Transcript Financial Planning Lecture 5 Capital Budgeting

FINANCE 7311
CAPITAL BUDETING
1
Outline

Projects

Investment Criteria

NPV v. IRR

Sources of NPV

Project Cash Flow Checklist
2
Projects

A project is any potential real investment
opportunity
 Distinguish real from financial

Mutually Exclusive - can do only one

Independent - decision about one does not
affect decision w/r/t the others

Replacement - special case
3
Investment 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
4
Accounting Rate of Return

ARR = Avg. Income / Avg. Investment

Uses Income rather than Cash Flow

Ignores Time Value of Money
5
Payback

Years needed to recover initial investment

To Find: Calculate where cumulative cash
flows become positive

Project A:
 Project B:
2 1/6 years
2 6/7 years
6
Problems with Payback

Ignores Time Value of Money
 Can use Discounted Payback; Why?
Ignores CF’s after payback
 To 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 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 Value
CF
NPV  
 CF
(1 R)
n
i
i 1
i
0
9
NPV example
Y ea r
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)

IRR - That rate which causes NPV to = 0.
CF
0
 CF
(1 IRR)
n
i
i 1
i
0
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IRR

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 & 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 & IRR

Mutually Exclusive Projects - can get
different answers

NPV Profile for Example

Reinvestment Assumption
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NPV v. IRR Example

Project 1:
 Project 2:

Project 1
 Project 2
(100,000)
1,000
NPV
13,636
818
125,000
2,000
IRR
25%
100%
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NPV v. IRR, cont.

IRR ==> Do Project 2
 NPV ==> Do Project 1

Problem: Reinvestment Assumption
 What are you going to do with the other
$99,000?
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Profitability Index

PV Cash Inflows / PV Cash Outflows
 Independent: Choose all with PI > 1
 Mutually Exclusive: Choose highest PI
Project 1:
Project 2:
1.136
1.818
May be useful for capital rationing
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Other Real Options

Option to Expand
 Option to Abandon
 Strategic Options

Excluding biases NPV down
 Decision Tree: Capital Budgeting should be
dynamic, not static
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Source of NPV
Market Opportunities - ‘deviations from
equilibrium’
 Economies of Scale
 Cost Advantages
 Product differentiation
 Distribution Advantage
 Regulatory Protection

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Relevant Cash Flows

We can always write:
EBIT
+ Depreciation
- Taxes (t x EBIT)
= Operating Cash Flow
- ∆ NWC
- Capital Spending
= FCF
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Cash 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 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.
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
Cash flows should be after tax
∆Rev/Exp x (1-t)
Depreciation x t
Do not include interest as a cash flow
5
6
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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
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