FIN534 Week 6 Scenario Script How to use the Different Capital Bu.docx
- 1. FIN534 Week 6 Scenario Script: How to use the Different Capital Budgeting Methods, and Identifying Relevant Cash Flows Slide # Scene/Interaction Narration Slide 1 Intro Slide Slide 2 Scene 2 · In Don’s office · Maybe Fitness Olympic banner · Situation room · End of scene Don: Hi Linda, how was your workout? I knew I would see you exercising before work. Linda: That is right Don. Our annual Fitness Olympics challenge is coming up and I want to be in shape for it. Don: I forgot about the company Fitness Olympics. Linda: Well, I did not forget. Last year our department just missed out on the top honors. This year we are planning on being the winning department. I may even try to recruit our intern! Don: Great attitude, Linda. Don: Before the Fitness Olympics, we still have a lot of work to do concerning this expansion project and whether or not we should go with it. Things are starting to move quickly.
- 2. Recently, I heard from Joe and he wants us to do some capital budgeting analyses on the project. This analysis may be our make or break analysis for the project so we really need to be detailed. Linda: Okay Don. The intern and I are right on it. I plan on meeting the intern in the “Situation Room”. We dubbed the conference room that name as we are constantly making informed decisions. Slide 3 Scene 3 · Linda in conference room · · Go to next slide Linda: We have our hands full. The project is getting close to decision making time. Joe and Don want us to analyze the proposed expansion project from a capital budgeting standpoint. Currently, we have completed many internal analyses on TFC. Now, we must look at the viability of the expansion project. Capital budgeting does just that. At the end of it, we should have a better idea of what our recommendation would be. Linda: Capital budgeting can be done whenever there is an initiative to invest in assets for the long term. Our project is doing just that. We want to be confident in our decision as this project is for the long term and is costly. Don is going to be joining us with the expected cost of the project. Slide 4 Scene 4 · Don in conference room with papers in hand? · Show on the papers - seven hundred fifty million dollars · Go to next slide Don: Hello all. With this expansion project we will double in
- 3. asset size. But it comes with a price. The Accounting Department told us that the projected price to expand out West is seven hundred fifty million dollars. I also have the projected cash flow numbers. Now, I need the both of you to determine if we should proceed with the expansion. To do so you will need to use many capital budgeting techniques to arrive at a highly confident decision. Good luck! The faith of this expansion and the future success of TFC depend on your analysis. Linda: Don, the Intern and I will begin working on this now! Slide 5 Scene 5 · Linda In conference room (Don not in room) · Net Present Value · WACC =10.92% · Go to next slide Linda: We have our assignment so let’s starting working through this analysis. There are many capital budgeting techniques and the plan is to use some of them for our project as Don said. But, it ultimately comes down to money. If the project is expected to bring in more cash than its costs, the project is a go, within reason, that is. As we have been saying all along, cash is the driving force behind our decision-making. To analyze our cash flows ,we need to look at the net present value of our future cash inflows and outflows including the cost of the project. Since these cash flows are being expected over time, we need to discount them back to today so we are valuing everything at the same point in time. Since we do not know the actual cost for undertaking the project, we will use our WACC, which is ten and ninety-two hundredths percent, as our discount rate. We also need our anticipated cash flows in the future years. This can be difficult to project, but it is extremely important that these numbers are as realistic as possible.
- 4. From what I was told, the Accounting Department expects cash flows for this project only to be negative ten million in projected year one as the company will still be opening up fitness centers at a high rate. In year two, the cash flow is projected to be two hundred million, then two hundred fifty million, three hundred million, and four hundred million, respectively, for years two through five. A five-year projection will enable us to see where we will be in the immediate future. Anything after five years may be difficult to estimate as things change over time.. Linda: Now that we know all the inputs to our calculation, we can determine if this expansion project will have a positive net present value. While I gather data for our second cash budgeting technique, can you run the numbers to see what the outcome is? Slide 6 Scene 6 · CYU Linda would like you to determine the Net Present Value of the expansion project. Using a 10.92% discount rate and the cash flows as follows: Cash Flow Year 0 = $-750,000,000 Cash Flow Year 1 = $ - 10,000,000 Cash Flow Year 2 = $+200,000,000 Cash Flow Year 3 = $+250,000,000 Cash Flow Year 4 = $+300,000,000 Cash Flow Year 5 = $+400,000,000 Using present value calculations for an uneven stream of cash flows what will the Net Present Value of the project be? (Round to whole dollars)
- 5. Answer: $23,164,711 (can you put a variance in there of $20?) If right – Great job. This project will generate cash for TFC If wrong – Nice try. Remember to discount each cash flow back at 10.92% and then sum all the amounts including the - $750,000,000 Slide 7 Scene 7 · Net Present Value · Go to next slide Linda: Nice work! From the calculations, the net present value of the project is expected to be over twenty-three million dollars. Now, that is some great news. But, we have to be careful here. We are assuming our discount rate to be ten and ninety-two hundredths, which is in line with our required rate of return under the WACC. If this rate changes, it can affect the project’s value. Linda: Having a positive expected net present value indicates that we should proceed with the project. The capital budgeting technique is the best choice to use as it tells us the expected cash value of the project. If the numbers that came back were negative, we would suggest that we should not proceed with the project. As you can see, it all depends on cash. Linda: Even though the Net Present Value measure is the best one to use, it is good practice if we look at a few of the other ones. Slide 8 Scene 8 · Conference Room · Show calculation from excel · IRR =11.84%
- 6. · Next slide Linda: Another measure is the Internal Rate of Return, or the IRR for short. It is the discount rate that makes all the future cash flows equal to the beginning cash outlay. Basically, it measures the expected rate of return on the project. If the IRR is greater than the project’s cost of capital, the shareholders will benefit by the project. The calculation can be quite involving if done by hand. Luckily at TFC, we have a financial calculator that handles the calculation and leaves the decision making up to us. Our calculator is showing eleven and eighty-four hundredths percent as the IRR. This is above our cost of capital of ten and ninety- two hundredths percent which shows a return higher than cost. So far everything is pointing toward proceeding with the project. Slide 9 Scene 9 – · Linda in room · Cost of debt Linda: The third measure, called the Modified Internal Rate of Return or MIRR is similar to the IRR but it looks at cash inflows and outflows separately and then together. What I mean by that is, in order to do the calculations: First, take all negative cash flows and discount them back to today. Then, take all positive cash flows and compound them at our WACC to our last projected year, which is year five. At that point we have a present value amount and a future value amount.
- 7. The MIRR is the rate that links the two cash flows, the present value and future value. Keep in mind, the present value cash flows are all the negative cash flows discounted, including today, while the future cash flows are all the positive cash flows compounded to the future, which is year five for TFC. Linda: Let’s now calculate the MIRR. Slide 10 Scene 10 · CYU Linda would like you to determine the MIRR of the expansion project. Using a 10.92% as the discount and compounded rates to rate and the cash flows as follows: Cash Flow Year 0 = $-750,000,000 Cash Flow Year 1 = $ - 10,000,000 Cash Flow Year 2 = $+200,000,000 Cash Flow Year 3 = $+250,000,000 Cash Flow Year 4 = $+300,000,000 Cash Flow Year 5 = $+400,000,000 Answer: 11.56% · (If they get it wrong. ) Nice try but remember to compound the positive cash flows in Years 2,3,4,5 and discount the negative cash flow in year 1. Add that amount to the beginning cash outlay. Then find the rate over 5 years Correct, The formula is to discount negative cash flow in year 1 to year zero and add it to that amount to get $759,015,506.67. Year 5 total cash flows would be $1,313,276,378.14. Discounting that back at 5 years would give 11.56%
- 8. Slide 11 Scene 11 · Set up the cash flows on a clip board Cash Flow Year 0 = $-750,000,000 Cash Flow Year 1 = $ - 10,000,000 Cash Flow Year 2 = $+200,000,000 Cash Flow Year 3 = $+250,000,000 Cash Flow Year 4 = $+300,000,000 Cash Flow Year 5 = $+400,000,000 · Show $10,000,000/$400,000,000 =.025 of a year for a total of 4.025 years · Next Slide Linda: Great job! Another measure is the Payback Period. We like to say that this is our most straightforward measure but we need to be careful with it as it does not assume any rates. We use this measure when we think our cash balance for the project will be positive. To do this, we look at the initial cash outlay of seven hundred fifty million dollars. We also anticipate another cash outlay of ten million in the first year. In year two is when we plan on generating some positive cash flows of two hundred million dollars. If we just look at it from a net cash perspective after year two we would have negative five hundred sixty million. The cash outlays from the beginning of the project and year one would put us in a deficit of seven hundred sixty million. By adding the two hundred million in year two our deficit would be five hundred sixty million. With that same approach, after year three we would still be at a three hundred ten million dollar deficit.
- 9. After year four we are almost there at a deficit of ten million dollars. In year five, we anticipate the deficit to go away with the first ten million of the anticipated four hundred million in positive cash flows. When you take that ratio of what is needed to break even or ten million dollars over the expected cash flow in year five of four hundred million, the result is point zero two five of a year. When we put it all together, we can expect to be in the positive for the project in four point zero twofive years. So, the project will pay for itself in just over four years. Linda: This payback period measure has some drawbacks especially in the area of discounting. We are not factoring in time but for a quick measurement it is a good one to use. Also, this measure is not our deciding factor. As you know by now, our deciding factor is the net present value calculation. Slide 12 Scene 12 · Don in room · Show results on screen · Thumbs up! Don: I left you with the most critical piece of the project. What were you able to find out? Linda: Don, I think you will be pleased by our analysis. We did a number of capital budgeting measures and the results are as follows: Net Present Value is positive twenty three million, one hundred sixty-four thousand, seven hundred eleven dollars. Internal Rate of Return is eleven and eighty-four hundredths
- 10. percent, which is greater than our discount rate. Modified Internal Rate of Return is eleven and fifty six hundredths percent. And the Payback Period is four point zero two five years. Don: Wow. Great job. I can’t wait to share the results with Joe. But, before I do. Are you giving us thumbs up on the project? Linda: Of course from a financial standpoint we would always like to do some more analyses, but based on our numbers to date, Yes!A double thumbs up! Slide 13 Scene 13 · Linda talking about cash flows · Put words “Relevant Cash Flows” on board · Don enters Linda: Great job with the capital budgeting analysis. While we do four different measures here at TFC, there are others, such as the Profitability Index and using the discount rate on the payback period measurement. But in our decision making, it all comes down to cash flow and the net present value tells us the cash outlook for the project. Linda: So I’ve been mentioning cash a lot...... When we started on the cash budgeting, we were given projected amounts from the Accounting Department. I’ve even mentioned that there was much debate on the cash flows. Keep in mind these are projected cash flows, so a lot of analysis and decision making goes into it. Probably the most critical part of our expansion project is projecting the cash flows from it. Our Accounting Department spent countless hours discussing what should be included in the analysis and what is not relevant.
- 11. Don: That is right Linda. I spent some time in the Accounting Department when this analysis was being done and some of the points that were being considered included the following. First, there is a distinction betweenfree cash flows and accounting income. Typically accounting income is on an accrual basis which is different from actual cash flow. Remember for this project we are only concerned with the cash flows related to this project and not other areas of TFC. Second, depreciation needs to be added back into the project. It is a not cash item that needs to be added back when estimating cash flows. In fact all non cash charges related to the project should be added back for cash flow purposes. Third, we do not deduct any interest charges related to the project as this was already considered when we determined the WACC, which is the rate we use to discount all the cash flows. Fourth, change in net operating working capital is a factor. Any activity related to this expansion project, whether assets or liabilities, need to be considered. This is one of the areas that really need to be looked at closely. Another area involves sunk costs, which are cash outlays that occurred prior to moving forward with the project and should be ignored. The Accounting Department determined that all of the research on the different locations to expand into are sunk costs and are not included in the net cash flow. Slide 14 Scene 14 · Don and Linda in room · Next Slide Don: These are just a few of the areas that need to be considered. For the most part, if it is a cash transaction and it
- 12. is part of the project, then it should be included in determining cash flows. Linda: That is true. And at TFC we have many computer tools and spreadsheets that we use to aid us in making these cash flow decisions. That is why we were confident in our analysis. Don: And I passed that on to Joe. Working together as a team really helps in decision making. I can’t wait to see this project move forward. But like any hard day at work, it is always good to finish it with a workout. Before we head to the gym, let’s briefly go over what we accomplished today. Slide 15 Scene 15 · Summary Slide – Linda: Another great job by the team at TFC. We covered many capital budgeting techniques when looking at a project’s cash flows including the Net Present Value, Internal Rate of Return, Modified Internal Rate of Return, and Payback Period. While all are important, the Net present Value should be used at the final deciding factor. We also looked at identifying relevant cash flows. They should be those activities that are related to the project now. There are many software packages that can help in the decision making. Don: Linda, you and the intern are doing fabulous work. You two made the determination to proceed with the project but your work is not done. Enjoy your workout as I have another project when you are finished. Slide 16 Scene 16 · Closing slide
- 13. Closing slide FIN 534 Week 6 Part 1: The Basics of Capital Budgeting: Evaluating Cash Flows Slide 1 Introduction Welcome to Financial Management. In this lesson we will discuss the basics of capital budgeting: evaluating cash flows. Next slide Slide 2 Topics The following topics will be covered in this lesson: An overview of capital budgeting; Net present value; Internal rate of return; Multiple internal rates of return; Reinvestment rate assumptions; Modified internal rate of return; NPV profiles; Profitability index; Payback period; Conclusions on capital budgeting methods; Decision criteria used in practice; and
- 14. Other issues in capital budgeting. Next slide Slide 3 An Overview of Capital Budgeting Unlike stocks and bonds which are part of the securities market where investors choose from the available set, capital budgeting involves project creation because firms create capital budgeting projects. Provide the company executes its plans well their capital budgeting projects will be successful. As we do when we analyze a security we must forecast cash flows, calculate the present value of the cash flows associated with each investment opportunity and make the investment if and only if the present value of the future expected cash flows is greater than the project’s cost. The firm has available several methods with which to evaluate projects and decide whether to accept or reject them. Specifically, the project evaluation methods are: Net present value also known called NPV; Internal rate of return, also known called IRR; Modified internal rate of return, also known called MIRR; Profitability index, also known called PI; and The payback period. Next slide Slide 4 Net present value (NPV) The NPV method for project evaluation is defined as the present value of a project’s cash flows minus the present value of its costs. It tells the firm how much the project contributes to shareholder wealth. Higher NPVs mean a higher stock price for the firm because the project increases to shareholder wealth. The NPV method is considered the best project evaluation method because it is directly related to the objective of maximizing the firm’s intrinsic value. To determine the NPV using Excel we use the following procedure:
- 15. First, determine the present value of each cash flow which is net of depreciation, taxes, and salvage value and is discounted at the project’s risk adjusted cost of capital; Next, add discounted cash flows to obtain the project’s NPV. In general the NPV of a project is given by: NPV equals summation t equals zero through N CF sub t divided by the quantity one plus r raised to the tth power; Where CF sub t is the expected net cash flow at time T; R is the project’s risk adjusted cost of capital or the WACC; and N is the project’s life. Any project usually requires an initial investment which is entered as a negative number in Excel and is not discounted because it occurs at times zero. When we use the NPV method it is important that we know whether or not the projects in question are independent or mutually exclusive. Independent projects have cash flows that are not impacted by other projects. If projects are mutually exclusive all the projects can be rejected but not all of them can be accepted at the same time. According to the NPV method, if NPV is greater than zero we accept the projects if they are independent, but if the projects are mutually exclusive the firm must accept the project with the highest NPV. To use the NPV method all projects under consideration must be either independent or mutually exclusive. Next slide Slide 5 Internal rate of return (IRR) Recall, the YTM is the discount rate that equates the present value of a bond’s cash inflows to the price of the bond. The IRR is analogous to the yield to maturity for a bond because the IRR is the rate of return that sets the present value of cash inflows equal to the cost of the proposed project. This is the same as determining the rate of return that equates the NPV of a project to zero. To calculate the IRR we can solve the equation given by:
- 16. NPV equals summation T equals zero through N CF sub T divided by the quantity one plus IRR raised to the tth power equals zero. For IRR, use a financial calculator to solve the problem, or use the IRR in function in Excel. Then, if the IRR is greater than zero the cost of funds to finance the project the difference is a bonus to the stockholders and the firm’s stock price rises because the IRR is an estimate of the project’s rate of return. If the firm uses the IRR method to rank projects, it uses the following decision rule: If the projects are independent and the IRR is greater than the WACC the project should be accepted otherwise they should be rejected; If the projects are mutually exclusive the firm should accept the project with the highest IRR and reject any project if its IRR is less than or equal to its WACC. However, if the projects are mutually exclusive the NPV and IRR methods yield conflicting results. In the case of a conflict, the NPV method is better. Next slide Slide 6 Multiple internal rates of return When a project has a cash outflow that occurs after the inflows have started the project may have more than one IRR and the cash flows are said to be non-normal. It is difficult to determine multiple internal rates of return since it must be done using trial and error procedure. If however the number of years ranges from zero to two we can use the quadratic formula, from algebra, to solve for the two internal rates of return. Next slide Slide 7 Reinvestment rate assumptions The NPV method assumes that cash inflows are reinvested at the risk adjusted rate of return or WACC, and the IRR method assumes the cash flows are reinvested at the IRR itself. For most firms the assumption of reinvestment at the WACC is
- 17. better for several reasons. First, if the firm has fairly good access to the capital markets it can raise the capital it needs at the going rate. Then, assuming the firm can obtain capital at its WACC the firm should accept those investment opportunities with positive NPVs and finance them at its weighted average cost of capital. If the firm operates in a competitive environment its return on investment opportunities is probably close to its cost of capital. Finally, if the firm uses retained earnings from past projects rather than external capital its weighted average cost of capital is the opportunity cost of the cash flows and hence is the effective rate of return on reinvested funds. Next slide Slide 8 Modified internal rate of return (MIRR) Usually cash flows cannot be reinvested at the IRR and for this reason the IRR usually overstates the expected return for accepted projects. This upward bias is a fundamental flaw in the IRR method. Therefore, we calculate the MIRR in which we assume that the cash flows are reinvested at the weighted average cost of capital or some other reasonable rate. Mathematically, the MIRR method is given by summation T equals zero through N COF sub T divided by the quantity one plus R raised to the tth power equals summation T equals zero through N CIF sub T times the quantity one plus R raised to the N minus tth power divided by the quantity one plus MIRR raised to the Nth power; Where COF sub T is expected cash outflow at time T; CIF sub T is the expected cash inflow at time T; R is the project’s risk-adjusted cost of capital or WACC; and N is the life of the project. By using the MIRR method we eliminate the problem of multiple IRRs and therefore the results can be compared with the cost of capital when deciding to accept or reject projects. If
- 18. projects are independent then NPV, IRR, and MIRR yield the same results. However, if projects are mutually exclusive and differ in size conflicts arise but NPV is the best method because it picks the project that maximizes value. Next slide Slide 9 NPV profiles To construct a NPV profile for a project we determine the project’s NPV for a number of different discount rates and plot the values to create a graph with NPV plotted on the Y-axis and the cost of capital plotted on the X-axis. Recall that the IRR is the discount rate that equates NPV to zero. It turns out that the IRR is the rate at which the profile line crosses the horizontal axis. If there are two competing projects constructing NPV profiles show the conditions under which conflicting rankings may occur. The crossover rate is rate at which the NPVs for competing projects are equal. NPV profiles intersect at the crossover rate because of differences in cash flows and project size. Next slide Slide 10 Profitability index The profitability index, PI, is another method used to evaluate projects. Mathematically, the PI is given by the following: PI equals summation t equals one through N CF sub T divided by the quantity one plus R raised to the tth power that quantity divided by CF sub zero; Where CF sub T is the expected future cash flow at time T and CF sub zero is the initial cost. It shows the relative profitability of a project which is also the present value per dollar of initial cost. Using the PI method a project is acceptable if its PI is greater than one. The higher the PI the higher the project’s ranking. For normal, independent projects NPV, IRR, MIRR, and PI always lead to the same accept or reject decisions. Whenever a project’s NPV exceeds a zero, its IRR and MIRR are always greater than R and its PI
- 19. exceeds one. However, if projects are mutually exclusive the methods may yield conflicting results when the projects differ in the timing or size of cash flows. Whenever there is a conflict between the PI and NPV methods, the NPV ranking should be used. Next slide Slide 11 Payback period While the NPV end IRR are the most commonly used project evaluation methods historically the method used by firms was the payback period. It is defined as the number of years required by a project to recover the funds invested in a project from its operating cash flows. Mathematically the payback period is given by: Payback equals the number of years prior to a full recovery plus unrecovered cost at the start of the year divided by cash flow during full recovery year. The firm compares the calculated payback period with its required payback period and accepts a project provided the calculated payback period is less than the required payback period. But the payback period has three problems. It ignores the time value of money. It ignores cash flows beyond the payback period. Last the method only tells us how long it takes to recover the initial investment and tells us nothing about the amount of wealth the project adds to the investor wealth. To address the time value of money issue analysts calculate the discounted payback period in which cash flows are discounted at the WACC. The discounted cash flows are used to determine the payback period. However, this method also ignores cash flows beyond the payback period. Additionally, the results of both the payback period and the discounted payback period can conflict with NPV if projects are mutually exclusive. As a result, we don’t know how to specify an acceptable payback period. Next slide
- 20. Slide 12 Conclusions on capital budgeting methods Of the available capital budgeting decisions NPV is the best method because it yields a direct measure of the value a project adds to shareholder wealth. IRR and MIRR measure a project’s profitability as a percentage rate of return while the PI measures profitability relative to the amount of investment. MIRR is a better decision method then IRR because it avoids the problem of multiple rates of return and uses the WACC as the reinvestment rate. In addition to the quantitative information provided by the various decision-making methods, qualitative information such as the possibility of a tax increase or a major liability lawsuit should also be considered in capital budgeting decisions. Next slide Slide 13 Decision criteria used in practice Historical surveys of managers indicate that prior to the nineteen eighties the NPV method was not the primary method used to evaluate projects but since nineteen ninety-nine this method is widely used and is second only to the IRR method. In the opinion of the authors if a survey were taken today the NPV method would most likely be the predominant evaluation method. However, managers still use the payback method because it is easy to calculate. Next slide Slide 14 Other issues in capital budgeting Suppose we have two mutually exclusive projects. Project one has a life of three years while project two has a life of six years. To evaluate the projects using the NPV method we must make an adjustment using either the replacement chain also called the common life approach or the equivalent annual annuities or EAA method. If we use the replacement chain or, life approach we assume that project one of is replaced in years four through six and assume its annual cash inflows and its cost of capital do
- 21. not change. This allows us to compare the projects. If we use the EAA method we convert the annual cash flows for both projects into a constant cash flow stream whose NPV equals a NPV of the initial stream. Sometimes it is advantageous to terminate a project prior to the end of its physical life and sell the asset is sold for its expected salvage value. The manager determines the project economic life which is the life that maximizes the NPV and hence shareholder wealth. This method should always be used if the expected salvage value is relatively high. A firm’s optimal capital structure is that set of independent projects with positive NPVs and mutually exclusive project with the highest NPV. These are the projects that maximize value the firm. But there are two complications that can arise: the cost of capital can increase as a size of the capital budget increases and the firm may set an upper limit on the size of their capital budget which is referred to as capital rationing. Next slide Slide 15 Check Your Understanding Slide 16 Summary We have now reached the end of this lesson. Let’s review what we’ve covered. First, we provided an overview of capital budgeting. We learned the firm has several methods it can use to evaluate investment projects. Next, we learned that the NPV method is considered the best project evaluation method because it is directly related to the objective of maximizing the firm’s intrinsic value. Also, we identified and described the NPV, IRR, MIRR and PI methods. If projects are independent the NPV, IRR, MIRR and PI methods yield the same result. If, however, projects are
- 22. mutually exclusive conflicting results may occur and the NPV method should be used for project evaluation. Next, we learned that the payback period is used by firms because it is easy to calculate. However, it ignores the time value of money and cash flows beyond the payback period and only tells us how long it takes to recover the initial investment and nothing about the amount of wealth the project adds to the investor wealth. Also, we discussed that in order to address the time value of money issue; analysts calculate the discounted payback period in which cash flows are discounted at the WACC. The discounted cash flows are used to determine the payback period. However, this method also ignores cash flows beyond the payback period. Next, we discovered that the results of both the payback period and the discounted payback period can conflict with NPV if projects are mutually exclusive. As a result, we don’t know how to specify an acceptable payback period. Then, we learned that it is important to consider qualitative information when making capital budgeting decisions. Also, we looked at how to modify the NPV formula if we have two mutually exclusive projects with unequal lives. This is done using either the replacement chain or equivalent annual annuities. Finally, our last two topics dealt with terminating a project prior to the end of its useful life and the optimal capital structure of the firm. This concludes this lesson.