Capital Budgeting

Economic concepts and finance

decision-making tools

Building Blocks of Knowledge

Time value of money – a dollar

in the future is worth less than a

dollar in hand now

Net present value

1. NPV = PV of cash flow

benefits– Investment cost

2. Accept project if NPV > $0

Financial Statements

Cash is king

What is this module about?

Integrates several

topics in Corporate

Finance

– NPV

– Discounted cash-

flow (DCF) analysis

– Project analysis

Capital Budgeting

Investment decisions involving capital assets

(tangible property, including durable goods,

equipment, buildings, installations, land) .

Capital refers to the fixed assets of an organization

(factories, hospitals, schools, and their major

equipment fit into this category),

Capital Budgeting (more)

A budget is a plan which explains the projected cash flows during some future period.

A capital budget is therefore an outline of planned expenditures on fixed assets, and capital budgeting is the whole process of analyzing projects and deciding whether they should be included in the capital budget

Capital Budgeting - Public Sector

Capital budgeting is done in the public sector too,

although it is not always referred to as such.

Economic analysis and investment analysis are

synonymous terms that one my hear.

Cost-benefit analysis and cost-effectiveness analysis

play an important role in the process of capital

budgeting

Capital budgeting decisions are

among the most important ones

made by managers and

executives.

Importance

Results of investments in plant and other assets

continue for many years.

Once these decisions are made, the organization

loses some of its flexibility.

Once a major piece of equipment is purchased, the

organization is “locked in” to using it for the long term.

Importance (more)

Errors in the forecast need for big ticket assets can have serious consequences

Imagine a factory or hospital being built, or a school established, and then there is not enough demand to

utilize the services.

Conversely, what happens if not enough is spent. Inadequate capacity in a business, hospital or school

can have disastrous results.

Importance (even more)

Timing is another reason that good capital budgeting is so essential.

Essential assets need to be ready to come “on-line” when needed. Early arrivals cause extra expenses

that will strain resources.

Funding of such major projects involves very substantial expenditures. Large amounts of money

are not available instantaneously in any organization, be it a large corporation, school district or the federal

government.

Capital budgeting has become more

effective, and more fun, during the past

decade

Used to be math and manpower intensive, because the underlying theory needs a lot of calculations

Nowadays, most modern organizations are able to use computers to transform data to information

Capital budgeting used to take man years of work, mostly in manual calculations. Now capital budgeting is done in hours with spreadsheets

“What was once a budget

exercise becomes an

analysis of policy” (Peter

Drucker)

Steps in the Capital Budgeting Process

1. Determine the economic life of the project or alternatives you are considering.

2. Estimate their Incremental Cash Flows

3. Determine the discount rate.

4. Calculate Net Present Value

5. Apply the appropriate criterion to arrive at an initial preference

More Steps in the Capital Budgeting Process

6. Do Sensitivity & Scenario Analysis

7. Interpret the results of the basic analysis and the sensitivity/scenario analysis, and make a decision.

8. If you decide to acquire the use of an asset, evaluate: lease versus buy

9. Check to make sure you can afford your decision by putting it in the organization’s budget.

10. Implement & Verify your decision.

Capital Budgeting Decision making

Concepts you must understand to be able to

participate:

– incremental cash flows

– the time value of money and

– sensitivity analysis

Incremental Cash Flows

Two Rules

Annual cash flow, and not accounting profits or costs, are to be used. Depreciation and the need for Working Capital are causes of major differences between profits and cash flow

Only Incremental cash flows are relevant for evaluating investment projects.

Only those cash flows that would result directly from a decision to accept a project are considered

Working Capital

The payroll needs to be paid before revenues from

the days work are received

Working capital is the cash you need to pay

expenses before the benefits are realized

Taxes and Depreciation

Taxes are a fact of life, and need to be considered in

all financial decisions

Depreciation is an expense that is not a negative

cash flow; to the contrary depreciation results in a tax

shield (a positive cash flow) that offsets taxes to

some extent

Incremental Cash Flows Example

A firm considering the establishment of a branch office in a newly developing section of a city

Incremental cash flows will consist of the costs of investment and operating the new office, costs that it would not have been incurred unless the project was undertaken.

It will also include the revenues derived from the business, benefits that would not have been realized

otherwise.

Incremental Cash Flows

Three conceptual problems

Sunk costs

Opportunity costs and

Externalities.

Sunk Costs

Sunk costs are cash outlays that have already been

incurred and cannot be recovered regardless of any

present or future decision.

Sunk costs are not incremental costs and should not

be included in capital budgeting analysis.

Sunk Cost Example

The firm and its branch office decision.

Suppose it hired a consulting firm two years ago to

do a site analysis. The $75,000 they paid is irrelevan

No matter whether or not they decide to build their

new branch office.

Easier said than done

It may be psychologically impossible for policy makers to ignore sunk costs for future decisions, even though it is accepted practice in higher circles.

There is a natural tendency to continue with a course of action, unable to see that it was incorrect, even when there is evidence to show the project is doomed to fail.

The term used for this behavioral process is escalation of commitment

Opportunity costs

Consider the firm with the branch office decision.

Suppose they own land upon which the branch could be built.

Should they ignore the cost of the land because they will not have a cash outlay to acquire it?

No, because if they don’t use the land they could sell it, for let us say $100,000.

An opportunity cost is a benefit lost

Opportunity cost is the maximum worth of an asset

among possible alternative uses

Opportunity cost is thus a cash flow that could be

generated from assets the organization already owns

provided they are not used for the project in question

Externalities

Externality is an economic term, which comes from

the idea that we should account for the direct effects,

whether positive or negative, on someone’s welfare

that arise as a by-product of some other person’s or

firm’s activity

Synonyms are neighborhood, interactive or spillover

effects

Externalities (more)

Consider the firm’s present customers who might use

the new branch office. Business they do at the

branch will reduce business at the main office. That

effect needs to be accounted for in the analysis.

Branch office incremental revenues should be

reduced by the amount of decreased revenues at the

main office, say $25,000/yr.

Summary - Economic Concepts for use

in discounted cash flow analysis

Do use – Incremental Cash inflows

and outflows

– External benefits/costs

– Opportunity costs

Do not include – Accounting profits

– Sunk costs

Time Value of Money

What do you do with future incremental cash flows of

a project?

Calculate their Net Present Value!

– Start with displaying them on a time line

Example

A Firm invests $500,000 in a new branch next year, estimates it would return a net* of $100,000 ($500,000 in revenues offset by $400,000 in expenses) annually beginning a year later.

Sunk costs are not included. A $100,000 opportunity cost is added to the initial investment for a first year total cost of $600,000.

$25,000/yr. external cost of the reduced revenues at the home office should be accounted for.

*i.e. the effects of taxes and depreciation are included

Time Line: Incremental Cash Flows for the New Branch Office Project

Year 0 1 2 3 4 5 6 7 8 9

Cash Flow ($600k) 75k 75k 75k 75k 75k 75k 75k 75k 75k

Underlying Data & Calculations for the New Branch Office Project

Investment $500k

Opportunity Cost 100k

External Cost 25k 25k 25k 25k 25k 25k 25k 25k 25k

Operations Cost* 400k 400k 400k 400k 400l 400k 400k 400k 400k

Revenues 500k 500k 500k 500k 500k 500k 500k 500k 500k

Net Cash In (out) (600k) 75k 75k 75k 75k 75k 75k 75k 75k 75k

*Includes effects of taxes and depreciation

The dilemma facing the firm

Do you invest something now with a promise of a return in the future?

It’s not a simple case of foregoing $600,000 and recovering $650,000($75,000 x 9) over the next 9 years.

Dollars received in the future cannot be equated to dollars spent in the near term.

Money in hand has more value than a like amount of money in the future because of the opportunity it represents. The challenge is how to account for this time value of money.

Calculating the Project’s NPV

Determine the discount rate

Calculate the present value of each year’s cash flow

Sum PV of future cash flows, then subtract the

investment to get NPV

Discount rates are estimates of an

organization’s cost of capital

If you as an individual were going to invest in a

project, the alternative use of your money would be

the clue to your cost of capital.

A firm’s cost of capital depends on where it would get

the cash to fund the project.

Firm’s cost of capital

If it borrowed it, the cost of capital would be the after tax interest rate it pays on a loan or the bonds it issues.

If the business sold more stock to raise the money, the cost of capital would be the rate of return the stockholders expect to get.

Cost of capital

If the project is funded with cash from the company’s

accounts, then the cost of capital would be the

estimated rate of return on alternative investments.

Often, businesses get money from all three sources.

When this is the case, they estimate their cost of

capital by a weighted average calculation.

Riskier Projects > Higher Discount Rate

Weighted average cost

of capital is a good

discount rate for

average risk projects

Higher risk projects

should use a higher

than average cost of

capital

NPV of the Firm’s Project

Year 0 1 2 3 4 5 6 7 8 9

Net

Cash

Flow

$

(600)

K

75 75 75 75 75 75 75 75 75

PVFactor

7%

1.000 .935 .873 .816 .763 .713 .666 .623 .582 .544

PV

@7%

$

(600)

70 66 61 57 53 50 47 44 41

NPV $

(111)

K

Calculating NPV

Can use the Formula

Tables (as done on the previous slide)

Calculator

Spreadsheets make it really easy

Making an Initial Decision

Follow a criterion, or decision rule.

Which rule to follow depends upon the

circumstances.

If you are in business and your objective is to turn a

profit and increase shareholder’s wealth, the rule is

simple: you accept any project that has a positive net

present value

Special Rule

If projects are mutually exclusive, then you choose

among them by picking the one with the highest

positive net present value

Mutually exclusive projects are ones that would not

be chosen together, like building a bridge and buying

ferry boats to traverse the same route.

Sensitivity Analysis

Nothing is certain in the future. Since that is where

the consequences of capital budgeting decisions

occur, we must challenge the assumptions underlying

our calculations.

We know estimates are wrong. Its a matter of how

wrong they have to be to cause us to make a bad

decision.

Definition

Sensitivity analysis in general refers to a repetition of

analysis using different values for uncertain factors.

If a reasonable change in an assumed value results

in a change in preference among choices, then the

decision is said to be sensitive to that assumption or

that variable

How to do “what if”

In capital budgeting, sensitivity analysis measures the effect of changes to a particular variable, say annual operating cost, on a project’s present value

All variables are fixed at their expected values, except one. That one variable is then changed, often by specified percentages, and the resulting effect on present value is noted

Sensitivity Analysis Routine

Spreadsheets and contemporary PC technology

make the performance of sensitivity analysis a piece

of cake.

Excel is ideally suited for sensitivity analysis. Once

a model is created, it is very easy to change the

values of variables and obtain new results.

Usefulness

Identify those variables which potentially have the greatest impact on success or failure

Helps policy makers focus attention on these variables that are probably most important.

The sources of the estimates of these variables should be further scrutinized, and alternative sources sought.

Sensitivity Analysis

Above all else, it serves as a risk assessment tool

If a reasonable change in an estimate causes the

outcome to go from a success to a failure, then the

decision is risky

How To Handle Uncertainty

Sensitivity Analysis - Analysis of the effects of changes

in single variables (sales, costs, etc.) on a project.

Scenario Analysis - Project analysis given a particular

combination of assumptions.

– Worst Case Scenario

– Best Case Scenario

– Most Likely Scenario

Summary

Capital budget decisions are among the most important ones a firm can make

Steps. For each project:

1. Estimate economic life

2. Estimate Incremental Cash Flows

3. Determine the discount rate

4. Calculate Net Present Value

5. Order preference of all projects based on NPV

6. Do Sensitivity & scenario analysis

7. Interpret the results of the basic analysis and the sensitivity/scenario analysis, and make a decision.

8. Decide: lease or buy

9. Plan to implement what you can afford

10.Follow up, verify and adjust

Capital Budget Decision Process

Discounted cash-flow analysis

NPVInitial

Choice

Criterion

StartSensitivi ty &

Scenario Analysis

End: decision

Accounting Projections

(Income Statement)

Determine Relevant

Incremental Cash Flows

Determine Discount Rate

Cost of Capi tal

Do the Project?

Lease or buy

assessts?

yes

no