AEC 422Fall 2012
Unit 2Financial Decision Making
Capital Budgeting
Defined as process by which a firm decides which long term investments to make
Decision to accept or reject a capital budgeting project depends on an analysis of the cash flows generated by the project and its cost
Five Capital Budgeting Performance Measures
1. Payback
2. Average Rate of Return
3. Net Present Value
4. Profitability Index
5. Internal Rate of Return
Starting with Net Cash Flow Statement
Cash Flow Statement: sources and uses of cash for a business over a certain period of time.
Period coincides with the reporting period of the income statement.
Cash Flow Statement is basic to calculating performance measures
Cash Flow Statement
A cash flow statement shows how your business is performing on a “cash” basis
The income statement shows how your business performs on an “accrual” basis while the cash flow statement provides a source of cash receipts shown in the income statement
Cash Versus Accrual Accounting Methods
Basic difference between the two is the timing of the income and expense recording.
Cash versus Accrual Cash accounting is based on real time
cash flow. Revenues (expenses) are reported when received (paid).
Accrual accounting reports income (expenses) when earned (or received) and expenses when earned and not necessarily when received (or paid).
Three General Categories of a Cash Flow Statement
Net flows from operations activities
Net flows from investing activities consisting primarily of purchase or sale of equipment
Net flows from financing activities such as issuing and borrowing funds.
Steps in Preparing a Cash Flow Budget
1. Prepare a sales forecast
2. Project anticipated cash inflows
3. Project anticipated cash outflows
4. Putting the projections together to come up with your cash flow “bottom line”
Capital Budgeting Decision Rules
1. You must consider all the project’s cash flows
2.Must consider time value of money. Dollar earned next year is not the same as a dollar earned today
3. Must always lead to the correct decision when choosing among mutually exclusive projects
Time Value of Money
At it’s most basic level, the time value of money demonstrates that it is better to have money now rather than later.
Would you rather have $10,000 today or receive it next year?
Why?
Would You Rather Receive $10,000 Today or Next Year?
Inflation
Could have it invested and earning money
Project Classification
Projects being considered and evaluated can be divided into two categories:
1. Independent projects
2. Mutually exclusive projects
Independent Projects
A project whose cash flows are not affected by the accept or reject decision of other projects.
Mutually Exclusive Projects
Defined as a set of projects from which at most one will be accepted.
All the projects being considered may be acceptable, but we’ll choose the “best” one.
Can’t always do everything – often have a budget constraint
Capital/Investment Projects in Agribusiness
Wind turbine New ag chemical Plastic reusable containers vs cardboard High speed wine bottling equipment Flash freezer vs IQF freezer for fruit Electronic Point of Sale systems for retail store Employee health insurance plan A vs B New line of equipment for a farm supply store New service division for a bank
Cash Flow Returns
Based on project outcomes that either lead to New net revenue New net cost savings
Typically over a period of time
The Discount Rate
It’s the firm’s cost of capital. The latter reflects the firm’s cost of acquiring capital to invest in long term assets.
Discount rate reflects future value of money. Has two components: An adjustment for inflation A risk-adjusted return on the use of
the money
Investment Example
Initial Investment: $400,000 Cash Flow Returns
Year 1: $115,000 Year 2: $115,000 Year 3: $115,000 Year 4: $115,000 Year 5: $115,000
Salvage Value: $50,000
Payback Period
A capital budget performance measure
Defined as the length of time it takes for a capital budgeting project to recover it’s initial cost
Calculating Payback
Net Investment
Average Annual Net Cash Flow
*Note that net cash flow is after taxes
Payback =
Calculating Payback
Using the Net Cash Flow example provided, what is the payback period?
Example Calculating Payback
Net Investment
Average Annual Net Cash Flow
$400,000 $115,000
Decision Rule: The lower the better!
Payback =
= = 3.48 Years
Payback
Advantages: Easy to calculate Give you a rough idea of liquidity
Disadvantages: Ignores time value of money Ignores project profitability
Average Rate of Return
A second capital budgeting performance measure
Defined as:
Average Annual Net Cash Flow – Average Annual Depreciation Net Investment
Average ROR
Calculate the Average ROR using the example net cash flow statement
Calculating Average ROR
$115,000 - $70,000 $400,000
Decision Rule: Must be positive and the higher the better!
ROR = = 11.25%
Average ROR
Advantages: Again, simple to calculate Does account for salvage value Begins to consider profitability
Disadvantages: Ignores time value of money
Net Present Value
A third capital budgeting performance measure concept
Net Present Value is a measure of how much value is created or added today by undertaking an investment.
Net Present Value
It does this by accounting for the time value of money. A $ today is worth more than a $ tomorrow because of the “erosive” effects of inflation
Net Present Value
It is the present (discounted) value of future cash inflows minus the present value of the investment and any associated future cash outflows
It’s the net result of a multiyear investment expressed in today’s dollars
Net Present Value
T
∑ NCFt
t=1 (1 + r)t
- NINV
Net Present Value Key NCFt Net Cash Flow in Year t
T is the life of the project
r is the discount rate or cost of capital
NINV is the net investment of the project
Note that in year T, Net Cash Flow must include the salvage value of the initial investment
Calculate Net Present Value
Using the example provided, how would you structure the equation for calculating net present value?
Assume Discount Rate = 10%
Calculating Net Present Value
$115,000 $115,000 $115,000 $115,000 $115,000 + $50,000 (1.1)1 (1.1)2 (1.1)3 (1.1)4 (1.1)5
$115,000 $115,000 $115,000 $115,000 $165,000 1.1 1.21 1.331 1.4641 1.61051
$104,545 + $95,041 + $86,401 + $78,547 + $102,452 - $400,000
$466,984 - $400,000
$66,987
- $400,000+ + + +
- $400,000+ + + +
Net Present Value
Decision Rule: Accept project if NPV > 0
$66,987 > 0 so we accept the project given it’s the only one we’re considering
Note if mutually exclusive projects being considered, accept the one with the highest NPV
NPV
Advantages:-Accounts for time value of money correctly-Considers firm profitability-Consistent with notion of
maximizing owner wealth
NPV
Disadvantages:
-More complex to calculate-Difficult to explain to non-
financial managers-Not always easy to determine
the correct “discount rate”
Profitability Index (PI)or Benefit Cost Ratio (BCR)
Defined as the present value of the future cash flows divided by the initial investment
Profitability Index
NCFt
(1 + r)t
NINV
T
∑ t = 1
Profitability Index--Where NCFt = Net Cash Flow in Year t
T = Life of the Project
r = Discount Rate
NINV= Net investment of Project
Note that Net Cash flow must include the salvage value of the initial investment
Calculating PI
Using the example provided, what is the profitability index?
Calculate PI For our example:
$466,987 $400,000
PI = = 1.17
Calculate PI Decision Rule: Accept if PI >1.0
But the bigger the PI the better
Hence, we accept this project
Note: PI is a unit free performance measure
Pros and Cons of PI Advantages:
Accounts for time value of money Considers project profitability Considers owner wealth maximization
Disadvantages: Complex to calculate Difficult to explain to non-financial types May not pick project with largest NPV
Internal Rate of Return (IRR)
The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate
In some ways it’s an alternative to NPV
Internal Rate of Return
Note that NPV is some mathematical function of r (the discount rate)
So IRR is the level of r (call it r*) such that the NPV = 0
Thus,
Internal Rate of Return
NCFt
(1 + r*)t
- NINV = 0 T
∑ t = 1
Internal Rate of Return
Unfortunately, one cannot solve for IRR using algebra.
Rather we must solve by trial and error
Calculating IRR-Using Example r % NPV ($) PI
6 121,785 1.38 93,191 1.2310 66,987 1.1712 42,921 1.1114 20,773 1.0516 349 1.018 -18,520 .9520 -35,986 .9122 -52,181 .8724 -67,225 .83
Calculating IRR From previous table we note that
NPV = 0 somewhere between r = 16% and r = 18%.
Bit more trial and error and we can discover that IRR = 16.04%
Plug 16.04% into NPV formula and you get NPV = 0
Calculating IRR Decision Rule says that for a single
project accept if IRR > 0.
The higher the better.
Pros and Cons of IRR Advantages:
Accounts for time value of moneyConsiders profitabilityConsistent with maximizing wealthDoesn’t require analyst to specify r
Disadvantages:Complex to calculateDifficult to explainMay not pick project with largest NPV
Monforte Dairy Case Considering a variety of new business
extensions at the same time Auffinage Charcuterie Auberge Cheese school Which ones make sense financially?
Strategically? All, some, none? What’s the investment impact on the firm’s
overall financial health?