chapter 17 capital budgeting analysis © 2011 john wiley and sons

Chapter 17

Capital Budgeting Analysis

© 2011 John Wiley and Sons

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Chapter Outcomes

Explain how the capital budgeting process should be related to a firm’s mission and strategies.

Identify and describe the five steps in the capital budgeting process.

Identify and describe the methods or techniques used to make proper capital budgeting decisions.

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Chapter Outcomes, continued

Explain how relevant cash flows are determined for capital budgeting decision purposes.

Discuss how a project’s risk can be incorporated into capital budgeting analysis.

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Capital Budgeting Projects

Seek investment opportunities to enhance a firm’s competitive advantage and increase shareholder wealth– Typically long-term projects– Should be evaluated by time value of

money techniques– Large investment– Relate to firm’s mission

Mutually exclusive versus independent

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Identifying Potential Capital Budget Projects

Time value concepts tell us:

Value = present value of expected cash flows

Separating out the initial up-front cost, we have:

Net Present Value = Present value of expected cash flows – cost of project

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Net Present Value = Present value of expected cash flows – cost of project

If NPV >0 the project adds value to the firm.

Where do firms find attractive capital budgeting projects with potentially positive NPVs?

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Planning tools: MOGS: Mission, Objectives, Goals,

Strategies SWOT: (Internal to firm):Strengths,

Weaknesses

(External to firm): Opportunites, Threats

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Capital Budgeting Process

Identification Development Selection Implementation Follow-up

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Data Needs

Economic and Political Data

Financial Data

Non-Financial Data

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Oil/Gas Company ProjectsRanking of items from most to least

important on capital spending:

1. Natural gas price forecast

2. Crude oil price forecast

3. Natural gas demand forecast

4. Crude oil demand forecast

5. Availability and cost of capital

6. Regulatory requirements on projects

7. Tax considerations

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Forecasts

Note the multiple uses of the word “forecast” in the previous list

Managers must make educated guesses about the future to estimate future cash flows

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Capital Budgeting Techniques

Net Present Value

NPV = Present value of all cash flows minus cost of project

Inputs: cash in/outflows, required rate of return or “cost of capital”

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Cash Flow Data

YEAR PROJECT A PROJECT B

0 (today) -20,000 -25,000

1 5,800 4,000

2 5,800 4,000

3 5,800 8,000

4 5,800 10,000

5 5,800 10,000

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NPV of Project ACASH 10% PRESENT

YR FLOW x PVIF = VALUE

0 –$20,000 1.000 –$20,000

1 5,800 0.909 5,272

2 5,800 0.826 4,791

3 5,800 0.751 4,356

4 5,800 0.683 3,961

5 5,800 0.621 3,602

Net Present Value =$ 1,982

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NPV of Project BCASH 10% PRESENT

YR FLOW x PVIF = VALUE

0 -$25,000 1.000 -$25,000

1 4,000 0.909 3,636

2 4,000 0.826 3,304

3 8,000 0.751 6,008

4 10,000 0.683 6,830

5 10,000 0.621 6,210

Net Present Value = $ 988

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What Does the NPV Represent?

NPV represents the dollar gain in shareholder wealth from undertaking the project

If NPV > 0, do the project as shareholder wealth rises

If NPV <0, do not undertake; it reduces shareholder wealth

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Internal Rate of Return

It is the discount rate that causes NPV to equal zero

N

NPV = [CFt / (1 + IRR)t ] – Inv = 0 t = 1

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NPV Profile

Figure 13.1 Relationship Between NPV and Discount Rates: NPV Profile

-2000.00

0.00

2000.00

4000.00

6000.00

8000.00

10000.00

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12 0.13 0.14 0.15 0.16 0.17

Discount Rate (in decimal)

NP

V (

$)

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Solution Methods

Compute the IRR by:

–Trial and error

–Financial calculator

–Spreadsheet software Accept the project if IRR > minimum

required return on the project

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What Does the IRR Measure?

IRR measures the return earned on funds that remain internally invested in the project

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(1) (2) (3) (4) (5) (6)

Year Beginning Cash 10% Return Reduction Ending

Investment Inflow on the in the Value of

Value (savings) Invested Invested Invested

Funds Funds Funds

(2) x 0.10 (3) - (4) (2) - (5)

1 $5,000.00 $2,010.57 $500.00 $1,510.57$3,489.43

2 3,489.43 2,010.57 348.94 1,661.63 1,827.80

3 1,827.80 2,010.57 182.78 1,827.79 0.01*

*Value is not 0.00 due to rounding.

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NPV vs. IRR They will always agree on whether to

accept or reject a project So if projects are independent: either

method is acceptable Problem: they may rank projects

differently What to do if projects are mutually

exclusive and the rankings conflict? Answer: use NPV as it measures the

change in shareholder wealth occurring because of the project.

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NPV vs. IRR

Another issue with IRR: a project may have more than one IRR!

Can occur if project has alternative positive and negative cash flows.

Most likely to occur if project requires substantial renovations or maintenance during its life or if end-of-life shut-down costs are high.

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Modified Internal Rate of Return

MIRR developed to solve some of the issues associated with IRR.

MIRR will agree with NPV on the accept/reject decision

MIRR gives a single answer—there is only one MIRR

MIRR agrees with NPV rankings when the initial investments are of comparable size.

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Modified Internal Rate of Return:Three step process

1. Find the present value of all cash outflows

2. Find the future value of all cash inflows at the end of the project’s life at year n. This lump sum is called the terminal value.

3. MIRR is the discount rate which equates the present value of the outflows and the future value of the inflows:FV at year n = PV (1 + MIRR)n

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MIRR for Project A

1. Present value of outflows = 20,000 (no additional calculation needed)

2. Find FV as of year 5 for cash inflows from years 1-5:5800 (1.10)4 = 8491.785800 (1.10)3 = 7719.805800 (1.10)2 = 7018.005800 (1.10)1 = 6380.00 5800 (1.10)0 = 5800.00

Terminal value (sum of FV) = 35,409.58

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MIRR for Project A PV of outflows: 20,000 Terminal value (sum of FV of inflows)

= 35,409.58 Step 3: FV = PV(1 + MIRR)n

= $35,409.58= $20,000(1 + MIRR)5

Solving, we find the MIRR is 12.10 percent

Accept project as MIRR>10% required return

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Profitability Ratio (Benefit/Cost Ratio)

Profitability Index = Present value of cash flows/initial cost

Accept project if PI > 1.0 Reject project if PI < 1.0 Interpretation: Measures the present

value of dollars received per dollar invested in the project

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Project A and B

Project A’s profitability ratio:

PI = $21,982/$20,000 = 1.099

Project B’s profitability ratio:

PI = $25,988/$25,000 = 1.040

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Relationships

NPV, IRR, PI will always agree on the Accept/Reject decision

If one indicates we should accept the project, they will all indicate “accept”

NPV > 0 always means that: IRR>minimum required return and that the: PI > 1

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Reject Decision, too

If one indicates we should reject the project, they will all indicate “reject”

NPV < 0 always means that the

IRR < minimum required return and that the

PI < 1

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Conflicts Between NPV, IRR, MIRR, Profitability Index

May occur as different rankings may occur if projects are mutually exclusive. Most likely when projects have:

Different cash flow patterns– Projects with larger and earlier cash

flows may have higher IRR rankings than those with larger later cash flows

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Different time horizons– Project Long and Project Short require

$100 investment– Short: returns $200 in 2 years IRR =

41.42% and NPV (at 10% required return) = $65.29.

– Long: returns $2,000 in 20 years IRR =16.16% NPV (at 10% required return) = $197.29.

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Different Sizes– Projects with smaller initial investments may

have higher IRR and higher PI and smaller NPV than projects with larger initial investments.

Initial PV of Cash Profitability

Project Outlay Cash Flows NPV Index

Small $100 $150 $50 1.5

Large 1,000 1,100 $100 1.1

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Four discounted cash flow methods: NPV, IRR, MIRR, profitability index Goal in capital budgeting is to select

projects that will help maximize shareholder wealth.

NPV is the best as it measures the absolute dollar change in shareholder wealth.

The others are relative measures of project attractiveness.

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A popular, but flawed, measure...

Payback period = number of years until the cash flows from a project equal the project’s cost

Accept project is payback period is less than a maximum desired time period

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Project A Payback ExampleInvestment: $20,000

Cash Cumulative Dollars

YR Flow Cash flow Needed

1 5,800 5,800 14,200

2 5,800 11,600 8,400

3 5,800 17,400 2,600

4 5,800

Fraction of year: 2,600/5,800 = 0.45

Payback = 3.45 years

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Payback’s Drawbacks

Ignores time value of money Any relationship between the

payback, the decision rule, and shareholder wealth maximization is purely coincidental!

It ignores the cash flows beyond the payback period

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What Managers Use

75% of CFOs used NPV, IRR or both to evaluate projects

IRR is most popular Over half still use payback as a

secondary or supplementary method of analysis

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Why Are IRR and Payback Used So Much?

Safety margin– IRR gives managers an intuitive feel for

a project’s “safety margin”—amount by which cash flows can be incorrect and the project can still increase shareholder wealth.

Project Size Managerial flexibility and options

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Estimating Project Cash Flows

Important concepts: Stand-alone principle Incremental after-tax cash flows

from the base case Cannibalization or enhancement

effects Opportunity costs

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Ignore….

Sunk costs

Financing costs

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Project Cash Flows

Project sales (generally a cash inflow)- Project costs (generally a cash outflow)- Depreciation (a noncash expense) EBIT = EBT (earnings before interest and taxes,

which also equals earnings before taxes as financing costs are ignored in cash flow analysis)

- Taxes (a cash outflow) Net income

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Firm versus Project Statement of Cash Flows The Firm's Cash Flow Statement A Project's Cash Flow Statement Cash Flow from Operations Cash Flow from Operations

Net Income Net Income+Depreciation +Depreciation+current asset/liability sources +current asset/liability

sources

-current asset/liability uses -current asset/liability uses

Cash Flow from Investment Activities Cash Flow from Investment

Activities-change in gross fixed assets -Funds invested in the

project-change in investments

Cash Flow from Financing Activities Cash Flow from Financing

Activities-Dividends paid Not applicable+net new bond issues+net new stock issues

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Project Cash Flows

Cash flows from operations: Net income + depreciation – change in net working capital

Cash flows from investment activities: change in gross fixed assets

Cash flows from financing activities: ignoreRecall, as the cash account is always zero,

that the change in NWC does not include the cash account

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Operating Cash Flow OCF = Net Income + Depreciation – ΔNWC From the project’s income statement, this

is the same as: (Sales-Costs-Depreciation) – Taxes +

Depreciation – ΔNWC If the firm’s tax rate is t then Taxes = t(pre-tax income) = t(Sales-Costs-

Depreciation) so operating cash flow is:

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Operating Cash Flow

OCF = Sales-Costs-Depreciation – t(Sales-Costs-

Depreciation) + Depreciation – ΔNWC Simplifying, we have a general formula for

estimating operating cash flow: OCF = (Sales-Costs-Depreciation)(1– t)

+ Depreciation – ΔNWC

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Why do we subtract the change in NWC (ΔNWC) ?

Recall NWC = Current Assets (excluding the cash account) minus Current Liabilities

If NWC rises: either CA has risen, CL has fallen, or both

Example: Cash is used to pay AP; cash flows out of the firm and NWC (CA-CL) rises

A use of cash leads to an increase of NWC; to measure operating cash flow, this amount is subtracted.

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Why do we subtract the change in NWC (ΔNWC) ?

If NWC falls: either CA has fallen, CL has risen, or both.

Example: Cash comes into the firm if a customer pays their AR. AR falls, CA falls, and NWC falls

A source of cash leads to a decrease of NWC; when we subtract this negative change in NWC it becomes a positive addition to OCF.

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The Depreciation Tax ShieldWith Deprec Without Deprec Expense Expense

Sales $1000 $1000-Costs -300 -300-Deprec -100 0EBT $600 $700-Taxes (40%) 240 280Net Income $360 $420OCF=Net Income + Depreciation

$460 $420Difference is $40—which equals tax rate x

depreciation (04.0) ($100) = $40

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Reality: Keeping Managers Honest

Pet projects can be accepted into the capital budget by inflating cash flow estimates so their NPV is positive

Possible solutions:– Review spending in implementation stage;

additional requests for funds needed in case of overruns

– Compare forecasted cash flows with actuals– Record names of those issuing forecasts

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Risk-related Considerations

Expected return/risk tradeoff

Higher (lower) than average risk projects should have a higher (lower) than average discount rate

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Cost of Capital

Required return on average risk project = firm’s cost of capital, or cost of financing

For average risk projects, use this number as the discount rate (NPV, PI) or the minimum required rate of return (IRR)

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Risk-adjusted Discount Rate

Adjust the project’s discount rate up or down from the firm’s cost of capital for projects of above-average or below-average risk

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An Example

Below-average risk:

Discount rate = cost of capital –2%

Average risk:

Discount rate = cost of capital

Above-average risk:

Discount rate = cost of capital + 2%

High risk:

Discount rate = cost of capital + 5%

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Web Links

www.benjerry.com

www.wendys.com

www.wellsfargo.com

www.merck.com

www.dell.com

www.ebay.com

www.salvagesale.com

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Learning Extension 17: Estimating Project Cash Flows

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Up-front or “time zero” investment

Investment =

cost + transportation, delivery, and installation charges

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Project Stages and Cash Flow Estimation

Initial Outlay– Engineering estimates (designs,

modifications)– Current market prices of new items– Bid prices from possible supplies or

construction firms–Will be reduced if new project is

replacing old equipment/building that can be sold

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Cash Flows During the Project’s Life For each period of time during the

project’s life, use the general equation: OCF = (Sales-Costs-Depreciation)(1– t)

+ Depreciation – ΔNWC Estimating the inputs: marketing studies,

production cost estimates, suppliers

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Salvage Value and NWC Recovery– After-tax salvage value = Asset selling

price – t (selling price – book value)– Project’s NWC may be assumed to be

liquidated (converted to cash) and returned to the firm as a cash flow

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Salvage value example. Asset purchased for $100; depreciation of $10/year. Sold in year 7. Book value will be $30. Tax rate is 25%.

After-tax salvage value if selling price is $50: $50 – .25 ($50-30) = $45



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If project is expected to continue indefinitely:

Estimate operating cash flows for several years and then estimate its “going concern value” using the constant dividend (cash flow) growth model:

Dividendtime t+1

Valuetime t = ----------------------- r - g

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Example: Revenue-Expanding Project

Initial outlay:

t = 0

Depreciable Outlays ‑$4.5

Expensed Cash Outlays, after tax ‑0.4

‑‑‑‑‑‑‑

‑$4.9

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Annual Project Income Statement years 1-5

Sales $3.000

-Costs -0.635

-Depreciation -0.900

EBT $1.465

-Taxes (40%) -0.586

Net income $0.879

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OCF estimatestax rate = 40%

Year 1 Year 2-4 Year 5Saless $3.000 $3.000 $3.000 -Cost -$0.635 -$0.635 -$0.635 -Depreciation -$0.900 -$0.900 -$0.900SUM $1.465 $1.465 $1.465 x (1-t) $0.879 $0.879 $0.879+Depreciation $0.900 $0.900 $0.900 -change NWC -$0.100 $0.000 $0.100Operating CF $1.679 $1.779 $1.879

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Salvage Value

Market value in year 5 of project assets: $1 million

They will be fully depreciated at that time. After-tax salvage value = Asset selling

price – t (selling price – book value) = $1 million – (0.40)($1 million-0) = $0.600 million

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Cash Flow Summary Initial Operating Salvage Total

Year Outlay Cash Flows Value Incremental Cash Flows

0 $-4.9 $ 0.000 $ 0.0 $-4.90 1 0.0 1.679 0.0 1.679 2 0.0 1.779 0.0 1.779 3 0.0 1.779 0.0 1.779 4 0.0 1.779 0.0 1.779 5 0.0 1.879 0.6 2.479At 10%, NPV = $2.20 million

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Other Examples

Cost-saving project Setting a minimum bid price on a

project so NPV=0 Tables, data in textbook

chapter 17 capital budgeting analysis © 2011 john wiley and sons

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