Capital Budgeting and Financial Planning

1. Capital Budgeting and Financial Planning Course Instructor: M.Jibran Sheikh

2. 4) Residual Income (Economic Value Added) Residual Income measures the income beyond that required to achieve the required return on capital, the surplus income or value added. RI = NOPAT - Capital x WACC Where: NOPAT is Net Operating Profit after Tax Capital is the starting book value of assets employed in the business (remember also funds employed = Equity + IBD) WACC is the required rate of return, the weighted average cost of capital. TOPIC 1: Capital Investment Appraisal

3. Residual Income (Economic Value Added) The concept of Residual Income is used in corporate financial management for many purposes, but mainly to measure whether a business unit is earning an adequate return on the capital it uses in a particular year. Residual Income (RI) is measured in different ways The difference between the versions generally arises from how "capital" and NOPAT are defined. RI is generally measured for each year of a project's life. RI is connected to NPV by the fact that: Net Present Value is equal to the PV of all forecast RI from a project TOPIC 1: Capital Investment Appraisal

4. Decision making using Residual Income Example ABC Firm had Total Assets of Rs. 30m, Rs. 20m receivables and Rs. 10m in fixed assets. The firm made an annual profit of Rs. 9m and so earned a 30% pre-tax ROA. The firm was approached by a finance company that offered to buy the receivables for an effective annual cost of 20%. The firm had a 15% pre-tax WACC. TOPIC 1: Capital Investment Appraisal

5. What effect would the transaction have on the ROA for the firm? 2. What effect would it have on the residual income of the rod mill? TOPIC 1: Capital Investment Appraisal

6. Relationship b/w Residual Income and Net Present Value Assume a $500 investment, 4 year life, straight line depreciation, 10% WACC TOPIC 1: Capital Investment Appraisal

7. Residual Income and Net Present Value Exercise: Repeat the previous example Assume a Rs. 500 million investment, 5 year life, straight line depreciation, 12% WACC. No Change in EBITDA and Tax TOPIC 1: Capital Investment Appraisal

8. 5) Profitability Index Ratio of Present Value of Cash Inflows to Initial Investment (or present value of cash outflows) P.I = You can see that it is like the NPV criterion by comparing PV with I0. The NPV is the excess of ƩPV over Io, and the PI is the amount of PV obtained for each $1.00 of initial investment. A project is accepted if the PI is greater than 1. The PI is useful in capital rationing, as we shall see soon. TOPIC 1: Capital Investment Appraisal

9. 6) Internal Rate of Return (IRR) The rate of return (or discount rate) at which Present Value of Cash Inflows is equal to Initial Investment (or present value of cash outflows). i.e. at IRR the NPV of the Project is = 0 Mathematically: Difficult to calculate manually. Use a Financial Calculator or MS Excel TOPIC 1: Capital Investment Appraisal

10. 6) Internal Rate of Return (IRR) Calculation If CFs are even and for indefinite period of time, Use Perpetuity Formula i.e. PV = CF/I For even CFs for certain period, IRR can be calculated using annuity formula (or table). PV = Initial Investment C = CF = Periodic CF Solve for i = IRR TOPIC 1: Capital Investment Appraisal

11. Internal Rate of Return (IRR) calculation TOPIC 1: Capital Investment Appraisal

12. Interpolation method • If we are appraising a 'typical' capital project, with a negative cash flow at the start of the project, and positive net cash flows afterwards up to the end of the project, we could draw a graph of the project's NPV at different costs of capital. It would look like this. • The interpolation method assumes that the NPV rises in linear fashion between the two NPVs close to zero. The real rate of return is therefore assumed to be on a straight line between the two points at which the NPV is calculated.

14. Advantages and Deficiencies of IRR Advantages: IRR measures profitability as a percentage, showing the return on each dollar invested. IRR provides information on the margin of safety that the NPV does not. From the IRR, we can tell how much below the IRR (estimated return) the actual project return could fall, in percentage terms, before the project becomes uneconomic (has a negative NPV). Disadvantages: The possibility of producing rankings of mutually exclusive projects different from those from NPV analysis, and The possibility that there are multiple IRRs or no IRR for a project. TOPIC 1: Capital Investment Appraisal

15. Comparison of NPV and IRR – Simple (independent) projects • NPV and IRR always lead to the same accept/reject decision for independent projects IRR > k and NPV > 0 Accept. k > IRR and NPV < 0. Reject. NPV ($) k (%) IRR

16. IRR and NPV Comparison – Complex Projects Note: Project A NPV negatively correlated to discount rate Project B NPV positively correlated to discount rate For mixed projects there will be more than one IRR TOPIC 1: Capital Investment Appraisal

17. IRR and NPV Comparison NPV and IRR may give different results (rankings) when choosing between mutually exclusive projects: The scale problem (smaller projects may have higher IRR but their NPV is usually lower than larger projects). The timing problem (More CFs occur sooner than later) TOPIC 1: Capital Investment Appraisal

18. IRR and NPV Comparison Suppose that the CB Corporation has two alternative uses for a warehouse. It can store toxic waste containers (investment A) or electronic equipment (invest­ment B). The cash flows are as follows: TOPIC 1: Capital Investment Appraisal

19. NPV assumes that intermediate cash flows are re-invested at Cost of Capital [which is more likely] • IRR assumes periodic cash flows are re-invested at IRR [less likely] • If there is no reinvestment, there is no conflict between the two methods. • If the assumed reinvestment of the intermediate cash flows does not occur then the IRR is a misleading measure of the rate of return on a project. • Many people like the IRR because it seems to measure “how much value you get for a given investment. As we shall see, the Profitability Index is a much better measure for that. Why NPV and IRR rankings are often inconsistent? TOPIC 1: Capital Investment Appraisal

20. Why NPV and IRR rankings are often inconsistent? Exercise: Consider the following 5-year project:  t=0 t=1 t=2 t=3 t=4 t=5 -1,000 100 200 300 400 1,250 IRR = 22.78% Assume that the intermediate cash flows are invested at the following rates. What is the overall rate of return once the project is over? TOPIC 1: Capital Investment Appraisal

21. NPV Profiles A project's NPV profile is a graph that shows a project's NPV for different discount rates. TOPIC 1: Capital Investment Appraisal

22. NPV Profiles TOPIC 1: Capital Investment Appraisal

23. Comments NPV Depend on the Cost of Capital (WACC) Inverse Relationship: Higher WACC lower NPV, Lower WACC Higher NPV Projects' IRRs are the discount rates where the NPV profiles intersect the x-axis NPVs intersect each other at Cross Over Point, the rate at that point is called Cross Over Rate NPVs intersect because of difference in size and timing of cash flows Calculating Cross Over rate? Take difference of cash flows (in each period) Use MS Excel and find IRR of the CF differences IRR of the CF differences is the Cross Over Rate TOPIC 1: Capital Investment Appraisal

24. Use of NPV Profiles? Provides wealth of information about sensitivity of NPVs to discount rates Different projects are preferred at discount rates higher or lower than the cross over rate. For instance in the given example Project B is preferred over Project A if discount rate is lower than Cross Over Rate (7.2%) but Project A becomes more valuable if discount rates are more than 7.2%. Clearly, discount rate used in the analysis can determine which one of two mutually exclusive projects will be accepted. TOPIC 1: Capital Investment Appraisal

25. Comparing Projects of Unequal lives Misapplication of the NPV method can lead to errors when two mutually exclusive projects have unequal lives. There are also situations in which an asset should not be operated for its full life. When choosing between two mutually exclusive alternatives with significantly different lives, an adjustment is necessary. TOPIC 1: Capital Investment Appraisal

26. Comparing Projects of Unequal lives Example: Simple NPV analysis shows Project C is more valuable. But Project F can be repeated after 3 years. Would that be valuable? TOPIC 1: Capital Investment Appraisal

27. Comparing Projects of Unequal lives: Replacement Chain/Common Life Approach: Analyse both projects using a common life (repeat shorter project when it ends). TOPIC 1: Capital Investment Appraisal

28. Comparing Projects of Unequal lives: Alternatively: Again NPV at 11.5% is $9281 Assumptions: 1) Cost and annual cash inflows of the Project being replaced will not change if the project is repeated and (what about Inflation?) (2) The cost of capital will not change Realistic? TOPIC 1: Capital Investment Appraisal