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Capital Budgeting: To Invest or Not To Invest Capital Budgeting Decision –usually involves long-term and high initial cost projects. –Invest if a project’s “value” >= “cost”. Estimating initial costs Estimating “value” –Estimate future cash flows: timing (when?) size (how much?) risk (standard deviation, range, Min-Max?) –Estimate discount rate Opportunity cost of capital –Risk of future cash flows

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Mutually Exclusive vs. Independent Project Mutual 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

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Net Present Value (NPV) Net Present Value (NPV) = Total PV of future CF’s – Initial –Reminder: PV = CF t / (1 + r) t Reinvestment assumption –the NPV rule assumes that all cash flows can be reinvested at the discount rate. Minimum Acceptance Criteria: –Accept if NPV >= 0 Ranking Criteria: –Choose the highest NPV

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Good Attributes of NPV Rule 1. Uses cash flows, not accounting earnings 2. Uses ALL cash flows of the project 3. Discounts ALL cash flows properly –Incorporates TVM 4. Reinvestment assumption makes economic sense

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The Profitability Index (PI) PI = Total Present Value of future CF’s / Initial Investment Reinvestment assumption –the PI rule assumes that all cash flows can be reinvested at the discount rate. Minimum Acceptance Criteria: –Accept if PI >= 1 Ranking Criteria: –Select alternative with highest PI

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PI (continued) Disadvantages: –1. May lead to incorrect decisions when comparing mutually exclusive investments Advantages: –1. May be useful when available investment funds are limited –2. Easy to understand and communicate –3. Correct decision when evaluating independent projects

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Internal Rate of Return (IRR) IRR –Defined as the discount that sets the NPV to zero Reinvestment assumption: the IRR calculation assumes that all future cash flows are reinvested at the IRR Minimum Acceptance Criteria: –Accept if the IRR >= required return Ranking Criteria: –Select alternative with the highest IRR

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IRR (continued) Disadvantages: 1.IRR may not exist or multiple IRR’s 2.May lead to incorrect decisions when comparing mutually exclusive investments 3.Reinvestment assumption may be unrealistic if project IRR is exceptionally high Advantages: 1.Easy to understand and communicate 2.Correct decision when evaluating independent projects with conventional cash flows

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NPV Profile A graph showing the relationship between discount rate and NPV –Usually a downward sloping curve Negative relationship between discount rate and NPV –A tool for computing IRR before computers –Useful for detecting multiple IRRs when project has abnormal cash flows Crossover Rate –Discount rate at which 2 projects have the same NPV

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Payback Period Rule How long does it take for the project to “pay back” its initial investment? Payback Period = # of years to recover initial costs Minimum Acceptance Criteria: –Set by management. Ranking Criteria: –Select alternative with the shortest payback period

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Payback Rule (continued) Disadvantages: –1. Ignores the time value of money –2. Ignores CF after payback period –3. Biased against long-term projects –4. Payback period may not exist or multiple payback periods –5. Requires an arbitrary acceptance criteria –6. A project accepted based on the payback criteria may not have a positive NPV Advantages: –1. Easy to understand –2. Biased toward liquidity

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Discount Payback Rule Similar to Payback except use discounted cash flow instead of cash flow to compute payback period. Still has all the disadvantages of the payback rule except taking into acount TVM

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Investment Rules: An Example Capital Budgeting Example.xls

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Cash Flows Estimation Cash, CASH, CASH, CASH Incremental –Sunk Cost –Opportunity Costs –Side Effects Tax After-tax (AT) value = Before-tax (BT) value * (1- Tax rate) Inflation

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A Simplified (Incremental) Cash Flow Statement Revenue= Unit price x units sold - Variable Costs= Unit cost x units sold Gross Profit - Cash Fixed Costs - Depreciation EBIT (Earnings Before Interest and Tax, Operating Income/Profit) - Interest EBT (Earnings Before Tax, Taxable Income) - Tax Net Income/Profit (Profit After Tax) Two common ways to computing Operating Cash Flow (OCF) OCF = EBIT + Depreciation – Taxes OCF = Net Income + Depreciation + AT interest

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Cash Flows for Projects (Free Cash Flows) Net after-tax cash flow to the firm (Free Cash Flows) = Cash Flow from Operations - Addition to Fixed Assets - Addition to Net Working Capital Net Working Capital (NWC) = Current assets – current liabilities Additions to NWC = Ending NWC – Beginning NWC Additions to fixed assets = Ending Net Fixed Assets (NFA) – Beginning NFA + depreciation –Or simply = the aggregate net assets purchased

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Depreciation Depreciation is a non-cash expense –Affects taxes, which is a cash expense Depreciation tax shield = Depreciation expense x tax rate Depreciation Methods –IRS regulations –Accelerated method versus straight line Depreciable basis = Purchase cost + shipping and installation –Depreciation Schedule Book value = Depreciable Basis – Accumulated depreciation Sale of Depreciated Assets Capital Gain/loss = Resale value – Book value Taxes on capital gain/loss = capital gain/loss x tax rate

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Another Way to Compute Cash Flows After-tax cash revenue = Before-tax cash revenue x (1 - Tax Rate) After-tax cash costs = Before-tax cash costs x (1 - Tax Rate) Tax Shield from Depreciation = Depr. Expense x Tax Rate OCF = AT revenue - AT costs + Depr tax shield Addition to Fixed Assets Addition to Net Working Capital Net AT CF = AT revenue - AT costs + Depr tax shield - addition to assets - addition to NWC

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Summary on Estimating Cash Flows Income statement approach –Use income statement to compute tax OCF = Cash Revenue – Cash Expenses – taxes Tax shield approach OCF = (Cash Revenue – Cash Expenses) x (1- tax rate) + tax rate x Depreciation expense Net after-tax cash flows to firm = OCF – additions to fixed assets – additions to NWC

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Two Ways to Compute NPV Discount Net Total After-tax Increment Cash Flows –Discount all CFs at one rate Discount Each Source of Cash Flows Individually –Allow each source of CF to be discounted at different rate –1. Revenue and cost: nominal risky rate –2. Depreciation tax shield: nominal risk-free rate

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Investments of Unequal Lives Assumption: Both projects can and will be repeated Repeat both projects until they begin and end at the same time Compute NPV’s for the “repeated projects”

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Replacement Projects Compute NPV of New Machine Compute Equivalent Annual Cost (EAC) –NPV- as PV –Life of New Machine- as NPER –Discount rate used in computing NPV- as RATE –Equivalent Annual Cost (EAC)- compute PMT Decision: Replace if EAC <= Cost of keeping the machine one more year

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The Bottom Line NPV, IRR and PI will generally give us the same decision Exceptions –Non-conventional cash flows cash flow signs change more than once –Mutually exclusive projects Initial investments are substantially different Timing of cash flows is substantially different NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV

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Capital Budgeting In Practice We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is a commonly used secondary investment criteria

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