FIN 468: Intermediate Corporate Finance

1. FIN 468: Intermediate Corporate Finance Topic 3–Capital Budgeting Larry Schrenk, Instructor

2. Topics • Review of Decision Rules • Incremental Cash Flow Analysis • Model to Value the Net Cash Flows • Investments of Unequal Lives

3. Decision Rules

4. Decision Rules • Payback Period • Discounted Payback Period • Net Present Value (NPV) • Internal Rate of Return (IRR) • Modified Internal Rate of Return (MIRR)

5. Criteria for Decision Rules • Recognize the time value of money • Incorporate all relevant free cash flows • Minimize arbitrary assumptions • Minimize need for uncertain data • Minimize excessive calculation complexity • Minimize problems

6. Data • For simplicity, we shall use the following cash flows for many of our examples (r = 10%):

7. Payback Period • EXAMPLE: • 3 Year Payback Period Calculation • 300 + 200 + 400 = 900 < 1,000 • Result: $900.00 < $1,000.00 Bad Project

8. Discounted Payback Period • EXAMPLE (r = 10%): • 3 Year Discounted Payback Period Calculation: • Result: $738.54 < $1,000.00 Bad Project

9. Net Present Value (NPV) • EXAMPLE (r = 10%): • NPV Calculation: • Result: $216.65 > 0 Good Project

10. Internal Rate of Return (IRR) • EXAMPLE (r = 10%): • IRR Calculation: • Result: 18.1% > 10% Good Project

11. Modified Internal Rate of Return • EXAMPLE (r = 10%): • Find the MIRR that makes the present value of all cash outflows equal to the present value of the terminal value. • Result: 15.53% > 10% Good Project

12. Summary of the Five Rules • Ineffective Rules: • Payback Period: Payback period cash flow > investment • Discounted Payback Period: Discounted payback period cash flow > investment • Effective Rules • NPV: NPV > 0 • IRR: IRR > r • MIRR: MIRR > r

13. Some Additional Issues

14. Some Additional Issues • Comparing NPV, IRR, PI and MIRR • Using Decision Rules to Compare or Select among Projects • Sign Changes in the Cash Flows and Multiple IRR’s

15. Capital Budgeting

16. Topics • Two General Principles • Factors in Cash Flow Analysis • Fixed versus Variable Costs • Depreciation • Working Capital • Taxes • Interest Payments and Financing Costs • Sunk Costs • Opportunity Costs • Externalities

17. Two General Principles • Principle One: Use Increments. • The Incremental Approach to Cash Flow Analysis • Principle Two: Use Real Cash Flows. • Real versus Accounting Cash Flows

18. The Incremental Approach • The Incremental Approach to Cash Flow Analysis • Incremental: How real cash flows change • Alternate: Averages

19. Comparison Example • New Project Costs

20. Comparison Example • Average Approach

21. Comparison Example • Incremental Approach • change in costs, i.e., the increment, associated with the new project:

22. Comparison Example • Conclusion: Use the increment

23. Real versus Accounting Values • Real: Actual transfers of value at this time; Market values • Money, assets, etc. • Accrual Accounting • May not be market values • Goodwill, depreciation • May not be current • ‘accrued’, ‘payable’ NOTE: Possible ambiguity… Real versus Accounting Real versus Nominal

24. Real versus Accounting Example • Payment of $6,000 for insurance over the next three years.

25. Real versus Accounting Example • Accrual Accounting Cash Flow • ‘Matching’ • Profit

26. Real versus Accounting Example • Real Cash Flow

27. Real versus Accounting Cash Flows • A Complication • Non-real cash flow has an effect on a real cash flow. • Incorporate the effect, but not non-real cash flow itself. • Depreciation

28. Factors in Cash Flow Analysis

29. Factors in Cash Flow Analysis • Depreciation • Working Capital • Taxes • Interest Payments and Financing Costs • Sunk Costs • Opportunity Costs • Externalities

30. Depreciation

31. Depreciation • Depreciation not real cash flow! • Effects on real cash flow, i.e., taxes • If a firm had no taxable income, then we could ignore depreciation. • Incorporate • the tax effect of depreciation • not the depreciation itself.

32. Classes of Expenditures • Costs: ‘expensed’ • In theory, the value is exhausted during that one period • E.g. Stationary, production materials, etc. • Deductible Investments: Over time. • In theory, the value is exhausted over multiple periods. • E.g. Factory equipment, computers, etc. • Non-Deductible Investments: Never • In theory, the value is never exhausted • E.g. Land

33. Depreciation • Different methods (‘schedules’) and over different lengths of time.

34. MARCS Example • Schedule • Capital investment $1,000,000 • Yearly depreciation is:

35. For More Depreciation Details… • If you actually want to know more… • To dip in your toe: http://www.irs.gov/businesses/small/article/0,,id=137026,00.html • Not for the faint of heart: Publication 946 (2005), How To Depreciate Property http://www.irs.gov/publications/p946/index.html

36. Depreciation Calculation • Begin with gross income/EBDIT. • Subtract the depreciation to get taxable income/EBIT. • Subtract the taxes based on this taxable income to get net income. • Add depreciation back to net income to get operating cash flow.

37. Depreciation Example▪ Gross Income/EBDIT $200,000 Less: Depreciation $50,000 Taxable Income/EBIT $150,000 Less: Taxes (tC = 35%) $52,500 Net Income $97,500 Plus: Depreciation $50,000 Real Cash Flow $147,500 ▪

38. Working Capital

39. Working Capital • Metaphorically, the grease that keeps the machine of business going! • Production takes place over time. • Materials paid for long before product sold • Money must be available for suppliers, employees, etc. • This investment is ‘working capital’.

40. Working Capital • All working capital eventually returned • Working capital as a ‘loan’ to the project • But ‘cost’ to tying up value in working capital • Calculations • Increase in working capital → negative CF • Decrease in working capital → positive CF

41. Working Capital Example • Initial working capital required $10,000 • Working capital must be10% of sales: * Remember that at the end of the project all remaining working capital is recovered―$9,000 = $4,000 released plus $5,000 remaining.

42. Taxes, Interest Payments, Sink Costs, etc.

43. Taxes • The corporate tax rate is tC. • Marginal Tax Rate • Negative Earnings Issue

44. Interest/Financing Payments • Not included in cash flows • Accounted for in the discount rate • ‘Double counting’ • Contrast income statement

45. Sunk Costs • Past expenditures • No value to project • No value as salvage • Irrelevant to project the. • Ignore sunk costs • Psychological Problem • Behavioral finance

46. Opportunity Costs • What you give up • Technically: next most valuable use for the asset • The value from selling or renting, • The value for another project, • Nothing, • Etc.

47. Opportunity Costs • Using Unoccupied Factory Space • Could be rented out for $10,000/year. • Opportunity cost = $10,000/year. • Otherwise unused. • Opportunity cost = $0/year. • Include all opportunity costs.

48. Externalities • Project not independent of the firm. • Externalities • Possible interactions with other parts of firm • Positive: Synergies • Negative: Cannibalization • Incremental principle • Externality costs must be applied to the new project,

49. Steps in Estimating Cash Flows▪ • Get input parameters. • Determine investment. • Determine operating cash flow. • Determine working capital needs. • Incorporate after tax salvage value • Find annual, net project cash flows. • Apply decision criteria. ▪

50. Example: Data • Production • Units/year • Costs • Fixed = $50,000 (real) • Variable = $150.00/unit (nominal) • Revenue • Initial Price = $300.00/unit (nominal) • Increase in Price = 2%/year