Capital Budgeting

Prof. Larry Tan Asian Institute of Management Franklin Baker Co. of the Phils.

Capital Budgeting
USING THE NET PRESENT VALUE RULE TO MAKE VALUE-CREATING INVESTMENT DECISIONS
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Background

A good investment decision

One that raises the current market value of the firms equity, thereby creating value for the firms owners Comparing the amount of cash spent on an investment today with the cash inflows expected from it in the future

Capital budgeting involves

Discounting is the mechanism used to account for the time value of money

Converts future cash flows into todays equivalent value called present value or discounted value

Apart the timing issue, there is also the issue of the risk associated with future cash flows

Since there is always some probability that the cash flows realized in the future may not be the expected ones

Background

After this session, participants should understand:

The major steps involved in a capital budgeting decision How to calculate the present value of a stream of future cash flows The net present value (NPV) rule and how to apply it to investment decisions Why a projects NPV is a measure of the value it creates How to use the NPV rule to choose between projects of different sizes or different useful lives How the flexibility of a project can be described with the help of managerial options

The Capital Investment Process

Capital investment decision (capital budgeting decision, capital expenditure decision) involves four steps

Identification Evaluation Selection Implementation and audit

Investment proposals are also often classified according to the difficulty in estimating the key valuation parameters

Required investments Replacement investments Expansion investments Diversification investments 5

EXHIBIT 1: The Capital Investment Process.

Assessing a Capital Budget

Without time value of money

Payback period Bailout payback Discounted payback Net present value Profitability index Internal rate of return Annuity equivalent cash flow

With time value of money

Why The NPV Rule Is A Good Investment Rule

The NPV rule is a good investment rule because

Measures value creation Reflects the timing of the projects cash flows Reflects its risk Additive

A Measure Of Value-Creation

The present value of a projects expected cash flows stream at its cost of capital

Estimate of how much the project would sell for if a market existed for it

The net present value of an investment project represents the immediate change in the wealth of the firms owners if the project is accepted

If positive, the project creates value for the firms owners; if negative, it destroys value

Adjustment For The Timing Of The Projects Cash Flows

NPV rule takes into consideration the timing of the expected future cash flows

Demonstrated by comparing two mutually exclusive investments with the same initial cash outlay and the same cumulated expected cash flows
But with different cash flow profiles

Exhibit 2 describes the two investments Exhibit 3 shows the computation of the two investments net present values
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EXHIBIT 2: Cash Flows for Two Investments with CF0 = $1 Million and k = 0.10.
END OF YEAR 1 2 3 4 5 Total Cash Flows INVESTMENT A CF1 = $800,000 CF2 = 600,000 CF3 = 400,000 CF4 = 200,000 CF5 = 100,000 $2,100,000 INVESTMENT B CF1 = $100,000 CF2 = 200,000 CF3 = 400,000 CF4 = 600,000 CF5 = 800,000 $2,100,000

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EXHIBIT 3: Present Values of Cash Flows for Two Investments.

Figures from Exhibit 2

END OF YEAR 1 2 3 4 5 END OF YEAR 1 2 3 4 5

INVESTMENT A OPPORTUNITY COST OF CAPITAL = 10% PV($800,000) = $800,000 0.9091 = PV($600,000) = 600,000 0.8264 = PV($400,000) = 400,000 0.7513 = PV($200,000) = 200,000 0.6830 = PV($100,000) = 100,000 0.6209 = $727,273 495,868 300,526 136,602 62,092 Total Present Values $1,722,361

INVESTMENT B OPPORTUNITY COST OF CAPITAL = 10% PV($100,000) = $100,000 0.9091 = PV($200,000) = 200,000 0.8264 = PV($400,000) = 400,000 0.7513 = PV($600,000) = 600,000 0.6830 = PV($800,000) = 800,000 0.6209 = $ 90,909 165,289 300,526 409,808 496,737 Total Present Values $1,463,269

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Adjustment For The Risk Of The Projects Cash Flows

Risk adjustment is made through the projects discount rate

Because investors are risk averse, they will require a higher return from riskier investments
As a result, a projects opportunity cost of capital will increase as the risk of the investment increases
By discounting the project cash flows at a higher rate, the projects net present value will decrease

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EXHIBIT 4: Cash Flows for Two Investments with CF0 = $1 Million, k = 0.12 for Investment C, and k = 0.15 for Investment D.
END OF YEAR 1 2 3 4 5 Total Cash Flows INVESTMENT C CF1 = $300,000 CF2 = 300,000 CF3 = 300,000 CF4 = 300,000 CF5 = 300,000 $1,500,000 INVESTMENT D CF1 = $300,000 CF2 = 300,000 CF3 = 300,000 CF4 = 300,000 CF5 = 300,000 $1,500,000

Exhibit 4 describes two investments with the same initial cash outlay, the same cumulative cash flows, the same cash flow profile, but with different cost of capital. 14

EXHIBIT 4a: Present Values of Cash Flows for Two Investments.

Figures from Exhibit 4

END OF YEAR 1 2 3 4 5

INVESTMENT C OPPORTUNITY COST OF CAPITAL = 12% PV($300,000) = $300,000 0.8929 = $267,857 PV($300,000) = 300,000 0.7972 = PV($300,000) = 300,000 0.7118 = PV($300,000) = 300,000 0.6355 = PV($300,000) = 300,000 0.5674 = Total Present Values 239,158 213,534 190,655 170,228 $1,081,432

Exhibit 4 shows the computation of the two investments net present values. 15

EXHIBIT 4b: Present Values of Cash Flows for Two Investments.

Figures from Exhibit 1.3

END OF YEAR 1 2 3 4 5

INVESTMENT D OPPORTUNITY COST OF CAPITAL = 15% PV($300,000) = $300,000 0.8696 PV($300,000) = 300,000 0.7561 PV($300,000) = 300,000 0.6575 PV($300,000) = 300,000 0.5718 PV($300,000) = 300,000 0.4972 Total Present Values = $260,869 = 226,843 = 197,255 = 171,526 = 149,153

$1,005,646

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Additive Property

If one project has an NPV of $100,000 and another an NPV of $50,000

The two projects have a combined NPV of $150,000

Assuming that the two projects are independent

Additive property has some useful implications

Makes it easier to estimate the impact on the net present value of a project of changes in its expected cash flows, or in its cost of capital (risk)

An investments positive NPV is a measure of value creation to the firms owners only if the project proceeds according to the budgeted figures

Consequently, from the managers perspective, a projects positive NPV is the maximum present value that they can afford to lose on the project and still earn the projects cost of capital

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Special Cases Of Capital Budgeting

Comparing projects with unequal sizes

If there is a limit on the total capital available for investment

Firm cannot simply select the project(s) with the highest NPV
Must first find out the combination of investments with the highest present value of future cash flows per dollar of initial cash outlay Can be done using the projects profitability index 18

Special Cases Of Capital Budgeting

Firm should first rank the projects in decreasing order of their profitability indexes

Then select projects with the highest profitability index

Until it has allocated the total amount of funds at its disposal

However, the profitability index rule may not be reliable

When choosing among mutually exclusive investments When capital rationing extends beyond the first year of the project
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EXHIBIT 5: Cash Flows, Present Values, and Net Present Values for Three Investments of Unequal Size with k= 0.10.
INVESTMENT E (1) Initial cash outlay (CF0) Year-one cash flow (CF1) Year-two cash flow (CF2) (2) Present value of CF1 and CF2 at 10% Net present value = (2) (1) $1,000,000 800,000 500,000 INVESTMENT F $500,000 200,000 510,000 INVESTMENT G $500,000 100,000 700,000

$1,140,496 $140,496

$603,306 $103,306

$669,421 $169,421

Exhibit 5 describes the analysis of three investment projects of different sizes. 20

EXHIBIT 6: Profitability Indexes for Three Investments of Unequal Size.

Figures from Exhibit 6.12

INVESTMENT E (1) Initial cash outlay (2) Present value of future cash-flow stream (3) Profitability index =
(2) (1)

INVESTMENT F $500,000

INVESTMENT G $500,000

$1,000,000

$1,140,496 $1,140,496 $1,000,000 = 1.14

$603,306 $603,306 $500,000 = 1.21

$669,421 $669,421 $500,000 = 1.34

Exhibit 6 shows the profitability index of the three investments.

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Special Cases Of Capital Budgeting

Comparing projects with unequal life spans

If projects have unequal lives

Comparison should be made between sequences of projects such that all sequences have the same duration
In many instances, the calculations may be tedious Possible to convert each projects stream of cash flows into an equivalent stream of equal annual cash flows with the same present value as the total cash flow stream Called the constant annual-equivalent cash flow or annuity-equivalent cash flow Then, simply compare the size of the annuities

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EXHIBIT 7a: Cash Outflows and Present Values of Cost for Two Investments with Unequal Life Spans.
SEQUENCE OF TWO MACHINE AS END OF YEAR Now 1 2 3 4 CASH OUTFLOWS MACHINE 1 MACHINE 2 $80,000 4,000 4,000 $80,000 4,000 4,000 TOTAL $80,000 4,000 $84,000 4,000 4,000 PRESENT VALUE COST OF CAPITAL = 10% $80,000 3,636 69,422 3,005 2,732 $158,795

Present Value of Costs

Exhibit 7 illustrates the case of choosing between two machines, one having an economic life half that of the other.

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EXHIBIT 7b: Cash Outflows and Present Values of Cost for Two Investments with Unequal Life Spans.
ONE MACHINE B END OF YEAR Now 1 2 3 4 CASH OUTFLOWS $120,000 3,000 3,000 3,000 3,000 Present Value of Costs PRESENT VALUE COST OF CAPITAL = 10% $120,000 2,727 2,479 2,254 2,049 $129,509

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EXHIBIT 8: Original and Annuity-Equivalent Cash Flows for Two Investments with Unequal Life Spans.
Figures from Exhibit 6.14 and Appendix 6.1

Machine A Original Cash Flow -$80,000 -4,000 -4,000 -50,096 -50,096 AnnuityEquivalent Cash Flow

Machine B Original Cash Flow -$120,000 -3,000 -3,000 -3,000 -3,000 -40,855 -40,855 -40,855 -40,855 -$129,509 AnnuityEquivalent Cash Flow

End of Year Now 1 2 3 4 Present value (10%)

-$86,942

-$86,942

-$129,509

Exhibit 8 shows how to apply the annuityequivalent cash flow approach to the choice between the two machines. 25

Limitations Of The Net Present Value Criterion

Although the net present value criterion can be adjusted for some situations

It ignores the opportunities to make changes to projects as time passes and more information becomes available
NPV rule is a take-it-or-live-it rule

A project that can adjust easily and at a low cost to significant changes such as

Marketability of the product Selling price Risk of obsolescence Manufacturing technology Economic, regulatory, and tax environments
Will contribute more to the value of the firm than indicated by its NPV
Will be more valuable than an alternative project with the same NPV, but which cannot be altered as easily and as cheaply

A projects flexibility is usually described by managerial options 26

Managerial Options Embedded In Investment Projects

The option to switch technologies

Discussed using the designer desk lamp project of Sunlight Manufacturing Company (SMC) as an illustration Can affect its net present value Demonstrated using an extended version of the designer-desk lamp project
Although the project was planned to last for five years, we assume now that SMCs management will always have the option to abandon the project at an earlier date
Depending on if the project is a success or a failure

The option to abandon a project

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Dealing With Managerial Options

Above options are not the only managerial options embedded in investment projects

Option to expand Option to defer a project

Managerial options are either worthless or have a positive value

Thus, NPV of a project will always underestimate the value of an investment project The larger the number of options embedded in a project and the higher the probability that the value of the project is sensitive to changing circumstances
The greater the value of those options and the higher the value of the investment project itself

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Dealing With Managerial Options

Valuing managerial options is a very difficult task

Managers should at least conduct a sensitivity analysis to identify the most salient options embedded in a project, try at valuing them and then exercise sound judgment

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EXHIBIT 10: Steps Involved in Applying the Net Present Value Rule.

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Capital Budgeting
ALTERNATIVES TO THE NPV RULE

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Background

We will examine four alternatives to the NPV method

Ordinary payback period Discounted payback period Internal rate of return Profitability index The four alternatives to NPV method and how to calculate them How to apply the alternative rules to screen investment proposals Major shortcomings of the alternative rules Why these rules are still used even though they are not as reliable to the NPV rule

You should understand

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Conditions of a Good Investment Decision

Does it adjust for the timing of the cash flows? Does it take risk into consideration? Does it maximize the firms equity value?

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The Payback Period

A projects payback period is the number of periods required for the sum of the projects cash flows to equal its initial cash outlay

Usually measured in years

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The Payback Period Rule

According to this rule, a project is acceptable if its payback period is shorter than or equal to the cutoff period

For mutually exclusive projects, the one with the shortest payback period should be accepted

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Does the payback period rule meet the conditions of a good investment decision?

Adjustment for the timing of cash flows?

Ignores the time value of money Ignores risk

No objective reason to believe that there exists a particular cutoff period that is consistent with the maximization of the market value of the firms equity The choice of a cutoff period is always arbitrary The rule is biased against long-term projects
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Adjustment for risk?

Maximization of the firms equity value?

Why Do Managers Use The Payback Period Rule?

Payback period rule is used by many managers

Often in addition to other approaches Simple and easy to apply for small, repetitive investments Favors projects that pay back quickly
Thus, contribute to the firms overall liquidity
Can be particularly important for small firms

Redeeming qualities of this rule

Makes sense to apply the payback period rule to two investments that have the same NPV Because it favors short-term investments, the rule is often employed when future events are difficult to quantify
Such as for projects subject to political risk

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The Discounted Payback Period

The discounted payback period, or economic payback period

Number of periods required for the sum of the present values of the projects expected cash flows to equal its initial cash outlay
Compared to ordinary payback periods
Discounted payback periods are longer May result in a different project ranking

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The Discounted Payback Period Rule

The discounted payback period rule says that a project is acceptable

If discounted payback period is shorter or equal to the cutoff period

Among several projects, the one with the shortest period should be accepted

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Does the discounted payback period rule meet the conditions of a good investment decision?

Adjustment for the timing of cash flows?

The rule considers the time value of money The rule considers risk If a projects discounted payback period is shorter than the cutoff period
Projects NPV when estimated with cash flows up to the cutoff period is always positive

Adjustment for risk?

Maximization of the firms equity value?

The rule is biased against long-term projects

The discounted payback period rule cannot discriminate between the two investments 40

The Discounted Payback Period Rule Vs. The Ordinary Payback Period Rule

The discounted payback period rule is superior to the ordinary payback period rule

Considers the time value of money Considers the risk of the investments expected cash flows

However, the discounted payback period rule is more difficult to apply

Requires the same inputs as the NPV rule Used less than the ordinary payback period rule

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The Internal Rate Of Return (IRR)

A project's internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of the project equal to zero An investments IRR summarizes its expected cash flow stream with a single rate of return that is called internal

Because it only considers the expected cash flows related to the investment
Does not depend on rates that can be earned on alternative investments

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The IRR Rule

A project should be accepted if its IRR is higher than its cost of capital and rejected if it is lower

If a projects IRR is lower than its cost of capital, the project does not earn its cost of capital and should be rejected

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Does the IRR rule meet the conditions of a good investment decision?

Adjustment for the timing of cash flows?

Considers the time value of money The rule takes risk into consideration The risk of an investment does not enter into the computation of its IRR, but the IRR rule does consider the risk of the investment because it compares the projects IRR with the minimum required rate of return--a measure of the risk of the investment

Adjustment for risk?

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The IRR Rule May Be Unreliable

The IRR rule may lead to an incorrect investment decision when

Two mutually exclusive projects are considered A projects cash flow stream changes sign more than once

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Investments With Some Negative Future Cash Flows

Negative cash flows can occur when an investment requires the construction of several facilities that are built at different times When negative cash flows occur a project may have multiple IRRs or none at all

Firm should ignore the IRR rule and use the NPV rule instead
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Why Do Managers Usually Prefer The IRR Rule To The NPV Rule?

IRR calculation requires only a single input (the cash flow stream)

However, applying the IRR rule still requires a second inputthe cost of capital
When a projects cost of capital is uncertain, the IRR method may be the answer

Most managers find the IRR easier to understand

Managers usually have a good understanding of what an investment should "return If they agree, use the IRR If they disagree, trust the NPV rule

Advice: Compute both a projects IRR and NPV

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The Profitability Index (PI)

The profitability index

Benefit-to-cost ratio equal to the ratio of the present value of a projects expected cash flows to its initial cash outlay

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The Profitability Index Rule

According

to the PI rule a project should be accepted if its profitability index is greater than one and rejected if it is less than one

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Does the PI rule meet the conditions of a good investment decision?

Adjustment for the timing of cash flows?

Takes into account the time value of money

Projects expected cash flows are discounted at their cost of capital

Adjustment for risk?

The PI rule considers risk because it uses the cost of capital as the discount rate

Maximization of the firms equity value?

When a projects PI > 1 the projects NPV > 0 and viceversa
Thus, it may appear that PI is a substitute for the NPV rule Unfortunately, the PI rule may lead to a faulty decision when applied to mutually exclusive investments with different initial cash outlays

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Use Of The Profitability Index Rule

The PI is a relative measure of an investments value

NPV is an absolute measure

Thus, the PI rule can be a useful substitute for the NPV rule when presenting a projects benefits per dollar of investment

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Capital Budgeting
IDENTIFYING AND ESTIMATING A PROJECTS CASH FLOWS

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Background

Fundamental principles guiding the determination of a projects cash flows and how they should be applied

Actual cash-flow principle

Cash flows must be measured at the time they actually occur

With/without principle
Cash flows relevant to an investment decision are only those that change the firms overall cash position
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Background
Participants should understand
The actual cash-flow principle and the with/without principle and how to apply them when making capital expenditure decisions How to identify a projects relevant and irrelevant cash flows Sunk costs and opportunity costs How to estimate a projects relevant cash flows

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The Actual Cash-flow Principle

Cash flows must be measured at the time they actually occur If inflation is expected to affect future prices and costs, nominal cash flows should be estimated

Cost of capital must also incorporate the anticipated rate of inflation

If the impact of inflation is difficult to determine, real cash flows can be employed

Inflation should also be excluded from the cost of capital

A projects expected cash flows must be measured in the same currency

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The With/Without Principle

The relevant cash flows are only those that change the firms overall future cash position, as a result of the decision to invest

AKA: incremental, or differential, cash flows Equal to difference between firms expected cash flows if the investment is made (the firm with the project) and its expected cash flows if the investment is not made (the firm without the project)

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Identifying A Projects Relevant Cash Flows

Sunk cost

Cost that has already been paid and for which there is no alternative use at the time when the accept/reject decision is being made
With/without principle excludes sunk costs from the analysis of an investment

Opportunity costs

Associated with resources that the firm could use to generate cash, if it does not undertake the project
Costs do not involve any movement of cash in or out of the firm

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Identifying A Projects Relevant Cash Flows

Costs implied by potential sales erosion

Another example of an opportunity cost

Sales erosion can be caused by the project, or by a competing firm
Relevant only if they are directly related to the project If sales erosion is expected to occur anyway, then it should be ignored

Allocated costs

Irrelevant as long as the firm will have to pay them anyway

Only consider increases in overhead cash expenses resulting from the project 58

Estimating A Projects Relevant Cash Flows

The expected cash flows must be estimated over the economic life of the project

Not necessarily the same as its accounting lifethe period over which the projects fixed assets are depreciated for reporting purposes

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Measuring The Cash Flows Generated By A Project

Classic formula relating the projects expected cash flows in period t to its expected contribution to the firms operating margin in period t: CFt = EBITt(1-Taxt) + Dept - WCRt - Capext Where:
CFt = relevant cash flow EBITt = contribution of the project to the Firms Earnings Before Interest and Tax Taxt = marginal corporate tax rate applicable to the incremental EBITt Dept = contribution of the project to the firms depreciation expenses WCRt = contribution of the project to the firms working capital requirement Capext = capital expenditures related to the project

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Estimating the Projects Initial Cash Outflow

Projects initial cash outflow includes the following items:

Cost of the assets acquired to launch the project Set up costs, including shipping and installation costs Additional working capital required over the first year Tax credits provided by the government to induce firms to invest Cash inflows resulting from the sale of existing assets, when the project involves a decision to replace assets, including any taxes related to that sale
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Estimating The Projects Intermediate Cash Flows

The projects intermediate cash flows are calculated using the cash flow formula

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Estimating The Projects Terminal Cash Flow

The incremental cash flow for the last year of any project should include the following items:

The last incremental net cash flow the project is expected to generate Recovery of the projects incremental working capital requirement, if any After-tax resale value of any physical assets acquired in relation to the project Capital expenditure and other costs associated with the termination of the project
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Sensitivity Analysis
Sensitivity analysis is a useful tool when dealing with project uncertainty Helps identify those variables that have the greatest effect on the value of the proposal Shows where more information is needed before a decision can be made

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