be launched. The consulting fees are paid no matter launched. The consulting fees are paid no matter what.what.
Should notShould not be included in incremental cash flows! be included in incremental cash flows!
Valuation is always forward looking!Valuation is always forward looking!
5-33Opportunity CostsOpportunity Costs
Firm paid $300,000 land to be used for a warehouse. Firm paid $300,000 land to be used for a warehouse. The current market value of the land is $450,000.The current market value of the land is $450,000.
Opportunity Cost = $450,000Opportunity Cost = $450,000Sunk Cost = $300,000Sunk Cost = $300,000
ShouldShould be included be included in incremental cash flows - in incremental cash flows -
but beware of tax consequences!but beware of tax consequences!
5-34
Side Effects and ErosionSide Effects and Erosion
A drop in Big Mac revenues when A drop in Big Mac revenues when McDonald's introduced the Arch Deluxe.McDonald's introduced the Arch Deluxe.
ShouldShould be included be includedin incremental cash flowsin incremental cash flows
5-35
Net Working CapitalNet Working Capital
(incremental) Investments in inventories and receivables. (incremental) Investments in inventories and receivables.
This investment is assumed to be This investment is assumed to be recovered at the end of project.recovered at the end of project.
ShouldShould be includedbe included
in incremental cash flowsin incremental cash flows
5-36Financing Costs
Interest, principal on debt and dividendsInterest, principal on debt and dividends.
Should notShould notbe includedbe included
in incremental cash flowsin incremental cash flows
5-37Aspects of Incremental Aspects of Incremental Cash FlowsCash Flows
Sunk Costs Sunk Costs N N
Opportunity Costs Opportunity Costs Y Y
Side Effects (Erosion) Side Effects (Erosion) Y Y
Net Working Capital Net Working Capital Y Y
Financing Costs Financing Costs N N
All Cash Flows should All Cash Flows should bebe after-tax cash flowsafter-tax cash flows
5-38Pro Forma Financial Statements Pro Forma Financial Statements and DCF Valuationand DCF Valuation
Pro forma financial statementsPro forma financial statements
Best current forecasts of future years operationsBest current forecasts of future years operations
used for capital budgetingused for capital budgetingdetermine sales projections, costs, capital requirementsdetermine sales projections, costs, capital requirements
Use statements to obtain project cash flowUse statements to obtain project cash flow
If stand-alone principle holds:If stand-alone principle holds:
Project Cash Flow Project Cash Flow = Project Operating Cash Flow = Project Operating Cash Flow – – Project Net Capital Spending Project Net Capital Spending – – Project Additions to Net Working CapitalProject Additions to Net Working Capital
5-39
Depreciation
Depreciation is a non-cash charge, but has cash flow Depreciation is a non-cash charge, but has cash flow consequences because it affects the tax bill consequences because it affects the tax bill
To estimate depreciation expense:To estimate depreciation expense: Calculate depreciable basis.Calculate depreciable basis. Ignore economic life and future market value (salvage value). Ignore economic life and future market value (salvage value). Use tax accounting rules for depreciation.Use tax accounting rules for depreciation.
• Modified Accelerated Cost Recovery System (MACRS)Modified Accelerated Cost Recovery System (MACRS)• Straight lineStraight line• Half-year conventionHalf-year convention
Book value versus market valueBook value versus market value
5-40
Modified ACRS Property ClassesModified ACRS Property Classes
Class Examples
3-yearEquipment used in
research
5-year Autos, computers
7-yearMost industrial
equipment
5-41
Modified ACRS Depreciation Modified ACRS Depreciation AllowancesAllowances
4.45%
Year 3-year 5-year 7-year
1 33.33% 20% 14.29%
2 44.44% 32% 24.49%
3 14.82% 19.2% 17.49%
4 7.41% 11.52% 12.49%
5 11.52% 8.93%
6 5.76% 8.93%
7 8.93%
8
5-42
Straight Line vs. MACRS Depreciation
The Union Company purchased a new The Union Company purchased a new computer for $30,000.computer for $30,000.
The computer is treated as a 5-year The computer is treated as a 5-year property under MACRS and is expected to property under MACRS and is expected to have a salvage value of zero in six years.have a salvage value of zero in six years.
What are the yearly depreciation What are the yearly depreciation deductions using Modified ACRS deductions using Modified ACRS depreciation? Straight line depreciation?depreciation? Straight line depreciation?
5-43
Straight Line vs. MACRS Depreciation
Year MACRS Percentage MACRSDepreciation
Straight-lineDepreciation
1 20.00%
2 32.00%
3 19.20%
4 11.52%
5 11.52%
6 5.76%
$6000
$9600
$5760
$3456
$3456
$1728
$3000
$6000
$6000
$6000
$6000
$3000
5-44Additions to Net Working CapitalAdditions to Net Working Capital
Given NWC at the beginning of the project (date 0), Given NWC at the beginning of the project (date 0), we can calculate future NWC in two wayswe can calculate future NWC in two ways
NWC will grow at a rate of X% per period (e.g 3%)NWC will grow at a rate of X% per period (e.g 3%)NWC(year 2) = NWC(year1)*1.03NWC(year 2) = NWC(year1)*1.03
NWC will equal Y% of sales each period (e.g. NWC will equal Y% of sales each period (e.g. 15%)15%)
NWC(year 2) = 0.15*Sales(year 2)NWC(year 2) = 0.15*Sales(year 2)
All NWC is recovered at the end of the project.All NWC is recovered at the end of the project. Inventories are run downInventories are run down Unpaid bills are paid.Unpaid bills are paid. Bring NWC account to zero.Bring NWC account to zero.
5-45
Recovering NWC at the end of the project
Year
NWC
Additions to NWC
0
$500,000
1
$600,000
2
$800,000
Recovery in year 2
Year
NWC
Additions to NWC
0
$500,000
1
$700,000
2
$600,000
Recovery in year 2
-$500,000
-$100,000
-$200,000
+$800,000=$600,000
-$500,000
-$200,000
$100,000
$600,000
5-46Ways to Capital Budgeting Ways to Capital Budgeting
ProblemsProblems
Item by item DiscountingItem by item Discounting
Whole Project DiscountingWhole Project Discounting
Calculate project cash flows from pro Calculate project cash flows from pro forma forma financialsfinancials
Operating Cash FlowsOperating Cash Flows
Net Capital SpendingNet Capital Spending
Additions to NWCAdditions to NWC
5-47
Evaluating equipment Evaluating equipment
with different economic liveswith different economic lives
AssumptionsAssumptions
initial cost versus maintenanceinitial cost versus maintenance
perpetuityperpetuity
Equivalent Annual Costs - present value of Equivalent Annual Costs - present value of project’s costs calculated on an annual basisproject’s costs calculated on an annual basis
annuityannuity
5-48
Machine A Machine B
Costs
Annual Operating Costs
Replace
$100 $140
$10 $8
Every 2 years Every 3 years
Evaluating equipment Evaluating equipment
with different economic liveswith different economic lives
5-49
Evaluating equipment Evaluating equipment with different economic liveswith different economic lives
The equivalent annual cost (EAC) is the The equivalent annual cost (EAC) is the present value of a project's costs present value of a project's costs calculated on an annual basis.calculated on an annual basis.
)( factorAnnuity EAC = PV(Costs)
r)+(1
1 - 1
r
EAC = PV(Costs)
t
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