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Capital Budgeting Introduction

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Capital Budgeting Introduction

Sound

Capital Budgeting Introduction

0 1 2 3 4 . . . . . N

cash

outlays

terminal

flows

cash flow from

operations

Capital Budgeting Introduction

Capital Budgeting Introduction

1.Not Sunk Costs

2.Working Capital Changes (i.e., increases in inventory)

3.Selling or Salvaging Old Equipment

Capital Budgeting Introduction

Q: Is depreciation a cash flow?

A: No, not directly, but yes, indirectly through taxes

A detour on depreciation

Capital Budgeting Introduction

Internal Revenue Service

Publication 586A

The Collection Process

(Income Tax Accounts)

Capital Budgeting Introduction

Save $8 ($20 times 40%) in taxes (cash outflow) due to depreciation.

Capital Budgeting Introduction

Class

3-year MACRSAll property with ADR midpoints of four years or less. Autos and light trucks are excluded from this category.

5-year MACRSProperty with ADR midpoints of more than 4, but less than 10 years. Key assets in this category include automobiles, light trucks, and technological equipment such as computers and research-related properties.

7-year MACRSProperty with ADR midpoints of 10 years or more, but less than 16 years. Most types of manufacturing equipment would fall into this category, as would office furniture and fixtures.

10-year MACRSProperty with ADR midpoints of 16 years or more, but less than 20 years. Petroleum refining products, railroad tank cars, and manufactured homes fall into this group.

Capital Budgeting Introduction

Categories of Depreciation Write-Off (cont.)

Class

15-year MACRSProperty with ADR midpoints of 20 years or more, but less than 25 years. Land improvement, pipeline distribution, telephone distribution, and sewage treatment plants all belong in this category.

20-year MACRSProperty with ADR midpoints 25 years or more (with the exception of real estate, which is treated separately). Key investments in this category include electric and gas utility property and sewer pipes.

27.5-year MACRSResidential rental property if 80% or more of the gross rental income is from non transient dwelling units (e.g., an apartment building); low-income housing.

31.5-year MACRSNonresidential real property that has no ADR class life or whose class life is 27.5 years or more.

39-year MACRSNonresidential real property placed in service after May 12, 1993

Capital Budgeting Introduction

Depreciation3-Year5-Year7-Year10-Year15-Year20-Year

YearMACRSMACRSMACRSMACRSMACRSMACRS

1 . . ..333.200.143.100.050.038

2 . . ..445.320.245.180.095.072

3 . . ..148.192.175.144.086.067

4 . . ..074.115.125.115.077.062

5 . . ..115.089.092.069.057

6 . . ..058.089.074.062.053

7 . . ..089.066.059.045

8 . . ..045.066.059.045

9 . . ..065.059.045

10 . . ..065.059.04511 . . ..033.059.045

12 . . ..059.045

13 . . ..059.045

14 . . ..059.045

15 . . ..059.045

16 . . ..030.045

17 . . ..045

18 . . ..045

19 . . ..045

20 . . ..045

21 . . ..017

1.0001.0001.0001.0001.0001.000

Capital Budgeting Introduction

Find the annual operating cash flow.

Capital Budgeting Introduction

Capital Budgeting Introduction

OCF = (ΔEBDIT) (1 - t) + t(Depr.)

OCF= ($30,000) (1 - .40) + .4($11,784)

= $22,714

Capital Budgeting Introduction

0 1 2… 10

-117,840 22,714 22,714 22,714

NPV @ 13%= $5,411

IRR= 14.14%

Capital Budgeting Introduction

Capital Budgeting Introduction

Capital Budgeting Introduction

0 1 2… 10

-117,840 24,736 29,544 18,000

Capital Budgeting Introduction

Cash flow from sale= $200 + $160

(salvage value) (tax shield)

= $360

Capital Budgeting Introduction

Cash flow from sale= $800-$80

(salvage value) (tax due)

= $720

Capital Budgeting Introduction

- Should ABC Corp. buy the following asset?
- Facts
- Price of the new equipment* $10,000
- Installation and transportation costs 2,000
- Straight line depreciation over 10 years to zero valve
- Will be sold for scrap after 10 years at a price of $1,000
- Will generate $750 labor savings each year
- Tax rate 30%
- Discount or interest rate 10%
- Find NPV and IRR.
- *$10,000 price includes an adjustment for sales taxes and a reduction for early payment.

Capital Budgeting Introduction

0 1 2… 10

-12,000 885 885 1,585

Time zero:

Price$ - 10,000

Inst & trans - 2,000

$ - 12,000

Time 1 to 10:

OCF = ($750)(1-.3) + ($1,200)(.3)

= $885

NPV @10% = -$6,292 IRR = -3.7%

Capital Budgeting Introduction

- Sell machine A
- Purchase machine B
- Calculate differential cash flows using machine B

Capital Budgeting Introduction

As the Distribution Center manager of NuSkin, you are analyzing the replacement of an automated packaging system. The old system was purchased five years ago for $200,000; it has been depreciated to a zero book value, and it has five years of remaining life and a $50,000 salvage value (if sold after five years). The current market value of the old system is $100,000.

The new system has a price of $300,000, plus an additional $50,000 in installation cost. The new system falls into the MACRS five-year class, has a five-year economic life, and a $100,000 salvage value. The new automated packager will require a $40,000 increase in cardboard inventory. The primary advantage of the new system is that it will decrease operating costs (labor and maintenance) by $40,000 per year. Additionally the new equipment has higher capacity which may be needed if sales continue to grow. NuSkin has a 14 percent cost of capital and a marginal tax rate of 40 percent. Should NuSkin buy the new system? Why? (Use both NPV and IRR).

Capital Budgeting Introduction

Time Zero

*

*

Capital Budgeting Introduction

*

* Operating cash flow, detail for Year 1

Capital Budgeting Introduction

NuSkin International, Inc.Buy the New, Sell the Old (cont.)

Terminal Cash Flows

a

b

Capital Budgeting Introduction

0 1 2 3 4 5

-330,000 52,000 68,80050,600 40,80039,400

+78,400

117,800

NPV @ 14%= $-111,955

IRR= 0%

Do not buy the new system! Stick with the old system.

Capital Budgeting Introduction

NewProject

Equity Cash Flow

Economic Rent

Savings

- Revenues
- -Operating Exp.
- EBDIT
- -Depreciation
- EBIT
- -Interest
- Pretax Profit
- -Tax
- Net Income
- +Depreciation
- Capital Exp
- +ΔNWC
- +/- ΔDebt
- Free Cash Flow

- Revenues
- -Operating Exp.
- EBDIT
- -Depreciation
- EBIT
- -Tax
- NOPAT
- +Depreciation
- Capital Exp
- +ΔNWC
- Cash Flow
- -Capital Cost
- EVA

- Revenues
- -Operating Exp.
- EBDIT
- -Depreciation
- EBIT
- -Tax
- NOPAT
- +Depreciation
- Capital Exp
- +ΔNWC
- Cash Flow

- EBDIT
- -Depreciation
- EBIT
- -Tax
- NOPAT
- +Depreciation
- Capital Exp
- +ΔNWC
- Cash Flow

Capital Budgeting Introduction

Capital Budgeting Introduction

Setting an absolute limit on the size of the capital budget that is less that the level of investment called for by the NPV or IRR criteria.

Capital Budgeting Introduction

- Rules out value maximizing
- New Goal: Maximize the value of the firm subject to the capital constraint.

Capital Budgeting Introduction

1.Increase ability to take advantage of the projects in the future.

2.Small Firms: No Funds

- Low cash inflows
- No access to capital
- Reluctance to take equity partners
3.Large Firms: Top Management

- Cannot evaluate each project
- Allocate dollars to control strategic direction
4.General

- Reluctance to increase risk with debt
- Reluctance to decrease control with equity

Capital Budgeting Introduction

- List all positive NPV projects with capital outlay amount.
- Find all possible subjects of projects which do not exceed the budget constraint.
- Choose that subset with the largest total NPV summed over the projects.

Capital Budgeting Introduction

- Using a 10% discount rate, which projects should be accepted?
- Using a 10% discount rate, which projects should be accepted with a budget constraint of $700,000?

Capital Budgeting Introduction

Capital Rationing Problem

- Accept all projects except C.
- $700,000 capital constraint.

Capital Budgeting Introduction

Index Ordering:

Best subset is still B, D, F, G

Capital Budgeting Introduction

1.Under rationing, existing projects with positive NPV’s may not be acceptable.

2.Liquidation of ongoing projects may free up funds--relaxing the budget constraint.

Capital Budgeting Introduction

Discounted at ROA of 17%

PV of inflows = $10,975,672

NPV = <$24,328>

Capital Budgeting Introduction

- Conservative or unfair
- More years or terminal value
- PV of inflows with 15 year horizon is $14 million or NPV of $3 million

Capital Budgeting Introduction

- Discount rate includes expected inflation
- Cash flows are in constant dollars
- Must be consistent
- PV of inflows with 3% inflation of cash flows is $13 million or NPV of $2 million

Capital Budgeting Introduction

- Assumed all flows are at the end of year;
- However, inflows occur throughout the year.
- PV of inflows with semi-annual inflows is $11.5 million or NPV of $.5 million

Capital Budgeting Introduction

- High rate low NPV
- Weighted average cost of capital
- Managers are more risk averse than the company
- Discount rate (WACC) is between 13% and 16%
- PV of inflows with 13% to 16% discount rate is $13.5 million or NPV of $2.5 to .5 million.

Capital Budgeting Introduction

One trust of our presentation is that NPV analysis is a superior capital budgeting technique. It treats sunk costs, timing of cash flows, side effects, and opportunity costs properly. It uses all the CFs, only the incremental CFs, and discounts them properly.

Capital Budgeting Introduction

Getting NPV To Live Up To Full Potential

But is there a “false sense of security,” as those in industry often say? With positive NPV, temptation is to just say “yes.” Nevertheless, the projected CF often goes unmet in practice, and the firm ends up with a money loser. How can we get NPV to live up to its potential???

Capital Budgeting Introduction

- NPV analysis requires many assumptions and projections, all leading to one number--the NPV. What if some projections are off?
- Sensitivity analysis forces us to consider how NPV is affected by our forecasts of key variables.
- Examines variables one at a time.

- In a recession, selling price may be lower than expected at the same time costs are high.

Capital Budgeting Introduction

Example of Sensitivity Analysis

Toulouse Coupling Case

Capital Budgeting Introduction

Capital Budgeting Introduction

Labor Savings Sensitivity

Net Present Value ($)

Labor Savings ($)

Capital Budgeting Introduction

- Bias is the deviation of the expected value of an estimate from the actual quantity it estimates.
- Biases are systematic (i.e. not due to chance).
- Awareness of bias does not automatically eliminate it.
- There are two kinds of bias
- Cognitive
- Motivational

Capital Budgeting Introduction

- Availability - The easier information is to recall, the greater the weight put on it.
- Adjustment and anchoring - Tendency to anchor on an initial estimate and fail to adjust for the actual uncertainty.
- Representativeness - If an outcome “seems to be” representative of the possibilities it is given greater weight.
- Implicit conditioning - Unstated assumptions are not communicated with the estimate. Low probability events are given too much weight.

Capital Budgeting Introduction

- Reasons
- Fear - What does my boss want to hear? Will I be perceived as indecisive?

- Asymmetric Reward
- How will I be rewarded for going over/under budget?

- Dishonesty
- What does the project require to look good?

- Greed -Will my career benefit?
- These biases are controllable, but depend on the culture of the organization and the structure of incentives.

Capital Budgeting Introduction

- Recognize that numbers alone don’t mean good business. NPV analysis is a good check on operational and strategic decisions
- Use scenario analysis to check NPV estimates (e.g. price of a key input doubles).
- Use breakeven analysis. How bad does a project have to be before losing money.
- Be aware of real options like the option to expand and option to abandon.

Capital Budgeting Introduction

- Two examples: Deferral and Abandon Options
- Gold Mining project with a 10% discount rate and gold selling for $250 per ounce
- Initial investment, CFo = $110,000
- Annual and Perpetual free cash flow,
CFt = ($250/oz - 240/oz) * $1,000/oz = $10,000

- NPV = ($10,000/.10) - $110,000 = -$10,000
- Would you sell the mine for $100?

Capital Budgeting Introduction

- No! Suppose that one year from now, the price of gold will either be $260/oz or $240/oz with equal probability. Next year:
- NPV = ($20,000/.10) - $110,000 = $90,000
or

- NPV = ($0/.10) - $110,000 = -$110,000

Capital Budgeting Introduction

Don’t give up the rights to the project, yet! You can wait until next year, and then commence the project if it proves profitable at the time. There is a 50% chance the project will be worth $90,000 next year; consequently, the project has value now due to the presence of a deferral option.

Capital Budgeting Introduction

- Only after spending the $110,000 on equipment and mining will you know how much gold is in the mine.
- The mine will yield either 1,500 oz/yr or 500 oz/yr with equal probability—annual cash flow is either $15,000 or $5,000.
- NPV = -110,000 + .5(15,000/.10) + .5(5,000/.10)
- NPV = -110,000 + .5(150,000) + .5(50,000) = -$10,00
- Would you sell the mine for $100?

Capital Budgeting Introduction

- No! Suppose that the assets purchased to initiate the project have a liquidation value of $80,000. Then the payoff to making the $110,000 investment is the maximum of the value from operating the project or $80,000, so:
- NPV = -110,000 + .5(Max(150,000, 80,000)) + .5(Max(50,000, 80,000))
= -110,000 + .5(150,000) + .5(80,000)

= $5,000

Capital Budgeting Introduction

- The option to abandon is worth $15,000
- Correct NPV of $5,000—Ignorant NPV of -$10,000
- 50 percent probability of exercise x $30,000 savings (equals the $15,000 difference)

- Real options, such as the option to defer and the option to abandon can make up a considerable portion of a project’s value.

Capital Budgeting Introduction

- One ‘line of defense’ is to think about NPV in terms of underlying economics.
- NPV is the present value of the project’s future ‘economic profits’.
- Economic profits are those in excess of the ‘normal’ return on invested capital.
- In ‘long-run competitive equilibrium’ all projects and firms earn zero economic profits.

- In what ways does the proposed project differ from the theoretical ‘long run competitive equilibrium’?
- If no plausible answers emerge, the positive NPV is likely illusory.

Capital Budgeting Introduction

Capital Budgeting Introduction

- Compare different product market strategies
- New product introduction
- Trade credit policy/decisions
- Merger and acquisition opportunities
- Evaluate TQM effort. 6 sigma
- Lease or buy
- Evaluate plant replacement possibilities
- Establish the market value of a going concern
- Evaluate R & D plans
- Evaluate marketing strategy

Capital Budgeting Introduction

Capital Budgeting Introduction