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FINANCE 7311FINANCE 7311

CAPITAL BUDETING

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OutlineOutline

Projects

Investment Criteria

NPV v. IRR

Sources of NPV

Project Cash Flow Checklist

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ProjectsProjectsA project is any potential real investment

opportunityDistinguish real from financial

Mutually Exclusive - can do only oneIndependent - decision about one does not

affect decision w/r/t the others

Replacement - special case

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Investment CriteriaInvestment Criteria

Investment criteria are the rules by which we decide whether or not to accept a particular project; consider the following:

Year Project A Project B

0 (10,000) (10,000)

1 6,500 3,500

2 3,000 3,500

3 3,000 3,500

4 1,000 3,500

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Accounting Rate of ReturnAccounting Rate of Return

ARR = Avg. Income / Avg. Investment

Uses Income rather than Cash Flow

Ignores Time Value of Money

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PaybackPayback

Years needed to recover initial investment

To Find: Calculate where cumulative cash flows become positive

Project A: 2 1/6 yearsProject B: 2 6/7 years

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Problems with PaybackProblems with Payback

Ignores Time Value of MoneyCan use Discounted Payback; Why?

Ignores CF’s after paybackTo see: Assume Project B’s cash flow in

year 4 is 1,000,000; how does this affect payback

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Net Present ValueNet Present Value

This rule is always consistent with maximizing the value of the firm

Economically, take all projects for which benefits > costs (in PV dollars)

Mathematically, sum the present values of all the cash flows

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Net Present ValueNet Present Value

CFR

CFn

ii

iNPV0

1 )1(

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NPV exampleNPV exampleYear Project A Project B

0 (10,000) (10,000)

1 5,804 3.125

2 2,392 2.790

3 2,135 2,491

4 636 2,224

967 630

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Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRR - That rate which causes NPV to = 0.

0 iCFi

(1IRR)i1

n

0CF

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IRRIRR

Independent Projects - select all projects for which IRR > Cost of Capital

Mutually Exclusive - select project with highest IRR

Use ‘well-designed’ spreadsheet

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Comparison of NPV & IRRComparison of NPV & IRR

Business people are accustomed to thinking in rates of return, so does it matter which of NPV or IRR we use?

Independent - the two rules are equivalent

NPV > 0 <==> IRR > Cost of Capital

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Comparison of NPV & IRRComparison of NPV & IRR

Mutually Exclusive Projects - can get different answers

NPV Profile for Example

Reinvestment Assumption

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NPV v. IRR ExampleNPV v. IRR Example

Project 1: (100,000) 125,000Project 2: 1,000 2,000

NPV IRRProject 1 13,636 25%Project 2 818 100%

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NPV v. IRR, cont.NPV v. IRR, cont.

IRR ==> Do Project 2NPV ==> Do Project 1

Problem: Reinvestment AssumptionWhat are you going to do with the other

$99,000?

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Profitability IndexProfitability IndexPV Cash Inflows / PV Cash OutflowsIndependent: Choose all with PI > 1Mutually Exclusive: Choose highest PI

Project 1: 1.136 Project 2: 1.818

May be useful for capital rationing

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Other Real OptionsOther Real Options

Option to ExpandOption to AbandonStrategic Options

Excluding biases NPV downDecision Tree: Capital Budgeting should be

dynamic, not static

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Source of NPVSource of NPV

Market Opportunities - ‘deviations from equilibrium’

Economies of Scale Cost Advantages Product differentiation Distribution Advantage Regulatory Protection

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Relevant Cash FlowsRelevant Cash Flows

We can always write: EBIT + Depreciation - Taxes (t x EBIT) = Operating Cash Flow - ∆ NWC - Capital Spending = FCF

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Cash FlowsCash Flows

1. Focus on Cash Flows; not accounting #’s Depreciation Not a cash flow Affects Cash Flow through depreciation Capital spending Capitalized for accounting purposes Cash outflow for finance purposes

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Project Cash FlowsProject Cash Flows

2 Focus on Incremental Cash Flows “What is different if project is accepted?”

Sunk Costs - those costs which have been incurred and are not affected by project decision

Opportunity Cost - highest value use of an asset if not used in project

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Project CF’s, cont.Project CF’s, cont.3 Externalities - less obvious costs/benefits

which should be included in analysis

4 Change in NWC - often a cash outflow initially and cash inflow at end

5 Cash flows should be after tax ∆Rev/Exp x (1-t) Depreciation x t6 Do not include interest as a cash flow

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Project CF’s, cont.Project CF’s, cont. Replacement problem - should you keep an

existing asset, or replace it with a new one

∆ in Cash Flows Net of tax proceeds from disposal of

existing asset