The Basics of Capital Budgeting

1. The Basics of Capital Budgeting FIL 404 Keldon Bauer

2. Capital Budgeting Basics • Definition: Planning and evaluating expenditures on assets whose cash flows are expected to extend beyond a year. • Any purchase of long-lived assets should be justified by the techniques discussed in this chapter.

3. Capital Budgeting Basics • Project: In the lingo of capital budgeting any purchase of long-lived assets is called a project. • Projects can only be justified if the purchase is expected to enhance shareholder wealth (if the value of the firm will increase after adoption of the project).

4. Steps in Capital Budgeting • Estimate cash flows (inflows & outflows). • Assess risk of cash flows. • Determine r = WACC for project. • Evaluate cash flows.

5. Independent versus Mutually Exclusive Projects • Projects are: • independent, if the cash flows of one are unaffected by the acceptance of the other. • mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

6. Evaluation Techniques • Six methods to evaluate capital budgeting projects: • Payback period, • Discounted payback period, • Net present value (NPV), • Internal rate of return (IRR), • Modified internal rate of return (MIRR). • Profitability Index

7. Payback Period • Meant to measure the time it takes to recoup the initial investment (ignoring the time value of money). • The quicker the payback period (smaller the number), the better! • To calculate payback period follow the following 4 steps:

8. Payback Period - Steps • Create cash flow time line. • Add a line for cumulative cash flow. • Identify the last year that cumulative cash flow is negative, we will call it A. • Payback period is calculated as follows:

9. Payback Period - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects.

10. Step 1 -1,500 450 460 470 480 490 Cumulative 2 3 4 5 0 1 Step 2 -1,500 -1,050 -590 -120 360 850 Step 4 Payback Period - Example 1 Step 3 Last negative year is 3 È

11. Step1 -3,000 755 855 955 1,054 1,150 Step 2 -3,000 -2,245 -1,390 -435 619 1,769 Cumulative 2 3 4 5 0 1 Step 4 Payback Period - Example 2 Step 3 Last negative year is 3 È

12. Discounted Payback Period • Meant to adjust payback period for the time value of money. • Still the quicker the payback period (smaller the number), the better! • To calculate payback period follow the following 5 steps:

13. Payback Period - Steps • Create cash flow time line. • Convert cash flow to present value. • Add a line for cumulative PV(CF). • Identify the last year that cumulative PV(CF) is negative, we will call it A. • Payback period is calculated as follows:

14. Discounted Payback - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects. Assume a 9% discount rate.

15. Step 1 -1,500 450 460 470 480 490 PV Cumulative 2 3 4 5 0 1 Step 2 Step3 -1,500 -1,500 -1,087 413 387 -700 363 -337 340 3 321 318 Step 5 Discounted Payback - Example 1 Step 4 Last negative year is 3 È

16. Step 1 -3,000 755 855 955 1,054 1,150 Step 3 Step 2 -3,000 -3,000 -2,307 693 -1,588 720 737 -850 -104 747 747 644 Cumulative PV 2 3 4 5 0 1 Step 5 Discounted Payback - Example 2 Step 4 Last negative year is 4 È

17. Net Present Value • The philosophy behind the net present value (NPV) is how much should adoption of the project have on the overall value of the firm. • NPV is the sum of all outlays in present value terms. • Since outlays are negative, and inflows are positive, the net represents addition to value of the firm.

18. NPV - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects. Assume a 9% discount rate.

19. -$1,500 $412.84 2 3 4 5 0 1 9% $387.17 $362.93 $340.04 $450 $460 $470 $480 $490 $318.47 NPV - Example 1 $ 321.45 = Net Present Value

20. 9% -$3,000 $755 $855 $955 $1,054 $1,150 $692.66 2 3 4 5 0 1 $719.64 $737.44 $746.68 $747.42 NPV - Example 2 $ 643.83 = Net Present Value

21. NPV - Excel • Excel has some unnecessary challenges doing NPV. • The NPV function assumes that all cash flows begin in year 1 (not in year 0), so the easiest way of getting it to do NPV correctly is: =NPV(Rate, Range of CF1 : CFn) + CF0 For example: =NPV(9%,A3:A7)+A2

22. NPV - Example Excel Formula: = NPV(18%, B3:B7)+B2 = $321.45 Excel Formula: = NPV(18%, C3:C7)+C2 = $643.83

23. Internal Rate of Return • The internal rate of return (IRR) represents the effective interest earned on the investment. • The internal rate of return, therefore, is defined as the discount rate at which NPV equals zero. • The only way to solve this problem is for a computer or a calculator to iterate to the answer.

24. IRR - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects.

25. IRR - Example Excel Formula: = IRR(B2:B7) = 16.82% Excel Formula: = IRR(C2:C7) = 16.37%

26. IRR Problems • IRR has two major problems. • First, it assumes that all cash inflows will earn the IRR rate instead of the much more likely discount rate. • Second, depending on the cash flow streams there can be more than one IRR.

27. Multiple IRRs • As an example of more than one IRR, let’s assume you have a project that will return a net $4,000 in year zero (salvage of old machine, and financing, etc.), nets a negative $25,000 in year one, and finishes with a positive $25,000 in year two.

28. Multiple IRRs - Example • Since the IRR is defined as the discount rate which yields an NPV of zero:

29. Multiple IRRs - Example • Multiplying both sides by (1+k)2 yields: Factoring the above polynomial: k = IRR = 25% or 400%

30. Multiple IRRs - Example

31. NPV Profiles • To create an NPV profile, plot NPV on the Y axis and the discount rate on the X axis. • Since the discount rate should be sensitive to changes in project risk, the NPV profile will show how sensitive the projected NPV is to the appropriate discount rate.

32. Crossover Rate 8.1% NPV Profiles

33. NPV Profiles • The crossover rate is the rate at which both projects have the same NPV. • If one knows the crossover rate, then one can assess the probability of the discount rate being that low (high), and can better rank the priority of potential projects.

34. NPV Profiles • The slope of the lines in an NPV profile measures the sensitivity of NPV to the discount rate chosen. • In the book’s example the L represents a longer payback and S a shorter payback. • The longer the payback the more sensitive the NPV will be to the discount rate.

35. Note on MIRRs • Modified IRRs (or MIRRs) can be used in place of an IRR, and all of the problems will be solved. • For Excel to yield an IRR, it needs the cash flows. You will also need the finance rate (your WACC), and the reinvestment rate (the rate at which you will be able to reinvest proceeds). • These two rates can be the same.

36. Notes on MIRRs - continued • To get Excel to calculate an MIRR use the following formula: =MIRR(Cash Flow Range, WACC, Reinvest %) For example: =MIRR(A2:A7, 9%, 9%)

37. MIRR - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects.Assume a 9% discount rate.

38. MIRR - Example Excel Formula: = MIRR(B2:B7, 9%, 9%) = 13.32% Excel Formula: = MIRR(C2:C7, 9%, 9%) = 13.32%

39. Profitability Index • Measures the benefit per unit cost, based on the time value of money • A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value • This measure can be very useful in situations where we have limited capital

40. Profitability Index - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects. Assume a 9% discount rate.

41. Profitability Index - Example • Step 1 – Calculate the present value of all future cash flows: • PV of G = 1,821.45 • PV of Y = 3,643.83 • Step 2 – Divide the present value from step 1 by the initial outlay:

42. 0 1 2 3 4 60 33.5 60 33.5 33.5 33.5 Project S: (100) Project L: (100) S and L are mutually exclusive and will be repeated. r = 10%.

43. NPVL > NPVS. But is L better?

44. Put Projects on Common Basis • Note that Project S could be repeated after 2 years to generate additional profits. • Use replacement chain to put on common life.

45. 0 1 2 3 4 60 (100) (40) 60 60 60 60 Franchise S: (100) (100) 60 60 NPV = $7,547. Replacement Chain Approach (000s).Franchise S with Replication:

46. Or, use NPVs: 0 1 2 3 4 4,132 3,415 7,547 4,132 10% Compare to Franchise L NPV = $6,190.

47. 0 1 2 3 4 Franchise S: (100) 60 60 (105) (45) 60 60 NPVS = $3,415 < NPVL = $6,190. Now choose L. Suppose cost to repeat S in two years rises to $105,000.

48. Economic Life versus Physical Life • Consider another project with a 3-year life. • If terminated prior to Year 3, the machinery will have positive salvage value. • Should you always operate for the full physical life? • See next slide for cash flows.

49. Economic Life versus Physical Life

50. CFs Under Each Alternative (000s)