Chap007

Capital Budgeting The future of a company lies in the investments it makes today. Investment project proposals are the responsibility of all managers in the organization. Capital budgeting is the financial evaluation of project proposals. Weigh outlay today vs. expected future benefits.

DCF Discounted cash flow analysis is the backbone of modern academic finance. DCF is used to evaluate cash flow streams whose costs and/or benefits extend beyond the current year.

Figures of Merit Three-step procedure. Estimate the relevant cash flows. Calculate a figure of merit for the investment, summarizing the investment’s economic worth. Compare the figure of merit to an acceptance criterion.

Estimating Cash Flows The first step is challenging. Doing it well requires a thorough understanding of the company’s markets, competitive position, and long-run intentions. Potential estimation difficulties relate depreciation, financing costs, working capital investments, shared resources, excess capacity, and contingent opportunities.

TABLE 7-1 Cash Flows for Container-Loading Pier ($ millions)

FIGURE 7-1 Cash Flow Diagram for Container-Loading Pier

Payback Period and Accounting Rate of Return The payback period is the amount of time the company must wait before recouping its original investment. The pier’s payback period is 5 1/3 = 40/7.5. Accounting rate of return (arr) is the ratio of annual average cash flow to total cash outflow. The pier’s arr = 21.1% = [(7.5 x 9 + 17)/10]/40.

Issues The payback period ignores cash flows after payback, and also ignores the time value of money. The payback period is sometimes useful as a rough guide to project risk. The arr ignores the timing of cash flows.

Time Value of Money Reasons why a dollar today can be worth less than a dollar in the future. Inflation Uncertainty Opportunity cost

Compounding and Discounting The future value received in a year, from $1 invested today at 10%, is $1.10. The present value of $1.10 to be paid in a year when the interest rate is 10% is $1. With compounding, the future value received in 2 years, from $1 invested today at 10%, is $1.21 = 1 x 1.1 x 1.1. In reverse, the present value of $1.21 to be paid in two years when the interest rate is 10% is obtained by dividing the 1.21 by 1.1 2 .

Interpretation The discount rate is the interest rate and the term 1.1 -2 is called a discount factor. If a company has cash on hand, the discount rate reflects the company’s opportunity cost of capital. If a company raises the cash externally, the discount rate measures the investor’s opportunity cost of capital.

Calculator Conventions FV PMT PV 1 2 3 4 … n 0 …

n i PV PMT FV Input: 4 15 ? 2 -- Output: -5.71 Using a Calculator to Find the Present Value of a $2 million, 4-year Annuity, Discounted at 15%

Equivalence and NPV Two cash flow streams with the same present value can be transformed into each other. Net present value is the present value of the future expected cash flows minus the initial investment. NPV measures the amount of value creation. Decline negative NPV projects, and accept non-negative NPV projects.

$5,710,000 Today is Equivalent to $2 million a Year for 4 Years When the Interest Rate is 15 %

Benefit-Cost Ratio BCR = PV of cash inflows divided by PV of cash outflows. The BCR is also known as the profitability index.

IRR The internal rate of return (IRR) is “the” discount rate that makes the PV of a stream of cash flows equal to zero. Loosely speaking, the IRR can be regarded as the rate of return associated with the cash flows.

TABLE 7-2 NPV of Container Pier at Different Discount Rates

FIGURE 7-2 NPV of Container Pier at Different Discount Rates

TABLE 7-3 Calculating Container Pier’s Estimated NPV, IRR, and BCR with a Computer Spreadsheet

Applications and Extensions Bond valuation. Par value of $1,000. Coupon rate of 8%. Maturity is 9 years. Required return is 7%. PV = $1,065.15.

IRR of Perpetuity A paid per year into perpetuity, when required return is r. P = A/r. r = A/P

Equivalent Annual Cost Example: find lease payment such that leasing produces a 10% IRR. Find equivalent annual payment such that the NPV of the initial expenditure and salvage value together with an equivalent annual payment at 10% interest is the same as the NPV of an alternative.

Mutually Exclusive Alternatives and Capital Rationing Situation  there is more than one way to accomplish an objective, and the investment problem is to select the best alternative. When investments are independent, all three figures of merit – NPV, IRR, BCR – will generate the same investment decision.

Capital Rationing Capital rationing exists when the decision maker has a fixed investment budget that is not to be exceeded. Task is to rank the opportunities according to their investment merit. Capital rationing can alter the ranking of alternative independent investments.

IRR in Perspective IRR has more intuitive appeal than NPV and BCR. IRR can sometimes allow the decision maker to sidestep the question of what is the right discount rate for the investment. At the same time, there might be multiple values for IRR, or no IRR at all. IRR might be invalid for analyzing mutually exclusive alternatives under capital rationing.

Determining the Relevant Cash Flows Two principles. Cash flow principle: time stamp cash flows, recording them when they actually occur. With-without principle: record only cash flow differences that occur because an investment is made as opposed to not made.

Example Consider Table 7.4, showing forecasted costs and benefits for a project introducing a new line of cell phones. The Capital Expenditure Review Committee attacked the proposal from all sides. Where are the problems?

Structure of Table 7.4 Top portion shows initial investment and anticipated salvage value. Center portion shows forecasted income statement. Bottom portion shows “Free Cash Flow.” FCF = Earnings after tax + Noncash charges - Investment

TABLE 7-4 Division Financial Analysis of New Line of Cellular Telephones ($ millions)

Depreciation Is it OK to subtract depreciation from gross profit to compute profit after tax? Is physical depreciation captured by salvage value being less than the initial investment? Does including both depreciation and salvage value amount to double counting?

Tax Depreciation is relevant for computing tax. After-tax cash flow = Operating income - Taxes Deduct depreciation to compute tax and then add it back to find relevant cash flow ATCF (investment’s after-tax cash flow). The next slide illustrates the concept.

The Two-Step Treatment of Depreciation when Calculating Aftertax Cash Flow (ATCF)

Working Capital and Spontaneous Sources The with-without principle indicates that changes in working capital that are the result of an investment decision are relevant to the decision. Working capital needs typically fluctuate with sales. Working capital investments typically have large salvage values, with associated inflows approximately as large as the outflows.

Calculating the Investment in Working Capital Note error in line 3, period 4

Sunk Costs The with-without principle implies that sunk costs are not part of project cash flows. They might need to be recorded, but elsewhere. Psychologically difficult to ignore sunk costs. In some circumstances, it will have been unwise to adopt a project, but once undertaken, appropriate to continue the project.

Allocated Costs Bearing the fair share of overhead? With-without principles says to ignore allocated overhead because it’s fixed. The thing is that over time, overhead might not be fixed but indeed vary with the size of the business.

Excess Capacity Is the use of excess capacity free? If the excess capacity has no alternative use, then that is the case. If using the excess capacity prevents the generation of cash flows from an alternative, then the with-without principle indicates that the foregone cash flows should be part of the analysis to reflect the opportunity cost. Often important to link to future decisions.

Financing Costs Financing costs refer to any dividend, interest, or principal payments associated with financing an investment. The standard procedure is to reflect the cost of money into the discount rate and ignore financing costs. This issue comes up again in the next chapter.

Table 7.5 The following table presents the revised figures for the project proposal. The bold figures reflect changes stemming from the treatment of depreciation, working capital, sunk costs, interest expenses, allocated expenses, and excess capacity.

TABLE 7-5 Revised Financial Analysis of New Line of Cellular Telephones ($ millions)

APPENDIX Mutually Exclusive Alternatives and Capital Rationing When investments are independent, the decision to accept or reject is the same regardless of which figure of merit is employed. When investments are mutually exclusive, the decision task is not as simple.

Example Figure 7A-1 illustrates two alternative projects, an inexpensive option and an expensive option. At the bottom of the Figure the three figures of merit are displayed. What do these figures suggest if the two projects were to be independent? What do these figures suggest if the two projects are mutually exclusive?

FIGURE 7A-1 Cash Flow Diagrams for Alternative Service Station Designs

TABLE 7A-1 Figures of Merit for Service Station Designs

NPV Although the inexpensive option has higher IRR and BCR, it is NPV that is the criterion that is relevant. NPV measures total value creation, not value creation per dollar invested.

Unequal Lives In the previous example, the two projects had the same lives. What happens if they have different lives? Suppose alternative #1 has a lower initial cost, higher maintenance costs, and a shorter life than alternative #2. Straight NPV is not apples-to-apples comparison because the time frames are different, and some cash flows are implicitly neglected.

What to Do? Restructure the problem with a common investment horizon, to factor in omitted cash flows, such as replacement for alternative #1 at the end of its life. Compute equivalent annual cost, in an attempt to measure apples-to-apples. Beware of hidden assumptions when doing either, such as inflation, changing prices, etc.

Capital Rationing Table 7A-2 describes 4 investments that are mutually exclusive in a capital rationing decision environment. The capital budget is capped at $200K. One approach is rank order alternative investments by BCR, and proceed to adopt stepwise until the budget is exhausted or BCR falls below 1.

TABLE 7A-2 Four Independent Investment Opportunities under Capital Rationing (Capital budget =$200,000)

Fractional Investments The “rank by BCR” rule will work if fractional investments are allowed. For example choose C, D, and 7/12 of B. Otherwise, it is typically necessary to look at every possible configuration of projects selected to choose the one that creates the most value.

Additional Issues What’s wrong with just ranking by NPV? In this setting, the goal is to maximize total NPV across project configurations, but because of the different investment amounts, doing so requires looking at NPV per dollar first. This is what BCR does. Be careful about IRR, because it does not always give the same answer as BCR.

Future Opportunities Keep in mind that budgets apply over time periods, not just at points in time. Therefore, focus on future opportunities as well as current opportunities, since undertaking an investment today can preclude undertaking a better investment in the future if they fall within the same budgeting period.

A Decision Tree Figure 7A-2 provides a capsule summary of the key points involved in capital budgeting.

FIGURE 7A-2 Capital Budgeting Decision Tree

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