Course F-303:CAPITAL BUDGETING & Project Mgmnt.

Prof. Shabbir Ahmad

Introduction Definition, types of projects, techniques of CID etc. Cash Flow Estimation Determination of cash out flow and cash inflows Techniques of Capital Budgeting Discounted (NPV, IRR, MIRR, PI, and DPB) and non-discounted (PB & AAR) cash flow techniques, decision criteria, advantages and disadvantages of each technique. Special Issues in Capital Budgeting Projection evaluation, costcutting projects, bid price setting, projects with different lives. Project Analysis and Evaluation Forecasting risk, sensitivity and scenario analysis, break-even analysis, operating leverage and capital budgeting.

Course F-303:CAPITAL BUDGETING & Project Mgmnt.

Inflation and Capital Budgeting Options in Capital Budgeting Strategy and Analysis in Using Net Present Value Cost of Capital and Capital Budgeting Capital Budgeting for Levered Firm Risk and Capital Budgeting Absolute measure and relative measure of risk, certainty equivalent method and risk adjusted discount rate method. Text Books
Fundamentals of Corporate Finance by Ross, Westerfield, JORDAN Corporate Finance by Ross, Westerfield, JAFFE Capital Budgeting & Long-term Finance by Neil Seitz Managerial Finance by Lawrence J GITMAN Essentials of Managerial Finance by Eugene F. Brigham

CAPITAL BUDGETING OR CAPITAL INVESTMENT DECISION

Capital Investment Decisions or Capital Budgeting involves companys long term investment decision. It includes evaluation of the firms expenditure decisions that involve current outlays but are likely to produce benefits or returns over a long period of time. Capital Budgeting is the process of evaluating and selecting long-term investments in fixed or capital assets that are consistent with the firms goal of maximizing owners wealth.

CAPITAL BUDGETING OR CAPITAL INVESTMENT DECISION

Why a firm makes capital investment?
In order to secure a stream of benefits in future years that add value to the firm through cash inflows over future times.

CAPITAL BUDGETING OR CAPITAL INVESTMENT DECISION

Applications
Purchase of fixed assets Mechanization of production method Selection from alternative equipments Introduction of new products Expansion of business Modernization and replacement

FEATURES/CHARACTERISTICS OF CID (IMPORTANCE)

Long term investment decision (future profitability of firm). Returns or benefits are expected over number of years Investment involves huge amount of cash outflow (determines the destiny of the firm) Investment decision is generally irreversible (once made can not be changed) Relatively high degree of risk Relatively long time period between the initial outlay and the anticipated return

CLASSIFICATION OF PROJECTS
By Size: Major Project. Minor Project.

By Benefit: Cost Reduction Project. Market Expansion Project. Project for new products.

CLASSIFICATION OF PROJECTS
By Degree of Dependence:
Mutually Exclusive Projects. Independent Projects.

By Cash Flow pattern:

Conventional Project.( - + + + + + i.e. outflow followed by a series of inflow). Non Conventional Projects ( - + + - + - + i.e. if the project inflows & outflows are mixed & zigzag pattern).

CAPITAL INVESTMENT DECISION

Determination of Cash Outflow or Investment Projection or Forecast or Estimation of Future Cash Inflows

Determination of Appropriate Discount Rate (i.e. Cost of Capital)

CASH FLOW DETERMINATION

A project should be evaluated on the basis of Incremental After Tax Cash Flows. Incremental After Tax Cash Flows for project evaluation consist of any and all changes in the firms future cash flows that are a direct consequence of taking the project or the difference between a firms future cash flows with a project and those without the project.

CASH FLOW DETERMINATION

Only the relevant cash flows should be taken under consideration in determining the cash flows (i.e. inflows or outflows) for making capital investment decision. Relevant cash flows should be included in a capital budgeting analysis. These cash flows will only occur if the project is accepted Relevant cash flows are those which influence the firms decision regarding accepting or rejecting a project.

CASH FLOW DETERMINATION

Irrelevant cash flows are those which do not affect the firms decision regarding accepting or rejecting a project i.e. they exist if the firms accepts a project or if rejects a project.
Irrelevant cash flows should NOT be included in capital budgeting analysis.

CASH FLOW DETERMINATION

Asking the Right Question Will this cash flow occur ONLY if we accept the project?
If the answer is yes, it should be included in the analysis because it is incremental If the answer is no, it should not be included in the analysis because it will occur anyway If the answer is part of it, then we should include the part that occurs because of the project

CASH OUTFLOW OR INVESTMENT DETERMINATION

Cost of new asset or project Add installation cost (if any) Add transportation cost (if any) Add removal cost of old asset (only if borne by the company) Less selling price of old asset (if new asset replaces old asset) + / - Tax on sale of old asset Less Amount of investment tax credit (AITC)

Depreciation
Depreciation is a non-cash expense, consequently, it is only relevant because it affects taxes
Depreciation tax shield = DT
D = depreciation expense T = tax rate

Computing Depreciation
Straight-line depreciation
Annual Dep. = Installed cost / number of useful years

MACRS
Need to know which asset class is appropriate for tax purposes Multiply percentage given in table by the installed cost

Example: Depreciation
You purchase equipment for $100,000 and it costs $10,000 to have it installed. The companys tax rate is 40%. What is the depreciation expense each year?

Example: Three-year MACRS

Year 1 2 3 4 MACRS percent .3333 .4444 .1482 .0741 D .3333(110,000) = 36,663 .4444(110,000) = 48,884 .1482(110,000) = 16,302 .0741(110,000) = 8,151

BV in year 6 = 110,000 36,663 48,884 16,302 8,151 = 0

CASH OUTFLOW OR INVESTMENT DETERMINATION

Example The Sprint Inc. is trying to estimate the net cash outflow required to replace an old machine with a new one. The new machines purchase price is $270,000. An additional $7,000 will be required for transportation and $5,000 will be required to install the machine. As the new machine has greater capacity to produce, there will be an additional investment of $20,000 in raw material inventory in the initial year. The new machine will be depreciated on straight-line basis over five years of useful life. The old machine was purchased two years ago at a cost of $70,000 has a remaining useful life of five years. It is also subject to straight-line depreciation. The company is entitled to investment tax allowance of 25%. The corporate tax rate is 55% and the capital gain tax rate is 30%. Find the net cash outflow considering separately each of the following scenarios: i) If the old machine is sold for $40,000 ii) If the old machine is sold for $50,00. NCO.xls iii) If the old machine is sold for $60,000. iv) If the old machine is sold for $90,000.

CASH INFLOW DETERMINATION

Operating Cash Flow (OCF)
Operating Cash Flow (OCF) = EBIT + depreciation taxes OCF = Net income + depreciation when there is no interest expense OCF = Sales Costs Taxes (Dont subtract non-cash deductions) OCF = (Sales Costs)(1 T) + Depreciation*T

Opportunity Cost Sunk Cost Erosion or Side Effects Financing Cost Change in Net Working Capital

Common Types of Cash Flows

Sunk costs costs that have accrued in the past and should not be included capital budgeting analysis Opportunity costs costs of lost options and should be included in capital budgeting analysis Side effects
Positive side effects benefits to other projects Negative side effects costs to other projects

and should be included in capital budgeting analysis Changes in net working capital (should be included in capital budgeting analysis) Financing costs (should not be included in capital budgeting analysis) Taxes should be considered

PROJECTCASH FLOW DETERMINATION

Year 0 1 OCF Change in NWC Opportunity Cost Capital Spending/CO 2 3

ATSV

PCF

After-tax Salvage
If the salvage value is different from the book value of the asset, then there is a tax effect Book value = installed cost accumulated (i.e. total ) depreciation After-tax salvage value (ATSV) = salvage Tc(salvage book value)

TECHNIQUES OF CAPITAL BUDGETING

The techniques of capital budgeting are divided into two broad groups A) Non discounted cash flow techniques i.e. techniques that do not consider time value of money as such do not discount the future cash flows B) Discount cash flow (DCF) techniques i.e. techniques that do not consider time value of money as such do not discount the future cash flows

TECHNIQUES OF CAPITAL BUDGETING

A) Non-DCF techniques include the following: i) Payback Period Method ii) Average Accounting Return or Accounting Rate
of Return

B) DCF techniques include the following: i) Net Present Value (NPV) ii) Internal Rate of Return (IRR) iii) Profitability Index (PI) or Benefit-Cost Ratio (BCR) iv) Discounted Payback Period Method

The Payback Period Rule

How long does it take the project to pay back its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria:
set by management

The Payback Period Rule (continued)

Disadvantages:
Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria A project accepted based on the payback criteria may not have a positive NPV

Advantages:
Easy to understand Biased toward liquidity

The Discounted Payback Period Rule

How long does it take the project to pay back its initial investment taking the time value of money into account?

The Average Accounting Return Rule

Average Net Income AAR Average Book Value of Investent Another attractive but fatally flawed approach. Disadvantages:
Ignores the time value of money Uses an arbitrary benchmark cutoff rate Based on book values, not cash flows and market values

Advantages:
The accounting information is usually available Easy to calculate

The Net Present Value (NPV) Rule

Net Present Value (NPV) =
Total PV of future CIs - Initial Investment
PV of Cash Inflows PV of Cash Outflows Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV

Why Use Net Present Value?

Accepting positive NPV projects benefits shareholders. NPV uses cash flows NPV uses all the cash flows of the project NPV discounts the cash flows properly

Good Attributes of the NPV Rule

1. Uses cash flows 2. Uses ALL cash flows of the project Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate or cost of capital.

The Internal Rate of Return (IRR) Rule

IRR: the discount rate that sets NPV to zero or the rate of return available from investing in a project. Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return.

Ranking Criteria:
Select alternative with the highest IRR

Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.

Disadvantages:
IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments

Advantages:
Easy to understand and communicate

The Internal Rate of Return: Example

Consider the following project:
$50 $100 $150

0 -$200

The internal rate of return for this project is 19.44%

$50 $100 $150 NPV 0 2 (1 IRR ) (1 IRR ) (1 IRR )3

The NPV Payoff Profile for This Example

If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.
Discount Rate 0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% NPV $100.00 $71.04 $47.32 $27.79 $11.65 ($1.74) ($12.88) ($22.17) ($29.93) ($36.43) ($41.86)

$120.00 $100.00 $80.00

NPV

$60.00 $40.00 $20.00 $0.00 ($20.00) -1% ($40.00) ($60.00)

IRR = 19.44%
9% 19% 29% 39%

Discount rate

Problems with the IRR Approach

Multiple IRRs. The Scale Problem The Timing Problem Investing or Financing

Multiple IRRs
There are two IRRs for this project:
$200
0 -$200
NPV
$100.00 $50.00 $0.00 -50% 0% ($50.00) ($100.00) ($150.00) 50% 100% 150% 200%

$800
2 3 - $800

Which one should we use?

100% = IRR2

0% = IRR1

Discount rate

The Scale Problem

Would you rather make 100% or 50% on your investments? What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment?

The Timing Problem

$10,000 Project A 0 1 2 3 $1,000 $1,000

-$10,000
Project B

$1,000 0 1

$1,000 2

$12,000 3

-$10,000 The preferred project in this case depends on the discount rate, not the IRR.

The Timing Problem

..\TimingProb.xls
$5,000.00 $4,000.00 $3,000.00 $2,000.00

Project A Project B

NPV

$1,000.00 $0.00 ($1,000.00) 0% ($2,000.00) ($3,000.00) ($4,000.00) 10% 20%

10.55% = crossover rate

30% 40%

12.94% = IRRB
Discount rate

16.04% = IRRA

Mutually Exclusive vs. Independent Project

Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system.
RANK all alternatives and select the best one.

Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria.

The Profitability Index (PI) Rule

Total PV of Future Cash Flows PI Initial Investent
Minimum Acceptance Criteria:
Accept if PI > 1

Ranking Criteria:
Select alternative with highest PI

Disadvantages:
Problems with mutually exclusive investments

Advantages:
May be useful when available investment funds are limited Easy to understand and communicate Correct decision when evaluating independent projects

The Practice of Capital Budgeting

Varies by industry:
Some firms use payback, others use accounting rate of return.

The most frequently used technique for large corporations is IRR or NPV.

Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%. Year 0 1 2 3 Project A -$200 $200 $800 -$800 Project B -$150 $50 $100 $150

Example of Investment Rules

CF0 PV0 of CF1-3
NPV = IRR = PI = Project A -$200.00 $241.92 $41.92 0%, 100% 1.2096 Project B -$150.00 $240.80 $90.80 36.19% 1.6053

Example of Investment Rules

Payback Period: Project A Project B Time CF Cum. CF CF Cum. CF 0 -200 -200 -150 -150 1 200 0 50 -100 2 800 800 100 0 3 -800 0 150 150 Payback period for project B = 2 years. Payback period for project A = 1 or 3 years?

Relationship Between NPV and IRR

Discount rate NPV for A -10% -87.52 0% 0.00 20% 59.26 40% 59.48 60% 42.19 80% 20.85 100% 0.00 120% -18.93 NPV for B 234.77 150.00 47.92 -8.60 -43.07 -65.64 -81.25 -92.52