Principles of Corporate Finance

1. Principles of Corporate Finance Session 17 & 18 Unit III: Capital Budgeting And its Practices

2. Introduction • Capital Budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities. • It seeks to identify investments that will enhance a firm’s competitive advantage and increase shareholder wealth. • The typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. • Poor capital budgeting decisions can ultimately result in company bankruptcy.

3. Key Motives for Capital Investments

4. Examples • Replacing worn out or obsolete assets • improving business efficiency • acquiring assets for expansion into new products or markets • acquiring another business • complying with legal requirements • satisfying work-force demands • environmental requirements

5. The Capital Budgeting Process Step 1: Identify Investment Opportunities - How are projects initiated? - How much is available to spend? Step 2: Project Development - Preliminary project review - Technically feasible? - Compatible with corporate strategy? Step 3: Evaluation and Selection - What are the costs and benefits? - What is the project’s return? - What are the risks involved? Our Focus Step 4: Post Acquisition Control - Is the project within budget? - What lessons can be drawn?

6. Independent versus Mutually Exclusive Investments • Mutually Exclusive Projects are investments that compete in some way for a company’s resources. A firm can select one or another but not both. • Independent Projects, on the other hand, do not compete with the firm’s resources. A company can select one, or the other, or both -- so long as they meet minimum profitability thresholds.

7. Relevant Cash Flows • Incremental cash flows • only cash flows associated with the investment • effects on the firms other investments (both positive and negative) must also be considered For example, if a day-care center decides to open another facility, the impact of customers who decide to move from one facility to the new facility must be considered.

8. Relevant Cash Flows • Incremental cash flows • only cash flows associated with the investment • effects on the firms other investments (both positive and negative) must also be considered • Note that cash outlays already made (sunk costs) are irrelevant to the decision process. • However, opportunity costs, which are cash flows that could be realized from the best alternative use of the asset, are relevant.

9. Relevant Cash Flows • Examples of relevant cash flows: • cash inflows, outflows, and opportunity costs • changes in working capital • installation, removal and training costs • terminal values • depreciation • sunk costs • existing asset affects

10. Relevant Cash Flows • Categories of Cash Flows: • Initial Cash Flows are cash flows resulting initially from the project. These are typically net negative outflows. • Operating Cash Flows are the cash flows generated by the project during its operation. These cash flows typically net positive cash flows. • Terminal Cash Flows result from the disposition of the project. These are typically positive net cash flows.

11. Example Operating Cash Flow Calculation Existing Hoist

12. Example Operating Cash Flow Calculation

13. Example Terminal Cash Flow Calculation

14. Example Terminal Cash Flow Calculation

15. Example Incremental Cash Flow Summary

16. Principles of Corporate Finance Session 19 & 20 Unit III: Capital Budgeting And its Practices

17. Project Evaluation: Alternative Methods • Payback Period (PBP) • Internal Rate of Return (IRR) • Net Present Value (NPV) • Profitability Index (PI)

18. Proposed Project Data Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.

19. Independent Project • Independent – A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. • For this project, assume that it is independentof any other potential projects that Basket Wonders may undertake.

20. Payback Period (PBP) PBPis the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. 0 1 2 3 4 5 –40 K 10 K 12 K 15 K 10 K 7 K

21. Payback Solution (#1) PBP = a + ( b– c ) / d = 3 + (40 – 37) / 10 = 3 + (3) / 10 = 3.3 Years (a) 0 1 2 3 4 5 (-b) (d) –40 K 10 K 12 K 15 K 10 K 7 K (c) 10 K 22 K 37 K 47 K 54 K Cumulative Inflows

22. Payback Solution (#2) PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. 0 1 2 3 4 5 –40 K 10 K 12 K 15 K10 K 7 K –40 K –30 K –18 K –3 K 7 K 14 K Cumulative Cash Flows

23. Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.] The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type. Should this project be accepted? PBP Acceptance Criterion

24. Strengths: Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows Weaknesses: Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective PBP Strengths and Weaknesses

25. Principles of Corporate Finance Session 20 Unit III: Capital Budgeting And its Practices

26. NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. Net Present Value (NPV) CF1CF2CFn -ICO NPV = + + . . . + • (1+k)1 (1+k)2 (1+k)n

27. Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. NPV Solution $10,000$12,000$15,000 NPV= + + + (1.13)1(1.13)2(1.13)3 $10,000$7,000 + - $40,000 (1.13)4(1.13)5

28. NPV Solution NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $ 7,000(PVIF13%,5) – $40,000 NPV = $10,000(0.885) + $12,000(0.783) + $15,000(0.693) + $10,000(0.613) + $ 7,000(0.543) – $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 – $40,000 = - $1,428

29. No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV< 0 ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted? NPV Acceptance Criterion

30. Strengths: Cash flows assumed to be reinvested at the hurdle rate. Accounts for TVM. Considers all cash flows. Weaknesses: May not include managerial options embedded in the project. See Chapter 14. NPV Strengths and Weaknesses

31. Net Present Value Profile $000s Sum of CF’s Plot NPV for each discount rate. 15 10 Three of these points are easy now! Net Present Value 5 IRR NPV@13% 0 -4 0 3 6 9 12 15 Discount Rate (%)

32. PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. Profitability Index (PI) Method #1: CF1CF2CFn PI = ICO + + . . . + • (1+k)1 (1+k)2 (1+k)n << OR >> PI = 1 + [ NPV / ICO] Method #2:

33. No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI< 1.00 ] PI = $38,572 / $40,000 = .9643 (Method #1, previous slide) Should this project be accepted? PI Acceptance Criterion

34. Strengths: Same as NPV Allows comparison of different scale projects Weaknesses: Same as NPV Provides only relative profitability Potential Ranking Problems PI Strengths and Weaknesses

35. Principles of Corporate Finance Session 23 Unit III: Capital Budgeting And its Practices

36. IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. Internal Rate of Return (IRR) CF1 CF2 CFn ICO = + + . . . + • (1 + IRR)1 (1 + IRR)2 (1 + IRR)n

37. Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000. IRR Solution $10,000 $12,000 $40,000 = + + (1+IRR)1(1+IRR)2 $15,000 $10,000 $7,000 + + (1+IRR)3(1+IRR)4(1+IRR)5

38. $40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5) $40,000 = $10,000(0.909) + $12,000(0.826) + $15,000(0.751) + $10,000(0.683) + $ 7,000(0.621) $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 = $41,444 [Rate is too low!!] IRR Solution (Try 10%)

39. $40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5) $40,000 = $10,000(0.870) + $12,000(0.756) + $15,000(0.658) + $10,000(0.572) + $ 7,000(0.497) $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 = $36,841 [Rate is too high!!] IRR Solution (Try 15%)

40. 0.10 $41,444 0.05IRR$40,000$4,603 0.15 $36,841 X$1,4440.05$4,603 IRR Solution (Interpolate) $1,444 X =

41. 0.10 $41,444 0.05IRR$40,000$4,603 0.15 $36,841 X$1,4440.05$4,603 IRR Solution (Interpolate) $1,444 X =

42. 0.10 $41,444 0.05 IRR $40,000 $4,603 0.15 $36,841 ($1,444)(0.05) $4,603 IRR Solution (Interpolate) $1,444 X X = X = 0.0157 IRR = 0.10 + 0.0157 = 0.1157 or 11.57%

43. No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR< Hurdle Rate ] The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted? IRR Acceptance Criterion

44. Strengths: Accounts for TVM Considers all cash flows Less subjectivity Weaknesses: Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs IRR Strengths and Weaknesses

45. Evaluation Summary Basket Wonders Independent Project