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Principles of Corporate

Finance
Session 17 & 18
Unit III: Capital Budgeting
And its Practices

Introduction

Capital Budgeting is the process of identifying,


evaluating, and implementing a firms investment
opportunities.
It seeks to identify investments that will enhance a
firms 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.

Key Motives for Capital Investments

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

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


Our Focus

- What are the costs and benefits?


- What is the projects return?
- What are the risks involved?

Step 4: Post Acquisition Control


- Is the project within budget?
- What lessons can be drawn?

Independent versus Mutually Exclusive


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

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.

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.

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

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.

Example
Operating Cash Flow Calculation
Existing Hoist
After-Tax Operating Cash Flows: Existing Hoist
Profits before
Year

Profits before

Dep & Taxes

Deprec.

14,000

$ 5,440

14,000

Taxes
$

Profits After

After Tax

Taxes

Inflow s

Taxes

8,560

$ 3,424

1,600

12,400

14,000

14,000

5
6

5,136

10,576

4,960

7,440

9,040

14,000

5,600

8,400

8,400

14,000

5,600

8,400

8,400

14,000

14,000

5,600

8,400

8,400

Example
Operating Cash Flow Calculation
Calculation of Incremental Operating Cash Flows
Increm ental Cash Flow
Year
1

Hoist A
$

16,440

Hoist B
$

18,000

Existing
$

10,576

Hoist A
$

5,864

Hoist B
$

7,424

18,744

22,080

9,040

9,704

13,040

16,248

20,160

8,400

7,848

11,760

14,904

18,480

8,400

6,504

10,080

14,904

18,480

8,400

6,504

10,080

960

1,200

960

1,200

Example
Terminal Cash Flow Calculation
Terminal Cash Flow (Year 5)
Hoist A
Proceeds from sale of New

12,000

Hoist B
$

20,000

Book Value of New

2,400

3,000

Capital Gain (New )

9,600

17,000

Tax on sale of New

(3,840)

(6,800)

Net Proceeds (New )

8,160

13,200

Proceeds from sale of Old

1,000

1,000

Tax on sale of Old

(400)

(400)

Net proceeds (Old)

600

600

Change in NWC

4,000

6,000

Terminal Cash Flow

12,760

19,800

Example
Terminal Cash Flow Calculation

Year 5 Relevant Cash Flow


Hoist A
Operating Cash Flow

Terminal Cash Flow


Net Cash Flow

6,504

Hoist B
$

12,760
$

19,264

10,080
19,800

29,880

Example
Incremental Cash Flow Summary

East Coast Drydock


Net Incremental After Tax Cash Flows
Year
0

Existing
$

Hoist A
$

(37,488) $

Hoist B
(51,488)

9,936

6,504

8,064

9,936

8,808

12,144

9,040

7,208

11,120

8,400

6,504

10,080

8,400

19,264

29,880

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

Project Evaluation:
Alternative Methods

Payback Period (PBP)


Internal Rate of Return (IRR)
Net Present Value (NPV)
Profitability Index (PI)

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.

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

Payback Period (PBP)


0

40 K

10 K

12 K

15 K

4
10 K

PBP is the period of time required


for the cumulative expected cash
flows from an investment project
to equal the initial cash outflow.

5
7K

Payback Solution (#1)


0
40 K (-b)

Cumulative
Inflows

3 (a)

10 K
10 K

12 K
22 K

15 K
37 K (c)

10 K (d) 7 K
47 K
54 K

PBP = a + ( b c ) / d =
3 + (40 37) / 10 = 3 +
(3) / 10 = 3.3 Years

Payback Solution (#2)


0

40 K
40 K

10 K
30 K

12 K
18 K

15 K
3 K

10 K
7K

7K
14 K

PBP
Cumulative
Cash Flows

= 3 + ( 3K ) / 10K
= 3.3 Years

Note: Take absolute value of last negative


cumulative cash flow value.

PBP Acceptance Criterion


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

PBP Strengths
and Weaknesses
Strengths:
Easy to use and

Weaknesses:
Does not account

understand
for TVM
Can be used as a
Does not consider
measure of
cash flows beyond
liquidity
the PBP
Easier to forecast ST Cutoff period is
than LT flows
subjective

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

Net Present Value (NPV)


NPV is the present value of an
investment projects net cash flows
minus the projects initial cash
outflow.
CF1
NPV =
(1+k)1

CF2
+
(1+k)2

CFn
ICO
+...+
(1+k)n

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

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

NPV Acceptance Criterion


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

NPV Strengths
and Weaknesses
Strengths:

Weaknesses:

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

Net Present Value Profile


Net Present Value

$000s
15

Sum of CFs
Thre
e of

10
5

Plot NPV for each


discount rate.
thes
e po
ints

IRR

are

NPV@13%

0
-4

6
9
12
Discount Rate (%)

eas
y

15

now

Profitability Index (PI)


PI is the ratio of the present value of a
projects future net cash flows to the
projects initial cash outflow.
Method #1:

CF1
PI =
(1+k)1

CF2
+
(1+k)2

CFn
+...+
(1+k)n

<< OR >>
Method #2:

PI = 1 + [ NPV / ICO ]

ICO

PI Acceptance Criterion
PI

= $38,572 / $40,000
= .9643 (Method #1, previous slide)

Should this project be accepted?


No! The PI is less than 1.00. This
means that the project is not profitable.
[Reject as PI < 1.00 ]

PI Strengths
and Weaknesses
Strengths:
Same as NPV
Allows
comparison of
different scale
projects

Weaknesses:
Same as NPV
Provides only
relative profitability
Potential Ranking
Problems

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

Internal Rate of Return (IRR)


IRR is the discount rate that equates the
present value of the future net cash flows
from an investment project with the
projects initial cash outflow.

CF1

ICO = (1 + IRR)1

CF2
(1 + IRR)

+...+

CFn
(1 + IRR)n

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
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.

IRR Solution (Try 10%)


$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 15%)


$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 (Interpolate)


0.05

X
0.05

0.10 $41,444
IRR $40,000
0.15 $36,841
$1,444
$4,603

$1,444

$4,603

IRR Solution (Interpolate)


0.05

X
0.05

0.10 $41,444
IRR $40,000
0.15 $36,841
$1,444
$4,603

$1,444

$4,603

IRR Solution (Interpolate)


0.05

0.10 $41,444
IRR $40,000
0.15 $36,841

($1,444)(0.05)
$4,603
X=

$1,444

$4,603

X = 0.0157

IRR = 0.10 + 0.0157 = 0.1157 or 11.57%

IRR Acceptance Criterion


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

IRR Strengths
and Weaknesses
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

Evaluation Summary
Basket Wonders Independent Project

Method Project Comparison Decision


PBP

3.3

3.5

Accept

IRR

11.47%

13%

Reject

NPV

-$1,424

$0

Reject

PI

.96

1.00

Reject