Chapter 11

1. Chapter 11 Managing Long-lived Resources: Capital Budgeting

2. Significant investments take place because of many factors As time passes, assets wear out and must be replaced Growth in demand has over-taken available capacity Launching new products / market expansion Changing production technology What is Capital Budgeting? LO1: Understand the reasons for capital budgeting

3. Such project decisions have two main components Evaluate Project profitability Allocate scarce capitalamong profitable projects Capital budgeting refers to the set of tools used to evaluate such large expenditures Let us begin by linking to two familiar topics Cost allocations and budgets What is Capital Budgeting? LO1: Understand the reasons for capital budgeting

4. Both allocations and capital budgeting deal with decisions concerning capacity. Allocations are quick and easy to implement But, suffer from two main drawbacks Do not consider Time value of money Lumpy nature of capacity Link to Cost Allocations LO1: Understand the reasons for capital budgeting

5. Time value of money $1 today is worth more than $1 a year from today! Capital assets last for many years. Thus, we need to consider time value for effective decision making In capital budgeting, we discount future cash flows to their present value so that we can consider projects with alternate patterns of cash flow Lumpy nature of capacity Capacity resources come in discrete sizes Allocations assume “smooth” capacity. That is, they allow for capacity to be bought in small increments. But, we cannot buy 15/16th of a machine. Capital budgets explicitly recognize lumpy capacity Defects: Cost Allocations LO1: Understand the reasons for capital budgeting

6. Capital budgets link strategic and operating budgets Strategic budgets Set the vision for the future Flesh out core competencies Operating budgets (see chapter 7) Deal with the here and now Take capacity resources more or less as a given Capital budgets consider both the needs as dictated by operating budgets and visions as dictated strategically Link To Budgets LO1: Understand the reasons for capital budgeting

7. Generate a list of projects Proposed by management as well as others Dictated by strategic visions Evaluate each project for profitability Choose projects to fund Ability to fund projects limited by capital / managerial talent Fit with strategic profile varies Qualitative dimensions (e.g., safety, environment) might dominate choice Steps in Capital Budgeting LO1: Understand the reasons for capital budgeting

8. Initial Outlay. What are the costs associated with acquiring the resource and getting it ready for use? Estimated Life and Salvage Value. How long do we expect to keep the resource? At the end of this period, what is the cash flow associated with selling / disposing off the resource? Timing and Amounts of Operating Cash Flows. What are the expected operating expenses every year? What are the expected revenues? Cost of Capital. What is the opportunity cost of capital required for the proposed investment? Elements of Cash Flow for Projects LO2: List the components of a project’s cash flows

9. Timeline: Project Cash Flow LO2: List the components of a project’s cash flows

10. Cash Flows for MRI Machine LO2: List the components of a project’s cash flows

11. Timeline for MRI Machine Cash Flow How should we evaluate whether this is a profitable investment? LO2: List the components of a project’s cash flows

12. Many Ways To Evaluate Profitability LO3: Apply discounted cash flow techniques

13. 1 2 3 4 1 $62.10 = $100 x 0.621 2 $152.10 = $100 x 1.521 $331.20 = $100 x 3.312 3 $811.50 = $100 x 8.115 4

14. NPV is present value of ALL cash flows PV of cash flow in period t = “r” is the discount rate 1/(1+r)t is the discount factor The net present value is the sum of all of the present values of the individual cash flows NPV recognizes a lump sum outflow at the start Periodic inflows over the life of the project Salvage value Net Present Value (NPV) LO3: Apply discounted cash flow techniques

15. NPV of MRI Project This is a profitable project. LO3: Apply discounted cash flow techniques

16. Can vary discount rates to reflect differing evaluations of risk associated with the project Can also calculate NPV for alternate scenarios Lower price to increase demand early on Benefit: Higher revenue with greater present value Cost: Lower revenue later on (but PV impact is also smaller) Usage rates Life of asset Such extensions are important because we need to make many assumptions to estimate the cash flow from this long-lived asset Sensitivity analysis LO3: Apply discounted cash flow techniques

17. High Discount Rates Lower NPV LO3: Apply discounted cash flow techniques

18. -$100,000 0.877 $52,620 0.769 $38,450 $6,750 0.675 Thus, the NPV = $6,750 + $38,450 + $52,620 – $100,000 = -$2,180. We reject the project because it has a negative NPV.

19. The initial cash outflow takes place at the beginning of the period. This assumption is the reason for not discounting the initial outlay. Subsequent cash inflows and outflows occur at the end of the relevant period. The net cash flow in year 1 occurs as a lump sum at the end of year 1, which is time t =1, or a year from time t = 0 NPV calculations assume that firms reinvest future cash inflows in projects that yield a return that equals the cost of capital None of these assumptions are particularly realistic but they are not unreasonable Assumptions in NPV Analysis LO3: Apply discounted cash flow techniques

20. Discount rate at which the NPV is zero Relation to NPV analysis NPV analysis fixes the discount rate and calculates the present value IRR fixes the NPV at zero and calculates the implied rate Project evaluation criterion NPV > 0 => project return exceeds cost of capital IRR > Cost of capital => project has positive NPV Internal Rate of Return LO3: Apply discounted cash flow techniques

21. This is like an annuity Use annuity tables to find annuity Factor Periodic flow * Annuity Factor = Initial outflow For the given project life, find rate that has the relevant annuity factor Example: Initial flow $50,000, $15,000 inflow for 5 years Annuity factor = $50,000 / $15,000 = 3.33 Looking down column for 5 periods, the rate is between 15% and 16% Calculating IRR: Equal flows LO3: Apply discounted cash flow techniques

22. This can be mathematically challenging It is much more convenient to use a program such as EXCEL. @IRR(A1..A10) function gives the IRR for a set of cash flows in cells A1 to A10 Remember to keep the signs consistent The IRR for the MRI project is 20.87% This is a highly profitable project because the IRR exceeds the cost of capital of 12% Calculating IRR: Unequal Flows LO3: Apply discounted cash flow techniques

23. Timing of cash flows Same as NPV Analysis Initial out flow now at start of period Inflows at end of period Reinvestment Takes place at the calculated IRR This is not a good assumption, particularly for projects with high IRR It is possible to construct examples where the same project has multiple IRRs Needs unusual cash flow patterns Assumptions: IRR LO3: Apply discounted cash flow techniques

24. Test Your Knowledge! The internal rate of return measures: • How quickly the initial investment can be re-couped • The discount rate at which the net present value of the project is zero • The profitability of an investment • The rate at which future cash flows must be invested in order to obtain profitability

25. Many people prefer NPV to IRR Unique answer for NPV Reinvestment assumption is more reasonable for NPV than IRR We are likely to have more projects that return the cost of capital than return a high IRR NPV favors larger projects with greater absolute profit while IRR focuses on profitability without concern for size Both methods have value Firms try to rank order projects by both methods Unfortunately, the above differences mean that sometimes the rank ordering of projects may not be the same Comparing NPV and IRR LO3: Apply discounted cash flow techniques

26. The Result In Excel, enter cash flows in cells A1 to A4 (starting with the –$100,000 for the initial outlay in A1). In cell A5, type “=IRR(A1:A4)” and Excel will reveal that the IRR = 12.40%. Using the same approach as in Check it! Exercise #2, we can calculate NPV(12%) = $550; NPV(13%) = -$820, and confirm the validity of our estimate. Finally, we reject the project because its IRR is lower than the cost of capital (14%).

27. Other Ways To Evaluate Profitability LO4: Compare various methods for evaluating projects.

28. Payback period is the length of time it takes to recoup the initial investment Initial out flow of $60,000 and periodic inflows of $24,000 Payback period = 2.4 years = $60,000/$24,000. Payback Method LO4: Compare various methods for evaluating projects.

29. Advantages It is a simple easy method Focuses on the downside risk But… Its biggest problem is that it ignores the time value of money Also ignores cash flows that occur after the payback period Not enough emphasis on the upside potential Acceptable payback period is unclear Evaluating Payback Method LO4: Compare various methods for evaluating projects.

30. Payback Period for MRI Project LO4: Compare various methods for evaluating projects.

31. Cumulative cash inflows through year 5 = $60,000 year 1 + $60,000 year 2 + $60,000 year 3 + $50,000 year 4 + $50,000 year 5 = $280,000 Payback period of 5.6 = 5 years + ($310,000 initial investment – $280,000 cumulative cash inflows through year 5)/$50,000 cash flow in year 6.

32. Calculates the payback period using discounted cash flows Overcomes a major defect of the payback period But, it still does not account for cash flows after the modified payback period Overall, Payback and modified payback can provide some measure of risk in project But, they are not preferred because of their shortcomings Use as a secondary criterion rather than as the main rule Modified Payback LO4: Compare various methods for evaluating projects.

33. Modified Payback: MRI project LO4: Compare various methods for evaluating projects.

34. Accounting Rate of Return Annual income = Annual cash flow – depreciation Investment = Average book value at start & end of period For MRI machine St. Vincent’s plans to depreciate the MRI equipment using the straight-line method and assuming zero salvage value. First, we decrease the book value of the MRI equipment by the depreciation amount. We then calculate the average investment balance for each year as the average of the beginning and ending book values. The final step is to compute ARR as the ratio of the average income to the average investment over the life span of the investment. LO4: Compare various methods for evaluating projects.

35. MRI Project: ARR Calculations LO4: Compare various methods for evaluating projects.

36. Easy and straight forward to calculate Ties in well with standard “accounting” measures of performance Ignores time value of money Ignores patterns of cash flow Most suited for simple projects with somewhat equal cash flows over the life of the project ARR: Evaluation LO4: Compare various methods for evaluating projects.

37. Comparing the Methods LO4: Compare various methods for evaluating projects.

38. Test Your Knowledge! The only method not used to evaluate capital projects is: • Payback/modified payback • Net present value • Internal rate of return • Regression analysis

39. Usage Patterns LO4: Compare various methods for evaluating projects.

40. We can depreciate the cost of a capital asset over time Accounting income = Operating cash flow – depreciation – other non-cash items We focus on effect of depreciation Taxes paid on accounting income. NOT cash flow Depreciation lowers income and thus taxes Provides a tax shield The Effect of Taxes LO5: Explain the role of taxes and depreciation tax shields.

41. Method 1: Depreciation tax shield = tax rate * depreciation Tax on operating cash flow = t * operating cash flow After-tax cash flow = (1-t)* operating cash flow + depreciation tax shield Method 2 (Same answer as method 1): Calculate Income = Cash flow – depreciation Calculate taxes = t * income After-tax cash flow = (1-t) * income + depreciation Calculating the Tax Shield LO5: Explain the role of taxes and depreciation tax shields.

42. Need to pay taxes on any gain or loss due to disposal of asset Gain/ loss may arise because accounting depreciation is not always the same as decline in economic value Calculation Gain or loss = sale proceeds – Net Book Value Net Book Value = Initial investment – accumulated depreciation Note: Tax is paid on the gain / loss and NOT on the proceeds Salvage Value and Taxes LO5: Explain the role of taxes and depreciation tax shields.

43. Calculations Annual depreciation = ($15,000 -$1,000) / 7 years = $2,000/year Book value (after 6 years) = $3,000 [$15,000 – (6 yrs *$2,000/yr)] Gain due to sale = $500 ($3,500 -$3,000) Taxes paid = 0.30 * $500 = $150 Cash flow at end of 6 years = $3,500 - $150 = $3,350. Example LO5: Explain the role of taxes and depreciation tax shields.

44. $304,000 in year 5 = $370,000 net cash inflow from Exhibit 11.2 – [($370,000 – $150,000 depreciation expense) x 0.30 in taxes due]. Alternatively, $370,000 – $150,000 = $220,000 in taxable income; $220,000 x 0.30 = $66,000 in taxes. Thus, $304,000 = $220,000 in income – $66,000 in taxes + $150,000 in depreciation in expense. $346,000 in year 10 = $430,000 net cash inflow from Exhibit 11.2 – [($430,000 – $150,000 depreciation expense) x 0.30 in taxes due].

45. Most firms have limited access to capital, managerial talent, and other organizational resources Use hurdle rate to select projects Hurdle rate > Cost of capital. Why? Risk inherent in estimation process Reduce slack built into budgets Force managers to come up with “best” projects Allocating Capital Among Projects LO6: Describe issues in allocating scarce capital among projects

46. Many benefits are hard to assess Environmental impact Worker / consumer safety Quality of products (image in marketplace) Costs can be difficult as well Training On-going maintenance Effect on other products The benchmark is usually the status quo But, difficult to evaluate cash flow under status quo Non-financial Costs and Benefits LO6: Describe issues in allocating scarce capital among projects

47. Pick The Right Benchmark LO6: Describe issues in allocating scarce capital among projects

48. All projects involve some degree of uncertainty Some projects inherently have more flexibility than others Smaller upfront commitment (“dipping toe in water”) These projects let firms adjust more rapidly to any new information they may obtain Such flexibility (or the option to change one’s mind) has value Usually called a “real” option Flexibility LO6: Describe issues in allocating scarce capital among projects

49. Real Option AnalysisValue of Flexibility LO6: Describe issues in allocating scarce capital among projects

50. Exercise 11.31 Present value calculations (LO3). Refer to the data in the following table: Required: Treating each row of the table independently, compute the missing information. Use the present value/future value tables at the end of the book.