capital budgeting and cash flows estimation (2008)

8/8/2019 Capital Budgeting and Cash Flows Estimation (2008)

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Capital Budgeting and

the Estimation of Cash Flows



WHAT IS CAPITAL BUDGETING?

Analysis of potential additions to fixed assets,

whose benefits last for many years.

Long-term decisions; involve large

expenditures.

Will affect firm¶s performance for many years,

so is very important to firm¶s future.

Conceptually, capital budget process isidentical to decision process used by

individuals¶ making investment decisions



Steps:

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs (Cash Flows).

3. Determine R = WACC (adj.). determine appropriate

discount rate, based on riskiness of Cash Flows & general level int.rates

4. Find NPV of the expected cash flows and/or IRR.

5. Accept if NPV > 0 and/or IRR > WACC.



Good Decision Criteria for Capital

Budgeting Process

We need to ask ourselves the followingquestions when evaluating decision criteria

Does the decision rule adjust for the time value of

money?

Does the decision rule adjust for risk?

Does the decision rule utilize all relevant

information? (such as all cash flows)

Does the decision rule provide information onwhether we are creating value for the firm?



Net Present Value

The difference between the market value of aproject and its cost

How much value is created from undertaking

an investment? The first step is to estimate the expected future

cash flows.

The second step is to estimate the required return

for projects of this risk level. The third step is to find the present value of the

future cash flows and subtract the initial investment.



NPV ± Decision Rule

If the NPV is positive, accept the project A positive NPV means that the project is

expected to add value to the firm and will

therefore increase the wealth of the owners. Since our goal is to increase owner wealth,

NPV is a direct measure of how well thisproject will meet our goal.

0

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CF NPV

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CF NPV

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Computing NPV for the Project

Using the formulas:

NPV = 63,120/(1.12) + 70,800/(1.12)2 +91,080/(1.12)3 ± 165,000 = 12,627.42

Using the calculator:

CF0 = -165,000; C01 = 63,120; F01 = 1; C02 =70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I =

12; CPT NPV = 12,627.42 Do w e accept or reject the project?



Calculating NPVs with a

Spreadsheet

Spreadsheets are an excellent way tocompute NPVs, especially when you have to

compute the cash flows as well. Using the NPV function

The first component is the required return enteredas a decimal

The second component is the range of cash flowsbeginning with year 1

Subtract the initial investment after computing theNPV



Decision Criteria Test - NPV

Does the NPV rule account for the time valueof money?

Does the NPV rule account for the risk of thecash flows?

Does the NPV rule provide an indicationabout the increase in value?

Does the decision rule utilize all relevantinformation? (such as all cash flows)

Should we consider the NPV rule for our primary decision criteria?



Payback Period

How long does it take to get the initial costback in a nominal sense?

Computation Estimate the cash flows

Subtract the future cash flows from the initial costuntil the initial investment has been recovered

Decision Rule ± Accept i f the payback period is l ess than some preset l imit



Computing Payback For The Project

Assume we will accept the project if it

pays back within two years.

Year CF Cumulative CF

0 -165,000 -165,0001 63,120 -101, 880

2 70,800 -31,080

3 91,080 60,000

Payback Period: 2+ (31,080/91,080)=2.34 years



Decision Criteria Test - Payback

Does the payback rule account for the time value of money?

Does the payback rule account for the risk of thecash flows?

Does the payback rule provide an indication aboutthe increase in value?

Does the decision rule utilize all relevant information?(such as all cash flows)

Should we consider the payback rule for our primarydecision criteria?



Advantages and Disadvantages of Payback

Advantages

Easy to understand

Adjusts for uncertainty of

later cash flows Biased towards liquidity

Disadvantages

Ignores the time value of money

Requires an arbitrarycutoff point

Ignores cash flows beyondthe cutoff date

Biased against long-termprojects, such as researchand development, andnew projects



Discounted Payback Period

Compute the present value of each cash flowand then determine how long it takes to

payback on a discounted basis Compare to a pre-specified required period

Decision Rule - Accept the project i f it pays back on a discounted basis w ithin the

speci f ied time



Computing Discounted Payback For

The Project Assume we will accept the

project if it pays back within two years.

Year CF PV (CF) Cum PV(CF)

0 -165,000 -165,000 -165,000

1 63,120 56,357 -108,463

2 70,800 56,441 -52,022

3 91,080 64,829 12,807

The Discounted Payback 2+(52,022/64,829)=2.80 years



Decision Criteria Test ±

Discounted Payback

Does the discounted payback rule account for thetime value of money?

Does the discounted payback rule account for the

risk of the cash flows?

Does the discounted payback rule provide anindication about the increase in value?


Should we consider the discounted payback rule for our primary decision criteria?



Advantages and Disadvantages of

Discounted Payback

Advantages

Includes time value of money

Easy to understand Does not accept

negative estimated NPVinvestments

Biased towards liquidity

Disadvantages

May reject positive NPVinvestments

Requires an arbitrarycutoff point

Ignores cash flowsbeyond the cutoff point

Biased against long-termprojects, such as R&Dand new products



Average Accounting Return

There are many different definitions for average accounting return

The one used in the book is: Average net income / average book value

Note that the average book value depends onhow the asset is depreciated.

Need to have a target cutoff rate Decision Rule: Accept the project i f the AAR is g reater than a preset rate.



Computing AAR For The

Project

Assume we require an average accountingreturn of 25%

Average Net Income: (13,620 + 3,300 + 29,100) / 3 = 15,340

AAR = 15,340 / 72,000 = .213 = 21.3%

Do w e accept or reject the project?



Decision Criteria Test - AAR

Does the AAR rule account for the time value of money?

Does the AAR rule account for the risk of the cash

flows?

Does the AAR rule utilize all relevant information?(such as all cash flows)

Does the AAR rule provide an indication about theincrease in value?

Should we consider the AAR rule for our primarydecision criteria?



Advantages and

Disadvantages of AAR

Advantages

Easy to calculate

Needed information will

usually be available

Disadvantages

Not a true rate of return;time value of money is

ignored Uses an arbitrary

benchmark cutoff rate

Based on accounting netincome and book values,

not cash flows andmarket values



Internal Rate of Return

This is the most important alternative to NPV

It is often used in practice and is intuitively

appealing It is based entirely on the estimated cash

flows and is independent of interest ratesfound elsewhere



IRR ± Definition and Decision Rule

Definition: IRR is the return that makes the NPV = 0 Decision Rule: Accept the project i f the I RR is

g reater than the required return

NPV: Enter R, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

.

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Computing IRR For The

Project

If you do not have a financial calculator, thenthis becomes a trial and error process

Calculator Enter the cash flows as you did with NPV

Press IRR and then CPT

IRR = 16.13% > 12% required return

Do w e accept or reject the project?



Calculating IRRs With A

Spreadsheet

You start with the cash flows the same asyou did for the NPV

You use the IRR function You first enter your range of cash flows,

beginning with the initial cash flow

You can enter a guess, but it is not necessary

The default format is a whole percent ± you willnormally want to increase the decimal places toat least two



NPV Profile For The Project

-20,000

-10,000

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

Discount Rate

N P V

IRR = 16.13%



Decision Criteria Test - IRR

Does the IRR rule account for the time value of money?

Does the IRR rule account for the risk of the cash

flows?


Does the IRR rule provide an indication about theincrease in value?

Should we consider the IRR rule for our primarydecision criteria?



Advantages of IRR

Knowing a return is intuitively appealing

It is a simple way to communicate the value

of a project to someone who does not knowall the estimation details

If the IRR is high enough, you may not needto estimate a required return, which is often a

difficult task



Summary of Decisions For The

Project

Summary

Net Present Value Accept

Payback Period R eject

Discounted Payback Period R eject

Average Accounting Return R eject

Internal Rate of Return Accept



NPV Vs. IRR

NPV and IRR will generally give us the samedecision. (exactly the same decision if evaluating independent projects)

Exceptions

Non-conventional cash flows ± cash flow signschange more than once

Mutually exclusive projects Initial investments are substantially different

Timing of cash flows is substantially different



IRR and Non-conventional

Cash Flows

When the cash flows change signs more thanonce, there is more than one IRR

When you solve for IRR you are solving for the root of an equation and when you crossthe x-axis more than once, there will be morethan one return that solves the equation

If you have more than one IRR, which one doyou use to make your decision?



Another Example ± Non-conventional

Cash Flows

Suppose an investment will cost $90,000initially and will generate the following cashflows:

Year 1: 132,000

Year 2: 100,000

Year 3: -150,000

The required return is 15%. Should we accept or reject the project?



NPV Profile

($10,000.00)

($8,000.00)

($6,000.00)

($4,000.00)

($2,000.00)

$0.00

$2,000.00

$4,000.00

0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55

Discount Rate

N P V

IRR = 10.11% and 42.66%



Summary of Decision Rules

The NPV is positive at a required return of 15%, so you should Accept

If you use the financial calculator, you wouldget an IRR of 10.11% which would tell you toR eject

You need to recognize that there are non-

conventional cash flows and look at the NPVprofile



IRR and Mutually Exclusive Projects

Mutually exclusive projects If you choose one project, you can¶t choose the other

Example: You can choose to attend graduate schoolnext year at either Harvard or Stanford, but not both

Intuitively you would use the following decisionrules:

NPV ± choose the project with the higher NPV

IRR ± choose the project with the higher IRR



Example With Mutually Exclusive

Projects

Period Project A Project B

0 -500 -400

1 325 325

2 325 200

IRR 19.43% 22.17%

NPV 64.05 60.74

The required return

for both projects is

10%.

Which project

should you accept

and why?



NPV Profiles

($40.00)

($20.00)$0.00

$20.00

$40.00

$60.00

$80.00$100.00

$120.00

$140.00

$160.00

0 0.05 0.1 0.15 0.2 0.25 0.3

Discount Rate

N P V A

B

IRR for A = 19.43%

IRR for B = 22.17%

Crossover Point = 11.8%



Conflicts Between NPV and IRR

NPV directly measures the increase in value tothe firm

Whenever there is a conflict between NPV and

another decision rule, you should alw ays useNPV

IRR is unreliable in the following situations

Non-conventional cash flows

Mutually exclusive projects



Profitability Index

Measures the benefit versus per unit cost,based on the time value of money

A profitability index of 1.1 implies that for every $1 of investment, we create anadditional $0.10 in value

This measure can be very useful in situations

where we have limited capital



Define Profitability Index

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Advantages and Disadvantages of

Profitability Index

Advantages

Closely related to NPV,generally leading to

identical decisions Easy to understand and

communicate

May be useful whenavailable investment

funds are limited

Disadvantages

May lead to incorrectdecisions in

comparisons of mutuallyexclusive investments



Managers like rates--prefer IRR to

NPV comparisons. Can we give

them a better IRR?

Yes, MIRR is the discount rate which

causes thePV

of a project¶s terminalvalue (TV) to equal the PV of costs.

TV is found by compounding inflows

at WACC.

Thus, MIRR assumes cash inflows

are reinvested at WACC.



30.0 130.030.0

0 1 2 3

39.0

50.7

219.7

IRR ± the reinvestment hypothesis

-100.0

30%

30%

FV inflows-100.0

PV outflows



30.0 130.030.0

0 1 2 3

33.0

36.3

199.3

IRR ± the reinvestment hypothesis

-100.0

10%

10%

FV inflows-100.0

PV outflows



Why use MIRR versus IRR?

MIRR correctly assumes reinvestment at

opportunity cost = WACC. MIRR also

avoids the problem of multiple IRRs.

Managers like rate of return comparisons,

and MIRR is better for this than IRR.



Capital Budgeting In Practice

We should consider several investmentcriteria when making decisions

NPV and IRR are the most commonly usedprimary investment criteria

Payback is a commonly used secondaryinvestment criteria



Cash Flows Estimation:

Relevant Cash Flows

The cash flows that should be included in acapital budgeting analysis are those that willonly occur if the project is accepted

These cash flows are called incremental cash

flows

The stand-alone principle allows us to

analyze each project in isolation from the firmsimply by focusing on incremental cash flows



Asking the Right Question

You should always ask yourself ³Will this cashflow occur ONLY if we accept the project?´

If the answer is ³yes´, it should be included in theanalysis because it is incremental

If the answer is ³no´, it should not be included inthe analysis because it will occur anyway

If the answer is ³part of it´, then we should includethe part that occurs because of the project



InitialInvestment(-)

210 3

Cash flows Estimation ± New Project

OperatingCash Flow(+)

OperatingCash Flow(+)

Operating Cash Flow(+) Non-Op Cash Flow(+)



Initial Investment

Total cost for project: the cost incurred in order to make the asset readily available to operate.That includes the purchase cost for the asset,

shipping and testing costs. The firm needs toimpute opportunity cost for asset that isalready owned by the firm, and ignore thesunk costs for the project. Side effects should

be also included and considered. The net working capital increased by the

implementation for the project.



Sunk costs

Sunk costs ± costs that have accrued regardlessacceptance or rejection of the project, will beirrelevant for the decision making.

Example: the consulting fees for the feasibilityanalysis.

Impact: To wrongly include sunk costs may leadto wrong decision.

The NPV for a project (including 5 millionconsulting fees) is -3 million, should the firmaccept the project?



Opportunity costs

Opportunity costs ± costs of lost options, thehighest value given up in alternative uses.

Example: A firm uses a currently idled land tobuild a plant, should the firm impute any cost?

If the idled land was purchased 10 years ago for 1 million dollars, should the cost be 1 million?

The cost should be the highest value given up inalternative uses.



Side effects

Positive side effects ± benefits to other projects

Negative side effects ± costs to other projects



Accounting Income and Operating Cash Flow

Accrued Cash Flows

Revenue $100 $100

Cash Costs 50 50

Depreciation 20 0

Earnings Before Taxes 30 50

Taxes (50%) 15 15

Earnings After Taxes 15 35

CF = R - C - Dep t Dep = R - C t t * Dep* *1 1



Non-operating cash flows (NOCF)

Disposal Value

The recovery of NWCDisposal value = Market Value Taxes Effects



New Investment Example:

A toy company is thinking about to expand its

production line into stuff toys, in addition to itscurrent plastic toys. According to the firm, this expansion will notinfluence the cash flows of its current

operations. The purchase price for the newmachine is $10,000,000, and additional$2,000,000 is needed for the shipping andhandling. The firm will use straight line for its

depreciation, the depreciable life is set to be 5years, and zero salvage value. Themanufacturing department thinks the marketvalue for the machine will be $3,000,000 after

5 years.



The marketing department thinks theexpansion will results an increase of

$6,000,000revenue for the first two years,and $8,000,000 for the final three years. Theoperating costs for the first two years will be$2,000,000, and $3,000,000 for the finalthree years. The firm needs to investadditional $1,000,000 NWC, which isexpected to be recovered in the sameamount after 5 years, for the new expansion.

The tax rate is 25%, and after-tax cost of capital for the firm is 7%, should the firm gofor the expansion?



t=0 t=1 t=2 t=3 t=4 t=5

Purchase price

(10,000,000)

Shipping and

handling(2,000,000)

Total Cost (12,000,000)

NWCinvestment

(1,000,000)

Initial

Investment(13,000,000)

Revenue 6,000,000 6,000,000 8,000,000 8,000,000 8,000,000

Cost (2,000,000) (2,000,000) (3,000,000) (3,000,000) (3,000,000)

Depreciation 2,400,000 2,400,000 2,400,000 2,400,000 2,400,000

Operating

cash flow3,600,000 3,600,000 4,350,000 4,350,000 4,350,000



Market value 3,000,000

Book value 0

Disposal gain 3,000,000

Tax liability (750,000)

After-tax

cash flow

from disposal

2,250,000

Recovery of

NWC1,000,000

Non-op CF 3,250,000

CF (13,000,000) 3,600,000 3,600,000 4,350,000 4,350,000 7,600,000

1NPV=$5,797,050

2IRR = 20.52%

( 3 ) PI = 1.446



Why we do not consider the cash

flows related to the financing?

When you use the after-tax cost of capital to bethe discount rate, you basically take in the effectof the financing.

If you discount the project cash flows (without

financing) by the after-tax cost of capital, youwill get the exact net present value as you use itto discount the total cash flows (project cashflows plus the financing cash flows).

That is, when you use the after-tax cost of

capital to discount financing related cash flows,the net present value would be zero.



t=0 t=1 t=2 t=3 t=4

Initial invest.

(total cost)

(8,000,000)

Inc. rev. 6,000,000 6,000,000 6,000,000 6,000,000

Inc. cost (2,000,000) (2,000,000) (2,000,000) (2,000,000)

Deprec. 2,000,000 2,000,000 2,000,000 2,000,000

OP CF 3,500,000 3,500,000 3,500,000 3,500,000

NOP CF 3,000,000

Project CF (8,000,000) 3,500,000 3,500,000 3,500,000 6,500,000

Financing 8,000,000

Interest (AT) (360,000) (360,000) (360,000) (360,000)

Repay. (8,000,000)

Fin. Rel. CF 8,000,000 (360,000) (360,000) (360,000) (8,360,000)

Total CF 0 3,140,000 3,140,000 3,140,000 (1,860,000)



t=0 t=1 t=2 t=3 t=4Project CF (8,000,000) 3,500,000 3,500,000 3,500,000 6,500,000

NPV (at 4.5%) 7,072,024

t=0 t=1 t=2 t=3 t=4

Total CF 0 3,140,000 3,140,000 3,140,000 (1,860,000)

NPV (at 4.5%) 7,072,024

t=0 t=1 t=2 (t=3 t=4

Fin. Rel. CF 8,000,000 (360,000) (360,000) (360,000) (8,360,000)

NPV (at 4.5%) 0

Assuming that financing totally comes from debt, and the before-tax

cost of capital is 6%, tax rate 25%, so the after-tax cost of capital 4.5%.

capital budgeting and cash flows estimation (2008)

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