Transcript Capital Budgeting

Topics in Capital
Budgeting
7/20/2015
Richard MacMinn
Objectives
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Study how to determine cash flows
for capital budgeting analysis
Study capital budgeting under
uncertainty
Study how to incorporate risk in
capital budgeting decisions.
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Richard MacMinn
Guidelines for Capital
Budgeting
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Use cash flows rather than accounting
profits
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Cash flows correctly reflect the timing of
benefits and costs
Examine cash flows on an after-tax basis
Only include incremental after-tax cash
flows
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Cash flows with the new project versus cash
flows without the new project
Richard MacMinn
Guidelines for Capital
Budgeting
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Beware of cash flows diverted from
existing products
Decide if overhead costs are truly
incremental cash flows
Ignore interest payments and
financing flows as they are
accounted for when the cash flows
are discounted back to present
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Richard MacMinn
Inflation & Capital
Budgeting
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Increased inflation will cause the
required rate of return on project to rise.
Both anticipated cash inflows and
outflows could be affected by inflation.
The salvage value of the project could be
affected by inflation.
The fact that depreciation charges do not
change with inflation also distorts
capital-budgeting decisions.
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Richard MacMinn
Measuring The Cash Flows
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A project’s cash flows can be classified as:
Initial outlay
Differential cash flows
Terminal cash flow
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Richard MacMinn
Example
Existing Situation
Two Full Time Operators at $10000 each per year $
20,000
Annual Cost of Maintenance
$
5,000
Cost of Defects
$
5,000
Original Cost of the Old Machine
$
30,000
Expected Old Machine Life
10
Current Old Machine Age
5
Expected Salvage Value
$
Depreciation Method (Simplified Straight Line over 10 Years)
Current Salvage Value
$
10,000
Marginal Tax Rate
34%
Proposed Situation
Fully Automated Machine
Cost of Machine
$
55,000
Installation Fee
$
5,000
Annual Cost of Maintenance
$
6,000
Annual Cost of Defects
$
2,000
Expect Life
5
Expected Salvage Value
$
Depreciation Method (Simplified Straight Line over 5 Years)
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Richard MacMinn
Initial Outlays
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The installed cost of the asset
In case of a replacement decision, the after-tax
cash flow associated with the sale of the old
machine
Additional non-expense outlays incurred, e.g.,
Working capital investments
Additional expenses on an after tax basis, e.g.,
Training
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Richard MacMinn
Initial Outlays
Initial Outlay
Outflows:
Cost of Machine $ (55,000)
Installation
$ (5,000)
Inflows:
Tax Savings*
Salvage Value
$ 1,700
$ 10,000
Net Outlay
$ (48,300)
*The tax savings is the marginal tax rate times the difference
$15,000 - $10,000, i.e., depreciated value minus salvage value.
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Richard MacMinn
Differential Cash Flows
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Incremental after-tax cash flows resulting from
increased revenue from the proposal
Any labor and/or material savings incurred
Increases in overhead incurred
Do not include any financing charges as they
are implicitly taken care of in the discounting
process
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Richard MacMinn
Differential Cash Flows
Differential Outflows:
Book Profit Cashflow
Savings:
Reduced Salary
Reduced Defects
$20,000
$3,000
Costs:
Increased Maintenance
Increased Depreciation
Net Savings Before Taxes
Taxes
($1,000) ($1,000)
($9,000)
$13,000 $22,000
($4,420) ($4,420)
Annual Net Cashflow after Taxes
$20,000
$3,000
$17,580
*The increased depreciation charges are calculated as $12,000 - $3,000.
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Richard MacMinn
Terminal Cash Flows
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The project’s salvage value plus any taxable
gains or losses associated with the project
Any terminal cash flows needed, perhaps for
disposal of obsolete equipment
Recovery of any non-expense cash outlays
associated with the project, such as recovery of
increased working-capital needs associated with
the proposal
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Richard MacMinn
Terminal Cash Flows
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The salvage value of the new machine is zero
and so there is no terminal cash flow in this
example
The cash flows for the proposed project are as
shown:
$17,580 $17,580 $17,580 $17,580 $17,580
0
1
2
3
$48,300
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Richard MacMinn
4
5
t
Risk and Investment
Decisions
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The risk of an investment project is
defined as the variability of its cash flows
from the expected cash flows.
In capital budgeting, project’s risk can be
looked at in the following three levels:
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Project Risk
Firm Risk
Systematic Risk
Richard MacMinn
What measure of risk is
relevant for capital budgeting?
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According to CAPM, systematic risk is
the only relevant risk for capital
budgeting purposes.
For undiversified shareholders including
owners of small corporations the relevant
measure of risk may be the project’s
contribution-to-firm risk. This measure
is more appropriate if there are cost
associated with bankruptcy.
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Richard MacMinn
Methods for Incorporating
Risk into Capital-Budgeting
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Certainty Equivalent Approach
In this method the financial manager
substitutes the certain dollar amount
that he or she feels is equivalent to the
expected but risky cash flows offered by
the project.
In effect, the manager is indifferent
between both a safe set of cash flows and
the original set of risky cash flows.
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Richard MacMinn
Methods for Incorporating
Risk into Capital-Budgeting
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Risk Adjusted Discount Rates
In this method if the risk associated with
the project is more then the discount rate
is adjusted upwards to compensate for
the risk.
The expected cash flows are then
discounted back to present at the riskadjusted discount rate.
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Richard MacMinn
Certainty Equivalent versus
Risk Adjusted Discount Rate
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In the certainty equivalent approach, the
expected cash flows are adjusted downwards to
incorporate risk of the project.
In the risk adjusted discount rate approach, the
expected cash flows are unchanged but the
required rate of return is adjusted upwards to
incorporate risk of the project.
In either case the net result is a decrease in the
NPV of the investment proposal.
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Richard MacMinn
The Systematic Risk of a Project
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In order to determine the risk
adjusted discount rate for a project
we need to estimate the systematic
risk, i.e., the project beta.
Beta can be estimated using
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Accounting Return Data Method
Pure Play Method
Richard MacMinn
The Capital Budgeting
Decision
m
rf + b (ERm – rf)
b
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Richard MacMinn
Other Sources and
Measures of Risk
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Time Dependence of Cash Flows
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Many times, especially with the introduction of a new
product the cash flows experienced in the early years
affect the size of the cash flows experienced in later
years. This is called time dependence of cash flows.
Skewness
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A distribution that is not symmetric is said to be
skewed.
When distributions are skewed, the expected value
and standard deviation alone may not be enough to
differentiate between two distributions or risks.
Richard MacMinn
Methods for Evaluating Risk
in Capital Budgeting
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CAPM
Simulation
Sensitivity Analysis
Probability Trees
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Richard MacMinn
Summary
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Measured cash flows
Incorporated risk
Considered capital budgeting
methods
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Richard MacMinn